Do Entrepreneurs Pay Less Taxes Than Other Professionals?

Tax obligations vary depending on how income is earned. Entrepreneurs often benefit from tax deductions unavailable to traditional employees, creating the perception that they pay less in taxes. However, their tax burden depends on several factors, including business structure, deductions, self-employment taxes, and income levels.

Factors Influencing Entrepreneurial Tax Rates

An entrepreneur’s tax liability depends on income classification, tax credits, and compliance with federal and state regulations. Unlike salaried employees, who have taxes withheld from their paychecks, business owners must manage estimated tax payments, self-employment taxes, and varying tax rates based on how their earnings are categorized. The IRS differentiates between active business income, capital gains, and dividends, each taxed differently.

State and local taxes also impact liability. California’s top marginal income tax rate is 13.3%, while Texas and Florida impose no personal income tax. Some cities, including New York City, levy additional business taxes, complicating tax obligations further.

Tax credits can reduce liabilities, but eligibility depends on business activities. The Qualified Business Income (QBI) deduction under Section 199A allows eligible pass-through entities to deduct up to 20% of their income, though it phases out for high earners. Other credits, such as the Research and Development (R&D) credit and the Work Opportunity Tax Credit (WOTC), further lower tax burdens if used properly.

Legal Structures

A business’s legal structure determines tax treatment, income reporting, and liability exposure. Entrepreneurs must consider how each structure affects self-employment taxes, corporate levies, and available deductions.

Sole Proprietorship

A sole proprietorship is the simplest business structure, where the owner and business are legally the same entity. Income and expenses are reported on Schedule C of Form 1040, and profits are subject to both income tax and self-employment tax at a combined rate of 15.3% (12.4% for Social Security and 2.9% for Medicare). An additional 0.9% Medicare surtax applies to earnings above $200,000 ($250,000 for married couples filing jointly).

Sole proprietors can deduct business expenses such as home office costs, vehicle expenses, and health insurance premiums. However, they lack liability protection, putting personal assets at risk. Estimated quarterly tax payments are required if total tax liability exceeds $1,000 annually, with penalties for underpayment.

Partnership

A partnership involves two or more individuals sharing ownership, with income and losses passing through to partners based on their ownership percentage. Partnerships file Form 1065 to report earnings, but taxes are paid at the individual level via Schedule K-1. General partners pay self-employment tax on their share of business income, while limited partners only pay self-employment tax on guaranteed payments.

General partners have unlimited liability, while limited partners have liability protection but reduced management authority. Partnerships can deduct business expenses, including salaries, rent, and depreciation. They may also qualify for the QBI deduction, though phaseouts begin at $191,950 for single filers and $383,900 for joint filers in 2024.

Limited Liability Company

A Limited Liability Company (LLC) provides liability protection and flexible tax treatment. By default, a single-member LLC is taxed as a sole proprietorship, while a multi-member LLC is treated as a partnership. LLCs can elect to be taxed as an S corporation or C corporation by filing Form 2553 or Form 8832.

LLC owners pay self-employment tax on their share of profits unless they elect S corporation status, in which case only wages paid to the owner are subject to payroll taxes, while remaining profits are treated as distributions. This strategy can reduce tax liability but requires paying a reasonable salary to the owner. LLCs can deduct business expenses, including depreciation, health insurance premiums, and retirement plan contributions. State-level LLC fees vary, with California imposing an $800 minimum franchise tax plus additional fees for LLCs earning over $250,000.

Corporation

Corporations provide the strongest liability protection but have more complex tax structures. A C corporation (C-corp) is subject to a flat 21% federal corporate tax rate, with dividends taxed again at the shareholder level at rates ranging from 0% to 20%, plus a 3.8% Net Investment Income Tax (NIIT) for high earners.

An S corporation (S-corp) avoids double taxation by passing income through to shareholders, similar to a partnership, but must adhere to IRS requirements, including a limit of 100 shareholders and only one class of stock. Shareholders who actively work in the business must receive reasonable salaries, subject to payroll taxes, while remaining profits are distributed as dividends, avoiding self-employment tax.

Corporations can deduct employee salaries, benefits, and business expenses. C-corps can retain earnings for reinvestment without immediate tax consequences, though accumulated earnings beyond $250,000 ($150,000 for personal service corporations) may trigger a 20% Accumulated Earnings Tax. Compliance requirements include filing Form 1120 for C-corps and Form 1120-S for S-corps, with penalties for late filings.

Common Business Tax Deductions

Businesses can deduct various expenses to lower taxable income. Employee compensation, including salaries, wages, and bonuses, is fully deductible as long as it is reasonable and necessary. Employer-paid payroll taxes, such as Social Security, Medicare, and unemployment taxes, also qualify. Businesses offering retirement plans can deduct contributions, subject to annual IRS limits.

Professional service fees, including payments to attorneys, accountants, and consultants, are deductible if directly related to business activities. Legal fees for contract drafting or intellectual property protection qualify, while those related to personal matters do not. Accounting fees for tax preparation and audits are deductible, but penalties for late tax filings or underpayment are not.

Marketing and advertising expenses, including digital advertising, social media campaigns, website development, and traditional ads, are deductible if intended to generate revenue. Promotional costs, such as sponsoring industry events or providing branded merchandise, also qualify. However, lobbying expenses or payments made to influence legislation are non-deductible.

Interest expenses on business loans and lines of credit can be deducted, though businesses with average gross receipts exceeding $29 million over the past three years face a 30% limitation on adjusted taxable income. Smaller businesses can fully deduct interest on loans used for equipment, real estate, or working capital. Business credit card interest is deductible if the card is used exclusively for business transactions.

Depreciation allows businesses to recover costs for long-term assets. Businesses can immediately deduct up to $1.22 million in 2024 for qualifying property, such as machinery and office equipment. Bonus depreciation allows 60% expensing of eligible assets placed in service in 2024. Intangible assets, such as patents and trademarks, must be amortized over 15 years.

Self-Employment Tax Requirements

Self-employed individuals must pay self-employment tax, covering Social Security and Medicare, at a rate of 15.3%. Unlike traditional employees, they bear the full tax burden and must report it using Schedule SE.

Estimated quarterly tax payments are required if total tax liability exceeds $1,000 for the year. These payments are due on April 15, June 15, September 15, and January 15 of the following year. Failure to pay on time results in penalties. To avoid underpayment penalties, many entrepreneurs follow the safe harbor rule—paying either 100% of the prior year’s tax liability (110% for high earners above $150,000) or 90% of the current year’s expected tax.

How Earnings Affect Overall Obligations

Higher earnings increase tax liability, triggering additional taxes, phaseouts of deductions, and increased compliance requirements. The QBI deduction phases out above $191,950 for single filers and $383,900 for joint filers in 2024. The 3.8% Net Investment Income Tax applies to passive income for individuals earning above $200,000 ($250,000 for married couples). High earners may also face the Alternative Minimum Tax (AMT), which limits certain deductions. Structuring income effectively, such as balancing salary and distributions in an S corporation or deferring revenue through retirement contributions, can help reduce tax burdens.