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The U.S. tax code is known for its complexity. It’s hard enough for individuals to keep up with all the rules involved in preparing a personal tax return, but businesses have it even harder. Businesses are required to pay types of taxes, file entity tax returns, and ensure that they are compliant with all applicable regulations.
We’ll take a look at why it’s important for business owners to understand business taxes, the various types of taxes that businesses are subject to, and ways to minimize your business taxes.
As a business owner, you’re busy running your operation. It may be tempting to outsource all of your tax and accounting work to a professional. While it might be a good idea to hire a professional, it’s important to understand how your business is taxed so you can consider the tax implications when making business decisions.
Understanding these rates can help you properly plan and budget for your taxes, which can ultimately save you money in the long run. For example, you may want to consider making large purchases before the end of the year so you can realize the expense, or you may want to delay an investment if next year’s tax rules will be more favorable.
Your business income tax calculation will vary depending on what type of entity your business is. We’ll take a look at how the taxes are calculated for each type of entity.
Sole proprietors are required to pay several types of taxes. These taxes include both income tax and self-employment taxes.
Federal income tax is based on the sole proprietor’s net income for the year. A sole proprietor’s net income is calculated by subtracting business expenses from total revenue. Sole proprietors’ income tax rate depends on their total income for the year, so it can vary from 0% to 37%. Most states also impose income taxes on sole proprietor income.
Sole proprietors also pay self-employment taxes. Self-employment taxes are equivalent to the Social Security and Medicare taxes that are typically withheld from an employee’s paycheck. The current self-employment tax rate for 2024 is 15.3%, which includes 12.4% for Social Security and 2.9% for Medicare.
If your sole proprietorship has a profit, you’ll be required to pay quarterly estimates since you do not have an employer making payments on your behalf. Underpaying your estimates can lead to penalties and interest, so it’s important to calculate your payments carefully.
There are two main types of corporations: C-Corporations (C-Corps) and S-Corporations (S-Corps). These two types of corporations pay taxes differently.
C-Corps are subject to corporate income tax. The corporation pays tax based on its net income. In prior years, there were several business tax brackets. But, as of 2024, corporations pay a flat rate of 21%. Note that this tax rate may be reduced by tax credits (such as the R&D credit or certain employment-related credits).
S-Corps pass their net profit through the owner’s personal tax return. Each shareholder will pay their own personal income tax rate on their share of the corporate profit.
Partnerships make take several forms such as Limited Liability Companies (LLCs), Limited Partnerships (LPs), or general partnerships. Partnerships do not pay any federal income taxes.
Partnerships, like S-Corps, pass through their net income to the owners. The partners then pay income tax based on their personal tax rates. Unlike S-corporations, the net income from the partnership is often subject to self-employment taxes. Determining whether the partnership income is subject to self-employment taxes depends on the nature of the business and the partner’s participation in the operation of the business.
Along with income tax and self-employment taxes, there are several other taxes that businesses must pay. Each type of tax has its own payment frequency and deadlines.
Payroll taxes are taxes that employers are required to withhold from their employee’s paychecks and send to the government. Payroll taxes fund programs such as Social Security, Medicare, and unemployment insurance. Along with the amount withheld from employees’ paychecks, many of these taxes require matching employer contributions.
State and local governments may impose additional taxes on employers, so it’s important to stay informed about your local requirements to ensure you aren’t hit with penalties and interest for non-compliance.
Sales tax is collected by sellers based on the price of each sale. Each state has its own rules for what goods and services are subject to sales tax, while some states do not charge sales tax. If your business sells in multiple states, you’ll likely need to remit payments to several different state revenue departments.
Because the rules for sales tax can quickly become complicated for many businesses, it’s often best to seek out the assistance of a tax professional to navigate the complex sales tax environment.
Many businesses are subject to state and local taxes along with federal taxes. Local taxes often include business license filing and registration, which can cost as little as $20 or range up to thousands of dollars if the filings are based on your revenue.
Certain entities will need to pay state taxes which can be based on flat fees or a percentage of revenue or net income. For example, California charges LLCs a flat tax of $800 each year while it charges corporations 1.5% of net income. If you have business locations in multiple states, you may need to register your business with each state and pay the applicable tax in each location.
When trying to minimize your business tax burden, it’s important to work with a tax professional to ensure that you are taking appropriate deductions and correctly following tax regulations.
There are several ways that businesses can reduce their taxable income by taking advantage of favorable regulations. One example is the Section 179 deduction, which allows small businesses to deduct the full cost of qualifying equipment and software purchases in the year they were made, rather than depreciating the cost over several years. Another example is the research and development credit, which provides a tax credit for qualified research expenses. When claiming tax credits, it’s important to ensure that you are properly calculating the credit and that you meet all the eligibility requirements.
Tax planning is also an important part of managing a small business. By planning ahead and staying on top of tax laws and regulations, small business owners can avoid costly mistakes and ensure that they are properly managing their finances. Tips for tax planning include keeping detailed records, reviewing tax laws regularly, and consulting with a tax professional.
Unfortunately, even with the best intentions, small businesses can still make mistakes when it comes to their taxes. Common tax mistakes include failing to file on time, not keeping accurate records, and incorrectly claiming deductions or credits. These mistakes can result in penalties, fines, and other costly consequences.
To avoid these mistakes, small business owners should prioritize organization and attention to detail. Keeping accurate records and consulting with a tax professional can help to ensure that all taxes are properly filed and paid on time and that deductions and credits are properly claimed.
Understanding federal business tax rates and other taxes is crucial for small business owners. Small business taxes can be complex and confusing, but by taking the time to learn about them and plan accordingly, small business owners can ensure that they are in compliance with tax laws and minimize their tax liability.
Though it’s impossible to eliminate all risk of an audit, careful compliance with regulations can minimize your chances of facing an audit or achieving a favorable outcome in the event that you are audited.
It’s important to remember that there are various taxes that your small business is subject to, including income taxes, payroll taxes, sales taxes, and local taxes. Each of these types of tax has its own set of regulations. While it may be possible to navigate your taxes when your business is small and just starting out, you may need to consider hiring a tax professional as your business grows.
Casey Long is a CPA with over 15 years of experience. She has spent her career explaining complex financial concepts to various audiences. She started as a bookkeeper and worked her way up, so she understands all aspects of accounting processes.
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