How Taxes Affect Small Businesses

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The top 10 percent of earners pay approximately 75 percent of the entire income tax in the state. Most of these earners are small-business owners.

There are approximately 30 million small businesses operating in the United States. According to the U.S. Small Business Association, small businesses of all types pay an estimated effective tax rate of 19.8 percent: sole proprietorships pay 13.3 percent rate; partnerships pay 23.6 percent; S corporations pay 26.9 percent, and C Corporations pay 17.5 percent.

Businesses in general are responsible for paying various taxes:

  • Income tax
  • Self-employment tax
  • Employment tax
  • Excise taxes
  • Sales tax
  • Property tax
  • Other state and local taxes

Additionally, the burdens imposed by federal regulations and paperwork costs are greater for smaller businesses. The average compliance cost for companies with less than 20 employees incur approximately $7,647 per employee.

How federal income taxes apply to small business income depends on the type of business entity, which is briefly summarized below:

  • Sole proprietorships: Sole proprietors report income and deductions on their individual federal returns. They can deduct wages and salaries paid to employees but cannot deduct their own salaries or any business income they withdraw from the business;
  • Qualified Joint Venture: Married couples who own a business together were previously treated as a partnership under federal tax laws. Married couples can elect to be treated as a “qualified joint venture” and do not have to file as a partnership.
  • Partnerships: Partnerships are pass-through entities because the partnership is not individually subject to federal income tax. Partnership income and losses are passed-through to each partner pursuant to agreed-upon allocation among partners and taxed at the partner’s tax rate.
  • S Corporations: S corporations can elect to be treated as pass-through entities. Income or losses and credits are passed through to shareholders on a pro rata basis similar to partnerships. Shareholders report their share of the corporation’s separately stated items of income, deduction, loss, and credit and non-separately stated income or loss on their individual return.
  • C corporations: The C corporation computes its own income or loss, files its own tax return, and pays its own tax. Corporate income is again taxed to the shareholders on dividends or capital gains (from the sale of their stock or upon liquidating). C corporations can deduct an owner’s wages as well as fringe benefits (such as retirement and medical reimbursement plans).
  • Limited Liability Companies: An LLC may be treated either as a partnership (with flow-through treatment) or taxable as a corporation. If an LLC has one owner, the LLC is ignored for federal tax purposes. If the LLC has multiple owners, the LLC files a partnership return.

The type of business entity you choose may affect how much federal and state taxes you pay. If you are starting a business, or your business has changed (i.e. grown in revenue and size), then reexamine whether the business entity you selected still provides the best mixture of liability protection and tax benefits.

The information contained in this article is presented only for information purposes and may not be relied on as legal advice or construed as developing an attorney client relationship. If you need legal advice you should contact an attorney.