How Much Can a Small Business Make Before Paying Taxes?
A majority of small businesses are owned by individuals. Sole proprietorships, partnerships, S corporations, and Limited Liability Companies (LLCs) do not pay income taxes. Unless a specific election is made by a small business to be taxed as a C corporation, the IRS (Internal Revenue Service) considers these various entity types to be “pass-through” entities. Income from these entities is “passed through” to their owners and is taxed at the owners’ personal tax rates.
On average, small business owners pay an estimated effective tax rate of 19.8 percent. Calculate the effective tax rate by dividing the owner’s total tax paid by taxable income.
According to an SBA (Small Business Administration) report, the average effective tax rate for owners of sole proprietorships is 13.3 percent, the small partnerships rate is 23.6 percent, and the S corporation rate is 26.9 percent.
In addition to this income taxation, small business owners also face the prospect of self-employment taxes on their pass-through income. Also called FICA tax, self-employment tax which is a flat rate of 15.3 percent, encompassing Social Security (12.4 percent) and Medicare (2.9 percent). S corporation owners do not pay self-employment tax on pass-through income but are required to pay themselves a “reasonable” officer wage and will pay these taxes on the wage component of their business profits.
Determining your Small Business’ Taxable Income
For sole proprietorships, the most basic and easy business entity to set up, determining how much tax is due starts with completing a Schedule C that will be submitted along with your personal Form 1040 tax return. This form reports your income and allowable business deductions or “write-offs” and results in your calculated net business income. Obviously, if you arrive at a negative number, then you have had a business loss, which might be able to be used to offset other income.
Instead of filing a Schedule C, owners of partnerships and S corporations are required to file a separate tax return (Form 1065 or Form 1120s respectively) to report income and expenses of the business. These returns are considered “informational” and no tax is calculated on them. Owners will receive a K-1 form that shows that owner’s individual share of the business’ profits.
Remember that business expenses could include a home office or workspace. This permits you to deduct a percentage of your rent or mortgage interest, utilities, property taxes, and insurance equal to the percentage of your home’s square footage that you use only for business purposes. Additional write-offs can include tools, supplies, vehicle expenses, advertising costs, legal costs, and telephone and internet expenses.
The total remaining net income after these subtractions is your business income, which is transferred from your Schedule C or K-1 to your personal tax return (Form 1040).
Small businesses are required to maintain receipts, bank statements, or other records that will substantiate the reported business income and expenses.
How Much Can Your Small Business Make Before Paying Taxes?
There is no single formula or tax rate that entrepreneurs can rely on to calculate how much income a business can earn without having to pay taxes on it. There are too many factors that affect the determination of a business’ taxable earnings for any specific number to serve.
Additionally, your business income will be combined with other business and nonbusiness income on your tax return. On top of that, your filing status, potential itemized deductions, and other allowable deductions will all serve to determine your taxable income and resulting tax bracket. You might also have to consider whether the alternative minimum tax will apply to you and erase a portion of your deductions.
A tax professional can help you consider all of these factors to estimate what your tax liability might be based upon your estimated business profit. There are also tools and calculators available online that can help.
Any income (business or nonbusiness) above the standard deduction ($12,400 for single filers and $24,800 for a married couple) will result in income tax and any self-employment income over $400 will result in the previously mentioned self-employment tax.
In essence, credits decrease the tax owed on your taxable income and they can increase the amount of business income you can earn and not have to pay tax on. For example, assume you report $5,000 of taxable income – all of which relates to net business profits – and your effective tax rate is 10 percent. Your tax would be $500. If you also claimed a $500 American opportunity tax credit for your child’s college tuition, your tax bill would be eliminated by the credit and you would have been able to earn $5,000 of business income and not pay any income tax. Other common tax credits include the child tax credit ($2,000 per child under age 17 in 2020) and the child and dependent care credit for child care costs of working parents.
Some tax credits are “refundable,” meaning that any surplus credit after reducing your tax to zero would be refunded. The child tax credit and American opportunity tax credit are both partially refundable. In the example above, a $1,200 tuition credit would have resulted in a $700 refund. A $1,200 nonrefundable childcare credit would have only eliminated the $500 in tax and had no further effect.
The Qualified Business Income Deduction
Think of this deduction as a gift for your small business. Essentially, the Qualified Business Income, or QBI deduction, permits you to remove another 20 percent off your small business income if you qualify to claim it.
The deduction is not computed and applied on your Schedule C or other pass-through business tax return. Rather, the deduction is applied on line 10 of your Form 1040. A single business owner claiming the $12,400 standard deduction could earn up $15,500 and not pay any income tax thanks to this deduction. The QBI would cut 20%, or $3,100, of the business income and the standard deduction would eliminate the remaining taxable income. This business owner would, however, be subject to the 15.3% self-employment tax on the $15,500 of business income.
Eligibility for this deduction may be based upon your total taxable income and the nature of your small business. Furthermore, your small business has to be a “pass-through” tax entity. C corporations do not qualify. You will need to file Form 8995 or Form 8995-A in order to claim the QBI deduction.
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