Business Taxes - MARKETING

LAP-EC-027-SP © 2014, MBA Research and Curriculum Center® Pay Your Share 1

LAPLeadership, Attitude, Performance...making learning pay!Economics LAP 27 Performance Indicator: EC:072 Student Guide

Explain the importance of taxes to the government and the economy.

Objectives:

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Business Taxes

Pay Your Share Tax Basics

Describe the different types of taxes businesses must pay.

Now It’s Time to Pay

Why bother learning about business taxes?

What would you do?

Use what you’ve learned—right now!

Table of Contents

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As a student, you might not worry

too much about paying taxes right

now. If you have a part-time job,

you’ve probably noticed that your

employer deducts taxes from your

paycheck, but you might not un-

derstand why or where the money

is going. As the famous old saying

goes, “Nothing is certain except

death and taxes.” Like it or not,

you’ll have to pay taxes throughout

your career and adult life. Individu-

als like you aren’t the only ones

who are responsible for paying

taxes—businesses pay them, too!

Learn more about why businesses

pay taxes and what types of taxes

they pay.

Tax BasicsSuper market

To learn the impact of taxes on individuals, businesses, and government in the

United States, you must first understand the market economy we live in.

A market economy is an economic system based on private enterprise. In a

private enterprise system, businesses compete against each other to win

scarce customer dollars, with limited restrictions or government intervention

(in theory, anyway).

Let’s take a quick look at some important roles in a market economy:

• Businesses. When a business is successful in a market economy, it generates more sales and more income, both of which create bigger tax revenues for the government.

• Individuals. When individuals become successful in a market economy, they earn greater personal incomes, which generate more tax revenue for the government, and contribute to business growth through spending.

• The government. The government contributes to a market economy by spending the money it collects in taxes. As a matter of fact, in the U.S., about one third of our economy is based on government spending.


Can you see how all the players in a market economy are connected and interdependent? Let’s investigate

a little further by looking at the circular flow of income model.

The circular flow of income model is a very simplified depiction of how money flows through a market

economy. It shows money going back and forth between consumers and businesses. Consumers pay

businesses for goods and services, and businesses channel money back to consumers by expanding,

hiring, and paying salaries to employees (and, in some cases, paying dividends to shareholders).

Factors of Production

Wages, Rent, Interest, or Profit

Consumer Spending

Consumers

Goods and Services

Icon credits: iStock/Thinkstock

Businesses

Circular Flow of Income Model


As you can probably guess, though, the economy doesn’t exactly work this way in

real life. There are always leakages in this circular flow. For instance, consumers don’t

spend all their money on goods and services—they might save some for the future or

buy imports (products from outside the domestic economy). Businesses don’t use all

their profits for paying employees or shareholders, either. They may retain some earn-

ings to reinvest in the business or to pay off debt. And, of course, the government inter-

rupts the circular flow when it levies taxes on both individuals and businesses. Even

though the government puts money back into the economy by spending, it’s often not

enough to cover these leakages. When this happens, the government may attempt to

create an inflow of cash by borrowing from foreign investors or by trying to increase

the economy’s exports.

Tax...

Federal, state, and local governments all levy taxes on individuals and businesses.

We’ll learn more about the specific types of taxes businesses must pay later in the

LAP, but here are a few quick facts on where most of the government’s tax revenue

comes from:

• Individual income taxes make up about 46 percent of federal tax revenue and 37 percent of state/local tax revenue.

• Business income taxes make up about 11 percent of federal tax revenue and 7 percent of state/local tax revenue.

• Payroll taxes (paid jointly by employees and employers) make up about 35 percent of federal tax revenue.

• Sales and property taxes make up about 30 percent of state/local tax revenue.

(The federal government does not levy sales and property taxes.)

Imports and exports cause some leakages in the circular flow of income model. Saving for the future, reinvesting in the business, and paying taxes also cause “hiccups” in the flow of money in the economy.

iStock/Thinkstock


For a more in-depth look at government tax revenues, check out the Center on Budget

and Policy Priorities’ website at http://www.cbpp.org/cms/?fa=view&id=3822 or the Tax

Policy Center’s breakdown at http://www.taxpolicycenter.org/briefing-book/state-local/

revenues/state_revenue.cfm .

...and spend...

So, how does the government use all this tax revenue? To answer this question,

let’s take a look at both the federal government and state/local governments.

The federal government. The federal government divides its tax revenue into two

parts—income taxes (both individual and business) and payroll taxes (if you don’t know

what these are, don’t worry—we’ll go over it in Objective B). Income taxes become

general funds. The President and Congress can spend these funds however they see fit.

Payroll taxes become trust funds. This means that they are designated for specific

uses and cannot be spent on anything else. In the U.S., the majority of these trust funds

pay for unemployment, Social Security, and Medicare benefits. Social Security is a

federal program intended to keep elderly and disabled people from living in poverty.

Medicare is a program that provides health care for the elderly and disabled.

The biggest single chunk of the federal government’s spending goes to unemploy-

ment, Social Security, and Medicare. In 2010, these programs accounted for about

35 percent of federal spending. Other social programs (e.g., student loans, emergency

food assistance, etc.) accounted for 25 percent. National defense, veterans, and foreign

affairs accounted for 24 percent. The rest went toward human and community develop-

ment, law enforcement, general government, and interest on the national debt.

Payroll taxes levied by the federal government become trust funds that are used to pay for Social Security, Medicare, and unemployment benefits.

iStock/Thinkstock

http://www.cbpp.org/cms/?fa=view&id=3822

http://www.taxpolicycenter.org/briefing-book/state-local/revenues/state_revenue.cfm

http://www.taxpolicycenter.org/briefing-book/state-local/revenues/state_revenue.cfm


For more information on federal spending, look at the National Priorities Project’s

Federal Budget 101 links, starting here—http://nationalpriorities.org/budget-basics/

federal-budget-101/spending/ .

State and local governments. State and local governments use

their tax revenue for a number of purposes, including:

• Education

• Welfare

• Medicaid (low-income health-care coverage)

• Police, fire, and emergency medical services

• Water and sanitation

• Transportation

• Housing

• Parks, recreation, and libraries

• Interest on debt

You can look up more data about your state’s spending here—

http://www.usgovernmentspending.com/compare_state_spending_F0p.

...and borrow

The U.S. federal government’s predicted tax revenue for the year 2014 is

approximately $3 trillion. In case you were wondering, that’s a three followed by

twelve zeroes. When tax revenue isn’t enough to cover government expenditures,

the U.S. Treasury must borrow money. In 2014, that amount is expected to be about

$616 billion. Eventually, it will all have to be paid back—with interest.

Many state and local governments “give back” to their citizens by using a portion of their tax revenue to build public parks and other recreational facilities.

iStock/Thinkstock

http://nationalpriorities.org/budget-basics/federal-budget-101/spending/

http://nationalpriorities.org/budget-basics/federal-budget-101/spending/

http://www.usgovernmentspending.com/compare_state_spending_F0p


1. What is a market economy?

2. What are the roles of businesses, individuals, and the government in a market economy?

3. Describe the circular flow of income model.

4. Where does the government’s tax revenue come from?

5. How does the government spend tax revenue?

6. What happens when tax revenue isn’t enough to cover government expenditures?

Certain loopholes in the tax code can allow individuals or businesses to get away with paying much lower tax bills than they technically owe. One of the most common tax loopholes involves companies that operate in both the U.S. and for-eign countries leaving their profits overseas to avoid taxation. You see, companies don’t have to pay in-come taxes on foreign profits until they transfer them back to the U.S. So, a lot of companies just leave the money in overseas “tax havens.” It’s estimated that the federal government misses out on about $100 billion a year in tax revenue due to this practice. It’s legal, but is it ethical? What do you think?

Summary

Individuals, businesses, and the government all play important roles in a market

economy. Individuals and businesses make money and pay taxes, and the

government puts money back into the economy through spending. Taxation is

just one of the leakages in a market economy’s circular flow of income model.

Federal, state, and local governments tax individuals as well as businesses.

This tax revenue is used for a number of purposes, including Social Security,

Medicare, national defense, education, transportation, etc. When tax revenue

isn’t enough, the government borrows money to cover its expenditures.


Now It’s Time to PayBusinesses are responsible for paying a number of different types of taxes. Business

taxes may seem confusing at first, and, yes, the tax code can be a dense read even

for professionals, but anyone pursuing a business career should try to understand the

basics. Let’s take a closer look at the different types of taxes businesses must pay.

Income taxes. Businesses must pay income taxes on the profits they make, just

as individuals are required to do. The federal government as well as state and local

governments levy income taxes on businesses. Depending on how much profit a

business makes, the federal income tax rate is anywhere from 15 to 35 percent.

The more profit a business makes, the higher its tax rate is on the amount of profits

over a certain dollar figure. Don’t worry—it’s simpler than it sounds. Here’s a chart

that should help you understand:

Taxable Income (Profits) Federal Tax Rate (2011)

$0 to $50,000 15%

$50,000 to $75,000 $7,500 plus 25% of the amount over $50,000



$335,000 to $10,000,000 $113,900 plus 34% of the amount over $335,000

$10,000,000 to $15,000,000 $3,400,000 plus 35% of the amount over $10,000,000

$15,000,000 to $18,333,333 $5,150,000 plus 38% of the amount over $15,000,000

$18,333,333 and higher 35%

The deadline for corporate tax returns is typically March 15th of each year, while individual tax returns are due by April 15th.

iStock/Thinkstock


So, according to the chart, if your business made $500,000 in profits last year, you

would pay $113,900 plus 34 percent of $165,000 (the amount you made over $335,000).

Thirty-four percent of $165,000 is $56,100. Therefore, your business would owe

$170,000 in federal income taxes. Choose another dollar figure to represent taxable

income, and try doing the calculations yourself.

As far as state income taxes for businesses go, the rates vary from state to state.

Some states, such as Maryland, charge only a flat tax (every business pays the same

percentage, no matter how much profit it makes). Other states, such as Utah, use a

graduated scale similar to the one the federal government uses. And four states—

Nevada, South Dakota, Washington, and Wyoming—levy no income taxes on

businesses at all.

This chart compiled by The Tax Foundation shows how business tax rates have

changed over the years — http://taxfoundation.org/article/federal-corporate-income-

tax-rates-income-years-1909-2012.

Payroll taxes. There are taxes associated with being employed as well as with being

an employer. These are known as payroll taxes. Employers must withhold certain

taxes from their employees’ paychecks. These include the employees’ federal, state,

and local income taxes as well as Social Security and Medicare taxes. The Social

Security tax is listed on an employee’s pay stub as FICA, in reference to the Federal

Insurance Contributions Act that authorizes the tax. The current FICA tax rate is

6.2 percent of an employee’s gross wages. The current Medicare tax is 1.45 percent

of an employee’s gross wages.

There are many loopholes in the tax code that allow busi-nesses to achieve lower tax rates. It’s not uncommon for two businesses that earn the same amount of profits to pay very different amounts in taxes. The Institute for Policy Studies has compiled an interesting list of some common loopholes here— http://www.ips-dc.org/reports/corporate_tax_dodgers .

http://taxfoundation.org/article/federal-corporate-income-tax-rates-income-years-1909-2012

http://taxfoundation.org/article/federal-corporate-income-tax-rates-income-years-1909-2012

http://www.ips-dc.org/reports/corporate_tax_dodgers

http://www.ips-dc.org/reports/corporate_tax_dodgers


Employers must pay a matching amount of FICA tax and Medicare tax for each

employee. The federal government, then, receives FICA tax in the amount of 12.4

percent of each employee’s gross wages and Medicare tax in the amount of 2.9 per-

cent for each employee’s gross wages. Half is paid by the employee, and half by

the employer. Make sense? In addition, employers pay taxes to fund unemployment

and workers’ compensation programs.

Self-employment taxes. Self-employment taxes are the equivalent of payroll

taxes for those who own their own businesses. Let’s say you work as a house

painter, going from job to job as you get hired. Even though your clients pay you,

they aren’t your employers. They won’t withhold any taxes from your earnings, nor

will they pay half of your Social Security and Medicare taxes. You’ll have to do that

yourself.

To make up for the missing employer contribution, self-employed people must

pay the entire 12.4 percent Social Security tax and 2.9 percent Medicare tax them-

selves. However, they may deduct half the amount from their taxable incomes as a

business expense (we’ll explain deductions in just a bit). Self-employed people must

also withhold their own income taxes and make estimated payments to the govern-

ment every three months.

Watch this video for more information and tips on paying self-employment

taxes — http://video.foxbusiness.com/v/2260954350001/last-minute-tax-tips-for-the-

self-employed/ .

Listen Up!

Five states do not levy state

sales taxes—Alaska, Delaware,

Montana, New Hampshire, and

Oregon. Eleven states do not

allow local sales taxes—Con-

necticut, Delaware, Indiana,

Kentucky, Maryland, Massachu-

setts, Michigan, New Hamp-

shire, Oregon, and Rhode Is-

land. So, that makes your retail

purchases in Delaware, New

Hampshire, and Oregon com-

pletely tax free!

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http://video.foxbusiness.com/v/2260954350001/last-minute-tax-tips-for-the-self-employed/

http://video.foxbusiness.com/v/2260954350001/last-minute-tax-tips-for-the-self-employed/


Excise taxes. For certain products, the government levies taxes that businesses

pay by building the amount into the customer’s purchase price. In other words,

instead of charging a tax in addition to the product’s price, the business just

charges a higher price to begin with, using the difference to pay the required tax

to the government. These are known as excise taxes. Examples of products that

carry excise taxes include gasoline, air travel, mobile phone services, alcohol,

tobacco, indoor tanning, and some luxury items such as boats.

Property taxes. Businesses must pay property taxes just as individuals do.

Property taxes are based on a percentage of the property’s value. They usually apply

to real estate, though sometimes businesses pay property taxes on their vehicles or

even their inventories. Typically, property taxes are levied by city or county govern-

ments and used to fund schools, road construction, and other local interests.

For a map of states that levy taxes on business inventories, click here—

http://taxfoundation.org/blog/monday-map-property-taxes-business-inventory .

Sales taxes. You know that when you buy a pair of jeans for $59.99, your total is

a few dollars higher than that. That’s because of the sales tax, a tax levied by state

and local governments on most retail products. Sales taxes are a percentage of the

total purchase price. So, if you buy $59.99 jeans where the state sales tax is 6.5 per-

cent and the local sales tax is 2 percent, you’ll pay $59.99 + $3.90 + $1.20 = $65.09.

Businesses are responsible for collecting sales taxes from customers and turning

them over to the appropriate governments. As far as businesses themselves, they

do not have to pay sales taxes on the items they purchase for resale. However, they

do pay sales taxes on products they purchase for use in operating the business (e.g.,

shelving, computers, office supplies, etc.).

In addition to deductions

for business expenses, some

companies can lower their

tax bills by qualifying for

certain tax breaks. Tax

breaks are indirect

government subsidies

(financial support aimed at

creating economic or social

benefits). For example, a lo-

cal government might give

a certain business or group

of businesses a tax break to

operate in its town or city.

The goal would be to attract

businesses and create jobs.

Give Me a Break!

http://taxfoundation.org/blog/monday-map-property-taxes-business-inventory


Don’t forget your deductions!

It may seem that businesses owe an awful lot in taxes, but

there are certain ways they can save money. Business owners

can count certain expenses as deductions from their taxable

income, lowering their tax bills. Here are just a few examples

of expenses that businesses can deduct:

• Start-up costs

• Vehicles

• Travel expenses

• Equipment expenses

• Advertising and promotion expenses

• Salaries and bonuses paid to employees

• The costs of benefits paid to employees (health care, 401k contributions, etc.)

• The costs of payroll taxes (the business’s matching amounts of FICA and Medicare contributions)

Here’s a simplified example. Let’s say your company made

$1 million in sales revenue last year, but it cost $750,000 to

keep the business running as a result of paying for salaries,

rent, equipment, etc. Your business will pay income taxes

only on the $250,000 in profits, not the entire $1 million

in revenue.

Small business owners typically claim their business profit or loss on their

personal tax returns. To lower their tax bills, they usually deduct their

business expenses (such as advertising, work vehicles, equipment, etc.)

from their taxable income.

iStock/Thinkstock


The Internal Revenue Service gives additional information on business

deductions here — http://www.irs.gov/Businesses/Small-Businesses-&-Self-Em-

ployed/Deducting-Business-Expenses .

You need some structure

A business’s ownership structure affects the way it is taxed. There are several

different types of business structures, but when it comes to taxes, the main

thing to know is whether or not the business is a corporation.

Non-corporations. Sole proprietorships (businesses owned by one individu-

al), partnerships (businesses owned by two or more individuals), and limited

liability companies (partnership-corporation hybrids) are all taxed similarly.

They are considered pass-through entities, meaning that all of the business’s

profits and losses are “passed through” to the owner(s) to be claimed on their

personal tax returns. Each owner’s individual portion of the business’s profits

and losses is known as her/his distributive share.

Business owners must pay taxes on their distributive shares whether or not

they withdraw money from the business. Let’s say you’re a partner in an LLC,

and your distributive share last year was $100,000. You take half that money

out as your “salary,” and leave half of it invested in the company. Even though

you only took home $50,000 in pay, you’ll still be taxed on the entire $100,000.

This is the reason that some business owners find it advantageous to change

the business’s structure and incorporate (become a legal corporation).

“Taxes are what we pay for civilized society.”

— Oliver Wendell Holmes, Jr.,

U.S. Supreme Court Justice

http://www.irs.gov/Businesses/Small-Businesses-%26-Self-Employed/Deducting-Business-Expenses

http://www.irs.gov/Businesses/Small-Businesses-%26-Self-Employed/Deducting-Business-Expenses


Here are a few more important things to note about non-corporations and taxes:

• There is no tax withholding for owners of these types of businesses. The owners are considered self-employed and must make quarterly estimated tax payments to the government.

• Businesses with multiple owners must file informational returns with the Internal Revenue Service to ensure that all partners are filing their individual returns correctly.

• Even though owners pay only personal taxes, they can still deduct business expenses from their taxable incomes. This makes accurate recordkeeping extremely important. It’s a good idea for owners to keep separate business and personal accounts.

Corporations. Corporations are the only businesses that are separate entities

from their owners and pay their own income taxes. Like other businesses,

corporations make estimated quarterly tax payments to the government.

The main advantage of the corporate structure is that the business can retain its

earnings at lower tax rates than individual owners can. If you refer back to the table

of corporate tax rates above, you can see that tax rates for a business’s first $75,000

in taxable income range from 15 to 25 percent. These rates are lower than what

owners would pay on their personal tax returns for distributive shares. Corporation

owners pay taxes only on their salaries and dividends. They are also protected from

shouldering personal liability for the corporation’s losses.

Most corporations are known as

C corporations. An S corporation,

however, is a special type of corpo-

ration that chooses to be taxed as a

pass-through entity. There are several

limitations regarding what an S

corporation can be. For example,

it must be a domestic corporation

with no more than 100 shareholders.

iStock/Thinkstock


Double Taxation

The main disadvantage of the corporate structure is double taxation. After the corporation

pays income taxes on its earnings, it may distribute dividends to shareholders. The shareholders

then report those dividends on their personal tax returns, paying income taxes on them as well.

This video explains more about business structures and tax implications—

http://www.videojug.com/interview/small-business-types-and-their-tax-implications .

http://www.videojug.com/interview/small-business-types-and-their-tax-implications


The IRS

The government agency that oversees taxes is the Internal Revenue Service,

or IRS. Headquartered in Washington, D.C., the IRS operates under the authority

of the U.S. Department of Treasury, and its major duties include:

• Checking tax returns

• Collecting tax payments

• Issuing tax refunds

• Conducting tax audits

Different divisions of the IRS specialize in individual taxpayers, small businesses,

medium to large businesses, and non-profit organizations.

Summary

Businesses may be responsible for paying a number of different taxes, including

income taxes, payroll taxes, self-employment taxes, excise taxes, property taxes,

and sales taxes. Businesses can deduct certain expenses from taxable income to

lower their tax bills. A business’s ownership structure affects the way it is taxed.

Non-corporations are “pass-through” entities, but corporations are taxed separately

from their owners. The Internal Revenue Service is the government agency that

oversees taxes.

1. What types of taxes apply to businesses?

2. How can businesses save money on taxes?

3. How does a business’s structure affect the way it is taxed?

4. What is the role of the Internal Revenue Service?


Think about your place of employment. If you aren’t

working right now, consider where a parent/guardian

works or perhaps a local business you visit frequently.

What is the ownership structure of this business? How

does this structure affect the way the business is taxed?

What types of taxes are the business or its owners

likely to pay?

Documents

Business Taxes - MARKETING