How Much Can a Small Business Make Before Paying Taxes?

Determining Business Taxable Income

Understanding how much a small business can earn before paying taxes starts with taxable income. A business pays tax on its profit, not its total revenue. Taxable income is the amount remaining after subtracting allowable business expenses from gross income. This net profit is the portion of earnings subject to taxation. The more expenses a business incurs, the lower its taxable income will be, potentially reducing its tax burden.

How Business Structures Affect Taxation

The way a small business is structured significantly determines how its income is taxed at the federal level. Different legal entities have distinct mechanisms for reporting profits and losses, impacting who ultimately pays the income tax. These structures dictate whether the business itself pays taxes or if the income “passes through” to the owner’s personal tax return.

For a sole proprietorship, and a single-member limited liability company (LLC) treated as a disregarded entity for tax purposes, business income or loss is reported directly on the owner’s individual tax return. This is typically done on Schedule C (Form 1040), Profit or Loss From Business. All profits are subject to the owner’s individual income tax rates.

Partnerships and multi-member LLCs operate as pass-through entities, meaning business income is not taxed at the entity level. The partnership files an informational return, Form 1065, U.S. Return of Partnership Income, to report its financial activity. Profits and losses are then allocated to individual partners or members based on their ownership percentages and reported to them on Schedule K-1 (Form 1065). Each partner or member includes their share of the business’s income on their personal Form 1040, where it is subject to their individual income tax rates.

An S corporation also functions as a pass-through entity, avoiding corporate-level income tax. It files Form 1120-S, U.S. Income Tax Return for an S Corporation, and reports income and losses to shareholders on Schedule K-1 (Form 1120-S). Owner-employees must be paid a reasonable salary for services performed, which is subject to payroll taxes. Any remaining profits can be distributed as non-salary distributions, which are not subject to self-employment tax.

Conversely, a C corporation is a separate legal entity subject to corporate income tax on its profits. This entity files Form 1120, U.S. Corporation Income Tax Return, and pays taxes at the corporate tax rate. If the C corporation then distributes its after-tax profits to shareholders as dividends, those dividends are taxed again at the individual shareholder level. This scenario is commonly referred to as “double taxation.”

Reducing Your Taxable Income with Deductions and Credits

Many strategies exist for small businesses to reduce their taxable income, primarily through legitimate deductions and tax credits. Business deductions lower the amount of profit subject to tax, while tax credits directly reduce the amount of tax owed.

Businesses can deduct ordinary and necessary expenses incurred during the tax year. An ordinary expense is common and accepted in the particular industry, while a necessary expense is helpful and appropriate for the business. Common deductible expenses include:
Rent for office space
Utility payments
Salaries and wages paid to employees
Cost of supplies
Advertising and marketing costs
Professional fees for legal or accounting services
Business travel expenses

Vehicle expenses related to business use, such as mileage or actual costs for gas, oil, and repairs, can also be deducted. For those operating a business from their home, the home office deduction allows a portion of home expenses, like mortgage interest, rent, utilities, and insurance, to be deducted if a specific area of the home is used exclusively and regularly for business. Large asset purchases, such as equipment or machinery, are expensed over their useful life through depreciation.

Startup costs incurred before a business begins active operations are generally capitalized. These costs can be amortized, meaning they are deducted over a period of 180 months, starting with the month the business begins. Various federal tax credits can further reduce a business’s tax bill. The general business credit, for instance, is a combination of several individual credits, and credits may also be available for hiring certain targeted groups or for qualified research and development activities.

The Qualified Business Income (QBI) deduction, under Section 199A of the Internal Revenue Code, allows eligible self-employed individuals and small business owners to deduct up to 20% of their qualified business income. This deduction applies to income from a qualified trade or business operated as a sole proprietorship, partnership, S corporation, or certain trusts. The availability and amount of the QBI deduction can depend on factors such as taxable income and the type of business.

Owner Tax Responsibilities for Small Businesses

For many small business owners, particularly those operating as sole proprietors, partners, or S corporation shareholders, tax responsibilities extend beyond the business entity itself to their personal tax obligations. These owners are directly responsible for paying taxes on the business’s profits, which are often not subject to traditional withholding.

A significant obligation for owners of pass-through entities is self-employment tax. This tax covers Social Security and Medicare contributions for individuals who work for themselves. It applies to the net earnings from self-employment, which is 92.35% of the business’s net profit. The self-employment tax rate is 15.3% on earnings up to the Social Security wage base, and 2.9% for Medicare on all net earnings.

Since income from pass-through businesses is not subject to employer withholding, owners are required to pay estimated taxes quarterly. These payments ensure that tax obligations for income and self-employment taxes are met throughout the year, rather than as a single lump sum at tax filing time. Estimated tax payments are due on April 15, June 15, September 15, and January 15 of the following year.

The amount of estimated tax to pay is based on the owner’s anticipated income, deductions, and credits for the year. Failure to pay enough estimated tax throughout the year can result in penalties. Profits from pass-through entities are added to any other personal income, such as wages or investment income, and are subject to the owner’s individual income tax rates as determined by their total taxable income.