Can a Small Business Deduct State Taxes Paid on Its Federal Return?
Part of operating a business is accepting that you’re going to pay a wide range of state and local taxes. Although you can never deduct federal income taxes on your U.S. income tax return, you can deduct most state taxes and fees you pay. The Internal Revenue Service only lets you deduct state taxes after you've paid them.
Many states and cities impose an income tax on businesses that earn money in or have a close connection to the jurisdiction. These taxes are always eligible for a deduction, but they are reported differently depending on how your business is structured. For corporations and partnerships, state income taxes are deducted directly on the corporate and partnership tax return, though for partners, the deduction ultimately flows down to their personal tax returns. Business owners who are treated as sole proprietors, however, cannot deduct state and local income taxes on Schedule C, which means payment of these taxes doesn’t reduce the net profit you calculate. But if you itemize deductions on Schedule A, you can report the deduction there.
When you purchase business real estate, such as a small office building, you’ll need to pay property taxes to your local government if such taxes are assessed on other real estate in the jurisdiction. If you’re treated as a sole proprietor for tax purposes, you can report all real estate tax payments directly on your Schedule C, which in this case, will reduce the taxable net profit reported. Real estate taxes are fully deductible to corporations as well but are reported on the relevant corporate tax return.
Many of the purchases you make for your business, such as office supplies, computer equipment and materials, may be subject to the sales tax if the jurisdiction where you make the purchase imposes the tax. Sales tax can also apply to services you receive and to goods you lease rather than buy. These taxes are deductible, but instead of separately deducting them on your return, the IRS allows you to include all sales tax in the underlying expense. For example, if you purchase $5,000 of office supplies and pay an additional $300 in sales tax, your office supplies deduction is simply $5,300, not $5,000. And if your business is a retail establishment that collects sales tax from customers, these aren’t deductible, as you only collect this tax on behalf of the state or city government.
Businesses that operate as legal corporations usually pay annual franchise taxes to their respective states of incorporation and to the states where they are authorized to do business. The IRS recognizes this as an ordinary cost of doing business and allows a full deduction for the tax. Local governments also impose regulatory and license fees on certain types of businesses, such as those that operate in the construction and restaurant industries. Regardless of whether the taxing authority calls it a fee or a tax, it’s also fully deductible as a business expense.