Virtually all businesses have to file a tax return, but whether they actually owe taxes on that return and what kind of taxes depend on several factors.
Tax rates and at least one deduction depend on whether your business is a "pass-through" tax entity. Income and deductions trickle down from these small business structures to be reported by their owners or shareholders on their personal returns – something you might want to consider if you're starting a business for tax purposes. Technically, it's not the business itself that pays taxes in this case, but taxes are paid all the same.
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Pass-through businesses include sole proprietorships, partnerships, LLCs and S corporations. C corporations are separate tax entities subject to their own tax rates.
The Net Income Formula
Determining whether taxes are due begins with completing Schedule C as part of your personal Form 1040 tax return if you have a pass-through business. This form determines your net business income – what's left and taxable after you've deducted your business expenses. You won't have to pay taxes if you arrive at a negative number – you had a business loss.
Your business expenses might include a home office or work space, allowing you to deduct a percentage of your rent or mortgage interest, utilities and insurance equal to the percentage of your home's square footage that you use exclusively for business purposes. You can also deduct the cost of tools or supplies, car or truck expenses, advertising costs and even legal costs.
The total remaining after these subtractions is your business income, to be transferred to your Form 1040.
Paying the Self-Employment Tax
You must file a tax return and pay the self-employment tax if the total of your business income after completing Schedule C is $400 or more. This tax is the equivalent of the FICA taxes – Medicare and Social Security – that you would normally share with your employer if you worked for someone else. Your employer would pay half and you would pay half, but you are the employer if you own a pass-through small business, so you must pay both halves.
The good news here is that you need only pay the Social Security portion of the tax up to a wage base of $137,700 annually. You would owe no Social Security on that extra dollar if your income was $137,701. And you can claim a tax deduction for half of your self-employment tax – the half your employer would have paid if you worked for someone else. This deduction is claimed on your tax return, not on Schedule C, so it doesn't reduce your business income but rather your overall income.
This requirement to pay self-employment tax doesn't necessarily mean that you'll owe income tax on your small business income, however. Remember – this income passes through to you, and you can claim the standard deduction or itemize your personal deductions when you file your tax return. The standard deduction is $12,400 for single taxpayers in 2020, so you would only owe an income tax if your small business earned you $12,401 or more after you complete Schedule C.
The Qualified Business Income Deduction
The IRS has one more gift for small business owners: the Qualified Business Income or QBI deduction. The rules for this one are a little tricky, but in simplest terms, the QBI deduction allows you to slice another 20 percent off your small business income if you qualify to claim it.
This deduction isn't claimed on Schedule C, either. You can deduct it on line 10 of your Form 1040 tax return, right after you claim the standard deduction or the total of your itemized deductions. Your total business income on Schedule C before this deduction might be $15,000, requiring you to pay taxes on $2,600 – the difference between the standard deduction and your income, but the QBI allows you to shave $3,000 or 20 percent off that $15,000. This drops your taxable income to $12,000, less than the standard deduction amount, so you would not owe income taxes.
The first major rule for this deduction is that C corporations don't qualify. Your small business must be a pass-through tax entity. Income limits apply as well, and some service trades don't qualify. You must file Form 8995 or Form 8995-A to claim the QBI deduction.