Today, I’ll provide a quick overview of the types of taxes small businesses pay, including how small business tax brackets work for sole proprietorships and company members. The question is, is “tax bracket” the right way to talk about business taxes?
There are no tax brackets for small businesses, only the owner, operators, or shareholders of the business.
A company’s business structure determines how it is taxed.
Corporate income tax rates apply to corporations’ profits. In contrast, pass-through entities—such as sole proprietorships, partnerships, limited liability companies (LLCs), and S-corps—pass profits and losses to their owners, who take on the tax burden according to their personal income tax rates.
Small business tax brackets are better understood as personal income tax brackets.
For 2023, federal income tax rates for individuals, which apply to many small business owners, range from 10% of income up to $11,000 and 37% for income over $578,126. These brackets are adjusted for inflation.
It’s important to note that your marginal tax rate is different from your effective tax rate.
Each dollar is taxed according to its bracket, with only the amount exceeding each threshold being taxed at a higher rate. So your first $11,000 is taxed at 10%, the next $33,725 is taxed at 22%, and so on.
In other words, if you made $578,128, only the two dollars above the tax bracket (which ends at $578,126) are taxed at the highest rate of 37%.
Various taxes impact the taxable income of small businesses.
Small businesses navigate a myriad of taxes that affect their taxable income, from gross receipts tax to sales taxes collected. Let’s go through them quickly.
Payroll taxes consist of FICA and Unemployment taxes.
The Federal Insurance Contributions Act (FICA) taxes employers and employees to fund Social Security and Medicare. The total FICA tax rate is 15.3%, split evenly between employer and employee. Payroll taxes also encompass federal and state unemployment taxes.
As a self-employed business owner, you must pay both the employer’s and employee’s portions of the FICA tax.
It sounds bad. Fortunately, tax deductions and tax credits, like the qualified business income deduction, can alleviate this burden with tax savings of up to 20% of your business’s gross taxable income. Furthermore, you’ll only be responsible for unemployment taxes if you have other employees who aren’t immediate family members.
Pass-through entities don’t pay federal income taxes directly.
Instead of taxing the company, business profits and losses “pass through” to the owners, so the income that is taxed is taxed according to personal income tax brackets. This classification includes four types of business ownership structures.
Sole proprietorships and general partnerships are pass-through entities with limited asset protection.
Sole proprietorships and general partnerships are not—and I repeat—not corporations, though they are recognized legally. So, if you do business as either of the two, you are personally representing your business.
With no business structure separating your personal assets from those of your business, you’re personally liable if your company ever gets into financial trouble. That means you and your partners are 100% responsible for all liabilities.
Both are still pass-through entities but are not formal business entities. This has tax and legal implications.
Limited liability companies (LLCs) provide flexibility and personal asset protection.
Many small businesses prefer to incorporate as an LLC, which can be single-member or multi-member. LLCs allow members to avoid corporate income tax while protecting their personal assets from liabilities.
An LLC is a formal business entity, e.g., a legal entity. It offers limited protection from liability, and members may elect to be taxed as other entities, like S-corps.
Corporations blend partnership benefits with liability protection and other advantages.
C-corps are subject to corporate taxes, and shareholders are taxed separately, allowing for profit retention and tax-advantaged benefits. While structuring as a C-corporation can make sense for certain large businesses with many shareholders, it can also lead to the same money being taxed twice. First, it is subjected to corporate tax before being taxed again at the individual level.
Here are some more valuable details on S-corps.
An S-corp avoids this double taxation by passing most of its financial gains and responsibilities to its shareholders. By accepting certain restrictions on who and how many individuals can be shareholders, S-corporations can enjoy many of the organizational perks of being a corporation while minimizing corporate income taxes.
S-corps can have a parent structure of general partnerships, LLCs, or corporations. Because this level of flexibility equates to complicated opportunities for tax evasion, the IRS tends to pay extra attention to these types of returns, so get help with tax preparation.
Ready to demystify small business taxes?
Let’s set your business on the path to financial clarity and success. Schedule a discovery call today.
Talk soon,
Jeremy A. Johnson, CPA