One of the most challenging parts of starting a business is figuring out your tax bill. As an entrepreneur, you might be wondering, "What is my tax liability, and what tax credits are we eligible for?" The answer depends on your company's location and business structure. With a little work throughout the year, you will know what to expect when tax time rolls around, and you'll have enough money put aside to fulfill your obligations.
TL;DR (Too Long; Didn't Read)
How much you can expect to pay in taxes depends on your income and business location. Most small businesses are pass-through entities, meaning that their earnings are only taxed at the individual level, not at the corporate level.
Business Tax 101
Starting a new venture can be exciting — after all, you're one step closer to bringing your vision to life. However, you might have a million questions about choosing a business structure, reporting your business income, making tax payments and deducting expenses. This is perfectly normal, especially for new business owners. At this point, you may have no idea about what to expect to pay in taxes and the types of taxes for which you are liable.
First of all, be aware that taxes depend largely on your business structure. Sole proprietorships, limited liability companies, partnerships and S corporations are classified as pass-through entities, meaning that their profits flow through to the owners and/or investors. Therefore, they are not subject to double taxation. Their business income is taxed at the owner's individual tax rate.
Another aspect to consider is your tax year, or fiscal year. Any business, whether it's a sole proprietorship or an LLC, needs to keep accounting reports and pay taxes annually. You will choose your tax year the first time you file a tax return, but you can modify it later by filing Form 1128 to get IRS approval. The fiscal year can be the same as the calendar year or any consecutive 12-month period.
If, say, you start your business in March 2020 and choose your fiscal year to be the same as the calendar year, then you will pay tax on the income earned from March to December 31. This is known as a short tax year. Companies that have no annual accounting period or no books or records must adopt the calendar year.
Consider Your Business Structure
About 75% of small businesses are pass-through entities, and their owners must report the income on their personal tax returns. Sole proprietors, for example, report their business income and losses on Schedule C of their individual tax return. Their net income is also subject to self-employment taxes.
Likewise, limited liability companies are taxed at the individual level. Those that have several owners, or members, can choose to be taxed as an S corporation, a C corporation or a partnership. C corporations are subject to double taxation, while S corporations are pass-through entities. With a partnership, you will report your share of income on your personal tax return.
Note that general partnerships are subject to payroll tax under the Self-Employed Contributions Act, just like sole proprietorships. Limited partnerships, on the other hand, must pay this tax only on net earnings resulting from guaranteed payments for services to which they are rendered. To put it simply, guaranteed payments are the equivalent of a salary for partners. Their role is to compensate them for the time and effort they put into the business and protect them in case the partnership fails.
Types of Small-Business Taxes
Companies are required to pay state taxes and local taxes. Their state income tax obligations depend on the type of business, but other taxes, which vary by state, may apply too.
For example, if you hire staff, you will need to pay state employment taxes on their wages. These may include Medicare, Social Security, unemployment taxes and more. About 39% of U.S. businesses outsource payroll to save time, avoid costly mistakes and ensure legal compliance. Failure to accurately report employment taxes can lead to hefty fines, which is why it's recommended to outsource this task to professional payroll firms.
In addition to employment taxes, small businesses may need to pay excise taxes, estimated taxes, sales taxes and property taxes. Companies registered as C corporations are subject to income tax. Although pass-through entities are not taxed at the corporate level, they must pay small individual taxes that add up. According to the National Federation of Independent Business, the number of business owners making capital investments decreased by 10% following a 5% increase in the individual tax rate.
Furthermore, tax regulations are constantly changing. As a small-business owner, you may not have the time or expertise to stay on top of these changes and understand their impact. Hiring an in-house accountant may not be an option because of the costs involved. For this reason, nearly 90% of small companies outsource tax preparation services.
What Is Self-Employment Tax?
Are you still wondering, "How much do small businesses pay in taxes?" Before going any further, make sure you understand why you pay taxes in the first place.
Self-employment tax, for instance, consists of Medicare and Social Security taxes and must be paid by individuals and businesses that don't have taxes withheld from their wages. Freelancers, independent consultants, artists and other self-employed workers who earn at least $400 per year are required to pay 15.3% of their net business income. The same applies to those who had church employee income of $108.28 and above.
Note that self-employed workers and other pass-through entities can deduct up to 20% of their business income. The deduction can be claimed by single individuals with a taxable income of up to $160,700 and married couples who file jointly on their income tax returns and earn up to $321,400 per year. If your annual income exceeds this threshold, you can still claim this tax break, but special conditions may apply.
What Are Excise Taxes?
Small businesses that sell alcoholic beverages, cigarettes, fuel and other specific goods are subject to excise taxes. Generally, companies pass on these taxes to consumers through higher prices. In 2017, federal excise tax revenue reached $83.8 billion.
Generally, excise taxes are associated with tobacco and other products that have a high social cost. However, that's not always the case.
Airline tickets, health insurance policies, branded prescription drugs, medical devices and other goods or services are subject to this tax too. If, say, you own a tanning salon or sell medical equipment, you must file Form 720 quarterly and pay the tax.
Who Pays Sales Taxes?
Depending on the location of your business, you may also need to pay a sales tax. Currently, 45 states and the District of Columbia have this requirement in place. California, for example, charges a sales tax of 7.25% on business transactions. The current sales tax rate is 4% in Georgia, 6% in Michigan, 6.85% in Nevada and 2.9% in Colorado.
This tax is paid by the end purchaser of certain products and services. As you would expect, the regulations are extremely complex and vary among states. Each jurisdiction has its own set of exemptions or charges lower rates on certain goods. If you operate in several states, you must register with the local taxing agency in each state.
Consult an accountant or a lawyer to determine the exact requirements in your case. Be aware that online businesses are subject to the same rules as brick-and-mortar stores. Therefore, if you sell certain goods online or on eBay, you must charge sales tax to customers living in your state (and those located outside your state in some cases).
How Much Do Small Businesses Pay in Taxes?
As you see, it's difficult to tell how much you will pay in tax. It depends on where you live, what products you sell and how much you earn, among other factors. Sole proprietorships, LLCs and other pass-through business entities pay 10% to 37% of their net income per year depending on their income and filing status. In this case, the federal small-business tax rate is the same as your personal income tax rate.
For example, a single individual who makes $0 to $9,875 in 2020 will pay 10% in personal income tax. If he earns $40,126 to $85,525, he will pay 22%. Those with an annual income of $518,401 or more can expect to pay 37%. Federal income tax brackets for married couples are different than those for singles.
The U.S. government has a progressive tax system with seven tax brackets. The more your business earns, the more your business pays in tax. However, this doesn't mean you have to pay 24% or 37% on everything you earn.
If, say, you earn $40,000 in 2020, that puts you in the 12% tax bracket. Therefore, you will pay 10% on the first $9,875 and 12% on the rest by April 2021. Remember to deduct any business expenses when filing your tax returns. Don't forget about the 15.3% self-employment tax, employment taxes, sales taxes and excise taxes.
Small-Business Tax Deductions
Any business has expenses that can be deducted from its taxable income. Car expenses, office supplies, utilities, repairs and travel expenses are just a few to mention. You can even deduct advertising costs. Other examples include:
- Business insurance
- Business meals
- Professional services
- Office furniture and equipment
- Employee wages and benefits
- Rent on your business location
- Interest on small-business loans
- Employee education
- Retirement plans
- Moving expenses, such as transportation and travel costs
- Banking fees
- Web hosting and software programs
- Legal fees
- Payroll processing
- Trademark, licenses and other intellectual property
A business expense must be both necessary and ordinary in order to be deductible. For example, you may deduct rent from your income only if the rent is for offices or other premises you use for business purposes.
If you work from home, you can deduct the expenses related to the room that you use as an office. Small-business owners can also deduct employee wages and benefits, but they may not deduct their own salaries (if they are sole proprietors).
Consider Hiring an Accountant
This may come as a surprise, but you can deduct up to $10,000 of most taxes, including excise, franchise and occupational taxes. You may also deduct a part of your self-employment tax. Federal income taxes are not deductible; you can write off state and local income taxes.
Many small businesses are missing out on important deductions. The best thing you can do is consult an accountant.
This tax professional can determine what taxes you need to pay and what you can and cannot write off. Furthermore, a qualified accountant can help you avoid costly tax mistakes, such as misreporting your income, filing your taxes late or not contributing enough to your retirement plan.
- Tax Policy Center: What Are Pass-Through Businesses?
- IRS: Tax Years
- IRS: Are Partners Considered Employees of a Partnership or Are They Considered Self-Employed?
- Robert Half: Benchmarking - The Accounting & Finance Function
- National Federation of Independent Business: Small Business Tax Rates and Tax Complexity
- IRS: Self-Employment Tax (Social Security and Medicare Taxes)
- Nolo: The 20% Pass-Through Tax Deduction for Business Owners
- Tax Policy Center: What Are the Major Federal Excise Taxes, and How Much Money Do They Raise?
- Sales Tax Institute: State Sales Tax Rates
- Debt.org: Small Businesses and Sales Taxes
- Tax Foundation: 2020 Tax Brackets and Rates
- IRS: Topic No. 503 Deductible Taxes