How are small businesses taxed?The average small business pays 19.8% in taxes depending on the organizational structure. For example, sole proprietors pay around 13.3% and small business corporations pay 23.6% on average. Granted, the corporate income tax rate of 21% only applies to the minority of small businesses.
The rest are not classified as corporations, but rather “unincorporated pass-through entities” and are subject to the personal tax rates of the owner. You can further reduce your tax burden in various ways. This includes claiming deductions such as:
- Internet and phone bills
- Salaries and wages
- Software subscriptions
- Transaction fees
- Vehicle expenses
It’s important to understand the relationship between taxes and your business, as it can significantly affect your bottom line. In this guide, we discuss the fundamentals of small business taxes and determine how much your company should set aside for the overhead.
As you may be aware, business taxes vary around the country and not all states charge income tax. In fact, certain states are ideal for small businesses in this regard. For instance, companies in Florida don’t pay individual income tax, while Nevada charges neither corporate nor individual income taxes for business owners.
On the other hand, states such as California, Minnesota and New York have afflictions ranging from complex nonneutral taxes to exorbitant rates and poor tax structures. The Tax Foundation’s leading states for favorable tax conditions are:
- South Dakota
When Taxes Apply
The IRS indicates that all businesses in the United States must submit an annual tax return, except for partnerships that need to send an information return instead. Also mandatory is employment taxes such as social security taxes.
If you earn less than $400 per month, you can forgo any self-employment tax payments. This is the only kind of tax that’s avoidable. Fortunately, the IRS is unlikely to audit your company until you start churning out a profit. Of course, you should still file your business taxes to prevent any legal issues in the future.
How Much to Set Aside
The general rule is to allocate between 30% and 40% of your earnings to federal and state taxes. It’s important to handle this regularly as you’ll be making these payments on a quarterly basis.
If your business was established recently, you should try to keep at least 30% of each payment. This can happen monthly when you start earning a profit. As your annual income stabilizes, you can move to quarterly savings based on what you earned the previous year.
It’s wise to keep your tax payment funds in a dedicated bank account. You can also streamline the process by enabling automatic transfers to the separate account.
Thanks to the “safe harbor” rule, you don’t need to stress about underestimating what your business owes. The IRS will not penalize you as long as your quarterly payments are equal to those from the year before.
At first, business taxes can be daunting. Fortunately, it’s mostly a matter of covering the basics.