Taxes are a fact of life for most businesses — but tax burdens do differ. How much do small businesses pay in taxes? Estimates indicate the average small business can expect to hand over about 20% of their gross income to Uncle Sam.
Your small business’s tax rate will depend on what type of business you run, and, more importantly, its legal structure. Fortunately, there are plenty of rules and strategies that can help you reduce your tax obligations and manage your money better.
Key Points
• Small businesses usually pay about 20% of their gross income in taxes.
• The structure of a business affects tax rates and legal protections.
• Deducting business expenses is one big way to reduce the taxes you owe.
• Self-employment and employment taxes total 15.3% and are shared between the business and employees.
• Missing tax deadlines leads to IRS penalties and interest charges on the unpaid balance.
Understanding Small Business Taxes
Your small business tax rate has a direct impact on your bottom line. Knowing the IRS’s rules can help you make smart business decisions that reduce your tax bill.
Why Small Businesses Pay Taxes
A profitable business may have to pay tax to the state and locality as well as to the IRS. Tax dollars support infrastructure and services that small businesses and their communities rely on, such as roads, fire and police departments, and regulatory agencies.
How Business Structure Affects Taxes
There are several types of business entities, and the one you choose for your business structure has a big tax impact.
For example, there are two types of corporation: C and S. Income from C corporations is taxed twice: once at the corporate level (at a flat rate of 21%) and then, after the money has been distributed to shareholders, on their individual returns. But S corporations’ income is passed through without taxation to shareholders; recipients then claim it on their personal returns and pay at their individual rates.
If you run a sole proprietorship — the default structure for small businesses unless you choose another — it’s considered a pass-through business. Your profits will be taxed at your individual income tax rate. (However, if your gross income from the business totals less than the standard deduction, you may not owe any federal income tax on that money.)
Types of Small Business Taxes
For a clearer view of how much small businesses pay in taxes, here’s a closer look at various levies your company may face.
Income Taxes
If you run a sole proprietorship or partnership, you’ll pay taxes at your own personal income tax rate. Profits are taxed only once, on your individual return. Limited liability companies (LLCs) can choose their tax treatment. They can be taxed like sole proprietorships, partnerships, or corporations. As mentioned above, C corporations pay a 21% tax rate on earnings before distributing them to shareholders.
Self-Employment Taxes
If you own your own business, you’ll be on the hook for self-employment taxes of 15.3%. The government collects this money to cover the cost of Social Security and Medicare.
Employment Taxes
If you have employees on your payroll, you’ll be responsible for employment taxes. As with self-employment tax, the total rate is 15.3% and the taxes pay for Social Security and Medicare. However, as an employer, only half of that (7.65%) will come out of your share. The other 7.65% is withheld from the employee’s wages.
Also, there is a federal unemployment tax, known as FUTA. This tax, in conjunction with state unemployment systems, is for unemployment compensation to workers who have lost their jobs. The FUTA rate is 6% on the first $7,000 of each employee’s wages, or $420, but widely used credits can reduce the effective rate to 0.6%.
Most employers pay both a federal and a state unemployment tax; it is not deducted from employee wages.
Excise Taxes
Depending on what type of business you own, you may have to pay excise taxes. These are taxes on certain goods, services, and activities.
For instance, imported goods may be subject to excise taxes. Businesses that participate in the sale of alcohol, tobacco, or even tires may owe excise taxes. In general, businesses pass on the cost of these taxes to consumers in the form of higher prices.
Sales Taxes
State and local governments may impose a sales tax on the sale of goods and services. As a small business owner, you have the responsibility to collect the tax at the point of sale and remit that money to the government. You may also have to file sales tax reports to serve as a record.
Not all states and municipalities levy a sales tax.
How to Calculate Small Business Taxes
Being able to estimate how much you’ll owe in business taxes helps you assess how much money you’ll have for operating costs and payroll. Here’s a look at how to calculate how much you’ll owe.
Estimating Federal and State Obligations
To estimate your federal and state taxes, start with an understanding of your net business income. This is your revenue minus operating costs, taxes, interest, and other expenses.
If your business isn’t taxed as a corporation, your net income will be taxed according to your individual income tax rate. You’ll also owe the 15.3% self-employment tax on the money you receive, plus half of that, 7.65%, on employee payroll.
State and local taxes vary widely, but you may owe income taxes, employment taxes, sales tax, and local business taxes as well. Your state department of revenue’s website can help you determine what taxes are required in your area.
Using Accounting Software or a Tax Professional
Professional accountants or accounting software can assist with tax calculations. Either one should help you track expenses, identify eligible deductions, and determine taxes owed.
Strategies to Minimize Small Business Taxes
Several strategies can help you reduce the amount of business tax you owe. Adopting them can keep more cash within the business for daily operations, payroll, and inventory. Additional money can be reinvested in the business; you could use it to increase marketing, hire new employees, or upgrade your facility with equipment financing.
Deductible Business Expenses
Small business tax deductions reduce the amount of income on which your taxes are calculated, in effect lowering the amount you pay. That’s why it’s smart to deduct as many expenses as possible.
Deductible costs related to your business could include equipment, insurance premiums, interest on small business loans, professional services, office supplies, work-related travel, and advertising costs. Many expenses related to employees are also deductible. For example, you can deduct salaries, wages, and bonuses, as well as payroll taxes and employee insurance premiums.
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Retirement Contributions and Tax Credits
The IRS also offers business owners a variety of tax credits, which reduce your tax bill dollar for dollar. If you set up and contribute to a qualifying retirement plan for your employees, you could claim a tax credit for those expenses. Other actions that could translate to tax credits: providing child care for your employees, purchasing an electric vehicle for work, or rehabilitating a historic building.
Choosing the Right Legal Structure
Choosing the right legal structure for your small business depends on several key factors. First, bear in mind the various small business tax rates and the implications mentioned above.
It’s also important to consider legal liability. Sole proprietorships and general partnerships don’t provide you with personal liability protection. In other words, if your business is involved in a lawsuit, your personal assets may be at risk.
LLCs and corporations do provide certain legal protections and shield your personal and business assets. That said, LLCs and corporations are usually more difficult to operate and manage than sole proprietorships.
When and How to Pay Small Business Taxes
Another aspect of choosing a legal business structure is figuring out what rules apply when paying taxes. Some business structures require estimated tax payments each quarter, while others require filings only once a year.
Quarterly Estimated Taxes
If you’re in business for yourself, you generally need to pay estimated taxes each quarter. Estimated tax filing is a requirement for individuals (including sole proprietors, partners, and S corporation shareholders) who expect to owe the IRS at least $1,000 on their annual return. C corporations are also expected to pay quarterly taxes if they expect to owe $500 or more when their annual return is filed.
Annual Tax Filing Requirements
• Sole proprietors: You’ll declare your income and deductions on Schedule C of your personal Form 1040 tax return. You’ll also have to attach Schedule SE for self-employment taxes. The return is due by April 15 (or, if that’s not a workday, by the stated tax deadline).
• Partnerships: Most operate on the calendar year. In that case, the partnership should file Form 1065 as an information return by March 15. The business income is passed through to the partners and taxed via their personal Form 1040 returns.
• S corporations: These entities need to file Form 1120S by March 15, but S corps with a pass-through structure pay no tax at this level. Instead, each shareholder receives a Schedule K-1 documenting their share of the income and expenses. The shareholder records that information on Schedule E of their individual tax return.
• C corporations: These businesses use Form 1120 to report their income, gains, losses, deductions and credits, and to figure their federal income tax liability. Corporations operating on the calendar year need to file by April 15 (or the IRS’s stated tax deadline).
Common Tax Mistakes Small Businesses Should Avoid
Business taxes can be complicated, and it’s not always easy to make sure all your i’s are dotted and your t’s are crossed. Here are some common pitfalls to watch out for.
• Overlooking valuable tax deductions: Try to take every deduction you can to lower the amount of tax you pay including less common options such as charitable business donations. At the same time, make every effort not to exaggerate deductions, which could bring you under scrutiny for an IRS audit.
• Mixing personal and business expenses: You are not allowed to deduct personal expenses on your business taxes, so it’s important to keep clear, careful records. For maximum clarity, you may want to have completely separate professional and personal accounts, including a dedicated business checking account.
• Misclassifying workers: If you have employees, you could face stiff penalties if the IRS determines they were misclassified and you didn’t pay proper payroll taxes.
• Missed deadlines: Missing tax filing deadlines can result in penalties and interest payments. Keep a tax calendar to help avoid this problem.
The Takeaway
Understanding the basics of small business taxes can help you stay compliant with state and federal laws while also revealing ways to reduce the amount you owe. It’s critical to keep organized records and seek professional guidance to help make paying taxes a manageable part of running your business.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
How do I know which taxes my small business has to pay?
The types of taxes your small business will have to pay will depend on its legal structure and location. The IRS website can help you determine what taxes are necessary for your type of business. Similarly, your state and local governments’ revenue websites can help you sort out any other taxes you’ll need to pay. You may want to seek professional guidance to help ensure you aren’t missing anything.
Does the type of business entity impact how much tax I pay?
The type of business entity directly affects how much tax you pay. For example, with sole proprietorships – which the IRS does not separate from the owner – business income is passed through and taxed at the owner’s individual income tax rate. C corporations, in contrast, pay a flat corporate income tax rate of 21%.
How can I reduce my small business tax burden?
You can reduce your small business tax burden by taking advantage of applicable tax credits and deductions. Look back through your receipts, invoices, and payments to see which credits and deductions may apply.
What are estimated taxes and who has to pay them?
Estimated taxes are tax payments made each quarter on income that’s not subject to withholding. Sole proprietors and C corporations are expected to pay estimated taxes.
What happens if my small business doesn’t pay taxes on time?
If you don’t pay your taxes on time, you may be subject to penalties and/or charged interest on the amount you haven’t paid.
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