Paying taxes is an inevitable part of owning and operating a small business. However, small business tax rates can vary significantly depending on the legal structure you choose for your company. Understanding how your business entity affects your tax obligations is crucial for proper financial planning and maximizing after-tax profits. This guide provides an in-depth look at federal income tax rates for the most common types of small business entities.
Pass-Through Entities
The majority of small businesses are organized as pass-through entities. This means the business itself does not pay income taxes. Instead, the company’s profits and losses “pass through” to the owners’ personal tax returns. The most common pass-through structures are sole proprietorships, partnerships, limited liability companies (LLCs), and S corporations.
Pass-through income is taxed at the owner’s individual income tax rate. For 2022, federal income tax brackets for individuals are:
- 10% for taxable income up to $10,275 (single filers) or $20,550 (married filing jointly)
- 12% for incomes between $10,276 and $41,775 (single) or $20,551 and $83,550 (joint)
- 22% for incomes between $41,776 and $89,075 (single) or $83,551 and $178,150 (joint)
- 24% for incomes between $89,076 and $170,050 (single) or $178,151 and $340,100 (joint)
- 32% for incomes between $170,051 and $215,950 (single) or $340,101 and $431,900 (joint)
- 35% for incomes between $215,951 and $539,900 (single) or $431,901 and $647,850 (joint)
- 37% for incomes above $539,900 (single) or $647,850 (joint)
In addition to regular income tax, owners pay a 15.3% self-employment tax on pass-through business profits to fund Social Security and Medicare.
The Tax Cuts and Jobs Act of 2017 created a new 20% qualified business income (QBI) deduction for pass-through entities. This deduction can reduce taxable income significantly for business owners below the $170,050/$340,100 thresholds. However, the QBI deduction may be limited or eliminated altogether for higher-income service businesses.
S Corporations
An S corporation is a specific type of legal entity that elects pass-through tax status with the IRS. Like other pass-through entities, S corps avoid double taxation on business income. Profits and losses flow through to the shareholders’ personal tax returns.
To qualify for S corp status, a business must meet the following requirements:
- Be a domestic corporation organized in the United States
- Have 100 or fewer shareholders
- Have only one class of stock
- Only have shareholders who are U.S. citizens or resident aliens
The main advantage of an S corp over other pass-through entities is liability protection. Shareholders are not personally responsible for business debts and lawsuits.
Limited Liability Companies (LLCs)
LLCs provide the liability protections of a corporation with the pass-through tax benefits of a partnership or sole proprietorship. Business profits and losses pass through to the owners’ (referred to as “members”) personal tax returns.
LLCs offer more flexibility than S corporations in terms of ownership structure. LLCs can have an unlimited number of members, and membership interests don’t have to be equally divided.
By default, single-member LLCs are taxed as sole proprietorships, while multi-member LLCs are taxed as partnerships. However, LLCs can elect to be taxed as S corporations by filing IRS Form 2553.
C Corporations
C corporations are separate legal entities that pay taxes on their profits. Business income is taxed once at the corporate level according to the corporate tax rates. Then, if profits are distributed to shareholders in the form of dividends, they are taxed again on shareholders’ personal returns. This double taxation often makes C corporations less attractive than pass-throughs for small businesses.
Under the Tax Cuts and Jobs Act, C corporations pay a flat 21% tax rate on taxable income. There are no longer graduated brackets for various income levels.
The new corporate alternative minimum tax (AMT) enacted under the Inflation Reduction Act will apply a 15% minimum tax on corporations with average annual adjusted financial statement income exceeding $1 billion. This will only impact about 150 of the largest corporations each year.
C corporations do receive some advantages in the form of tax deductions. For example, C corps can deduct the full cost of fringe benefits provided to employees, such as health insurance. They can also deduct state and local taxes up to $10,000 per year.
Limited Liability Companies (LLCs)
While most small LLCs are taxed as pass-through entities, they can elect to be taxed as C corporations by filing Form 8832 with the IRS. This may benefit companies that plan to reinvest most profits back into the business instead of distributing dividends. The lower 21% C corp rate applies to retained earnings that haven’t been paid out to owners.
Converting an existing LLC to a corporation has significant tax implications, however. The IRS treats this as if the LLC liquidated and transferred all assets and liabilities to a new corporate entity. Taxes will be due on the deemed liquidation.
Choosing a Business Structure
When deciding on a legal structure, business owners must consider factors such as liability protection, ownership flexibility, and administrative complexity along with the tax implications.
Pass-through entities benefit from single-layer taxation, but lack the liability protection of a corporation. S corps provide liability shields for shareholders but have strict ownership rules. LLCs offer the best of both worlds for many small businesses but require more complex record-keeping and operating agreements.
Projected profit margins may also influence the choice of entity. Businesses expecting lower profit margins may benefit more from the QBI deduction for pass-throughs. Those anticipating high margins may find the flat 21% C corp rate more favorable.
Consulting with accounting and legal professionals can help entrepreneurs make informed decisions about the optimal business structure. Take the time to understand both the short and long-term tax and non-tax ramifications.
Payroll Taxes
In addition to income taxes, employers must pay federal payroll taxes to fund Social Security, Medicare, and unemployment insurance programs. These include:
- Social Security Tax: 6.2% paid by employer and employee (12.4% total)
- Medicare Tax: 1.45% paid by employer and employee (2.9% total)
- Federal Unemployment Tax (FUTA): 6% paid by employer on the first $7,000 of each employee’s annual wages
Self-employed individuals pay self-employment taxes on pass-through business income to cover Social Security and Medicare. The self-employment tax rate is 15.3% since the individual pays both the employer and employee shares.
Independent contractors who receive Form 1099 do not have payroll taxes withheld. They must make quarterly estimated tax payments to cover self-employment taxes and income taxes.
Sales Taxes
If your business sells taxable tangible products or goods, you may need to register with state and local taxing authorities to collect and remit sales taxes. Requirements vary widely based on:
- Where your business has nexus (a taxable presence)
-Differing taxability of products/services
-Varying rates and exemptions
Forty-five states and the District of Columbia levy statewide sales taxes. Rates range from 2.9% to 7.25%. Some but not all states also allow counties, cities, and other districts to impose local sales taxes.
Retailers with no physical presence in a state may still be required to collect sales tax if they exceed economic nexus thresholds. Marketplace facilitator laws also require platforms like Amazon and Etsy to collect sales tax on behalf of third-party sellers.
Sales tax compliance can be extremely complicated for small e-commerce businesses. Using tax automation software can simplify the process and prevent costly errors and audits.
Excise Taxes
Federal and state governments impose selective excise taxes on the manufacture, sale, or consumption of specific goods and services. These include:
- Gasoline
- Alcoholic beverages
- Tobacco products
- Air transportation
- Heavy trucks, trailers, and tractors
- Firearms and ammunition
- Tanning services
- Telecommunications services
Excise taxes are indirect taxes passed on to consumers in the final price of the product or service. Brick-and-mortar retailers collect excise taxes upfront on certain sales. However, e-commerce sellers must register and file excise tax returns periodically to remit taxes to the proper government agency.
Other Business Taxes
Some additional taxes small businesses may encounter:
- Property taxes on business equipment, furniture, buildings, and inventory
- Franchise taxes on the privilege of doing business in a state as a foreign corporation
- Gross receipts taxes based on total revenue from sales and services
- Business license and permit fees to operate within a state, county, or city
- Annual business registration renewal fees charged by state governments
Maintaining proper business records and working with an accounting professional can help ensure you accurately calculate, file, and remit all required small business taxes. Stay up to date on tax law changes at both the federal and state levels as well. Considering taxes during long-term business planning allows you to maximize after-tax income.
