Calculating business income for tax purposes starts with accurate bookkeeping throughout the year to have a reliable income statement. Once you have your income statement, you need to do an extensive search for other sources of income, unclaimed tax deductions, and potential tax credits that can offset your tax. It’s a lot of work, but if you are a do-it-yourselfer (DIYer) and enjoy a good challenge, I’ll teach you how to calculate business taxes.
If you’d rather focus on other aspects of your business, we recommend Bench for both your bookkeeping and tax filing needs—its accounting and tax pros will do all the work for you. Plus, Fit Small Business readers receive their first two months of service for free.
This article provides a big-picture view of how to calculate your small business income taxes, which is essentially the same whether you’re a sole proprietorship, S corporation (S-corp), partnership, limited liability company (LLC), or C corporation (C-corp). If you’re looking for line-by-line instructions for how to complete tax forms, we have the following guides:
Step 1: Compile Your Income and Deductions and Print a Profit & Loss Report
The most important part of calculating the taxable income of your small business is having accurate books for the year. Here are a few of my most important bookkeeping tips:
- Subscribe to accounting software and keep your books up-to-date throughout the year.
- Keep your business and personal transactions separate by having dedicated business checking and credit card accounts.
- Reimburse yourself out of the business account for any business expenses you paid personally.
Regardless of the program you use, it’s important you have a profit and loss (P&L) report that includes all the income and expenses that flowed through your business accounts. Once you have a P&L report, we’ll look into the details of taxable revenue and deductions to see if anything might be missing.
Step 2: Look for Unrecorded Revenue
Your P&L report should reflect all of the income that flowed through your business bank accounts. However, there are some revenue sources that may not have made it onto your P&L report but are still taxable revenue. Consider the following items and determine if you have any taxable revenue to report:
Cash sales that you may have pocketed without depositing into your bank account are still taxable. There is nothing necessarily wrong with taking the cash but be sure it’s included in your revenue.
Barter transactions are taxable. If you exchange your services or products for anything of value, you must recognize revenue for that value. If what you received is business-related, you might also have a deductible expense to offset the revenue.
Here’s a sample scenario: You provide your accountant with lawn services worth $1,000 in exchange for preparing your business tax return. You must recognize $1,000 of lawn service revenue but can also record a $1,000 tax preparation expense.
Conducting business in cryptocurrency creates a major headache because the IRS treats crypto as an investment rather than as a currency. This means every time you spend crypto, not only will you record an expense for the payment, but you must recognize a gain or loss on the crypto spent. The gain or loss is computed based on the value of the crypto when you spent it compared to value when you earned it or purchased it.
Step 3: Search for Tax Deductions
Any expenses that are ordinary and necessary to conduct your business are generally deductible. If you have a bookkeeping system and run all your transactions through your bank accounts, the vast majority of these expenses should already be included on your P&L report.
I suggest you check out our list of IRS business expenses to see if there might be something you missed. If your business is managing rental properties, you can read our article on rental property deductions for guidance specific to you.
Here are a few major items you’ll want to review.
Ordinary & Necessary Expenses
The tax code does not have to specifically list an expense for it to be deductible. Any expense that is ordinary and necessary in the operation of your business is tax deductible—unless the expense is illegal or a penalty:
- Ordinary means that an expense is common and accepted in your industry. In other words, would other businesses in your industry faced with similar circumstances incur the expense? Ordinary does not mean recurring. A once-in-a-lifetime expense for your business can be an ordinary expense if other businesses in your industry commonly make the same decision.
- Necessary means appropriate and helpful. This could rule out certain expenses like paying a family member if they don’t provide something of value to the company. Read our article on IRS Business Expense Categories for a list of common ordinary and necessary expenses.
Fixed Asset Purchases
The general rule is that fixed asset purchases cannot be immediately deducted but must gradually be deducted over the life of the asset. However, there are some major exceptions to this rule. The first exception is bonus depreciation, which allows you to immediately deduct 80% (for 2023) of the cost of most fixed assets with a life of less than 20 years.
Another method of immediately deducting the cost of many types of fixed assets is through the Section 179 deduction. The maximum Section 179 Expense for 2023 is $1,160,000, so this will cover all the asset purchases for many small businesses.
While Section 179 Expense and Bonus Depreciation are similar, there are some important differences. You can read about them and how to choose the best strategy for your business in our comparison of Bonus Depreciation vs Section 179.
Fixed assets that are not deducted immediately under either Bonus Depreciation or Section 179 must be depreciated under the modified accelerated cost recovery system (MACRS) rules. You can learn more about this by checking our guide to MACRS depreciation. It includes a calculator to help you figure out your depreciation.
Similar to fixed assets, purchased intangible assets cannot generally be immediately deducted and must be deducted evenly over 15 years. Purchased intangible assets are referred to by the IRS as Section 197 intangibles and include items, such as goodwill, trademarks, patents, franchise agreements, and noncompete agreements, among other things.
The most common time to acquire Section 197 intangibles is when you purchase the assets of another company. You can read our guide on what amortization is to determine if you have any intangible assets that must be amortized.
Depletion is a unique deduction that is available to companies that mine or drill natural resources to account for the reduction in the mineral resources. The depletion deduction is available to both independent producers as well as royalty owners.
Percentage depletion calculates your depletion expense by multiplying a set rate times your gross revenue from the sale of resources. For instance, a natural gas producer can deduct 22 cents for every dollar of natural gas sold. If you think depletion might apply to your business, read our article on percentage depletion.
Dividends Received Deduction for C-corps
C-corps can exclude at least 70% of the dividend income they receive from other corporations—even if their ownership in the other corporation is very small and the stock is held as an investment. The percentage of the exclusion increases to 65% if you own more than 20% of the corporation paying the dividends.
If your C-corp owns 80% or more of the stock of a subsidiary C-corp, you can claim a dividends received deduction (DRD) for the entire amount of dividends received. You can learn more by reading our guide on what the DRD is and how to calculate it.
Net Operating Loss
If your business lost money in the prior year, you might be entitled to a net operating loss (NOL) in the current year that will reduce your taxable income:
- For C-corps, the NOL is essentially the negative taxable income from the prior year.
- For owners of flow-through entities, such as partnerships, S-corps, and sole proprietors, the calculation of the NOL from prior years is very complicated because you need to separate business and nonbusiness income and deductions.
20% Pass Through Deduction
Most sole proprietors, S-corps, and partnerships qualify for a deduction equal to 20% of the income flowing to their individual return. If the total taxable income on your Form 1040 tax return is $170,050 ($340,100 Joint) or less, you automatically qualify for the 20% pass through deduction—often called the qualified business income deduction (QBID)—regardless of your industry, wages paid, or assets owned.
If your total taxable income exceeds these amounts, then things become a little more complicated and your deduction could be limited. You can learn about these limitations and how to claim your deduction through our article on what the 20% pass through deduction is.
Step 4: Comply With Taxable Loss Limitations
Once you gather all of your income and deductions, you can calculate whether you have taxable income or a taxable loss for the year. If you have income, you can skip this step. However, if you have a loss, you need to determine if any of the rules discussed next will limit your ability to deduct your loss in the current year.
To deduct your business loss in the current year:
- Your loss must not exceed the amount you are at risk of losing in the business.
- You must materially participate in the business.
- You must conduct the business with the realistic expectation of making a profit.
Let’s discuss each of these requirements in more detail:
The at-risk rules essentially say you can’t claim a loss that exceeds the amount you’ve invested in your business. While rare, this rule may potentially apply to you if there are amounts invested in your company for which you are not at risk of losing. The most common items that create an amount not at risk are:
- Loans from related parties
- Loans secured with company assets where you are not personally liable—referred to as nonrecourse loans
- Guarantees, stop-loss agreements, or similar arrangements
At-risk limitations are most prevalent in S-corps and limited partnerships because the shareholders/partners are not personally liable for many of the debts of the business. While it is rare for sole proprietorships, if you have any of the loans or arrangements listed above, then you should read our article on at-risk limitations.
Passive Activity Rules
Losses from passive activities can only offset income from other passive activities—they can’t offset income from non-passive sources, like wages. Passive losses are not excluded forever—they are suspended until the business owner has sufficient passive income to offset or until the activity is disposed of. It’s important to track your suspended losses for the life of the activity so they can be deducted when the activity comes to an end.
There are two main types of passive activities:
- Business activities where the owner does not materially participate
- Rental activities
You can only deduct your business loss if you materially participate in the business. There are four primary ways that you can materially participate in your business:
- Work for 500 hours or more
- Your work was substantially all of the work done for the business, including non-owners
- Work for 100 hours or more and more than anyone else, including non-owners
- Participated on a regular, continuous, and substantial basis
The fourth item is a last-ditch effort to qualify as a material participant. It is much safer to qualify under the first three “bright-line” tests so you know the IRS will acknowledge your participation.
Other ways to qualify include combining multiple activities together and relying on prior years of material participation. Read our article on material participation for all the details to determine if your business is passive or nonpassive.
Rental activities are by definition passive activities regardless of whether you materially participate. This is true even for rental activities owned by otherwise nonpassive businesses.
For example, assume Chris owns and materially participates in an S-corp. In addition to conducting an active business, the S-corp leases out excess office space in a building that it owns. The income or loss generated by renting out the excess office space is passive even though the income or loss generated by the S-corp’s business activities are nonpassive income.
S-corps and partnerships must track income and loss from rental activities separately from their regular business income so that the owners can treat them appropriately. Ordinary business income and rental activity income are reported to the owners on separate lines of their Schedule K-1.
While material participation makes no difference in rental activities, a similar concept called “active participation” does make certain passive losses from rental real-estate activities deductible up to $25,000. Active participation is far easier to achieve than material participation and generally requires the owner to have substantial involvement in the activity, which could be as simple as making management decisions. Learn more about active participation in rental activities.
Hobby Loss Rules
The hobby loss rules require that a business activity be profit-motivated, rather than motivated by personal enjoyment. It doesn’t mean you can’t enjoy your work—just that you have the potential and intent to earn a profit. The classic example of a hobby disguised as a business is horse breeding and competitions. While immensely enjoyable, they rarely turn a profit and are generally done for pleasure rather than profit.
Here are a few things to consider when determining whether your activity is a business or a hobby:
- Do you treat the activity like a business? The business should have accounting records, a business plan, and preferably even separate bank accounts from your personal funds.
- Is there an element of personal pleasure? Without an element of personal pleasure, it is unlikely that the IRS will claim your activity is a hobby instead of a business.
- Do you depend on the activity to earn a living? If this activity is your primary means of support, then clearly you are expecting to make a profit. However, if you have a full-time job and conduct this activity in the evening, that leans toward a hobby.
- Do you have forecasts that show a profit? Make reasonable income and expense forecasts that show a profit. If you can’t, then show you are making changes to become profitable in the longer term. The expected increase in value of assets like real estate can be included in your projections of profit.
If your business is determined to be a hobby, all of the income is taxable, but none of the expenses except cost of goods sold (COGS) are deductible. It is truly a horrible tax treatment. The classification between hobby and business is a gray area where taxpayers and the IRS often collide. Read our article on the hobby loss rules for tips on how to show your activity is a business.
Step 5: Calculate the Tax on Your Small Business
The two primary taxes paid by small businesses are income and self-employment tax.
How you calculate income tax on your small business income depends on the entity type of your business. If your business is a C-corp—or an LLC taxed as a C-corp—then you’ll pay income tax at a flat 21% rate.
All other entities, such as sole proprietorships, partnerships, S-corps, and LLCs, have their income tax figured on the owner’s individual income tax return. This means that other sources of income outside your business, like wages, can push your business income into higher tax brackets and create more tax.
We provided links at the top of this article for help in completing the tax forms for the various entities that small businesses often operate within.
Self-employment tax is the equivalent of FICA taxes paid by employers and employees, but in the case of self-employed individuals, they must pay both the employer and employee side of the tax for a total of 15.3%. This is in addition to any income tax.
Self-employed taxpayers must pay self-employment tax on all net earnings from their sole proprietorship. General partners and members of an LLC treated as a partnership also must pay self-employment tax on their share of the business’ earnings. Head over to our free self-employment tax calculator to estimate your tax.
In addition to the two taxes based on taxable earnings, there are several other taxes that self-employed taxpayers should be aware of. Read our guide on independent contractor taxes for the list.
Step 6: Reduce Your Tax by Business Tax Credits
The final step in computing your small business tax is to reduce your gross income tax by available credits. Unlike deductions, credits reduce your taxable liability dollar-for-dollar. So, a $100 tax credit saves you $100 in taxes regardless of your tax rate. Our comparison of deductions vs credits provides more guidance.
Work Opportunity Tax Credit (WOTC)
The WOTC is a potentially large credit that all small businesses should investigate. The credit saves taxes for small businesses that hire employees from certain disadvantaged categories of job applicants:
While relatively simple, there is important paperwork that must be completed prior to you offering a job to the qualified individual. Read our complete guide to the Work Opportunity Tax Credit (WOTC) to learn how the credit is calculated and the proper forms to file.
Small Business Health Insurance Credit
If you are a very small business with fewer than 25 full-time equivalent employees (FTEs) and you pay over 50% of the cost of their health insurance through the Small Business Health Options Program (SHOP) you may qualify for a credit. The maximum credit is 50% of the employer-paid premiums but starts to be reduced if you have over 10 FTEs or if average salaries exceed $27,000.
You can learn more about the Small Business Health Insurance Credit and other credits geared toward small businesses in our article on small business tax credits.
Frequently Asked Questions (FAQs)
Federal business income tax is calculated on net profit, which is revenue minus cost of goods sold, minus operating expenses.
I recommend setting aside income taxes on your LLC based on your individual marginal tax rate, which depends upon all the income on your individual return. Marginal tax rates range from 10% to 37%, with most small business owners likely being in the 22% or 24% bracket. In addition to income tax, if your LLC is taxed as a sole proprietorship or partnership, you should set aside an additional 15% for self-employment tax.
An effective way for an LLC to lower its taxes is by electing to be taxed as an S-corp by filing Form 8832—which you can learn to fill out via our guide on Form 8332 instructions. While having no effect on income taxes, this election can save self-employment tax because S-corp owners don’t have to pay self-employment tax on all of the earnings of the company. Instead, they pay payroll taxes only on their salary.
Regardless of which entity you’ve selected for your business, the process of calculating your business tax involves the same basic steps. You must protect yourself with an extensive search for unreported income and then work equally hard to identify all your deductions that will lower your tax liability. Lastly, make sure you claim all the tax credits available to you.