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
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.
summary was prepared by Quantria Strategies, which wrote Effective
Federal Income Tax Rates Faced by Small Businesses in the United
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.
Graduated individual and corporate tax rates (IRC secs. 1 and 11)
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.
Small ethanol producer credit (IRC sec. 40(b)(4))
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.
Small agri-biodiesel producer credit (IRC sec. 40A(b)(5))
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.
Credit for increasing research activities (IRC sec. 41)
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.
Credit for expenditures to provide access to disabled individuals
(IRC sec. 44)
small businesses are entitled to claim a credit for 50 percent of the
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.
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
Credit for electricity produced from certain renewable resources (IRC
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.
Credit for portion of employer social security taxes paid with
respect to employee cash tips (IRC sec. 45B)
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.
Credit for small employer pension plan startup costs (IRC sec. 45E)
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.
Credit for production of low-sulfur diesel fuel (IRC sec. 45H)
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
Alternative minimum tax (IRC sec. 55)
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).
Election to expense certain depreciable business assets (IRC sec.
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.
Treatment of certain qualified film and television production (IRC
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.
Start-up expenditures (IRC sec. 195) and corporation organizational
expenses (IRC sec. 248)
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
Archer MSAs (IRC sec. 220)
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.
Golden parachute payments (IRC sec. 280G)
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
SIMPLE retirement accounts (IRC sec. 408(p))
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.
Special rules for top-heavy plans (IRC sec. 416)
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
Method of accounting for corporations engaged in farming (IRC sec.
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.
Limitation on use of cash method of accounting (IRC sec. 448)
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
Simplified dollar-value LIFO method for certain small businesses (IRC
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.
Exemption from federal income tax for small life insurance companies
(IRC sec. 501(c)(15))
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.
Small life insurance company deduction (IRC sec. 806)
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.
Alternative tax for certain small nonlife insurance companies (IRC
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.
Rollover of gain from qualified small business stock to another
qualified small business stock (IRC sec. 1045)
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.
Exclusion of capital gain from small business stock (IRC sec. 1202)
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.
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
Small business investment companies (IRC secs. 243(a)(2), 1242, 1243,
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).
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.
Losses on small business stock (IRC sec. 1244)
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
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
Averaging of farm income (IRC sec. 1301)
engaged in a farming business can elect to average their income over
three years for federal
income tax purposes.
S corporations (IRC sec. 1361)
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
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.
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