How Federal Taxes Work

By: Dave Roos

Business Income Taxes

Businesses are subject to income taxes, just like individuals. The amount of income tax a business pays depends on how much it earns and how it's structured. The IRS requires different tax forms and charges different tax rates for sole proprietorships, partnerships, C corporations, S corporations and limited liability companies (LLC). Nonprofit organizations -- those that successfully apply for 501(c) status -- pay no federal income taxes at all.

A sole proprietorship is a business owned and operated by a single person. In this case, the IRS treats all business income as personal income, so everything is taxed at the personal income tax rate. Since a sole proprietor is also self-employed, he or she will also have to pay self-employment tax to cover Social Security and Medicare contributions.


A partnership is when two or more people jointly own a small business. The partnership itself is treated as an employer, but the individual members of the partnership aren't employees. For tax purposes, they're self-employed. The individuals don't pay taxes on the earnings of the partnership. The earnings are "passed through" to the individuals, who pay normal income tax using form 1040, schedule C. The partnership, however, being an employer, must withhold and pay payroll taxes.

C corporations, which are owned by shareholders, are actually taxed twice. The corporate earnings are taxed at corporate rates. The shareholder distributions are taxed again at personal income tax rates. Corporate tax rates also increase with taxable earnings. If the corporation earns between $0 and $50,000, the tax rate is a flat 15 percent. If it earns between $50,000 and $75,000, the rate is $7,500 plus 25 percent of the amount over $50,000. If it makes between $10 million and $15 million, the tax is $3.4 million plus 35 percent of the amount over $10 million.

Just like individuals, businesses can lower their tax burden by deducting expenses and claiming tax credits. Why do you think they have accounting departments?

S corporations are small domestic corporations with no more than 100 shareholders. To avoid double taxation, all earnings are passed through to the shareholders, who are taxed at their personal income rate.

Limited liability companies (LLC) aren't recognized by the IRS as a unique tax entity. Members of the LLC must therefore pay taxes as either a corporation, partnership or a sole proprietorship.

Are those the only taxes that businesses have to pay? Not quite. Next we'll talk about payroll taxes.