Are businesses taxed on revenue or profit

What is taxable income?

Simply put, a company is taxed on the profit it makes after all allowable deductions are subtracted from its revenues. You can think of it like a formula:

Revenues – Deductions = Taxable Income

Revenues

Revenues is any income your business earns. In general, any revenue is taxable unless IRS rules specifically exclude it.

Your gross revenue includes all income received from sales, after you subtract things like returns and discounts. Then add any other income such as interest earned from bank accounts, other investment returns, and profits from the sale of assets.

To illustrate, say Stark Industries had gross sales of $500,000, allowed returns and discounts totaling $10,000. Stark Industries’ gross revenues would come to $490,000 ($500,000 – $10,000).

Business deductions

A business generally has two types of deductions that can be used to reduce its taxable income.

Cost of goods sold. A company’s cost of goods sold (COGS) is the total costs used to create its products or services. If you sell wool socks, COGS includes things like the wool and the wages of the sewers.
Operating expenses. A business’s operating expenses are the costs it incurs to run the company outside of COGS. Examples include advertising, bank fees, interest, legal and accounting fees, insurance, office supplies, property taxes, rent, and utilities.

Earlier, we calculated Stark Industries gross revenue to be $490,000. Let’s say they had costs of goods sold totaling $100,000 and operating expenses of $200,000. The company’s taxable income would be $190,000 ($490,000 gross revenue – $100,000 cost of goods sold – $200,000 operating expenses).

Personal deductions

There are also deductions you can claim to reduce your personal taxable income. These include:

Itemized deductions or the standard deduction. Taxpayers can claim either itemized deductions (such as medical expenses, state and local taxes like property taxes, home mortgage interest and donations to charity) or the standard deduction (a predetermined amount based on your filing status).
Pass-through deduction. Owners of pass-through businesses (sole proprietorships, partnerships, limited liability companies, and S corporations) may be able to take advantage of the new pass-through deduction. This deduction allows the business owner to deduct up to 20% of the business income on their Form 1040.

How to reduce your taxable income

Turning a healthy profit from your business can sometimes feel like a double-edged sword: making money is great, but the resulting tax bill isn’t. Here are a few tax-saving strategies to consider.

Save for retirement

Contributing to a tax-advantaged retirement account, such as an IRA, 401(k), or SEP-IRA can reduce your taxable income for the year.

For example, if you are self-employed, you can set up a SEP-IRA and contribute up to 20% of your earnings, up to a maximum of $58,000 for 2021 or $61,000 for 2022.

Purchase assets

Typically, business equipment is depreciated by writing off the cost of the asset over several years. However, under certain conditions, IRS rules allow business owners to write off the entire cost of the asset in one year by taking advantage of bonus depreciation or Section 179 deductions.

Accelerate expenses and defer income

A cash-basis taxpayer can lower taxable income by strategically timing income and expenses. At year-end, look ahead to bills that are due in January and beyond. Consider paying them by check or credit card before year-end so you can claim the deduction on this year’s return.

To defer income, wait until the end of the year to send invoices. You won’t have to claim the income on your tax return until you receive the cash or checks early in the next calendar year.

A caution on buying stuff to lower your taxes

Whether you’re purchasing assets or accelerating expenses, keep in mind you never want to spend money on things you don’t need just to save on your tax bill. That’s not smart tax planning. Only invest in your business or accelerate specific purchases you’re already planning to make.

Now that you’ve got a handle on calculating your taxable income, you can estimate your small business tax liability.

This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. Bench assumes no liability for actions taken in reliance upon the information contained herein.

Learn the benefits and drawbacks of corporate taxation.

Corporations are taxed differently than other business structures: A corporation is the only type of business that must pay its own income taxes on profits. In contrast, partnerships, sole proprietorships, S corporations, and limited liability companies (LLCs) are not taxed on business profits; instead, the profits "pass through" the businesses to their owners, who report business income or losses on their personal tax returns.

Understanding Corporate Taxation

Because a corporation is a separate legal entity from its owners, the company itself is taxed on all profits that it cannot deduct as business expenses. Generally, taxable profits consist of money kept in the company to cover expenses or expansion (called "retained earnings") and profits that are distributed to the owners (shareholders) as dividends.

Tax-Deductible Expenses

To reduce taxable profits, a corporation can deduct many of its business expenses -- money the corporation spends in the legitimate pursuit of profit. In addition to start-up costs, operating expenses, and product and advertising outlays, a corporation can deduct the salaries and bonuses it pays and all of the costs associated with medical and retirement plans for employees. To be sure you don't miss out on important tax deductions, see the Business Tax & Deductions area of Nolo's website.

Corporate Tax Payments

The corporation must file a corporate tax return, IRS Form 1120, and pay taxes at a corporate income tax rate on any profits. If a corporation will owe taxes, it must estimate the amount of tax due for the year and make quarterly payments to the IRS by the 15th day of the 4th, 6th, 9th, and 12th months of the tax year. If a corporation uses the calendar year as its tax year, the payments are due April 15, June 15, September 15, and December 15.

Shareholder Tax Payments

If the corporation's owners work for the corporation, they pay individual income taxes on their salaries and bonuses like regular employees of any company. Salaries and bonuses are deductible business expenses, so the corporation does not pay taxes on them.

Tax on Dividends

If a corporation distributes dividends to the owners, they must report and pay personal income tax on these amounts. And because dividends, unlike salaries and bonuses, are not tax-deductible, the corporation must also pay taxes on them. This means that dividends are taxed twice -- once to the corporation and again to the shareholders. Smaller corporations rarely face this problem: Because their owners typically work for the corporation as employees, the corporation can pay them in the form of tax-deductible salaries and bonuses, rather than taxable dividends.

S Corporation Taxes

The scheme of taxation described in this article applies only to regular corporations, called C corporations. By contrast, a corporation that has elected S corporation status pays taxes like a partnership or limited liability company (LLC): All corporate profits or losses "pass through" the business and are reported on the owners' personal income tax returns. To learn more about S corporations, see S Corporations.

No Pass-through Tax Deduction

The Tax Cuts and Jobs Act established a new income tax deduction for pass-through entities. During 2018 through 2025, owners of sole proprietorships, partnerships, limited liability companies, and S corporations may deduct for income tax purposes up to 20% of the net income from the entity. Regular C corporations are not pass-through entities; thus, their shareholders do not qualify for this deduction.

Benefits of the Separate Corporate Income Tax

Although reporting and paying taxes on a separate corporate tax return can be time consuming, there are some benefits to having a separate level of taxation. Here we explain a few of them, but you should see a tax expert for a complete explanation of the pros and cons of corporate taxation as it applies to your situation. This is a very complicated area, and for some companies -- especially those that may experience losses, are involved in investing, or may soon be sold -- corporate taxation can be a real disadvantage.

Lower Corporate Tax Rate

Starting in 2018, corporations pay a flat tax of 21% on all their profits. The 21% rate is lower than the top five individual income tax rates, which range from 22% to 37%. The benefit of the lower rates is largely lost due to double taxation if corporate profits are distributed to the shareholders, who must pay individual income tax on such dividends. However, many corporations want or need to retain some profits in the business at the end of the year -- for instance, to fund expansion and future growth. If it does, that money will be taxed only once, at the 21% corporate income tax rate. Thus, a corporation's owners can save money by keeping some profits in the company.

In contrast, owners of sole proprietorships, partnerships, and LLCs must pay taxes on all business profits at their individual income tax rates, whether they take the profits out of the business or not.

The IRS will allow you to leave profits in your corporation, up to a limit: Most corporations can safely keep a total of $250,000 (at any one time) in the corporation without facing tax penalties (some professional corporations may not retain more than $150,000).

Tax-Free Fringe Benefits

Another tax benefit of forming a corporation is that the company can deduct the full cost of fringe benefits provided to employees -- almost always including the business's owners -- and the owner-employees are not taxed on these benefits. Other types of business entities can also deduct the cost of many fringe benefits as a business expense, but owners who receive these benefits will ordinarily be taxed on their value.

To learn more about business taxes, read Tax Savvy for Small Business, by Frederick W. Daily (Nolo).

Do companies pay taxes on profits or revenue?

Corporate income taxes are usually assessed on declared profits – gross revenue net of costs incurred in the production process. There is ample evidence, however, that firms overreport their true costs to minimize their tax bills.

Is a business only taxed on profit?

A corporate or business tax is charged on the profits of a company. The figure used as a basis for taxes varies, depending on the business type: Small business owners pay tax on Schedule C as part of their personal tax returns. Partners in partnerships and LLC owners are taxed on their share of business net income.

How is business income taxed?

Corporation: Corporations are the only entities that pay federal taxes on their own based on net earnings. They are currently taxed at a flat 21% rate.