What You Need to Know About Small Business Tax Rates for 2020
If you plan on starting your own small business in this new decade, choosing the right business is essential to maximize your annual income. As of 2020, small business tax rates for C corporations is 21% but S corporations and sole proprietors are not taxed at the corporate level and are subject to personal income tax levels. This is an oversimplification, as your tax rate can vary depending on your specific business entity, what type of industry you are in, and more.
Trying to figure out what type of business suits you best can be difficult. Many business owners don’t know what tax cuts they are eligible for or what pass-through income even means. Plus, it doesn’t stop at just income taxes. Businesses are responsible for payroll taxes, unemployment taxes, and all other kinds of taxes! To make matters worse, the Tax Cuts and Jobs Act went into effect just last year so the IRS is expecting businesses to comply with these new rules and regulations.
As always, it’s recommended you work with a tax professional, preferably a CPA, and utilize some type of tax software. The purpose of this guide is to simplify the types of businesses, what type of business best fits your needs, and the different small business tax rates for each type of business so you can make an educated decision.
Classification of Small Business Tax Rates
Income Tax Rates
This is typically the tax everyone is familiar with. You, as an individual, must pay income tax on your wages, investment income, and other gains. Corporations also pay income tax on the net income it earns each year, where net income is the dollar amount remaining after subtracting business expenses. Small business tax rates can vary widely based on the legal structure of your business.
Pass-through entities are a popular business setup for new and small business owners and stipulates the business itself does not pay income tax but the owners do. LLCs and sole proprietors are the most common pass-through entities, and the owners pay tax on business income at their individual tax rate on their personal return instead of the business.
Employment/Payroll Tax Rates
If you have employees at your small business, you’re responsible for employment taxes, including both federal and state taxes. Most businesses will hire a payroll company to manage their payroll taxes and file their tax forms as there are many types of employment taxes and it can be complicated. Here are the following simplified:
- Federal Income Tax Withholding: Employers are required to subtract taxes from an employee’s pay and to pay those taxes to the government on behalf of the employee for that tax year.
- Medicare Tax: 2.9% (1.45% for the employer and 1.45% for the employee). If you employ someone making over $200,000 per year, there are additional requirements.
- Social Security Tax: 12.4% on wages paid up to $128,400 for 2019 (6.2% for the employer and 6.2% for the employee)
- Federal Unemployment Tax: 6.2% on the first $7,000 you paid to each employee. If you’ve paid your state unemployment taxes, you are usually entitled to a tax credit (up to 5.4%)
- State Unemployment Tax: varies by each state
Self-Employment Tax Rates
If you’re self-employed, and your net earnings were $400 or above. As noted above, most businesses are responsible for half of Social Security and Medicare, but if you’re self-employed then you pay the entire amount for these taxes on your own tax bill.
Excise Tax Rates
In industries like cigarettes and liquor, businesses are responsible for excise taxes on transactions and activities. An indirect tax, excise tax is often included in the price of the product or service. Businesses that sell products or services subject to excise tax are responsible for collecting the taxes and remitting them to the IRS.
Sales Tax Rates
There is no federal sales tax, but 45 states and thousands of local governments have sales tax. It varies on which state you’re in (origin-based state or destination based state). For example, Texas rate their sales taxes based on where the seller is located but for states like New York, they are based on where the customer is located.
Customers pay sales tax on goods and services when they purchase, but the business is responsible for calculating, collecting and reporting to local and state governments. Some ecommerce businesses must also collect and remit sales tax after a recent court decision.
Property Tax Rates
Similarly to sales tax, it depends on which city and county you are located. When purchasing a property, the agent or agency will provide you with information about the property tax and deadlines. Property taxes are charged on the property’s assessed value rather than the current market price of the property.
When to Pay Small Business Taxes
Now that you know the types of taxes, let’s make sure you meet those tax law deadlines so you don’t end up with a late tax filing and subsequent fee next tax season. A great way to stay on top of taxes is to use a tax software that allows you to e-file your tax payments .
As an individual, you will most likely be used to paying taxes one time at a specific date dictated by state and federal tax law. However, as a business owner, you are most likely responsible for paying estimated income taxes and self-employment taxes on an ongoing and recurring basis (any business owner expecting more than $1,000 in taxes for the year must pay quarterly estimated taxes i.e. 4 times a year).
What are the Types of Small Businesses?
With the recent tax reform, specifically on the corporate tax rate, there are pros and cons to each business structure and how you can maximize your business tax deductions and reduce taxable income is dependent on your specific situation.
What does the S stand for in S corporation (S corp)? It stands for “Subchapter S” or as some say “Small Business Corporation”. S corporations don’t pay income taxes. Instead, there are shareholders that split the income or losses amongst each other and report it on their personal income tax returns. But there are some restrictions to S corporations. There can’t be more than 100 shareholders, and all shareholders must be U.S citizens. S corps also follow a strict filing and operational process similar to a C corp.
An S corp avoids the double taxation corporations are subject to. The taxable income of a regular corporation is subject to 2 levels: 1) the corporate level and 2) the individual level. As an S corp, you are only responsible at the individual level.
You can also lower the self-employment tax as an S corp. Your taxable business income can be split into two components — salary and distribution. Only the salary is subject to the self-employment tax, while in the case of sole proprietorships, partnerships or LLCs, the self-employment tax is applicable on the entire net business income. You might be thinking, why take a salary at all? The IRS requires you take a “reasonable” salary before you can utilize the distribution tax break.
What does the C stand for in C-corporation (C corp)? You guessed it, it stands for “Subchapter C” or as some say “Corporation”. With C corporations, there can have be unlimited number of shareholders and all profits by the company are distributed to the shareholders. This means that the shareholders are subject to pay personal income taxes on the dividends they receive, in other words, they are double taxed. What percentage of dividends each shareholder pays is dependent on how many shares they own.
A C corporation’s tax liability is now a flat rate of 21%, down from the top rate of 35% before the Tax Cuts and Jobs Act of 2017. However, you are still paying a double tax, as the profit of a corporation is taxed to the corporation and then taxed to the shareholders when distributed as dividends.
This is the easiest type of small business to individual self-contractors and consultants. People who do business as sole proprietors do business under their own name using their own social security number. Sole proprietors are not legal entities like S corporations or C corporations, but a pass-through entity. In the end, sole proprietors can end up becoming a Limited Liability Company (LLC).
The self-employment tax rate is 15.3%, consisting of 12.4% for Social Security and 2.9% for Medicare. As a sole-proprietor, you may qualify for the new pass-through tax deduction that allows for up to 20% of net business income earned by sole proprietors. If you’re a sole proprietorship, you’ll need to keep excellent records to separate personal and business expenses. Separate bank accounts and credit cards are an easy way to track which expenses go where.
Limited Liability Company
The most popular business type is the Limited Liability Company (LLC). It is a business where the owners are not personally liable for the company’s debt or liabilities; therefore the word “liability” in LLC. You can view LLC’s as a hybrid that combine both corporate and sole proprietor.
LLCs can be a single or multiple-member LLC. Unlike sole proprietors, LLC’s are given an EIN (Employer Identification Number) in which you can use to file your taxes rather than filing under your social security number.
Summarized tax rates for small businesses:
- C-corporations: Flat 21% on net business income
- Double taxation: Taxed on the corporate and individual level
- S-corporations, Sole-proprietors and LLCs: 10% to 37% depending on filing status and income
- Sole proprietors and LLCs can deduct up to 20% of their business before their tax rate is calculated
- S-corporations can divide their net income into salary and distributions, avoiding self-employment taxes on distributions so long as they are paid a “reasonable” salary as deemed by the IRS
Settling on Your First Small Business Type
Opening up your first business can be very exciting, yet challenging and confusing. No matter how much you think you know about all the different types of small businesses and taxes, nothing can replace working with a seasoned tax professional.
If you are just starting your business or looking to start one, see Two Truths and a Lie: Small Business Idea Edition, an article on how even some off-sounding ideas can become successful businesses.