How is business income taxed?
If you’re coming to this page, it means one of two things – you either have a business that is doing well and you’re trying to figure out how much tax you owe, or you’re planning on having a business at some point in the future that does well and you want to know how much tax you will owe. And the good news is that you’re in the right spot. Business taxation, while complicated when you get into the details, is actually pretty straightforward when it comes to the broad strokes. Here are the key points.
In three common business structure types, the sole proprietorship, the limited liability company (LLC), and S-corp, profits that are earned by the business end up passing through the business untaxed, and are then taxed as personal income at personal income tax rates for the owners of the business. What makes up the profit of a business? Well, if you’re running a business, you take your income, subtract your expenses from it, and what is left over is profit. Businesses are allowed to deduct a number of expenses against their income, including employee salaries, health insurance costs, travel expenses, and a whole bunch of other expenses associated with running your business. This ensures that you don’t pay taxes on all of the money you take in, but rather on the difference between your income and expenses, or money you’ve actually earned in your pocket after you’ve paid all your operating costs.
Now, one of the key provisions passed during tax reform at the end of 2017 allows for all of these types of companies to potentially deduct up to 20 percent of the income that is passed through the business on your tax return. So let’s do a little math. Suppose you are a sole proprietor and you netted $50,000 last year after expenses. The current tax code might allow you to deduct up to 20 percent of that income, or $10,000, on your tax return, meaning only $40,000 would show up as earned income. Why do I use the word “might”? There are two reasons – first, in 2020, the deduction phases out for individuals with greater than $163,300 in taxable income and joint filers with over $326,600 in taxable income; second, the deduction is further limited in “specified service businesses,” such as law, finance, consulting, or pretty much anything that involves performing a service rather than building something. I highly, highly recommend you consult an accountant when dealing with this issue, as it has only been in place for a couple of years.
Why does that 20 percent deduction exist for pass-through businesses?
It exists primarily because one of the biggest components of the tax reform bill from 2017 was the reduction in the corporate tax rate from 35 percent to 21 percent. This corporate tax rate does not apply to any of the above corporate structures, but it does apply to the C-corp. Thus, in order to put other entities on a relatively level playing field with C-corps, the above deduction was created so as to try to manage pass-through taxation to a similar level.
As noted above, C-corps do have to pay the corporate tax rate of 21 percent on profits. If distributions, known as dividends, are made to corporation shareholders, those dividends are then taxed again, creating a situation of double-taxation for those shareholders. C-corps have access to many of the same business deductions that other structures do, and consulting an accountant usually makes sense to ensure that you are taking advantage of all of the potential breaks that are out there, as they likely have insight into the tax code that you may not possess.
So, to recap where things stand on business taxes, sole proprietors, LLCs, and S-corps are all treated as pass-through entities that pass income through to their owners, who are then taxed at personal income tax rates. Those owners may also be allowed to deduct 20 percent of the pass-through income, but it’s worth talking to an accountant to see if you qualify. Businesses set up as C-corps are taxed at the corporate rate, with additional taxation for profit distributions in the form of dividends if they are distributed. And those are the basics of business taxation.