Learn how small businesses are taxed and what tax breaks small business owners can take advantage of.
- The type of business structure you set up for your company – sole proprietorship, partnership, S corporation or C corporation – governs which tax return you'll need to use to file your taxes and how much you'll owe.
- Small business owners often have to pay income tax and self-employment tax.
- Keep detailed expense records so you can take advantage of tax deductions.
Preparing your business tax return is a complicated, frustrating process. However, it's important to do it right – you could face steep penalties for filing an inaccurate return.
The starting point for preparing your business tax return hinges on the structure of your business. Whether you're a sole proprietorship (like most small businesses), a partnership, or a C or S corporation, your business entity will define which form you must use to file your business return and how much you may owe the IRS.
Do you have to pay taxes on a small business?
In short, yes, you may be responsible for paying taxes like income tax, self-employment tax, employee payroll tax and local property tax. The amount you owe depends on factors such as your business type, whether you made a profit and applicable deductions.
Steven J. Weil, president of RMS Accounting, said the definition of a business is an activity engaged in with the intent of making a profit.
"If you don't intend to make a profit, then you have a hobby, not a business," Weil told business.com. "If you make a profit, that profit is subject to federal income tax and may also be subject to state income tax depending on the state you are doing business in. In fact, some states, like California, tax businesses even when they don't make a profit. How your business is taxed depends on how it is set up."
How are small businesses taxed?
When you set up your business, you choose a specific legal structure for your company: sole proprietorship, partnership, S corporation or C corporation. There are stipulations and requirements within each legal structure as well as certain tax advantages.
If you need additional time to file your business tax returns, you can receive an extension by filing Form 7004, the Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns. This extends the deadline for filing your tax return, but you still must pay any estimated tax owed on or before the tax return deadline for your company. (For most businesses, this deadline is March 15.)
Unless your single-member LLC elects to be treated as a corporation, the IRS considers it a "disregarded entity," which means you do not have to file business taxes as a separate entity. Instead, you'll report the profits or losses on your own personal income tax return, and you will be taxed based on the specific federal and state income tax bracket you fall under. You will also be subject to self-employment tax (Medicare and Social Security). [Read related article: Tax Filing Tips for Independent Contractors]
Taxation on multimember LLCs, or partnerships, is like that of sole proprietorships. Instead of filing a business tax return, each partner reports their share (according to their percentage of ownership in the business) of the business's profits or losses on their personal income tax return.
With an S corporation, income passes through the entity to the business's owners (or shareholders), who then pay taxes based on their percentage of ownership at their tax bracket rates. If you're a shareholder and an employee, though, you're expected to pay yourself a "reasonable salary." In other words, the salary that a shareholder-employee draws should take into account the duties they perform for the business, their experience, comparable pay in the industry and the size of the company.
C corporations are subject to what is commonly known as "double taxation." If you elect C-corp status, your business will be taxed at the 21% corporate tax rate. Additionally, shareholders are taxed on funds they take out of the business (e.g., salary and/or dividends).
Since a business's legal structure greatly impacts what its owners owe, it is recommended that you speak with a CPA or tax advisor to determine the best option for your business.
"Having the right tax professional who understands not only the tax laws but also how your business operates can help make sure you pay the lowest tax possible without overlooking any tax or other reporting requirements," said Weil. "One also needs to understand other taxes, both state and federal, to which their business may be subject. These other taxes include sales tax, use tax, franchise tax and excise tax, to name just a few. Not knowing about a tax does not remove the responsibility of the business to pay it."
Types of small business and tax rates
In addition to general taxes, based on the type of small business you may have, you're responsible for a variety of other taxes, according to USA.gov.
Most small businesses must pay taxes on all income they earned throughout the year. Partnerships are required to file an annual information return in lieu of income taxes. However, each partner is required to report their share of the partnership's losses or profits earned throughout the year.
If you have employees you are paying to work for your company, you will have to pay employment taxes. These are federal taxes that consist of the following:
- Social Security taxes: According to Intuit, the Social Security tax rate for small businesses is presently 15.3%. However, this is split between the employee and the company, each expected to pay 7.65%.
- Medicare taxes: Small businesses are also required to pay 1.45% for Medicare.
- Federal income tax withholding: Small businesses are required to pay a FICA tax rate of 15.3%.
- Federal unemployment taxes (FUTA): According to Investopedia, small businesses must pay a rate of 6% of the first $7,000 paid to each employee annually.
According to the IRS, excise taxes are paid when certain taxable goods are purchased. These taxes are typically included in the price of the product and thus often paid by the customer directly. These tax rates vary by the state you are located in. Some examples of these taxable items are fuel and coal.
According to USA.gov, all small businesses are required to pay taxes on the property where they do business. In particular, some states collect taxes on properties in commercial real estate locations. Some states also collect taxes on vehicles, computer equipment and other business assets. Either way, the rate is calculated by taking the total value of the property or a percentage of the property value. The amount you will pay depends on the state you live in.
Sales and use tax
Small businesses are also required to pay sales and use tax, which also varies by state. While some states require taxes on various goods and services, others do not require these taxes at all. Either way, the rate you will pay depends on where you are located. Common exclusions include food, clothing, utilities and newspapers. However, states may also tax companies on goods and services when sales tax has not been collected; this typically applies to situations in which the goods or services were purchased outside of the state in which the business was conducted.
Small businesses may be required to pay federal taxes on the income that is not subject to withholding. Alternatively, in the event that the amount of your federal income tax being withheld is not sufficient to cover the taxes you owe, you will then be required to pay an estimated tax. In particular, sole proprietors, partners, partners and S corporations are required to make estimated payments if they expect to owe $1,000 or more when the return is filed.
What is the small business tax rate?
According to the Small Business Administration, the average tax rate for a small business is approximately 19.8%. Additionally, according to FreshBooks, depending on the type of business you have, you will likely be subject to these tax rates:
- Sole proprietorships are expected to pay a tax rate of 13.3%.
- Small partnerships are required to pay a tax rate of 23.6%.
- Small S corporations are required to pay tax rates of 26.9%.
- Small businesses are required to pay a flat-rate tax of 15.3%.
The rate at which the IRS taxes your small business depends on the business entity you set up. Businesses filing as a C-corp are taxed 21% on their net taxable income. Sole proprietorships, partnerships and S-corps are considered pass-through entities; the owners or shareholders report business income on their personal tax returns and pay according to the specific income tax rate they fall into. Bret Scholl, CPA and CGMA at Scholl & Company LLP, said these tax rates range from 10% to 37% for federal taxes in 2020.
"If you are an unincorporated business owner, you will have to also include the self-employment tax," said Scholl. "For 2020, the self-employment tax rate is 15.3% on the first $137,700 worth of net income, plus 2.9% on net income over $137,700. This is the Social Security and Medicare contribution for the unincorporated business owner."
How much income can a small business generate without having to pay taxes?
Businesses do not have to pay federal income taxes if their expenses exceed their gross income – in other words, if the business generated a loss instead of a profit. However, even if this is your case, you may still be required to file a tax return and pay other taxes, like payroll taxes for employees and local property taxes.
"If you have any small business income, you must file a tax return even if you don't owe any taxes," said Scholl. "A common point of confusion for this question is that self-employment taxes are only owed if the net income from a small business is more than $400. I often hear and read that if you don't make more than $400, you don't need to pay taxes, which is not accurate."
How can small businesses maximize tax deductions?
Although you may not have much control over the rate at which your business is taxed, you can save money by claiming relevant tax deductions.
In 2018, the Tax Cuts and Jobs Act went into effect, granting pass-through entities (sole proprietorships, partnerships and S-corps) the ability to deduct 20% of their qualified business income. Scholl identified a few other ways the TCJA tax reform can help small business owners save money.
"With 100% bonus depreciation and increased Section 179 expensing in 2019, you can make significant purchases of equipment, machinery, and furniture and write off 100% of the value," said Scholl. "More businesses can use the cash basis method of accounting; the old limit was gross receipts up to $5 million and now up to $25 million average annual gross receipts."
To qualify as a deduction, a business expense must be both ordinary and necessary. The IRS states that an ordinary expense is one that is common and accepted in the trade or business, and a necessary expense is one that is helpful and appropriate for your trade or business.
There are several deductions that many business owners overlook. Scholl listed the following deductions as possible tax breaks that business owners may be able to take advantage of:
Vehicle reimbursements: You can cover a portion of the expenses you or a spouse or family member incur while running errands for your business (e.g., making a deposit or picking up supplies).
Home office deductions: If you have a home office, you may qualify for a deduction for the business use of your home (e.g., mortgage interest, repairs, insurance, maintenance, etc.).
Child wage deductions: The owner of a non-incorporated business can hire their children (under 18 years old) and reduce their tax liability. For example, a sole proprietor making $125,000 annually who pays their 16-year-old daughter $10,000 could save $4,000 or more in federal taxes.
Qualified retirement contributions: As a small business owner, you can deduct contributions to your Simplified Employee Pension (SEP) IRA. Certain rules and conditions apply. It's recommended that you work with a CPA if this is a deduction you want to take advantage of.
Medical expenses: In limited cases, you can deduct medical expenses from your business income. If you're a sole proprietor and you buy your own health insurance, you can deduct the amount of money you spent on premiums.
- Travel expenses: You may be able to deduct travel expenses if, according to the IRS, "your duties require you to be away from the general area of your tax home for a period substantially longer than an ordinary day's work, and you need to get sleep or rest to meet the demands of your work while away." The law says if you can prove that staying away instead of returning home right away saves you money, then you most likely qualify for a deduction. (Weekends, holidays and standby days can qualify for a deduction, if planned correctly.)
There are rules and exceptions for all of these deductions. A financial advisor can help you determine what you qualify for.
To save the most money on business taxes, you need to understand the tax implications of your business's legal structure, maintain accurate records of your expenses and deductions, and partner with a tax expert who understands your business and industry.