Small Business Taxes & ManagementTM--Copyright 2020, A/N Group, Inc.
Business owners in the start-up phase often ask who much will I owe in taxes? Unfortunately, the answer depends on a number of factors. This FAQ is designed to answer the question in general terms.
A C or regular corporation is the easiest to handle, so let's get it out of the way. If that's not how you're operating, skip to the next topic. A C corporation pays tax based on its income at a 21 percent flat rate. (Prior to 2018 it was at a graduated scale up to 35 percent). (On the other hand, the income of an S corporation is added to the personal income of the shareholders and taxed on their personal return. See below.) Most small businesses don't operate as a C corporation for a number of reasons, but the new 21-percent flat rate make them attractive in certain situations. (We won't go into the pros and cons here; it's too involved.) Here are the rates:
Example--Madison Inc. has sales of $565,000 and deductions of $187,000 for net income of $378,000 for the year. Madison's tax on the income is $81,270.But you've generally got to factor in a salary for the shareholder-officers because what a small business owner is really after is the net in his pocket. That's taxed at the normal income tax rates. See our Individual and Corporate Tax Data page.
What sounds simple can get more complicated. First, there are some "penalty" taxes for personal holding companies and excess accumulated earnings. Rarely a problem, but we've got to mention them. Of more concern are dividends from the corporation. If you take money out, other than through a salary, it's a dividend, which could be taxable to the shareholder(s) depending on their personal income. The rates are 10 percent, 15 percent and 20 percent if you're in the highest bracket. Depending on income, you could be subject to a 3.8 percent tax on net investment income. What about state taxes? Most states impose a state income tax. The rates range from a low of 1% on the first $10,000 of taxable income to 12% on taxable income over $250,000. To be accurate, get the rates from the states you'll be doing business in. For quick, rough, planning purposes, you can assume the rate is 7% and you won't be far off. (You also get a deduction on your federal return for state taxes paid, so that will lower the effective rate slightly.) Some states impose a franchise or excise tax based on tangible values or net worth. That's an issue if you have substantial assets.
Sole Proprietorships, S Corporations, Partnerships, and Limited Liability Companies (LLCs)
If you operate using one of these entities, the net income (or loss) is added to (or subtracted from) your personal income. The business entity doesn't pay a separate tax. (There are some state exceptions and some special federal rules but you're unlikely to encounter them.) In an attempt to equalize, in part, the treatment of S corporations and C corporations after the Tax Cuts and Jobs Act of 2017, the law provides a deduction equal to 20 percent of the S corporation, LLC's, etc. income. (See below for income limitations.)
Example 1--Madison Inc. is an S corporation owned 50% each by Fred Flood and Sue Ponds. Fred and Sue don't take a salary (more on that later). Madison has sales of $310,000 and deductible expenses of $194,000 for the year. That's $116,000 in taxable income that's passed through to the shareholders. Thus, Fred and Sue each report $58,000 on their personal income tax returns. From that he can subtract $11,600 (20 percent) and add the net ($46,400) in S corporation income to his regular taxable income. Fred's total income including his wife's salary, interest, dividends and capital gains as well as the net S corporation income less itemized deductions of $29,000 puts Fred and his wife's income in 24 percent bracket for all his S corporation income. So that would be your effective rate on the S corporation income. For 2020 income tax rates, go to Corporate and Individual Income Tax Rates.
Example 2--Sue's in a different situation. She's single and had the other half of the income from Madison, Inc. She left a large corporation last year and received a substantial severance package to be paid in 2020. She had no itemized deductions and her taxable income, before the S corporation income, is $401,000. Because her income is so high so is unable to use the 20-percent deduction for qualified business income. As a result her income from the S corporation includes the full $58,000. Looking at the table, she's in the 35% bracket already. So she'll pay 35% on the $58,000 of S corporation income.
Most, but not all, states use a similar approach. That is, there's no separate tax on the entity (there may be a minimum tax of $100 to $500), the owner's share of income is added to his or her personal return.
There are at least two nasty complication to the qualfied business income deduction. First, the deduction is phased out if your qualified business income is more than $326,000 (married, filing joint, 2020) or $163,000 for other filers (single, head-of-household, and married filing separate). Second, a special rule applies in the case of a specified service trade or business. A specified trade or business includes the performance of services in the fields of health, law, performing arts, consulting, athletics, financial services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees. The calculation here becomes more complex and involves the wages of the business and the unadjusted basis of the assets. See Form 8995 and the accompanying instructions Form 8995-A, and Schedule A, Schedule B, Schedule C, and Schedule D. If you're preparing your own return, or even doing serious planning, you should be using tax preparation software. The computations can be complicated.
The same approach applies to sole proprietorships (reported on a Schedule C attached to your personal return), partnerships, and LLCs. There's an additional twist to these entities, discussed below.
Tax reality. We've worked to keep the examples simple. Unfortunately, that's not the case in the real world. There are two major factors that will complicate your computations.
First, you can end up being taxed at several different rates, depending on how many tax brackets you go through. In that case you'll have to determine an effective rate.
Second, there are over 20 tax benefits that are phased out as your adjusted gross income increases. For example, the exemption amount for the American Opportunity Tax Credit (college tuition) credit, Lifetime Learning credit, child tax credit, etc. Taxpayers with very high income (over $200,000) often have less to worry about because these benefits are already gone.
CAUTION. Remember, when you go to do your tax return all your income is added together and taxed as a single amount. Except for dividends and capital gains, the source of the income doesn't matter.
Self-Employment and Other Taxes
In our example above we mentioned that Fred and Sue were not taking a salary from the S corporation. The IRS position is that S corporation shareholders who perform duties for the corporation (and every corporation must have officers) must take a salary. Were it not for social security and Medicare taxes, the effect would often be a wash. That is, the corporation pays the shareholder a salary increasing his or her income, but the salary is deductible decreasing the income of the corporation that's passed through. Social security (FICA) and Medicare taxes affect the individual by 7.65% (withheld from pay) of salary; the corporation pays a like amount, but it's is deductible by the corporation. For rough planning purposes you can figure the effect of the tax at about 12% of the individual's salary up to the $137,700 (2020 amount; it's indexed for inflation); amounts above that are still subject to the 2.9% Medicare tax. Above $200,000 you could be subject to an additional 0.9% Medicare tax. While you have to take a salary, it can be less than the income of the corporation.
The self-employment tax is the social security and medicare tax applied to a sole proprietorship, partnership, or LLC. But here all the income of the entity is subject to the tax. Sole proprietors, partners in a partnership and LLC members don't take a salary. (There is an exception for limited partners.) The self-employment tax is 15.3% on the first $137,700 (2020 amount) of self-employment income. (Self-employment income is the net profit on Schedule C or amounts from a partnership K-1 multiplied by 92.35%.) Amounts in excess of that are still subject to the 2.9% Medicare tax. These taxes are deductible on your personal return. Thus, the effective tax rate if you're subject to the full 15.3% tax is about 12% (the actual amount will depend on your tax bracket).
Tax Reality. One of the important points to remember if you're doing business as a sole proprietorship, partnership, LLC, or S corporation is that the income is passed through to you (whether or not you receive any cash or other property from the business), but no one is withholding taxes. That can come as a nasty surprise in April. You should compute the tax and make regular quarterly estimated payments.
Do the computations sound too involved? We're not surprised. Most professionals wouldn't do the calculations by hand. While you might do so if you're tax situation is simple and you only want a rough idea of your liability (or the income is subject to wide fluctuations), the best approach is to get a copy of TurboTax, TaxAct, or H&R Block (tax preparation software; all are inexpensive) and enter the data to see the before and after effects of adding the business income.
Other Taxes. We certainly haven't covered all the other possible taxes. Some states and localities impose a gross receipts tax, special surtaxes, personal property taxes, etc. These generally shouldn't affect your analysis.
Copyright 2007-2020 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject.--ISSN 1089-1536
--Last Update 02/11/20