Small Business Tax Basics

Starting a small business is an exciting venture, but it comes with important tax responsibilities. Understanding the basics of federal, state, and local tax obligations—as well as how your business structure affects your taxes—can help you avoid surprises and set your business up for success.

What Qualifies as a “Small Business”?

For federal tax purposes, a “small business” is generally an independently owned and operated entity that is not dominant in its field and meets size standards set by the Small Business Administration (SBA). These standards are based on either the number of employees or annual receipts and vary by industry. For example, many businesses qualify if they have fewer than 500 employees or average annual receipts below a certain threshold. Some tax provisions use different thresholds, such as $5 million or $25 million in gross receipts, depending on the benefit or program in question.

Overview of Federal, State, and Local Tax Obligations

  • Federal Taxes: All small businesses must file annual income tax returns. The form you use depends on your business structure. If you have employees, you must also pay employment taxes (Social Security, Medicare, and federal unemployment taxes). Some businesses may owe excise taxes on certain products or activities. You’ll also need to issue Forms 1099 to contractors and W-2s to employees.

  • State Taxes: Most states require businesses to pay income or franchise taxes, sales and use taxes (if you sell goods or certain services), and state employment taxes. Some states offer special credits or incentives for small businesses, and requirements can vary widely.

  • Local Taxes: Cities and counties may impose business license taxes, gross receipts taxes, or local sales taxes. You may also need to register your business locally and comply with additional regulations.

Business Structures and Their Tax Differences

  • Sole Proprietorship: The simplest structure. All business income and expenses are reported on your personal tax return (Schedule C of Form 1040). You pay income tax and self-employment tax on all net earnings.

  • Limited Liability Company (LLC): By default, a single-member LLC is taxed like a sole proprietorship, while a multi-member LLC is taxed like a partnership. LLCs can also elect to be taxed as S-corporations or C-corporations. LLCs offer flexibility in allocating income and losses among members.

  • S-Corporation: A pass-through entity. Income, deductions, and credits flow through to shareholders, who report them on their personal returns. Shareholder-employees must be paid a reasonable salary (subject to payroll taxes), and remaining profits are distributed as dividends, which are not subject to self-employment tax. S-corps have restrictions on ownership and stock structure.

  • Partnership: Owned by two or more people. Income, deductions, and credits are allocated among partners and reported on their individual returns. General partners pay self-employment tax on their share; limited partners generally do not, except on guaranteed payments.

How Business Income Is Taxed

For most small businesses (sole proprietorships, partnerships, S-corporations, and most LLCs), business income is not taxed at the business level. Instead, it “passes through” to the owners, who report and pay tax on their share of the income on their personal tax returns. Sole proprietors and general partners pay self-employment tax on their earnings, while S-corporation shareholders pay employment tax only on their wages, not on pass-through profits. Many owners may also qualify for a deduction of up to 20% of qualified business income through 2025.

Conclusion

Understanding your tax obligations and how your business structure affects your taxes is essential for every small business owner. Consult IRS resources and your state/local agencies for specific requirements, and consider seeking professional advice as your business grows.

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