How Are Business Taxes Calculated? A Detailed Breakdown

Businesses must pay taxes on their income, but how these taxes are calculated depends on several factors. Understanding taxable income and applicable deductions or credits helps reduce tax burdens legally. Errors in calculation or filing can lead to penalties, making it essential for business owners to grasp the basics.

Various components influence a company’s tax obligations, including revenue, expenses, federal tax rates, and filing requirements. Knowing how these elements interact ensures compliance and helps avoid costly mistakes.

Business Entity Types

A business’s structure affects taxation, paperwork, and owner liability. Sole proprietorships, the simplest form, do not create a separate legal entity, meaning the owner reports business income on their personal tax return using Schedule C of Form 1040. This setup avoids corporate taxes but subjects earnings to a 15.3% self-employment tax, covering Social Security and Medicare.

Partnerships pass income and losses to partners, who report them on individual tax returns. While the business itself does not pay income tax, it must file Form 1065 to report financial activity. Each partner receives a Schedule K-1 detailing their share of profits, losses, and deductions. Limited liability companies (LLCs) offer flexibility, as they can be taxed as sole proprietorships, partnerships, or corporations, depending on IRS elections.

Corporations, classified as C corporations or S corporations, face different tax treatments. C corporations are separate tax entities, filing Form 1120 and paying a flat 21% corporate income tax. Shareholders also pay taxes on dividends, leading to potential double taxation. S corporations pass income to shareholders, avoiding corporate tax but requiring compliance with IRS rules, such as a 100-shareholder limit and restrictions on ownership types.

Calculating Taxable Income

Taxable income is determined by subtracting allowable deductions from total revenue. This includes revenue, cost of goods sold, deductible expenses, and tax credits.

Revenue

Revenue includes all income earned before expenses, such as sales, rental income, interest, and dividends. Businesses report revenue using either the cash or accrual accounting method.

Under the cash method, income is recognized when received, while the accrual method records revenue when earned, regardless of payment timing. The IRS requires businesses with average annual gross receipts exceeding $27 million (as of 2024) to use the accrual method. Businesses must also account for returns, allowances, and discounts, which reduce total revenue. For example, if a company sells $500,000 worth of products but issues $20,000 in refunds, its net revenue is $480,000.

Cost of Goods Sold

Cost of Goods Sold (COGS) includes direct expenses related to producing or purchasing goods for sale, such as raw materials, direct labor, and manufacturing overhead. Businesses that sell physical products must calculate COGS to determine gross profit, which is revenue minus COGS.

The IRS allows different inventory valuation methods, including First-In, First-Out (FIFO), Last-In, First-Out (LIFO), and the weighted average cost method. Each method affects taxable income differently. In an inflationary environment, LIFO results in higher COGS and lower taxable income, while FIFO does the opposite. Businesses must consistently apply their chosen method and report inventory changes on Form 1125-A.

Deductible Expenses

Businesses can deduct ordinary and necessary expenses incurred in operations. Ordinary expenses are common in the industry, while necessary expenses are helpful and appropriate for the business. Common deductions include rent, utilities, employee wages, insurance, depreciation, and marketing costs.

Certain expenses have specific tax treatment. Business meals are generally 50% deductible, while entertainment expenses are not deductible. Depreciation allows businesses to recover the cost of long-term assets over time, with options like the Modified Accelerated Cost Recovery System (MACRS) or Section 179 expensing, which permits immediate deduction of qualifying asset purchases up to $1.22 million in 2024. The IRS may require documentation to substantiate deductions, making record-keeping essential.

Tax Credits

Tax credits directly reduce a business’s tax liability. Some credits are refundable, meaning they can generate a refund if they exceed the tax owed, while others are nonrefundable and only reduce taxes to zero.

Common business tax credits include the Research and Development (R&D) Credit, which allows businesses to claim a percentage of qualified research expenses. The Work Opportunity Tax Credit (WOTC) provides incentives for hiring individuals from targeted groups, such as veterans or long-term unemployed individuals. Small businesses offering health insurance may qualify for the Small Business Health Care Tax Credit, covering up to 50% of premiums paid for employees. To claim these credits, businesses must meet eligibility criteria and file the appropriate forms, such as Form 6765 for the R&D Credit or Form 5884 for the WOTC.

Federal Tax Rates and Brackets

A business’s tax liability depends on taxable income and applicable tax rates. The U.S. uses a progressive tax system for individuals and pass-through entities, while corporations are subject to a flat tax rate.

For pass-through entities—such as sole proprietorships, partnerships, and S corporations—tax liability is determined by individual tax brackets. The IRS adjusts these brackets annually for inflation. In 2024, individual rates range from 10% to 37%, with the highest rate applying to taxable income exceeding $609,350 for single filers and $731,200 for married couples filing jointly.

C corporations are taxed at a flat 21% rate. Unlike pass-through entities, corporations do not benefit from lower tax brackets on smaller amounts of income. However, they can take advantage of deductions unique to corporations, such as the dividends received deduction, which allows them to exclude a portion of dividends received from other taxable U.S. corporations.

Businesses eligible for the Qualified Business Income (QBI) deduction can reduce taxable income by up to 20%. This deduction applies to pass-through entities but is subject to income limits and business type restrictions. In 2024, the deduction begins to phase out for single filers earning more than $232,100 and joint filers exceeding $464,200. Certain service-based businesses, such as law and accounting firms, face additional limitations.

Filing Schedules and Methods

The IRS requires different forms and deadlines depending on a business’s structure and tax obligations. Businesses required to make estimated tax payments, such as sole proprietors and corporations expecting to owe at least $500 or $1,000 respectively, must make quarterly payments using Form 1040-ES or Form 1120-W. These payments are due on April 15, June 15, September 15, and January 15 of the following year.

Employers must withhold payroll taxes and submit them through the Electronic Federal Tax Payment System (EFTPS), with deposit schedules varying based on total tax liability.

State and local tax filings add complexity, as businesses operating in multiple jurisdictions may face apportionment rules under the Uniform Division of Income for Tax Purposes Act. Some states require franchise or gross receipts taxes, which must be filed separately from income tax returns. Businesses engaged in international transactions must comply with IRS transfer pricing regulations, ensuring intercompany transactions are conducted at arm’s length.

Late or Incorrect Filing Consequences

Failing to file business taxes on time or submitting incorrect information can result in penalties, interest charges, and legal consequences.

The failure-to-file penalty is 5% of the unpaid taxes per month, up to a maximum of 25%. If a return is more than 60 days late, the minimum penalty is either $485 or 100% of the unpaid tax, whichever is lower. The failure-to-pay penalty accrues at 0.5% per month on the unpaid balance, also capped at 25%. If both penalties apply in the same month, the failure-to-file penalty is reduced to 4.5%. Interest on unpaid taxes compounds daily based on the federal short-term rate plus 3%.

Businesses that submit incorrect returns may face accuracy-related penalties of 20% of the underpaid amount. If fraud is involved, the penalty increases to 75%. In extreme cases, criminal charges can be pursued, carrying potential fines and imprisonment. The IRS offers penalty relief options, such as the First-Time Penalty Abatement program. Filing extensions using Form 7004 can prevent late filing penalties but do not extend the deadline for tax payments.