How Much Income Can a Small Business Make Before Paying Taxes?
If you own part of or an entire business you may have asked yourself how much money can the business make before paying taxes?
The answer: no matter what type of businesses you have, you will always have to pay some amount of tax if you are running a profitable company.
So the key becomes how low can you get this tax liability while running a profitable business? The numerous small business tax breaks & deductions available to small business owners offer a large amount of relief by reducing the taxable nature of many facets of your business operations.
Pass-Through Businesses: What are they, and why are they important?
When it comes to taxation of income, there can be many factors based on the type of firm, and business one has. Business firms are basically of two types such as:
- Pass-Through Entities – many if not most small businesses fall into this category.
- C-Corporations – typically has its own set of tax issues we are not covering here
Let’s talk about Pass-Through Entities first!
Pass-Through Entities are businesses that “pass” their income through the business to their owners and investors. This means that the profits and income of the business are taxed in accordance to the owner’s or partner’s individual tax situation. In such a business entity, the taxes are not paid by the company itself, but the owners and investors file their individual tax returns as they are the one that gets the revenue. In short, the pass-through entities are typically used as a way to avoid the double taxation C-Corporations have to deal with.
C-Corporations have to pay corporate tax (currently set at a flat 21%), and in addition the shareholders pay taxes on their individual incomes. Hence, taxation happens twice. Since this likely doesn’t apply to most of our readers, we want to focus on the pass through entities.
If we talk about the types of pass-through entities, they can be classified into four basic categories:
If you are the business owner, all the tax responsibility falls on your shoulders. It is necessary to keep your business and personal expenses separated to avoid any tax trouble. All the expenses and taxes are reported via form 1040, with the exception of a few specific business types – like real estate.
Limited Liability Company
In an LLC, a firm’s profits and losses are passed on to its members and shareholders that pay their individual tax as per the tax brackets. However, it is not necessary for an LLC to be taxed based on their member’s income. They can instead elect special taxation treatment as certain types of corporations or partnerships. The individual members of the LLC are, however, subject to self-employment tax on their net earnings.
Limited partnerships file for entity-level tax return through form 1065. As the profit is distributed to the partners, the business’s general partners pay self-employment tax on all of their earnings. On the other hand, the limited partners pay only on the guaranteed payments.
This type of pass-through entities files their “corporate” tax return via the 1120S Form. However, as the profits are distributed across shareholders, and they are reported individually via form 1040. As a pro-tip from experience, we think that with a creative CPA this can often be the best type of structure when you start making profits of over $15,000 or so per year.
While all of these business entities are considered pass-through entities, each has minor differences. So be sure to confirm the best choice with your CPA for your specific situation
Schedule C and Net Income
We all know that legitimate taxes need to be paid, one way or the other. But, how does a business owner know how much?
Schedule C is a tax form that helps the owner of a pass-through entity know the overall profit and determine how much tax he or she needs to pay. After entering all of the business expenses and revenue, the net profit or loss is then listed on the 1040 form for the owner’s tax filing.
Some of the most common business expenses that can be deducted on the Schedule C include:
- Rent or mortgage of office space
- Advertising cost
- Medical cost
- Legal costs
- Office supplies
- Other Business Expenses
These expenses need to be tracked by the owners of the business throughout the year. If all the expenses total more than the overall income, the number will be negative. This implies a loss in the business; thus, you don’t have to pay any taxes. In some cases, this can even reduce the tax you pay on other sources of income.
As the title states this tax is for those who work independently or have an employer. We will explain the two scenarios later but let us take a look at the conditions that need to be fulfilled to pay the self-employment tax.
Here they are:
- If you are an independent worker (self-employed) and have net earnings of $400 and over in Schedule income , you are required to pay 15.3% of the total profit. For instance, if you make a profit of $56,000 and your expenses are $55,900. You won’t owe any tax on that remaining $100. On the other hand a more realistic scenario may be closer to earning $56,000 and your costs to make that add up to $47,000, the balance of $9,000 will be levied with self-employment tax, along with the regular tax due as the type of business structure you have chosen.
- If you are an employee working for any employer, both of you will pay the net self-employment tax. The tax will be split equally as 6.4% and 1.45% for a total of 7.95% for both the employee and the employer. This means that if you employ others, you will pay the 7.95% half of the tax for your employees as well.
- Another notable condition that impacts tax is if you work for the church or an organization controlled by the church. You will be required to pay the SE tax if you receive an income of $108.28 or over.
Note: The self-employment tax of 15.3% is split into 12.4% for social security and 2.9% for Medicare.
Apart from these conditions, some positive points may help in decreasing your taxes. As per 2020 small business tax breaks, you are required to pay 15.3% of the total income on all income up to 137,700. However, if it goes above $137,700, then the tax rate drops to only the 2.9% (Medicare part) of the self-employment tax.
For the year 2021, the IRS has updated the maximum taxable base to $142,800. Hence, if your income falls below it, you have to pay 15.3% of $142,800. In case you are an employee, you just need to pay 7.65%; your employer will pay the rest.
Qualified Business Tax Deduction (QBI)
This is a newer deduction that has been recently introduced by the IRS. The sole purpose of introducing this deduction is to reduce tax liability. It is applicable in the case of S corporations, partnerships, and sole proprietorships.
Using this, the business owners or eligible taxpayers can deduct 20% of their qualified business income. This helps them save more as the total taxable amount gets decreased.
Here are some parameters to be eligible for QBI deduction:
- If the taxable income is below $326,600 for a married couple filing the return jointly or $163,300 for any other filing status. You can claim a flat deduction of 20% on your qualified business income.
- If the taxable income is between $326,600 and $426,600 for a married couple filing the return jointly or $163,300 and $213,300 for any other filing status, there will be limitations to take care of before calculating the deduction. These limitations are the W-2 wage limitation and the W-2 wage and unadjusted basis limitation. They need to be calculated to get the final deduction amount.
- If the taxable income is above $426,600 for a married couple filing the return jointly or $213,000 for others, you are not eligible for QBI deduction.
Note: The numbers above are based on 2020 tax regulations, so be sure to review with your CPA any current numbers.
Certain businesses do not qualify for the QBI deduction if they are “service” type of businesses such as: health, law, accounting, athletics, and many more.
The Bottom Line
So how much can a small business make before paying taxes? Well, the simple answer is that the profit of the company assigned to a business owner has to be less than the standard tax deductions available to that owner.
As far as the necessity of paying taxes is concerned, you should take it seriously. Even if you don’t owe any taxes, it is necessary to file a return, or you may end up in legal trouble with the IRS, so keep this article handy in the future, and always work with a CPA to plan ahead of the end of year so that you can reduce your tax liability as much as possible.