The objective of every small business owner is to sell the company’s products and services, control expenses and make a profit. That’s good. But the small business tax rate determines how much you get to keep after taxes.
It isn’t just federal income taxes that take a bite — state and local taxes also get their share. And don’t forget about payroll taxes, workers’ compensation and unemployment taxes.
What Is the Small Business Tax Rate?
A company’s income tax rate depends on its type of legal structure. Those entities include the following:
- Sole proprietorships
- Limited liability companies (LLCs)
- C corporations
- S corporations
According to the National Federation of Independent Business, 75% of small businesses are “unincorporated pass-through entities.” This means that business owners pay their company’s income taxes on their personal tax returns at individual tax rates. Personal tax rates currently range from 10% to 37%.
According to a study conducted by Quantria Strategies for the Small Business Administration, small businesses, overall, pay an estimated average effective tax of about 19.8%. Single-owner sole proprietorships are the lowest with an average effective rate of 13.3%, while S corporations have the highest with rates of 26.9%. Small C corporations pay an average tax rate of 17.5%, and partnerships pay a higher rate at 23.6%.
Let’s look at how each of these entities is taxed.
Say an owner starts a business as a drywall contractor, but never takes the steps to incorporate or form an LLC. Businesses that have never set up an official structure with a state government will operate as sole proprietorships.
A sole proprietorship business and its activities are considered the same as the owner. That means:
- All income and losses from the business are reported on the owner’s personal income tax return.
- The business doesn’t file a separate return. The owner must pay taxes on the total earnings of the business, even if money is left in the company’s bank account to cover future expenses.
The income tax rate for a sole proprietorship depends on the individual personal tax rate of the owner. In addition, the owner of a sole proprietorship must pay all of his own self-employment taxes for Social Security and Medicare, which is 15.3% of income.
LLCs and Partnerships
While LLCs and partnerships are usually chosen to create some degree of separation of liabilities between the owners and the business, they are still considered pass-through entities for income tax purposes.
To make matters more complicated, LLCs have the option of being taxed as a C corporation or an S corporation. This means that owners have to calculate the pros and cons of each alternative form and the various ways to pay their own wages and distribute dividends.
Because an LLC is considered a pass-through entity, the owners must pay their share of taxes on the company’s profits. It doesn’t make any difference whether the money stays in the business.
Let’s say a company makes $90,000 in profits for the year, and management wants to retain $60,000 in the company to pay for a plant expansion.
Even though the owners might receive $30,000 in distributions, they would, nevertheless, be obligated to pay taxes on the entire $90,000. In more extreme situations, the owners could end up paying more cash out in taxes than they receive in dividend distributions. These situations are known as “noncash taxable events.”
A C corporation is the only legal entity that pays its own income taxes. The shareholders aren’t liable for taxes on any of the company profits. However, if an owner works in the business as an employee and receives a salary, that income is taxable on the individual’s return. In addition, any dividends that stockholders receive is taxable to the recipients.
The Tax Cuts and Job Act, signed in December 2017, simplified the corporate tax code. The corporate tax rate for companies of all sizes is now a flat 21%. Graduated income brackets for corporations no longer exist.
A C corporation has a disadvantage in that its profits could possibly be taxed twice at the federal level. First, the corporation will pay a 21% tax on its profits. Afterward, if the company disburses any dividends, these will come out of after-tax earnings and could be subject to further taxes on the individual’s tax returns. This double combination of corporate and individual tax rates could result in a marginal tax rate on dividends up to 39.8%.
As with partnerships and sole proprietorships, S corporations are considered pass-through entities. As such, shareholders of the business must report their proportionate share of the company’s income on their personal tax return and pay taxes at their personal income tax rates.
Even though an S corp files Form 1120S, an informational tax return, the business itself does not pay corporate taxes. This avoids the possibility of double taxation previously mentioned in C corporations.
Internal Revenue Service (IRS) rules allow S corporations to make 2 types of disbursements:
- Dividend distributions
However, these options lead to an interesting dilemma for the small business owner. Under S corporation rules, owners must pay self-employment taxes on their salaries. Dividends, on the other hand, aren’t subject to the self-employment tax. As a result, this interesting twist of rules creates an incentive for small business owners to draw small salaries to avoid the self-employment tax and take higher dividends.
However, the IRS is aware of this possibility and requires an owner to pay a reasonable salary for the job’s responsibilities. For example, the IRS won’t allow an owner to take a salary of $10,000 and a distribution of $50,000.
State Income Taxes
In addition to paying federal income taxes, small businesses, depending on the state where they operate, must pay state income taxes.
Business tax rates by state widely vary. A few states have additional separate taxes on LLCs and S corporations even though the owners pay business income tax on their personal state tax return.
Some states have a tax on the company’s gross receipts rather than a corporate income tax. Typically, a business isn’t allowed to take any deductions before calculating this tax.
A small business owner should consult with a professional accountant to determine the applicable rules for the domiciled state of the firm.
Payment of Estimated Taxes
Regardless of the type of entity, a business must make quarterly estimated tax payments if the amount owed is more than $1,000.
C and S corporations must pay estimated taxes on a quarterly basis. Shareholders in an LLC must make quarterly tax payments on their personal income tax forms.
Sole proprietorships will use IRS Form 1040-ES, Estimated Tax for Individuals to make their payments.
Self-employment tax – This tax is 15.3% and covers Social Security and Medicare. Self-employed business owners must pay this entire amount themselves if they earn more than $400. The Social Security tax of 12.4% is imposed on the first $142,800 of net earnings for 2021.
Payroll taxes – A small business is liable for 7.65% of their employees’ gross payroll. The other 7.65% is deducted from the employees’ payroll checks and remitted to the IRS on a monthly or semiweekly schedule.
Federal unemployment tax (FUTA) – The amount of the unemployment tax depends on the amount of your employees’ wages. A business must file Form 940 if employee wages exceed $1,500 in a quarter.
FUTA is 6% of the first $7,000 paid to an employee. You can take a credit up to a maximum of 5.4% against this tax for any state unemployment taxes you’ve paid.
State unemployment tax (SUTA) – Each state sets its own rate for SUTA. The rate can depend on the age and size of your business, the employee turnover rate, the industry and the number of former employees who have applied for unemployment benefits.
Franchise taxes – Some states levy a franchise tax against businesses that are chartered in that state. This tax can be determined by factors including the total assets of the business, its net worth, gross receipts and the value of the company’s capital stock. A franchise tax isn’t based on the company’s profits and must be paid whether the business makes a profit or not.