February 01, 2020

8 Tax Terms That All Business Owners Must Know

If you dread tax season each year, you aren't alone. Most small business owners would rather watch paint dry than to deal with filing their business taxes. In fact, many business owners don't even understand the tax terms, which causes additional anxiety during tax season.

The tax terms that affect most businesses aren't difficult to learn. When you find the right definitions, it makes the task even easier. While there are thousands of tax terms, it pays to focus on the ones that matter the most to business owners, which is what you'll learn about in this post.

Why Is It Important To Know Your Tax Terms?

Tax authorities require business owners to file tax returns. When businesses comply, the tax authorities may ask for further information. If you're filing small business taxes for the first time, learning tax terms will be useful to you, as failure to understand them could lead to a tax audit.

If you want to gain tax tips for your business, you should start with the basics, which are tax terms. Most business owners don’t have a lot of time to spend reading articles. Therefore, knowing basic tax terms will allow you to better understand the articles that you do read.

It’s not necessary to become an accountant to learn the most commonly-used tax terms. You may know about some terms but never learned what they were called, or you learned them as different names.

Learning tax terms comes in handy when you hire an accountant for your business. Your accountant will ask for information to complete your tax returns. This information will likely contain tax terms. You’ll streamline the requests when you know the terms beforehand.

The 8 Tax Terms You Need To Know

We have identified eight tax terms that most business owners should learn. These concepts associated with these terms are used even if it’s subtle. For instance, you probably have a sense for what assets and liabilities mean. These two components, along with equity, are a foundation for the accounting equation.

Before the widespread use of computers, business owners likely knew these terms as they had to enter their financial information manually. They needed to understand about profit and expenses to enter them in the correct places in their books. Today, accounting software abstracts much of the information.

1. Capital/Equity

Equity is defined as assets minus liabilities. This is the share of ownership after all obligations have been met. In comparison, capital is the funding used to acquire assets and equipment to help run the business. It’s easy to get these terms confused, but they have different meanings.

Assets that are purchased to generate future profits are considered capital. When companies raise cash via equity offerings or debt, this too is considered capital. Another form of capital is working capital, which is often defined as short-term assets minus short-term liabilities.

2. Assets

Assets are the materials a business uses to create economic value for the firm. Many assets aren't sold directly to customers but are used to transform other materials into something that gets sold.

Business owners continually measure assets in terms of the economic value they produce. They often measure alternatives in terms of opportunity costs, which is the difference between the gains in the two assets. If two investments both cost $100 and the gain in one is $5 and the other is $10, the opportunity cost is $5.

From the example, you can see that asset selection is crucial to the success of a business.

3. Liabilities

Assets can be funded in one of two ways. The business owners can chip in to buy them, or the company can borrow money to purchase these assets. Borrowing money is considered a liability.

Lenders may stake a claim in the assets when a company borrows money. This is why the term is called liability. Sometimes, the claim can be against the owner's personal assets, depending on the conditions of the loan.

The credit rating of the business is affected when the company’s liabilities increase. This increase can make it difficult for business owners to pay back the loan when the economy is weak.

4. Profit

Companies sell products or services and receive payment. These payments are called sales or revenues. However, the company has costs and expenses associated with the production of these products. When the total costs are subtracted from revenue, the remaining balance is the profit.

Accounting has three different levels of profit. When the cost of goods sold is subtracted from revenues, the result is the gross profit.

Costs that are indirect but support producing revenues are subtracted from the gross margin. The result is the operating margin.

The final level of profit is the net profit, which is calculated by subtracting the operating margin by the taxes and interest. This is also known as the bottom line.

5. Expenses

Items that you sell cost money to produce. The costs that are directly associated with sales are considered expenses. The timing of the expenses depends on whether you use cash or accrual accounting. Most small business owners qualify for cash accounting, which is easier to manage.

Companies work hard to keep expenses low. When they accomplish this goal, they have more cash available to grow the business or payout to investors. However, too much cost-cutting activities can adversely affect the operations of the business. Customers will recognize lower-quality products.

6. Financial Statements/Reports

There are three primary financial statements: the balance sheet, the income statement, and the cash flow statement. Some consider the statement of owner’s equity another significant report, but it's less popular.

The balance sheet is the book of record and survives the life of the firm. It helps determine the financial position of the company. The statement records the use of assets and liabilities, with the difference defined as the owner’s equity.

The income statement is also referred to as the profit and loss statement. This shows how profitable a company is for a given period. Usually, companies produce these statements quarterly and yearly.

The cash flow statement reports on the cash inflows and outflows for a specified period. The statement is divided into three sections: operating activities, investing activities, and financing activities.

7. Return on Investment

Most business owners try to maximize their earnings from their operations. These gains are used to calculate the return on investment. This measure is classified as a profitability ratio.

The calculation for return on investment is simple. Subtract the cost of the investment from the gain. Then, divide that number by the cost.

Return on investment is a popular ratio among investors. Venture capital firms will likely ask you about the return on investment for your business and your assumptions for the calculations.

8. Deductions

Most for-profit organizations can deduct certain business expenses. These expenses act as an offset to the profits reported during tax season. Knowing which expenses are tax deductible is crucial, as incorrect reporting could lead to an audit.

For companies with complicated tax structures, it’s often best to let tax professionals determine the proper deductions. While these professionals may cost money, they'll save you from penalties and interest as the result of an audit. If you decide to handle the taxes without help, check out the allowable deductions on the website of the IRS.

Our Final Thoughts

Tax authorities will refer to the terms defined in this article. However, these terms are used by other external sources. For instance, when you're seeking funding for your company, the financial institutions will use the terms as well. You’ll need to create financial reports and explain what you’ll use the funding for.

They tax and accounting terms that you learned about in this post are terms that you’ll likely hear frequently. Now, you can feel confident knowing what these terms mean, and you can provide the right information when requested.