According to a new report issued by the Office of Advocacy of the US Small Business Administration, the effective federal income tax rate—the actual amount of taxes paid by a firm as a percent of its net income—faced by small businesses varies according to the business' legal form of organization. Overall, small businesses of all types pay an estimated average effective tax rate of 19.8%. Sole proprietorships face a 13.3% rate, small partnerships face 23.6%, and small S corporations face 26.9%. While not directly comparable, the rate faced by small C corporations is 17.5%.
Now, this is different from the normal statutory tax rates. There is an element of progressivity at work in these differences. Firms with less income face a lower statutory rate. Nearly 60% of small sole proprietorships have a net income of less than $10,000, while only 3.1% have a net income of at least $100,000. On the other hand, more than 18% of small S corporations have a net income of at least $100,000. These exceptions also include things like credits. deductions, and exclusions and they lower the tax rates paid by firms. This results in the difference between the statutory rate and the actual or effective rate paid by the business or its owners and is discussed below.
This summary was prepared by Quantria Strategies, which wrote Effective Federal Income Tax Rates Faced by Small Businesses in the United States (http://www.sba.gov/advo/research/rs343tot.pdf). The list is generally organized in ascending order according to federal tax code provision. References to IRC sections are references to the Internal Revenue Code of 1986, as amended.
1. Graduated individual and corporate tax rates (IRC secs. 1 and 11)
The graduated income tax rates for individuals and corporations have the effect of providing a lower marginal tax rate for many small businesses. Sole proprietors, partners of small partnerships, S corporation shareholders, and members of LLCs may all benefit from the graduated individual income tax rates (and the reduced rates of taxation on capital gains and dividends). Small corporations will benefit from the graduated corporate income tax rates.
2. Small ethanol producer credit (IRC sec. 40(b)(4))
In addition to the alcohol fuels credits generally provided under IRC section 40, small ethanol producers are provided a small ethanol producer credit of 10 cents per gallon of ethanol produced up to 15 million gallons in a year. A small ethanol producer is defined as a producer with a production capacity of up to 60 million gallons of alcohol per year.
3. Small agri-biodiesel producer credit (IRC sec. 40A(b)(5))
In addition to the credits for biodiesel and renewable diesel used as fuel generally provided under IRC section 40A, small agri-biodiesel producers are provided a small agri-biodiesel producer credit of 10 cents per gallon of qualified agri-biodiesel production up to 15 million gallons in a year. A small agri-biodiesel producer is defined as a producer with a production capacity of up to 60 million gallons of agri-biodiesel in a year.
4. Credit for increasing research activities (IRC sec. 41)
Taxpayers are generally entitled to claim a federal income tax credit for increasing research activities. Qualified research expenses include in-house research expenses and 65 percent of contract research expenses. A special provision permits a taxpayer to use 100 percent of contract research expenses for amounts paid to eligible small businesses. For this purpose, an eligible small business is a business in which the average number of employees during the preceding two calendar years was 500 or less. While this provision does not provide a direct federal tax benefit to small businesses, it provides an incentive for other taxpayers to use eligible small businesses for qualified contract research activities.
5. Credit for expenditures to provide access to disabled individuals (IRC sec. 44)
Eligible small businesses are entitled to claim a credit for 50 percent of the expenditures incurredduring a year to make a business accessible to the disabled. The expenditures eligible for the credit are those in excess of $250 and less than $10,250. Thus, the maximum credit is 50 percent of $10,000 ($10,250-$250) or $5,000.
An eligible small business for purposes of the credit is any taxpayer that either (1) had gross receipts (less returns and allowances) for the preceding taxable year that did not exceed $1 million or (2) had no more than 30 full-time employees during the preceding taxable year.
6. Credit for electricity produced from certain renewable resources (IRC sec. 45)
The credit for electricity produced from certain renewable resources is available to qualified energy resources, which includes small irrigation power. For purposes of this credit, small irrigation power is defined as power generated without any dam or impoundment of water through an irrigation system canal or ditch and whose capacity rating is more than 149 kilowatts, but less than 5 megawatts.
7. Credit for portion of employer social security taxes paid with respect to employee cash tips (IRC sec. 45B)
An employer in the food and beverage industry is entitled to claim a credit against federal taxes for its portion of social security and Medicare taxes (FICA taxes) paid on employee tips. While this provision is not specifically applicable to small businesses, many food and beverage establishments qualifying for the credit are likely to be small businesses.
8. Credit for small employer pension plan startup costs (IRC sec. 45E)
Small employers are entitled to claim a credit for 50 percent of their qualified startup costs for establishing a retirement plan for their employees. The amount of the credit cannot exceed $500 per year for up to three years. A small employer eligible for the credit is defined as an employer that had no more than 100 employees who received at least $5,000 in compensation for the preceding year.
9. Credit for production of low-sulfur diesel fuel (IRC sec. 45H)
Qualified small business refiners are entitled to a credit for qualified expenditures for the production of low-sulfur diesel fuel. A small business refiner for this purpose is defined as a refiner of crude oil that employs no more than 1,500 individuals on any day during the year and had an average daily refinery production during the one-year period ending on December 31, 2002, which did not exceed 205,000 barrels.
10. Alternative minimum tax (IRC sec. 55)
Small corporations are exempt from the corporate alternative minimum tax. Small corporations are defined as those corporations that have average annual gross receipts of no more than $7.5 million for all 3-year periods ending before the taxable year ($5 million for the first 3-year period).
11. Election to expense certain depreciable business assets (IRC sec. 179)
Businesses are allowed to take a current deduction (expense) for the cost of certain property rather than take a depreciation deduction each year over the life of the property. The expensing deduction is only available for up to $250,000 (for 2008) of qualifying expenses and is phased out dollar for dollar if the total amount of such property purchased during the year exceeds $800,000 (for 2008). Although not specifically limited to small businesses, section 179 expensing tends to benefit small businesses.
12. Treatment of certain qualified film and television production (IRC sec. 181)
Expensing is allowed for the cost of any qualified film or television production if the aggregate cost does not exceed $15 million ($20 million in the case of production in certain areas). While not directly limited to small businesses, this provision has the effect of benefiting smaller film and television producers. The provision expires after 2008.
13. Start-up expenditures (IRC sec. 195) and corporation organizational expenses (IRC sec. 248)
In general, taxpayers cannot deduct currently the start-up expenditures for a new business. Instead, these start-up expenses are amortized over a period of at least 180 months, starting with the month in which the business begins. However, taxpayers can elect to deduct up to $5,000 for start-up expenditures for a new business (sec. 195). The $5,000 amount is phased out for each dollar of start-up expenditures in excess of $50,000. This provision has the effect of benefiting new small businesses. A similar provision applies with respect to the organizational expenditures for a new corporation (sec. 248).
14. Archer MSAs (IRC sec. 220)
Self-employed individuals and employees of small businesses are permitted to deduct contributions to an Archer medical savings account (MSA). A small employer for this purpose means an employer with an average of 50 or fewer employees during either of the two preceding calendar years. No new deductible contributions are permitted to Archer MSAs after 2007 unless the individual previously had an MSA or works for an employer that made MSA contributions.
15. Golden parachute payments (IRC sec. 280G)
No deduction is allowed for any excess parachute payment, which is a payment in the nature of a severance payment made to a former executive of a business after he or she leaves the business. There is an exception for payments made to an individual from a small business corporation which could qualify for S corporation treatment (generally has no more than 100 shareholders who are all individuals, estates, trust, and certain other entities). (See sec. 1361(b) and the discussion in Part V for a description of the requirements for S corporation treatment.)
16. SIMPLE retirement accounts (IRC sec. 408(p))
Small employers are entitled to adopt a simplified qualified retirement plan for their employees, called SIMPLE retirement accounts. These plans have fewer rules and restrictions than the rules that normally apply to employer-sponsored qualified retirement plans. For purposes of the SIMPLE retirement accounts, a small employer is defined as an employer that had no more than 100 employees who received at least $5,000 in compensation for the preceding year.
17. Special rules for top-heavy plans (IRC sec. 416)
Employer retirement plans that are top heavy are required to meet additional requirements, including providing minimum contributions on behalf of employees, which increases the cost of the retirement plan for the employer. An employer retirement plan is top heavy if more than 60 percent of the benefits or account balances under the plan benefit key employees. Key employees are certain owners and officers of the business. Although the top heavy rules do not specifically apply to small businesses, the rules are most likely to apply to such businesses.
18. Method of accounting for corporations engaged in farming (IRC sec. 447)
Corporations and partnerships that have a corporate partner engaged in farming generally are required to use the accrual method of accounting. However, an exception to this rule provides that an S corporation and a C corporation with gross receipts that do not exceed $1 million in the taxable year are not required to use the accrual method of accounting. In the case of family corporations, the gross receipts threshold is increased to $25,000.
19. Limitation on use of cash method of accounting (IRC sec. 448)
Certain taxpayers (C corporations, partnerships with a C corporation partner, and tax shelters) are not permitted to use the cash method of accounting. An exception applies for farming businesses, and qualified personal service corporations, and corporations or partnerships with average annual gross receipts of no more than $5 million for the three taxable years prior to the current year. A qualified personal service corporation is engaged substantially in the performance of service in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting.
20. Simplified dollar-value LIFO method for certain small businesses (IRC sec. 474)
An eligible small business may elect to use a simplified dollar-value method for pricing inventories. An eligible small business for this purpose must have annual average gross receipts for the three preceding taxable years of not more than $5 million.
21. Exemption from federal income tax for small life insurance companies (IRC sec. 501(c)(15))
Certain small life insurance companies are exempt from federal income tax. A small life insurance company is a life insurance company (1) with gross receipts for the taxable year that do not exceed $600,000 and more than 50 percent of the gross receipts consist of premiums or (2) is a mutual insurance company with gross receipts for the taxable year that do not exceed $150,000 and more than 35 percent of the gross receipts consist of premiums.
22. Small life insurance company deduction (IRC sec. 806)
A small life insurance company is permitted a deduction equal to 60 percent of the company’s tentative life insurance company taxable income (LICTI) up to $3 million. The deduction is phased out for tentative LICTI between $3 million and $15 million. In addition, the small life insurance company deduction is disallowed if a company has assets of $500 million or more.
23. Alternative tax for certain small nonlife insurance companies (IRC sec. 831(b))
In lieu of the normal corporate income tax rate structure, small property and casualty insurance companies are subject to tax only on their investment income. This provision applies to insurance companies other than life insurance companies if the net written premiums (or, if greater, direct written premiums) for the taxable year do not exceed $1.2 million.
24. Rollover of gain from qualified small business stock to another qualified small business stock (IRC sec. 1045)
Taxpayers can avoid paying taxes on gain from the sale of qualified small business stock (as defined by sec. 1202 (see item 25, below)) by rolling over the gain to other qualified small business stock within 60 days of the sale.
25. Exclusion of capital gain from small business stock (IRC sec. 1202)
An individual taxpayer can exclude up to 50 percent (60 percent if the qualified small business stock was issued by a small business in an empowerment zone) of the gain from the sale or exchange of qualified small business stock held for more than five years. There is a cumulative limit on the exclusion of the greater of $10 million or 10 times the taxpayer’s adjusted basis of all qualified stock the issuer disposed of during the taxable year.
For purposes of this exclusion, qualified small business stock must have been issued after August 10, 1993, and the issuing corporation must be a domestic C corporation with aggregate gross assets that do not exceed $50 million as of the date of issuance. At least 80 percent of the value of the corporation’s assets must be used in the active conduct of one or more qualified trades or businesses. Qualified trades or businesses do not include health, law, engineering, architecture, hospitality, farming, insurance, financing, or mineral extraction, but SSBICs qualify. (SSBICs are discussed in the following section).
26. Small business investment companies (IRC secs. 243(a)(2), 1242, 1243, and 1044)
A small business investment company (SBIC) is a private corporation operating under the Small Business Investment Act of 1958. SBICs provide capital to small businesses through the purchase of convertible debentures. An SBIC is entitled to special treatment under certain circumstances: First, an SBIC is entitled to a 100 percent dividends received deduction (rather than 70 percent) for the dividends received from taxable domestic corporations (sec. 243(a)(2)). In addition, an SBIC may treat as an ordinary (rather than capital) loss any loss from the sale or exchange of the stock of a small business under certain conditions (sec. 1243) and any loss on the sale of SBIC stock (or if the stock becomes worthless) (sec. 1242).
In addition, individuals and C corporations can defer recognition of capital gains on the sale of publicly traded securities if they use the sale proceeds within 60 days to purchase common stock or a partnership interest in a specialized small business investment company (SSBIC). An individual can defer up to $50,000 per year and $500,000 total; C corporations can defer up to $250,000 per year and $1 million total.
27. Losses on small business stock (IRC sec. 1244)
Individuals are allowed to take an ordinary loss deduction for losses on the sale, exchange, or worthlessness of small business stock. The maximum amount deductible in any year is $50,000 for a single individual and $100,000 for a married couple. The stock must have been issued to the individual (or a partner in a partnership) in exchange for money or property other than stock or securities.
For purposes of this provision, a small business corporation is a corporation with respect to which, at the time the stock was issued, the aggregate amount of money and other property received by the corporation as a contribution to capital and as paid-in surplus did not exceed $1 million and for the corporation’s five most recent taxable years, more than 50 percent of its gross receipts were derived from sources other than royalties, rents, dividends, interest, annuities, and gains from the sale of securities. In other words, the corporation must be conducting active, rather than passive, activities.
28. Averaging of farm income (IRC sec. 1301)
Individuals engaged in a farming business can elect to average their income over three years for federal income tax purposes.
29. S corporations (IRC sec. 1361)
A small business corporation (S corporation) can elect to be treated as a pass-through entity, rather than a corporation, for federal tax purposes. To be eligible for S corporation status, a small business corporation must (1) be a domestic corporation; (2) have no more than 100 shareholders; (3) have shareholders that are only individuals, estates, certain tax-exempt organizations, and certain trusts; (4) have no nonresident alien shareholders; (5) have only one class of stock; (6) not be a bank, insurance company, possessions corporation, or a domestic international sales corporation; and (7) meet certain other requirements.
This article is a place to start, but it is certainly not all the information you need. As with all tax issues, consult your tax professional and ask educated questions. For more information and a complete copy of the report, visit the Office of Advocacy website at www.sba.gov/advo.