The taxes you pay can depend on your line of business, the type of business entity you create, the tax designation you choose and where your business is based.
Federal income taxes
Whether you're an employee, a consultant or a business owner, you will have to file an individual federal tax return and pay federal income taxes. Your tax liability will vary depending on your business's structure, your income and other sources of household income for the year. For more information, see details below according to different business types and consult the IRS website's small business and self-employment page.
If you haven't created a separate business entity and are running your company as a sole proprietorship, you don't have to file a separate business income tax return — all business revenue and expenses get reported on your individual tax return. You'll still want to keep precise business records, as you'll record your business income and expenses on Schedule C, which is part of your individual tax return.
Once your business is operational, you might still be eligible for a variety of tax credits or deductions that can help lower your tax liability.
For example, you could get a deduction for the business percentage of your auto expenses (or take the 2019 standard mileage rate of 58 cents per mile) when you use your vehicle for business purposes, and you might be able to deduct a portion of your home's mortgage interest, real estate taxes, insurance, utility bills and repairs if you have a home office that qualifies for the home office deduction.
All profits from the business are subject to income taxes as well as “self-employment tax,” which are the employee and employer halves of Social Security and Medicare. Because no payroll is being run (as would be the case if you were an employee), the IRS wants to collect these taxes on your “earned income.”
Even if you regularly file your own tax return, you may want to hire an accountant who is familiar with your industry to review your return and explain which tax deductions or credits you can claim. You may also qualify for free tax preparation through the IRS's Volunteer Income Tax Assistance (VITA) program.
Partnerships are similar to sole proprietorships in that the tax responsibility “passes through” to the business's owners. Unlike a sole proprietorship, the business needs to file an information return with the IRS, Form 1065 U.S. Return of Partnership Income, also known as a partnership tax return.
The information return tells the IRS about your partnership, such as its revenue, expenses and tax credits for the year. But the partnership doesn't submit a tax payment with the partnership tax return because the profits pass through to the partners, who will then pay taxes on their individual tax returns.
The partnership return generates Schedule K-1s, which it must send to each partner showing his or her portion of the partnership's profits or losses. A copy of each Schedule K-1 also gets sent to the IRS as part of the partnership return. The partners will need this information to file their individual tax returns, where they'll determine how much tax they owe on their portion of the proceeds.
C corporations must file a corporate income tax return, Form 1120, and pay a flat 21 percent federal corporate income tax on the profits. This is much less than the top individual tax rate of 37 percent. However, not only does the corporation pay tax on any profits, but individual shareholders also pay taxes on any dividends they receive. In addition, if you are actively involved in the operation of the small business, you're likely an employee as well as an owner of the corporation.
The company must pay you a salary for your work, and it should withhold income, Social Security and Medicare taxes (i.e., withholdings) from your pay and send the money on to the IRS. The wages and employer portions of tax payments (employer halves of Social Security and Medicare, as well as unemployment taxes) are all business expenses that can decrease the corporation's taxable income.
The corporation should send you and the IRS a Form W-2 reflecting your salary and withholdings for the year, in addition it should send the IRS and your state other payroll related forms, such as a Form W-3. You'll use the W-2 to complete your individual tax return.
As the owner of the corporation (i.e., a shareholder), you could choose to distribute corporate profits as a dividend. A dividend isn't a business expense, it simply means the corporation is giving its profits to the people who own the corporation. Because it's not an expense, corporations pay corporate income taxes on the money.
The company should provide a Form 1099-DIV with your dividend income and file one with the IRS. You'll need the form to complete your individual tax return as it is taxable income to you as an individual.
Corporations that elect for S corporation taxation are pass-through entities. Similar to partnership returns, they don't pay corporate income taxes. Instead, the income from the S corporation passes through to the individual shareholders and gets reported on the owners' individual tax returns. The owners have to pay taxes on their share of the income. However, S corps still have to file an 1120S information return to report the business's activity to the IRS.
To understand why some small business owners choose to use an S corporation, consider a simplified example where you are the sole owner and only employee of an S corporation that made $90,000 in profit last year.
You receive a $60,000 salary as an employee of the company, which you determine is a reasonable salary based on how much employees of similar companies in your area make. That salary is subject to Social Security and Medicare taxes of approximately $9,000.
However, as the sole owner of the company, you can then receive the remaining $30,000 as an owner distribution (which is described later), which is not subject to Social Security and Medicare taxes This is a major difference from sole proprietorships and partnerships, where the entirety of the profits are subject to Social Security and Medicare.
S corporations file an information return with Form 1120S, file Form W-2s and other appropriate payroll forms for employee wages and report owners’ shares of income and losses with a Schedule K-1s.
Limited liability companies
With an LLC, how you report and pay federal income taxes will depend on how you elected to have your LLC taxed and the number of members (i.e., owners).
You could elect to have the LLC taxed as either a C corp or an S corp and follow the rules for those types of entities. This requires a special election by sending in a Form 2553 to the IRS requesting this treatment.
Or, if you're the sole owner and don't elect for corporation taxation, your LLC will be taxed as a sole proprietorship. The LLC's income or losses will flow through to your individual tax return and be reported on a Schedule C.
By default, the IRS will treat multi-member LLCs as partnerships. You will have to file an information return for the LLC, but the LLC doesn't have to pay any corporate income taxes, as the IRS views it as a partnership. All the profits and losses get passed through to the owners.
In most states, if you own an LLC with your spouse, the LLC is taxed as a partnership. However, if you live in one of the nine community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin), where one spouse's income or debt is considered both spouses' income or debt, you can choose whether you want the LLC to be treated as a partnership.
Taking profits out of your business
If you own a business that makes money, you may want to move the money from the business's account to your personal account. This is a best practice, as you do not want to pay personal expenses from your business account. Doing so can create a number of issues, including the IRS questioning whether or not your business expenses are valid. How you do this can depend on the type of business entity you created.
With a sole proprietorship or single-member LLC that doesn't pick a corporate tax election, there's no distinction between you and the business and you can transfer money back and forth between the accounts. Partnerships must track distributions to each partner, as this affects the partners’ cost basis in the partnership and helps ensure distributions are being taken fairly.
It's more complicated with C corps and S corps (or, LLCs taxed as C corps or S corps).
With C corps, profits can be distributed as a dividend. However, as noted previously, this can lead to "double taxation." The corporation pays income taxes on its profits, the profits get distributed as dividends and then you pay individual income taxes on the income from your dividend.
Alternatively, C corps can choose to keep the money and spend it on future business expenses. The corporation still has to pay income tax on the profits, but you won't receive a dividend and won't have to include the money on your personal tax return. However, this means you also won't be able to use the money for personal expenses.
S corporations are a little different because they must pass their profits on to their owners each year with what's called a shareholder distribution. The distributions will be included on the K-1 the corporate tax return generates, but do not directly affect your tax bill. The shareholders pay tax on their share of the profits of the company, not the actual money distributed.
However, the profits don't have to be physically transferred from the S corp's account to your personal account. This could happen when you want to keep the money in the corporation's account to invest in the company's growth or pay the company's bills.
Even if the money is kept in the corporation, you will still be taxed on money that wasn't transferred. This is referred to as "phantom income," because you have to pay taxes on the money as if it was income, but you didn't personally receive the money.
Paying taxes on business profits
Let's go back to the example of a company that has $90,000 in profit. With a sole proprietorship or LLC without a corporate election, you might receive the full $90,000 as income from the business. Absent other sources of “earned income,” you will also have to pay 15.3 percent in Social Security and Medicare taxes on the entire amount.
With an S corp, the owner might choose a $60,000 salary and the remaining $30,000 gets transferred to the owner's account as an owner distribution. As noted, one benefit of S corporations is that unlike your salary, owner distributions aren't subject to Social Security or Medicare taxes. The owner could save 15.3 percent ($4,590) in taxes by receiving the money as an owner distribution rather than having a higher salary.
You can't pay yourself a $0 salary and take all the money as an owner distribution. You must pay yourself a “reasonable salary” for the work you do as an employee of an S corporation.
If the company was a C corp, it might pay a $30,000 dividend. While the dividend isn't subject to Social Security or Medicare taxes, the C corp has to pay corporate income tax on the money and you'll have to pay individual income taxes on the dividend. The $30,000 gets "double taxed" as a result. This is the reason so few small businesses choose this tax treatment, instead choosing one of the other options mentioned.
In addition to understanding federal income taxes and how you can take and use the money your company makes, small business owners should know about the variety of local, state and federal taxes their business may have to pay.
Businesses are responsible for withholding Social Security and Medicare taxes from wages and making payments to the IRS throughout the year. Combined, these are called Federal Insurance Contributions Act (FICA) taxes. There may be an additional Medicare withholding and payment requirements for high-income employees.
If you have employees and run payroll, even if you're only running payroll for yourself, you should be making these payments biweekly or monthly. The person responsible for your company's payroll, which is likely the business owner in a small business, could be personally liable if FICA taxes go unpaid.
Your business may also have to pay a Federal Unemployment Tax Act (FUTA) tax. This money is used to fund unemployment programs for people who are out of work. These taxes aren't withheld from employee wages, but your business's requirement to pay FUTA taxes and the amount it pays will depend on how much was paid in wages throughout the year.
Some businesses collect taxes from consumers and pass on the tax payments. For example, if you sell fuel, cigarettes or liquor, you may add the cost of the tax to the product's price and then distribute the tax payments to local, state and federal governments.
You may need to pay self-employment tax on the money you make from your sole proprietorship, partnership or LLC when you file your individual tax return. Self-employment tax can be more than 15 percent, although you can also receive a tax deduction for half of the amount you pay in self-employment taxes.
Self-employment tax is made up of the employer and employee portions of Social Security and Medicare taxes. If you worked for someone else, your employer would pay half and you would pay half. However, because you run your own business, you have to pay both halves.
As a business owner, you might not be making income tax payments throughout the year if you run a pass-through entity, such as a sole proprietorship or LLC. By contrast, employees who work for a company typically get income taxes withheld from each of their paychecks.
Although you don't have to make income tax payments monthly, self-employed people should likely be making estimated tax payments at least four times a year (here are the due dates). If you don't make estimated tax payments and you wind up owing $1,000 or more in federal income taxes at the end of the year, you may have to pay additional penalties and interest.
Even if you started a C corporation or S corporation and withhold income taxes from your own wages, you may also want to make estimated tax payments depending on your projected dividend or owner distribution amounts in order to avoid those penalties and interest when you file your individual return.
Local and state taxes
Your local and state tax obligations and filing requirements can vary widely depending on where your business is based and operated. The IRS maintains a list with links to different states' websites, broken down by what you need to know about doing business and paying taxes in that state.
State and local taxes can include:
- Income tax: You may need to pay state income taxes on the money you earn or your business earns. As with federal income taxes, you may have to make estimated state income tax payments throughout the year.
- Unemployment taxes: This money funds the state programs that help temporarily unemployed workers.
- Sales tax: Local and state governments might impose a sales tax on the products you sell. You'll need to record what you sell, collect the tax from customers and pay the money to your local and state governments.
- Real estate tax: A local tax that you might have to pay if your business owns any land or buildings.
- Business personal property tax: A local tax you have to pay on business assets, such as equipment and furniture.
- Franchise tax: The annual or biannual tax that some states charge business entities that do business in their state. This may apply even if you don't have a store in the state, but still ship products to the state.
Consult an accountant or business tax attorney who is familiar with your industry and area. They can help you understand your tax obligations on the local and state levels and can recommend ways to minimize your taxes.