Small Business Taxes & ManagementTM--Copyright 2013, 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 using a set of graduated rates. (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 graduated rates can make them attractive in certain situations. (We won't go into the pros and cons here; it's too involved.) Here are the rates:
Corporate Income Tax Rates
Taxable income over Not over Tax rate $ 0 $ 50,000 15% 50,000 75,000 25% 75,000 100,000 34% 100,000 335,000 39% 335,000 10,000,000 34% 10,000,000 15,000,000 35% 15,000,000 18,333,333 38% 18,333,333 .......... 35%
Example--Madison Inc. has sales of $165,000 and deductions of $87,000 for net income of $78,000 for the year. The first $50,000 is taxed at 15% for a total of $7,500. Income between $50,000 and $75,000 is taxed at 25% or $6,250. The remaining $3,000 ($78,000 less $75,000) is taxed at 34% or $1,020. Madison's total tax for the year is $14,770.The rates in the table may look a little strange, increasing, decreasing, increasing, but that's the way Congress designed them.
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 in Alaska to 12% on taxable income over $250,000 in Iowa. 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.
Two additional points. First, doing business using multiple corporations generally won't save tax dollars. Corporations under similar ownership will receive only one graduated rate. Second, net losses for one year can be carried back and forward to offset earnings in prior or future years.
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.)
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. Fred's married and has taxable income (his wife's salary plus dividends and interest less itemized deductions for taxes, mortgage interest, etc. and personal exemptions) of $148,000. Fred adds the $58,000 in S corporation income to his regular taxable income to arrive at total taxable income of $191,000 and computes the tax. Looking at the table at the end of the article for 2013 you'll see that for a married taxpayer with taxable income between $146,400 and $223,050 is taxed at 28%. Since all of the S corporation income falls in this range, Fred and his wife pay $16,240 ($58,000 X 0.28) in federal taxes on the earnings from the S corporation.
Example 2--Sue's in a different situation. She left a large corporation last year and received a substantial severance package to be paid in 2013 She had no itemized deductions and her taxable income, before the S corporation income, is $401,000. Looking at the table, she's in the 35% bracket already. But the 39.6% bracket starts at $425,000. So she'll pay 35% on the first $24,000 of S corporation income and 39.6% on the remaining $34,000.
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.
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 three major factors that will complicate your computations.
First, like Sue, you can end up being taxed at several different rates, depending on how many tax brackets you go through.
Second, there are over 20 tax benefits that are phased out as your adjusted gross income increases. For example, the exemption amount for the AMT, the Hope credit, Lifetime Learning credit, child tax credit, etc. Many of the benefits expire around $100,000. Taxpayers with very low (under $75,000) or high (over $200,000) often have less to worry about.
Third, the alternative minimum tax (AMT) applies to income from sole proprietorship, partnership, etc. just as it does to other personal income. The impact of the AMT is beyond the scope of this article. See below for a hint on how to deal with it.
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 $113,700 (2013 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 $113,700 (2013 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).
For a much more detailed discussion of the self-employment tax, go to Self-Employment Tax.
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 some 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.
Taxable income: Tax: Over But not over Tax +% On amount over $ 0 $ 8,925 $ 0.00 10 $ 0 8,925 36,250 892.50 15 8,925 36,250 87,850 4,991.25 25 36,250 87,850 183,250 17,891.25 28 87,850 183,250 398,350 44,603.25 33 183,250 398,350 400,000 115,586.25 35 398,350 400,000 ....... 116,163.75 39.6 400,000
Taxable income: Tax: Over But not over Tax +% On amount over $ 0 $ 17,850 $ 0.00 10 $ 0 17,850 72,500 1,785.00 15 17,850 72,500 146,400 9,982.50 25 72,500 146,400 223,050 28,457.50 28 146,400 223,050 398,350 49,919.50 33 223,050 398,350 450,000 107,768.50 35 398,350 450,000 ....... 125,846.00 39.6 450,000
Copyright 2007-2013 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 05/02/13