How Are Small Businesses Taxed? A Beginner's Guide

Taxes are the number-one source of stress for new business owners, mostly because nobody explains the big picture. Here it is in plain language.

Federal taxes depend on your structure

Sole proprietorships and single-member LLCs Business profit flows to your personal tax return on Schedule C. You pay federal income tax on that profit plus self-employment tax (Social Security and Medicare). The business itself doesn't pay a separate federal income tax.

Multi-member LLCs and partnerships The business files an informational return (Form 1065) and gives each owner a Schedule K-1. Each owner reports their share of profit on their personal return and generally pays self-employment tax on it.

S corporations (including LLCs that elect S-corp status) The business files Form 1120-S. Owners who work in the business must pay themselves a reasonable salary through payroll. Remaining profit passes through on a K-1 and isn't subject to self-employment tax. This is why S-corp status can save tax once profits are high enough.

C corporations The corporation pays its own federal income tax. Owners pay tax again on dividends they receive. Most very small businesses don't start as C corporations.

"Pass-through" taxation

Sole proprietorships, partnerships and S corporations are called pass-through entities because profit passes through to the owners' personal returns. Many pass-through owners also qualify for the Qualified Business Income (QBI) deduction, which can deduct up to 20% of qualified business income.

You pay tax on profit, not on what you take home

This catches many new owners off guard. If your business makes $60,000 in profit and you only transfer $30,000 to your personal account, you still owe tax on $60,000.

You pay during the year

There's no employer withholding tax from your business income, so the IRS expects quarterly estimated tax payments. Skipping them can lead to penalties.

Washington State taxes

Washington has no personal income tax on wages or business profit. Instead, businesses deal with:

• Business & Occupation (B&O) tax: a tax on gross receipts (revenue), not profit. Many small businesses owe little or nothing thanks to the small business credit and filing thresholds.
• Retail sales tax: collected from customers on taxable goods and services and sent to the state.
• Use tax: owed on taxable items you buy for the business without paying Washington sales tax.
• City B&O taxes: some cities, including Seattle and Bellevue, have their own.
• Employer taxes and premiums if you have employees.

A simple rule of thumb

Many owners set aside 25% to 30% of profit for federal taxes, then adjust once they know their real numbers. Your actual rate depends on your income, deductions and entity type.

The bottom line

Your structure determines how you're taxed federally, and your activity determines what you owe Washington. Learn the basics, make quarterly payments, and get professional help the first year so you start with the right setup.

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Need help getting this right? TRIG Bookkeeping & Tax Services helps new business owners in Washington with company registration, monthly and annual bookkeeping, and government compliance. Contact us to talk about your business.

This article is general information, not legal or tax advice for your situation. Tax rules and fees change, so confirm current details with the IRS, the Washington Department of Revenue, or a qualified professional.