December 27, 2014
Most people are aware that businesses pay taxes differently than individuals. What you might not realize is that the differences don’t stop there. In fact, there are distinct differences in the way a small startup pays taxes versus a large corporation.
The Tax Differences between Startups and Large Corporations
The first thing you should understand is that the basic tax laws are the same for both large corporations and startups. What is different are the types of credits and incentives the companies have access to – all of which are based on profits. Small startups generally do not make the same level of profits as large corporations, and are therefore not usually eligible for these credits and incentives. However, that does not mean that small corporations are out of luck. Below is more information on how the size of a company, and its profits, influence taxes.
Corporate Profits and Corporate Tax Rates
As of 2014, the tax rate for corporations was 15 percent on the first $50,000 in profits. After the initial profits, the rate steadily increases to the maximum of 39 percent for profits over $335,000. However, the increases in tax rates aren’t particularly clear. For example, a small company that makes between $100,000 and $335,000 has a tax rate of 39 percent; but a company that makes between $335,000 and $10,000,000 is only taxed at 34 percent. So it’s to a small company’s advantage to make more than $335,000, or less than $100,000 in profits.
At the same time, a small start up that makes less than $50,000 in profits has a slight advantage because it only pays 15 percent in taxes, versus the 25 to 39 percent it would have to pay if it makes between $50,000 and $335,000. However, this advantage only lasts so long as the company can function and exist making less than $50,000 in profits every year.
Ultimately, the more money a company makes, the better its tax rate.
Editor's note: We received this information from one of our dedicated readers, who would like to clear up any possible misunderstanding:
“Ultimately, the exact opposite is true… the more money a company makes, the higher its effective tax rate will be (effective tax rate = actual percentage of the entire profit paid as taxes). There is actually no point where the effective tax rate ever goes down; it always goes up or stays the same. This is counterintuitive when you look at the tax bracket dropping from 39% to 34%. But if a company makes exactly $335,000 in profits, its effective tax rate is exactly 34% (that's why the federal government placed the return to a 34% bracket at precisely the $335,000 mark).
There is a common misunderstanding about how tax brackets work that is implied by some of this commentary: that a businesses entire profits are taxed at a single rate (34%, or 39%, or some other figure). This is emphasized in this sentence from the first paragraph: “So it’s to a small company’s advantage to make more than $335,000, or less than $100,000 in profits.” This $100,000 to $335,000 range that the writer referenced is the 39% bracket, and he has told the reader that companies should avoid this supposed danger zone.
The second paragraph make a similar assertion: that a company needs to stay below $50,000 in profits to retain a 15% tax rate. The implication in the wording here is that as soon as a business bumps up to $50,001 in profits, their profits are then taxed at 25%. Thankfully, this is not how tax brackets work.
Each tax bracket represents the rate at which that particular range of profits is taxed. So, for example, only the profit in between $100,00 and $335,000 is taxed at 39%. Every dollar of profit less than $100,000 is taxed at a lower rate. The table on the website that the article linked to actually displays this reasonably well:
Taxable income over Not over Tax rate
$ 0 $ 50,000 15%
50,000 75,000 25%
75,000 100,000 34%
100,000 335,000 39%
335,000 10,000,000 34%
10,000,000 15,000,000 35%
15,000,000 18,333,333 38%
18,333,333 ………. 35%
So, if my business has $200,000 in profits, then this is how those profits are taxed:
– The first $50,000 is taxed at 15%
– The next $25,000 is taxed at 25%
– The next $25,000 is taxed at 34%
– The final $100,000 is taxed at 39%
As a result, businesses need not fear that jumping from one tax bracket to another will impact their entire profit. Everybody wins.”
The above input was received by Mike Pesch. Thanks, Mike!
Effective Tax Rates versus Actual Tax Rates
Of course, what the IRS sets as the actual tax rate doesn’t really matter when you take into account the effective tax rate. The effective tax rate is the actual percentage an individual or company owes after deductions and other things. Remember those credits and incentives we mentioned earlier? According to ADP.com, it’s those credits and incentives that can lower a company’s effective tax rate. These credits and incentives can make a huge difference in how a company is taxed because they effectively lower the company’s income. This means that a company that earned $11,000,000 and was in the 35-percent tax bracket could take advantages of credits and incentives and lower itself to the 15 percent tax bracket, or even less.
One good example of this is Mitt Romney who made an estimated $21,000,000, which should have put him at approximately 35%, but after credits and incentives only paid taxes at an effective tax rate of 13.9 to 14 percent.
Unfortunately, many of these credits and incentives that the larger corporations use to lower their taxes are simply not available to small companies and startups.
That’s because many of these corporate tax loopholes require a company to spend a lot of money to qualify. For example, The IRS does not tax money earned in foreign countries, additionally, many foreign countries have very low corporate tax rates as compared to the United States. This means that large corporations like Google and Amazon, can move substantial parts of their operations abroad, pay much less in taxes than the 35 percent they would pay here, and, even if that money ends up in United States Bank accounts, not have to pay any taxes on those profits here. In fact, Burger King made the news earlier in 2014 when it contemplated moving its headquarters to Canada to avoid paying United States taxes.
Small companies and startups often don’t have the revenue to set up operations in foreign countries, at least not at a scale large enough to produce the kinds of profits they need to make it worthwhile.
Another issue is that large corporations can take greater deductions on business expenses, including things like executive stock options, private jets, and corporate sponsorships, because they have the financial resources to do so. A company like Papa John’s can spend millions of dollars to be the official sponsor of the Super Bowl, and hire old sports legends to appear in prime-time national commercials, and give away thousands of free pizzas, and then write it all off as a business expense to the tune of millions. A Mom-and-Pop pizza shop just doesn’t have the same resources to do that.
Small Business Tax Breaks
It may appear that small companies and startups don’t stand a chance when it comes to taxes. In fact, although a large number of corporate tax breaks tend to benefit the large wealthy corporations, smaller companies do have options.
The best course of action is to consult with a professional for tax tips, including information on the type of tax structure to use and the types of breaks available to small business, such as the Small Business Health Care Credit.
There are also organizations like Americans for Tax Fairness and Citizens for Tax Justice that are working for more equitable tax laws and codes that will close the large corporate tax loopholes, and level the financial playing field for small companies and startups.
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