Growing your income is one part of building wealth, but understanding how that income is taxed (and how to manage it correctly) is just as important. For many business owners, taxes are among the most significant ongoing expenses. Having a clear picture of how business income is taxed can give you helpful context for long-term financial planning and informed decision-making.
Keep reading for a general overview of how business taxes work and how business owners can think about building tax-efficient habits over time.
How Business Income Is Taxed
Small businesses may encounter several types of taxes depending on their structure and operations. While exact obligations vary, the following categories commonly apply:
Income Tax
Most businesses must file a federal income tax return each year. Partnerships typically file an informational return, while the individual partners report the income on their personal returns.
The specific forms you’ll need to fill out will depend on the legal structure of your business. For example, a sole proprietorship files differently from a corporation.
Self-Employment Tax
People who operate as sole proprietors or partners generally pay self-employment taxes, which cover Social Security and Medicare contributions. The current combined rate is 15.3%.
Employment Taxes
Businesses with employees, whether sole proprietors, partnerships, or corporations, are responsible for wage-related taxes, including withholding and payroll taxes.
Excise Taxes
Some goods and services are subject to excise taxes, including specific fuels, indoor tanning services, various equipment types, and items designated as “sin” goods. Some excise taxes are levied to discourage certain frowned-upon activities, or at least make them more expensive. These taxes can apply to businesses across different structures.
Sales Tax
Businesses selling taxable goods or services may need to collect and remit sales tax. Rates, rules, and deadlines vary by state and locality.
State and Local Taxes
Depending on location, businesses may also be subject to property taxes, state income taxes, franchise taxes, and other local assessments.
Revenue vs. Profit: What’s Actually Taxed?
Understanding taxable income begins with distinguishing revenue from profit:
- Revenue: Total earnings before expenses.
- Profit: Revenue minus allowable expenses.
Businesses are typically taxed on profit, not total revenue. Tracking business expenses accurately, from your office rent to supplies, is critical for determining the correct taxable amount.
The Building Blocks of Tax-Efficient Wealth
Tax efficiency is less about finding shortcuts and more about adopting consistent, organized practices that support more transparent financial decision-making over time.
1. Practical Cash Flow Organization
Keeping business and personal finances separate can make it easier to track spending, maintain cleaner records, and identify legitimate business expenses. Precise recordkeeping supports accurate reporting and helps reduce surprises during tax season.
2. Understanding Deductions and Credits
Business owners often encounter several categories of deductions and credits. These can vary based on business activities, structure, and expenses.
Common deduction categories include:
- Business expenses: Costs associated with operating the business, including rent, wages, utilities, office supplies, equipment, and advertising.
- Depreciation: Certain property purchases may be depreciated over multiple years, depending on IRS rules.
- Home office considerations: Individuals running a business from home may be eligible for home office deductions when the space is used regularly and exclusively for business.
Examples of credits:
Credits can reduce tax liability on a dollar-for-dollar basis. A few examples include:
- Work Opportunity Tax Credit: Businesses that hire individuals from eligible groups could be eligible for this credit.
- Employer-Provided Childcare Credit: For businesses assisting with employee childcare costs.
- Small Business Health Care Tax Credit: Eligible employers offering health insurance to employees could potentially take advantage of this credit.
The availability and requirements for deductions and credits can change over time, so referring to current IRS guidance or consulting a qualified tax professional can help ensure accurate reporting.
3. A Long-Term View of Tax Efficiency
Tax efficiency isn’t just about the current year. Instead, you’ll need a long-term view that involves understanding how different types of income may be taxed over time. Earnings from business operations, interest, dividends, or capital gains may each be treated differently under the tax code, and dividend payments are not guaranteed and may be reduced or eliminated at any time by the company.
Business owners often consider:
- How income is earned
- Where income is saved or reinvested
- When income might eventually be withdrawn or recognized
Since tax laws evolve, periodically reviewing your overall approach with a qualified tax professional can help ensure your planning aligns with current regulations.
Turning Business Success Into Long-Term Financial Stability
Building long-term wealth often requires more than operating or eventually selling a business. Businesses can experience fluctuations, and future income is not guaranteed. Developing a structured approach to managing profits supports your long-term financial stability and wealth management.
Tax advisors, financial planners, and other professionals can offer general guidance on areas like:
- Evaluating long-term income needs
- Organizing assets for clearer planning
- Understanding general withdrawal considerations in retirement
- Reviewing options for saving or investing in alignment with personal financial goals
These professionals can also help business owners remain compliant with reporting requirements and stay informed about evolving tax requirements.
General Considerations for Business Owners
While every business owner’s financial picture is different, the following concepts may be helpful to think about:
Clarifying Long-Term Goals
Having a general sense of future financial needs, like the amount of retirement income you’ll need, can provide useful direction for planning and help you begin with the end in mind.
Creating a Sustainable Income Approach
A structured framework for drawing income (especially after selling or stepping back from a business) can help manage cash flow in retirement years.
Understanding Sources of Income
Some business owners explore ways to generate income beyond active operations, such as building diversified income sources over time. Before you make any investment decisions, get a clear understanding of the risks, potential volatility, and your personal financial circumstances.
Final Thoughts
Tax-efficient wealth building is not about loopholes; it’s about informed decision-making, consistent organization, and an understanding of how business income is treated.
Consulting with qualified tax and financial professionals, like a CPA or CFA, can help business owners stay aligned with current regulations and develop informed, long-term financial strategies tailored to their individual circumstances and long-term goals.
Disclaimer: There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. Content in this material is for general information only and is not intended to provide specific advice or recommendations for any individual. All investing involves risk, including loss of principal. No strategy ensures success or protects against loss.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
Dividend payments are not guaranteed and may be reduced or eliminated at any time by a company.
