Welcome back gang!
This week we’re going to talk about business income. This is not to be confused with the corporate income taxes that companies like Google and Coca-Cola pay. This tax revenue typically comes from much smaller businesses as well as what are called pass through entities. Many small businesses pass through their income to their owners. Why would they do this? Corporate income taxes are higher than personal income taxes. Corporate income in the US often gets taxed twice. Let’s use an example.
Pretend you own a business and you make bread. To run your business, you first have to pay all of your expenses, (cost of flour, wheat, ovens, employees, rent on property etc.) then sell your bread, then as the owner you keep what’s left right? Not quite. If you are a corporation, like Apple or Costco, you have to pay corporate income taxes, which, similar to personal income taxes in that they fall under a corporate tax bracket. However, you own your business, if you want to move the money from the businesses bank account into your own personal bank account and you are a corporation, congress has decided that you now have to pay taxes on that money again at your personal rate. This is what is called double taxation. For example, a corporation might earn $1,000,000 and pay $150,000 of corporate income taxes on those profits. If the owner wants to take the remaining $850,000 and put it in their pocket, they now have to add that $850,000 to their personal AGI, which might cost them an additional $239,466 in taxes (depending on other incomes etc.) Their effective tax rate is now 38.9%, higher than an individual who makes $16,000,000!
With large corporations, congress has essentially said, deal with it. And don’t feel too bad, large corporations have found many clever ways to deal with it. However, with small companies, congress treats them differently. Congress allows small businesses to forgo paying the corporate income taxes altogether, but every year whatever the business reports in income, the business owner has to add to their personal AGI.
This comes with a tradeoff. It is undeniably better to avoid double taxation, however, when the owner of a corporation decides to keep money in the business, they can do so with no penalty. A small business might need to take money out of the business just to afford the personal income taxes. In a partnership this might not be ideal for every partner.
If multiple people own a small business, they each pay taxes proportionally. For example, if a business is owned 60/20/20 by three people, and the business earns $900,000 in profit, the taxes hit each partners AGI as follows: $540,000/$180,000/$180,000.
In the US these businesses showed $1.375 trillion of earnings in 2022. Which translates to roughly $260 billion dollars in federal revenue.
I won’t get into what deductions businesses can write off, but essentially most legitimate business expenses they are able to deduct. The most interesting part of our tax code in regard to businesses, besides the double taxation of corporations, is how we treat depreciation. When a business pays wages, they can write that off today, when a business buys a computer, they can deduct that money over time. That has serious implications for many capital intense businesses, especially during times of inflation. But it’s not very important to understanding out federal tax system.
I hope that our income tax system is starting to all make sense now. Small business owners essentially just pass their income onto themselves as wages and pay personal taxes on this. When we get into payroll taxes things get more complicated. See you next week.
Hey gang!
If you know anyone who would enjoy this series, please share the post with them. All of my old posts are available on my substack and I will put a glossary of the entire series below.
Have any comments you’d like to share? Did I make any statements that you are dying to correct? Subscribe to my page and reply to the next email and I’ll see it.
Thanks for reading Ed's Newsletter! Subscribe for free to receive new posts and support my work.
Table of contents:
Net Business Income Taxes 203