Small businesses are vital to the U.S. economy despite the pounding they took from the pandemic. While tens of thousands of small businesses went out of business, many new ones started up. Small businesses account for 99.9% of all firms, employ nearly half of the country’s private sector workforce, and contribute more than half of the nation’s gross national product.

It’s estimated there were more than 32 million small businesses—sole proprietorships, limited liability companies, partnerships, S corporations, and C corporations. While COVID-19 certainly hit many small businesses hard, the pandemic did not stop interest in entrepreneurship. The gig economy expanded and small businesses continued to be present on Main Street, farms, homes, and anywhere else that a business can be found.

Small businesses fall under the purview of the Internal Revenue Service’s (IRS) Small Business and Self-Employed Division. This division services approximately 57 million tax filers, including 47 million individuals filing Schedules C, E, or F. The IRS also oversees 3.8 million partnerships and 6.8 million corporations with assets of $10 million or less, more than 41 million of whom are full-time or partially self-employed, and about 7 million filers of employment, excise, and certain other returns. The Small Business and Self-Employment division accounts for about 40% of the total federal tax revenues collected. The goal of this IRS division is customer assistance to help small businesses comply with the tax laws.

As a small business owner, you work, try to grow your business, and hope to make a profit. What you can keep from that profit depends in part on the income tax you pay. The income tax applies to your net income rather than to your gross income or gross receipts. You are essentially taxed on what you keep after paying off the expenses of providing the services or making the sales that are the crux of your business. Deductions for these expenses operate to fix the amount of income that will be subject to tax. So deductions, in effect, help to determine the tax you pay and the profits you keep. And tax credits, the number of which has been expanded in recent years, can offset your tax to reduce the amount you ultimately pay.

Special Rules for Small Businesses

Sometimes it pays to be small. The tax laws contain a number of special rules exclusively for small businesses. But what is a small business? The average size of a small business in the United States is one with fewer than 20 employees with annual revenue under $2 million. Different government departments and agencies, as well as different industries, use their own definitions of “small business.” For federal tax purposes, the answer varies from rule to rule. Sometimes, it depends on your revenues, the number of employees, or total assets.  You may be a small business for some tax rules but not for others.

Reporting Income

Generally, all of the income your business receives is taxable unless there is a specific tax rule that allows you to exclude the income permanently or defer it to a future time.  When you report income depends on your method of accounting. How and where you report income depends on the nature of the income and your type of business organization.  Does your business report income on a Cash Basis or an Accrual Basis?

The IRS Commissioner said in 2021 that there’s a “tax gap” (the spread between revenues that should be collected and what actually is collected) estimated to be $1 trillion per year and that a great portion of this can be traced to entrepreneurs who underreport or don’t report their income, overstate their deductions, or fail to pay self-employment tax where warranted. While audit rates have recently been at historic lows due in part to budgetary issues, the SB/SE division wants to double the number of its examiners and plans to look carefully at self-employed individuals in an attempt to detect intentional or unintentional reporting errors.

Claiming Deductions

You pay tax only on your profits, not on what you take in (gross receipts). In order to arrive at your profits, you are allowed to subtract certain expenses from your income. These expenses are called “deductions.”

The nature and amount of the deductions you have often vary with the size of your business, the industry you are in, where you are based in the country, and other factors. The most common deductions for businesses include car and truck expenses, salaries and wages, utilities, supplies, legal and professional services, insurance, depreciation, taxes, meals, advertising, repairs, travel, rent for business property and equipment, and in many cases, a home office.

What Is a Tax Deduction Worth to You?

The answer depends on your tax bracket. The tax bracket is dependent on the way you organize your business. If you are self-employed and in the top tax bracket of 37% in 2021, then each $100 deduction will save you $37. Had you not claimed this deduction, you would have had to pay $37 of tax on that $100 of income that was offset by the deduction. For C corporations, there is a flat rate of 21%. This means that the corporation is in the 21% tax bracket. Thus, each $100 deduction claimed saves $21 of tax on the corporation’s income. Deductions are even more valuable if your business is in a state that imposes income tax.  However, you should explore the tax rules in your state and ascertain their impact on your business income.

When Do You Claim Deductions?

Like the timing of income, the timing of deductions—when to claim them—is determined by your tax year and method of accounting. Your form of business organization affects your choice of tax year and your accounting method.

Even when expenses are deductible, there may be limits on the timing of those deductions. Most common expenses are currently deductible in full. However, some expenses must be capitalized or amortized, or you must choose between current deductibility and capitalization. Capitalization generally means that costs can be written off ratably as amortized expenses or depreciated over a period of time. (Capitalized costs, such as for the purchase of machinery and equipment, are added to the balance sheet as company assets.) Amortized expenses include, for example, fees to incorporate a business and expenses to organize a new business. Certain capitalized costs may not be deductible at all, but are treated as an additional cost of an asset (basis).

Some expenses, even though related to business and not incurred but for business, are not deductible. The tax law specifically bars deductions for certain expenses (e.g., entertainment costs, transportation fringe benefits). And no deduction is allowed for personal expenses that are business-related, such as commuting costs. These nondeductible expenses are pointed out throughout the book.

Credits versus Deductions

Not all write-offs of business expenses are treated as deductions. Some can be claimed as tax credits. A tax credit is worth more than a deduction since it reduces your taxes dollar for dollar. Like deductions, tax credits are available only to the extent that Congress allows. In a couple of instances, you have a choice between treating certain expenses as a deduction or a credit. In most cases, however, tax credits can be claimed for certain expenses for which no tax deduction is provided. Most business tax credits are offsets for income taxes, but some reduce employment taxes.

Tax Responsibilities

As a small business owner, your obligations taxwise are broad. Not only do you have to pay income taxes and file income tax returns, but you must also manage payroll taxes if you have any employees. You may also have to collect and report on state and local sales taxes. Some businesses, such as farms, may have excise tax responsibilities. Finally, you may have to notify the IRS of certain activities on information returns.