Why it is important for small business owners to understand the impact of state taxes
In many discussions about taxes, federal taxes are the ones that are most discussed, but understanding state taxes should not be overlooked by small business owners because by not paying close attention to state taxation, it could be costly. There are several reasons why federal taxation gets more attention than state taxation, which include greater public awareness (federal tax policies are often debated by policymakers and are widely reported by news outlets), representing a much higher portion of tax liability (small business owners generally pay more federal taxes than state taxes), and economic policy implications (policy decisions on federal taxes impact economic factors such as consumer spending, investment, and savings). Given these reasons, it is understandable why federal taxes get more attention, but state taxes are still an essential part of the overall tax landscape for small business owners so understanding both federal and state tax laws is necessary for effective tax planning and financial decision-making.
State taxation systems in the United States
Each state maintains its own tax laws and regulations regarding income, sales, property, and other forms of taxation (if applicable). For example, there are states with no income tax that include Alaska, New Hampshire, Tennessee, Florida, Wyoming, South Dakota, Nevada, Texas, and Washington, whereas there other states such as New Jersey and Illinois that have high effective property tax rates. There are states that have a progressive income tax system (like the IRS), whereas other states impose a flat income tax (i.e., applies the same tax rate to every taxpayer regardless of income level). Each state uses its tax revenue differently (based on budget priorities) as it supports state-specific programs such as education, public safety, and transportation. To support economic growth of small businesses and/or address specific social priorities, states can have their own set of deductions, credits, and incentives in their tax code, which could have a significant impact (reducing tax liability, which enhances cash flow to reinvest in business growth) on small business owners operating within certain states.
Benefits of understanding state taxes
Staying compliant to avoid penalties
With each state operating under its own set of tax laws and regulations, specific requirements are going to vary from state to state so small business owners should understand the tax system related to their operating area to make sure their business is following tax regulations, which will help avoid any unnecessary penalties. Following requirements becomes even more challenging if a small business owner has operations in multiple states so in these types of situations, it becomes even more important to understand the states’ tax systems. Note that failure to stay compliant with state tax laws can result in penalties that will result in a negative impact on cash flow and financial health of a small business owner. Compliance with state tax laws is also a legal obligation for small business owners and failure to meet tax obligations could result in civil penalties. It is essential for small business owners to maintain their ethical obligations and avoid legal consequences by adhering to the state tax laws and regulations.
Helps make informed strategic decisions
For example, if a small business owner was deciding on opening an additional location in another state, then it is prudent to understand the state tax implications of this decision. Some states have more favorable tax environments (e.g., certain tax incentives) for small business owners than others so it would be important to take these factors into account when making this type of decision. Making informed strategic decisions can help minimize state tax liability, which helps profitability and long-term growth.
Assists with being ready for an audit
State tax authorities have the authority to conduct audits to ensure compliance with their tax laws and regulations. For example, the state of New Jersey website states, “The purpose of a tax audit is to verify that a taxpayer has filed returns properly and paid the correct amount of tax. Audits are essential for the efficient administration of self-assessed taxes and for ensuring that taxpayers pay neither more nor less tax than the law requires.” The New Jersey website also states, “The auditor’s responsibility is to determine whether the amount of tax has been properly reported and to help the taxpayer voluntarily comply with our tax laws. The auditor should be aware that it is the Division’s goal to administer the laws fairly and uniformly with minimal interference of taxpayers and their business affairs. The auditor also must inform you of your rights and privileges in connection with such determinations.”
Being ready for a state tax audit involves knowing that state’s specific tax provisions so small business owners who understand the state taxes put themselves in a position to be more equipped to go through the audit process and improve their chances of obtaining a favorable result.