Small Business Tax in United States

What entity structures are available for US small businesses?

The choice of business entity is the first and most consequential tax decision for a US small business. Six structures are commonly used [SC1]:

1. Sole proprietorship: Default for an individual conducting business without forming a separate entity. Income reported on Schedule C with the owner's Form 1040. All income subject to self-employment (SE) tax at 15.3 percent. No liability shield.
2. Single-member LLC (SMLLC): Disregarded entity by default for federal tax purposes — taxed like a sole proprietorship. State-level liability shield. May elect S-corp or C-corp tax treatment by filing Form 2553 or Form 8832.
3. Multi-member LLC: Default tax treatment is partnership. Files Form 1065 and issues K-1s to members. Members pay SE tax on their share of partnership earnings if they are general partners or LLC member-managers.
4. S corporation: Domestic corporation that elects S-corp status via Form 2553. Files Form 1120-S, issues K-1s to shareholders. Pass-through income is NOT subject to SE tax (a major advantage over sole prop / partnership), but owner-operators must take reasonable W-2 compensation subject to FICA.
5. C corporation: Default for corporations not electing S status. Files Form 1120, pays federal corporate income tax at 21 percent under IRC §11. Distributions to shareholders are taxed again as dividends — the classic double taxation.
6. Partnership (LP, LLP, general partnership): Files Form 1065. Partners pay tax on their distributive share whether or not cash is distributed.

The choice depends on income level, growth plans, owner involvement, and exit strategy. For a sole owner-operator earning USD 60,000 of net business income, a sole proprietorship or SMLLC works simply — SE tax of approximately USD 8,500 on 92.35 percent of net income is comparable to (or slightly higher than) S-corp tax with reasonable comp. For a single owner earning USD 150,000 of net income, S-corp election produces materially lower employment tax because the SS wage base (USD 168,600 for 2025) doesn't fully bite on pass-through distributions. For a business raising venture capital or seeking IPO, C-corp is required.

Entity choice is reversible but with friction. Conversion from sole prop to LLC is generally tax-free. Conversion from LLC to corporation is treated as a deemed transfer under IRC §351 (often tax-free if specific requirements are met). Conversion from S-corp to C-corp by revoking the §1362 election is generally tax-free but carries a five-year waiting period before re-electing S status without IRS consent.

How does federal corporate income tax work?

C corporations pay federal income tax at a flat 21 percent rate under IRC §11 [SC2]. The 21 percent rate was set by the Tax Cuts and Jobs Act of 2017 (reducing the prior top corporate rate of 35 percent) and unchanged through 2025. Form 1120 (US Corporation Income Tax Return) is the annual return.

Key C-corporation tax mechanics:

• Tax year: Most C corporations use a calendar year, but other fiscal years are allowed with IRS approval.
• Filing deadline: 15th day of the fourth month after the fiscal year-end. For calendar-year corporations, April 15. A six-month extension to October 15 is available via Form 7004.
• Estimated payments: Quarterly via Form 1120-W on the 15th day of the fourth, sixth, ninth, and twelfth months of the fiscal year.
• Corporate Alternative Minimum Tax (CAMT) under IRC §55, enacted by the Inflation Reduction Act of 2022: 15 percent on adjusted financial-statement income (AFSI) for corporations with average annual AFSI exceeding USD 1 billion across the prior three years. Affects large corporations only; small businesses generally exempt.
• Stock buyback excise tax under IRC §4501: 1 percent on the fair market value of stock repurchases, also from the Inflation Reduction Act, applicable to certain public companies.
• Net operating loss carryforward: NOLs generated after 2017 carry forward indefinitely (no carryback) and are limited to 80 percent of taxable income in the carry-forward year. NOLs from 2018-2020 had temporary five-year carryback under the CARES Act.

Branch profits tax under IRC §884: A 30 percent branch profits tax applies to US branches of foreign corporations, often reduced by treaty (covered in the Tax treaty relief crossover). The tax is in addition to the regular 21 percent corporate income tax on US source income.

Accumulated earnings tax under IRC §531: 20 percent additional tax on accumulated earnings of a C corporation deemed to be retained beyond reasonable business needs for the purpose of avoiding shareholder tax. The accumulated earnings credit shields the first USD 250,000 (USD 150,000 for service corporations) automatically.

S-corporation pass-through taxation

S corporations elect pass-through tax treatment under Subchapter S of the Internal Revenue Code [SC3]. Income, losses, deductions, and credits flow through to shareholders' personal returns proportional to ownership. The corporation itself generally pays no federal income tax, though some states impose entity-level taxes on S-corps.

Key S-corp requirements under IRC §1361:

• Domestic corporation only (cannot be incorporated outside the US)
• Maximum 100 shareholders (spouses count as one)
• Eligible shareholders only: Individual US persons, certain trusts, estates, and tax-exempt organizations. NOT corporations, partnerships, non-resident aliens, or most foreign entities.
• One class of stock: All shares must have identical rights to distribution and liquidation proceeds. Voting rights may differ.
• Calendar tax year generally required (or §444 election for specific business-purpose fiscal year)

The S-election is made via Form 2553 within 75 days of the start of the tax year for which the election is to take effect. Late elections can be granted under Rev. Proc. 2013-30 for non-wilful late filings.

Reasonable compensation requirement: S-corp owner-operators who provide services to the corporation must take reasonable W-2 compensation subject to FICA. The IRS audits this rigorously: a sole-owner S-corp paying USD 30,000 of W-2 to the owner while distributing USD 200,000 of pass-through profit will likely face recharacterization. "Reasonable" is determined by what an unrelated employer would pay for the same services in the same market — supported by industry compensation surveys (RIA, RCReports), Bureau of Labor Statistics data, and comparable transactions.

The payroll-versus-distributions split is where the S-corp tax savings live. Above the Social Security wage base (USD 168,600 for 2025), additional W-2 compensation only saves the 1.45 percent employee Medicare and 1.45 percent employer Medicare (plus the 0.9 percent Additional Medicare for high earners). Distributions in excess of reasonable comp avoid FICA entirely. For an owner with USD 300,000 of net business profit, splitting USD 130,000 to W-2 (under the SS wage base) and USD 170,000 to distributions could save approximately USD 15,000-USD 20,000 in employment tax versus sole-prop SE tax.

The Section 199A QBI deduction (covered in Self-employed tax) interacts: at higher income levels, the 50-percent-of-W-2-wages limit applies, so paying too little W-2 can throttle the QBI deduction. The compensation level that minimizes total tax is usually higher than the minimum that satisfies the reasonable-comp test.

Partnership taxation and K-1 reporting

Partnerships file Form 1065 (US Return of Partnership Income) and pass through income to partners via Schedule K-1 [SC4]. The partnership itself pays no federal income tax. Each partner reports their distributive share — proportional to the partnership agreement — on their own return, whether or not cash was distributed.

Partnership tax mechanics:

• Tax year: Generally must match the majority-interest partner's tax year, or use the principal-partners rule, or have a business-purpose fiscal year under §706(b).
• Filing deadline: March 15 of the following year (15th day of the third month after the partnership year-end), with six-month extension to September 15 via Form 7004. Earlier than the corporate / individual deadline so that K-1s reach partners before their personal returns are due.
• Centralized Partnership Audit Regime (BBA): Audits are conducted at the partnership level under the Bipartisan Budget Act of 2015 rules, with the partnership paying any imputed underpayment unless it makes a §6226 "push-out" election to flow the adjustment back to the partners who held interests in the audited year.
• Outside basis tracking: Each partner's outside basis (in their partnership interest) is critical to loss-deductibility (§704(d) loss limitation), tax-free distribution (§731), and gain on sale of partnership interest (§741). The partnership tracks each partner's capital account; partners must track their own outside basis.
• Hot assets under IRC §751: On sale of a partnership interest, the seller recognizes ordinary income equal to the share of partnership unrealized receivables and inventory items, with the remaining gain treated as capital gain. Common trap for partners selling out of professional services firms or real-estate partnerships.

Limited partners and LLC members who do not materially participate (under §469) generally treat partnership income as passive — subject to passive activity loss limitations and Net Investment Income Tax. General partners and managing LLC members treat partnership income as active, deductible without passive limits and subject to SE tax.

Section 179 expensing and bonus depreciation

Section 179 of the IRC allows businesses to immediately expense up to USD 1,250,000 of qualifying tangible personal property placed in service during 2025 (set by Rev. Proc. 2024-40, indexed annually for inflation) [SC5]. The deduction phases out dollar-for-dollar above an investment limit of USD 3,130,000 in qualifying purchases. The deduction is limited to the business's taxable income (cannot create or increase an NOL).

Qualifying property includes:

• Tangible personal property (machinery, equipment, furniture)
• Off-the-shelf computer software
• Qualified Improvement Property (interior improvements to non-residential real property)
• Certain real-property improvements (roofs, HVAC, fire protection, security systems on non-residential property)

Not eligible: real property (except qualifying improvements), inventory, intangibles other than off-the-shelf software, property used predominantly outside the US.

Bonus depreciation under IRC §168(k) is a separate first-year depreciation allowance applicable to most tangible property with a recovery period of 20 years or less. The TCJA-set 100 percent bonus depreciation phased down to:

• 80 percent for 2023
• 60 percent for 2024
• 40 percent for 2025 (current year)
• 20 percent for 2026 (scheduled)
• 0 percent for 2027 (scheduled)

The One Big Beautiful Bill Act of 2025 restored 100 percent bonus depreciation permanently effective for property placed in service after the OBBBA enactment date. For 2025 specifically, property placed in service before OBBBA's effective date uses the 40 percent rate; property placed in service after uses 100 percent. Practitioners track the specific dates carefully for asset acquisitions straddling the change.

The interaction between §179 and bonus depreciation is sequential: §179 expense applies first (subject to its investment and taxable-income limits), then bonus depreciation applies to the remaining basis. For a small business that can fully expense USD 200,000 of equipment under §179, both regimes produce the same result. For a business with USD 5,000,000 of equipment placed in service, §179 maxes out at USD 1,250,000 and bonus depreciation handles the rest at the applicable rate.

Payroll tax: FICA, FUTA, state UI, federal income tax withholding

Any small business with W-2 employees faces payroll tax obligations under IRC §§3101-3128 [SC6]. The mechanics:

• FICA (Federal Insurance Contributions Act): Employer and employee each pay 6.2 percent Social Security on wages up to USD 168,600 (2025) plus 1.45 percent Medicare on all wages. Employees pay an additional 0.9 percent Medicare on wages above USD 200,000 (single threshold; not a married-filer differential at the employer level) under IRC §3101(b)(2).
• FUTA (Federal Unemployment Tax Act): Employer pays 6 percent on the first USD 7,000 of each employee's annual wages, with a 5.4 percent credit for state UI payments (effective rate 0.6 percent for most employers).
• State UI: Employer pays state unemployment insurance at a rate set by the state, typically experience-rated based on the employer's claim history. Rates vary from approximately 0.1 percent to 6+ percent depending on state and history.
• Federal income tax withholding: Employer withholds federal income tax based on the employee's Form W-4 selections.
• State income tax withholding: Employer withholds state income tax in the 41 states with income tax.
• Local taxes: Some cities and counties require local payroll tax withholding (e.g., New York City, Philadelphia school district, Ohio school district taxes).

Forms and deadlines:

• Form 941 (Employer's Quarterly Federal Tax Return): Filed quarterly, due April 30, July 31, October 31, January 31. Reports FICA + federal income tax withholding.
• Form 944: Annual return for small employers with annual employment tax liability under USD 1,000.
• Form 940 (FUTA): Annual return due January 31 of the following year.
• Form W-2: Annual wage and tax statement issued to each employee by January 31 of the following year; W-2s plus Form W-3 transmittal filed with SSA by January 31.
• Form W-4: Withholding allowance certificate completed by each employee at hire and updated as life events change.

Federal employment tax deposits are made via EFTPS on a schedule that depends on the employer's average tax liability — monthly for smaller employers, semi-weekly for larger. Late deposits trigger penalties under IRC §6656 ranging from 2 percent (1-5 days late) to 15 percent (10+ days late after notice). Trust fund recovery penalty under IRC §6672 makes responsible persons personally liable for unpaid withholdings.

Employee vs. independent contractor classification

The distinction between an employee (W-2) and an independent contractor (1099-NEC) is the source of substantial small-business audit risk [SC7]. Classification determines payroll tax obligations (substantial for employees, none for contractors), benefits eligibility, and various state-law obligations (workers compensation, unemployment insurance, minimum wage).

The IRS applies a multi-factor common-law test that examines:

• Behavioral control: Does the business control how the worker performs the work?
• Financial control: Does the worker have unreimbursed expenses, opportunity for profit or loss, and a real investment in tools?
• Type of relationship: Written contract, employee benefits, permanency of relationship, services as a key activity of the business?

Form SS-8 allows a business or worker to request an IRS classification determination, but the IRS has historically been quick to classify as employee. The Section 530 "safe harbor" (Tax Reform Act of 1978 §530) protects a business from retroactive reclassification if it has consistently treated similar workers as independent contractors, has filed 1099-NECs, and has a reasonable basis for the classification (judicial precedent, prior IRS audit clearance, or industry practice).

State-law classification (especially in California under AB5 and Dynamex) is often stricter than federal. A worker who is properly classified as a federal independent contractor may be a state-law employee. The mismatch creates compliance burden and exposure for businesses using contractor labor across multiple states.

The practical 1099-NEC issuance workflow for small businesses generally runs through e-filing platforms like Tax1099 which handle TIN matching against IRS records, e-filing with the IRS, and recipient-copy distribution. Failure to issue a required 1099-NEC carries a USD 290 per failure penalty for 2025 (intentional disregard: USD 580 per failure with no annual cap).

R&D credit, employee retention credit, and other small-business credits

The small-business tax credit landscape includes several credits worth substantial dollars when applicable:

• Research and Development Credit (IRC §41): Credit for qualified research expenses, with a small-business simplified election (Alternative Simplified Credit) that yields 14 percent of QREs above 50 percent of average QRE in the prior three years. Software development, product engineering, and process improvements often qualify. Small businesses (<USD 5M gross receipts, <5 years in business) can elect to use up to USD 500,000 of the credit against payroll taxes rather than income taxes under IRC §41(h), valuable for startups not yet profitable.
• Work Opportunity Tax Credit (IRC §51): Credit for hiring members of targeted groups (long-term unemployed, veterans, ex-felons, certain SNAP recipients). Up to 40 percent of first-year wages up to USD 6,000 for most categories, higher for some.
• Small Employer Health Insurance Credit (IRC §45R): For small employers with fewer than 25 FTEs paying average wages under USD 64,400 (2025) and contributing at least 50 percent of premium for employee-only coverage through SHOP exchanges. Up to 50 percent of premium cost for two consecutive years.
• Section 1202 Qualified Small Business Stock: Original-issue stock of a C corporation acquired by a non-corporate shareholder and held more than 5 years qualifies for exclusion of gain on sale of up to the greater of USD 10 million or 10x basis, under IRC §1202. Material for startup founders considering a future exit.
• Employee Retention Credit (ERC): The pandemic-era credit for 2020 and 2021 wages — applications under aggressive enforcement scrutiny in 2024-2025 with substantial IRS pushback against frivolous claims. Legitimate retroactive ERC claims for 2020-2021 wages remain available within the statute of limitations.

Year-end planning and recordkeeping

Small business year-end work spans several categories:

• Equipment placed in service before year-end: §179 and bonus depreciation eligibility requires the asset to be placed in service (ready and available for use) by December 31, not merely purchased.
• Reasonable comp review for S-corps: Adjusting payroll near year-end to hit target W-2 levels for QBI optimization or audit-defensive reasonable-comp positioning.
• Retirement plan contributions: SEP IRA contributions can be made up to the federal return due date including extensions; Solo 401(k) employee deferrals must generally be made by year-end (employer profit-sharing by the return due date).
• Estimated payments: Final Q4 estimate due January 15 of the following year; year-end estimation reduces underpayment penalty risk.
• Inventory write-downs: Obsolete or damaged inventory should be written down or disposed of before year-end.
• 1099-NEC tracking: Identifying all non-employee compensation USD 600+ during the year for January 31 issuance.
• Document retention: Books and records for IRC §6001 requirements — generally three years post-filing, six years if substantial understatement, indefinitely for fraud or non-filing.

Multi-currency small businesses (US LLC with foreign clients or contractors) often manage USD-foreign-currency conversion through accounts like WorldFirst, feeding the USD-denominated revenue and expense streams into Schedule C, Form 1120-S, or Form 1065 reporting. The 1099-NEC e-filing for US-based contractors paid by small businesses commonly runs through Tax1099, which handles TIN matching and IRS submission.

For a complete picture of how small business tax connects to the rest of the federal stack, see the US federal tax overview. For SE tax mechanics on sole proprietorships and partnerships, see Self-employed tax. For capital gains on business sales and Section 1202 QSBS, see Capital gains tax. For state-level sales tax obligations and Wayfair economic nexus, see VAT and sales tax. The Business tax topic hub compares US treatment with other jurisdictions. To find a practitioner who handles small business returns, browse the US tax-pros directory.