What is tax liability and how to calculate it (Step-by-step guide)

Understanding tax liability is essential for small business owners to minimize their tax burden and keep their businesses compliant. This blog breaks down the different types of tax liabilities, including income, payroll, capital gains, and sales taxes, and provides practical examples to help them calculate their obligations accurately.

Are you one of the many small business owners in the USA who has a general understanding of tax liability but lacks detailed knowledge about how it specifically applies to your business?

Image source: NFIB^[1]

Despite the Tax Cuts and Jobs Act^[2]simplifying some aspects of tax filing, like increasing the standard deduction, most small business owners continue to rely on tax software and a tax preparer to help them file their taxes.

About 88% of owners use a tax preparer, mainly to ensure compliance. 

You aren’t entirely to blame here, though. The U.S. tax code is notoriously complex, and staying up-to-date with changing regulations can be a task. Plus, different business structures (e.g., sole proprietorships, partnerships, LLCs, corporations) have different tax liabilities, and understanding the nuances of each can be confusing.

This gap in understanding can lead to overpayments, underpayments, and compliance issues. Pair that with anxiety due to messy books come tax time, and you turn into a headless chicken.

In this blog, we’ll talk about tax liabilities—what they are, how to calculate them, and the different types of tax liabilities there are.

What is tax liability?

Tax liability refers to the total amount of taxes your business owes to the IRS and other taxing authorities. 

Here’s a breakdown of what tax liability entails:

• Income and earnings: Your tax liability arises when you earn income or sell an item for more than its purchase price. This includes profits from your business operations.
• Total annual tax owed: A business’s total tax liability for a year includes all taxes owed to the government, such as income, sales, and property taxes. It’s the cumulative amount that the IRS expects to collect.
• Net tax liability: This is the tax owed after accounting for deductions, credits, exemptions, and any prepayments made throughout the year. It’s the actual amount you need to pay after reducing the gross liability with applicable tax benefits.
• Tax refunds and underpayments: Tax liability is different from a tax refund. A refund indicates that you overpaid your taxes and the government owes you money back. Conversely, if you’ve underpaid, you will owe additional money when you file your taxes.

For small business owners, managing tax liability can be particularly challenging due to the diverse types of taxes involved:

• Income tax: Based on your business’s profits, higher earnings mean a higher tax liability, potentially pushing you into a higher federal tax bracket.
• Capital gains tax: Applies when you sell assets at a profit.
• Payroll taxes: Owed if you have employees.

Additionally, deferred taxes may come into play, resulting from timing differences between accounting rules and IRS regulations. This can further complicate your tax situation, requiring careful planning and management to ensure compliance and avoid penalties.

How much business tax do you owe?

Businesses need to send in tax payments throughout the year, not just annually like individuals. The exact amount your business owes will depend on what kind of business you are, how much you’ve sold, and the tax bracket you fall into.

C corporations:

• Taxation: C corporations are taxed at corporate income tax rates, which are separate from personal income tax rates. This means the corporation itself pays taxes on its profits.
• Double taxation: Shareholders also pay taxes on dividends received from the corporation, leading to double taxation (once at the corporate level and again at the personal level).

S corporations:

• Taxation: S corporations are pass-through entities, meaning the income, deductions, and credits pass through to the shareholders’ personal tax returns. They are taxed at individual income tax rates.
• Avoiding double taxation: This structure avoids double taxation, as there is no corporate tax—only the shareholders are taxed on their share of the income.

Sole proprietors:

• Taxation: Sole proprietors report their business income and expenses on their personal tax returns using Schedule C (Form 1040). Profits are taxed at the individual’s personal income tax rate.
• Self-employment tax: Sole proprietors must also pay self-employment taxes (Social Security and Medicare) on their net earnings.

Partnerships:

• Taxation: Partnerships are also pass-through entities. The business itself does not pay income tax. Instead, profits and losses are passed through to the partners, who report them on their personal tax returns.
• Forms: Partnerships file an informational return (Form 1065) and issue Schedule K-1s to partners detailing their share of income, deductions, and credits.

Limited liability companies (LLCs):

• Taxation options: LLCs have flexibility in how they are taxed. They can choose to be taxed as a sole proprietorship (single-member LLC), partnership (multi-member LLC), or corporation.
• Pass-through taxation: By default, single-member LLCs are taxed as sole proprietorships and multi-member LLCs as partnerships, with income passing through to the owners’ personal tax returns.

Non-profit organizations:

• Tax-exempt status: Non-profits can apply for tax-exempt status with the IRS (typically under Section 501(c)(3)), meaning they are exempt from federal income taxes on income related to their exempt purposes.
• Unrelated business income tax (UBIT): Non-profits may be subject to UBIT if they generate income from activities unrelated to their exempt purpose.

Types of tax liability

As mentioned above, there are different types of tax liabilities. Let’s take a brief look at each of them.

1. Business tax liability

The federal government requires businesses to pay taxes on the profits they earn. Some businesses, such as S corporations, LLCs, and sole proprietorships, use a pass-through taxation model. This means the business itself doesn’t pay the taxes; instead, the profits are passed through to the owners or shareholders, who then report this income on their personal tax returns.

On the other hand, C corporations are a bit different. Since these businesses are considered separate from their owners, they pay corporate income taxes directly to the federal government.

How to calculate your business tax liability (Step-by-step guide)

1. Estimate your business income for the year

The most accurate way to do this is to calculate your business income for the current quarter and then use that total as the basis for your yearly estimate. If you have a large influx of expenses or unexpected income in the following quarter, you can adjust your totals going forward.

For example, let’s say your interior design agency has a gross business income of $120,000 for the year.

2. Estimate deductible business expenses for the year

You would follow the same process for estimating expenses as you did for estimating income. For example, in the first quarter, let’s say your income was $30,000, while your qualified business deductions were $6,250, leaving you with taxable income of $23,750 for the quarter.

You can multiply your quarterly estimates by 4 to arrive at your yearly estimate. In this case, your yearly business expenses are estimated at $25,000.

3. Estimate taxable income

Now that you’ve estimated that your yearly pretax income is $120,000 and your deductible expenses total $25,000, your taxable income for the year is estimated at $95,000.

4. Calculate the qualified business income (QBI) deduction

The QBI deduction allows eligible business owners to deduct up to 20% of their qualified business income.

• Net business income: $95,000
• QBI deduction: $95,000 x 20% = $19,000

5. Subtract the QBI deduction from your net business income to determine your adjusted gross income (AGI)

• AGI: $95,000 – $19,000 = $76,000

6. Apply the standard deduction for a single filer

• Standard deduction: $13,850
• Taxable income after standard deduction: $76,000 – $13,850 = $62,150

7. Determine the tax brackets applicable to your taxable income

Your taxable income of $62,150 falls into the 22% tax bracket.

8. Calculate the tax liability for each tax bracket up to your taxable income

• First $11,000 is taxed at 10%: $11,000 x 10% = $1,100
• The amount over $11,000 but under $44,725 is taxed at 12%: $33,725 x 12% = $4,047
• The amount over $44,725 but under $95,375 is taxed at 22%: $17,425 x 22% = $3,833.50

9. Add the amounts owed for each bracket

• $1,100 (10% bracket) + $4,047 (12% bracket) + $3,833.50 (22% bracket) = $8,980.50

Your total federal tax liability as the owner of an interior design agency LLC is $8,980.50.

10. Divide into quarterly payments

Now that you know your yearly tax liability is estimated to be $8,980.50, you can divide that by four to make your estimated tax payments, which would come out to $2,245.12 for each quarter.

Additional considerations for LLC owners

In addition to your federal income tax liability, as an LLC owner, you may need to pay self-employment taxes, which cover Social Security and Medicare. The self-employment tax rate is 15.3%, applied to your net business income after deducting half of the self-employment tax.

Calculate self-employment tax

• Net business income: $95,000
• Self-employment tax: $95,000 x 15.3% = $14,535

Deduct half of the self-employment tax from net business income for AGI calculation

• Half of self-employment tax: $14,535 / 2 = $7,267.50
• Adjusted net business income for AGI: $95,000 – $7,267.50 = $87,732.50

2. Payroll tax liability

Businesses handle payroll taxes by deducting federal, state, and local income taxes directly from employees’ wages. They also handle contributions to Social Security and Medicare under the Federal Insurance Contributions Act (FICA)^[3] and pay state and federal unemployment taxes.

All these deductions or withholdings — comprising employee income, FICA, and unemployment taxes — add up to what’s known as a company’s payroll tax liability. It’s up to the business to ensure these funds are deposited with the IRS.

How to calculate your payroll tax liability (Step-by-step guide)

Imagine you own a small marketing agency with three employees. Their annual salaries are as follows:

• Employee 1: $50,000
• Employee 2: $40,000
• Employee 3: $30,000

Let’s break down the payroll tax calculation step-by-step.

1. Calculate social security taxes

• Social security tax rate: 6.2%
• Wage base limit for social security (2023): $160,200

For each employee:

• Employee 1: $50,000 x 6.2% = $3,100
• Employee 2: $40,000 x 6.2% = $2,480
• Employee 3: $30,000 x 6.2% = $1,860

Total social security tax for all employees:
$3,100 + $2,480 + $1,860 = $7,440

2. Calculate medicare taxes

• Medicare tax rate: 1.45%

For each employee:

• Employee 1: $50,000 x 1.45% = $725
• Employee 2: $40,000 x 1.45% = $580
• Employee 3: $30,000 x 1.45% = $435

Total medicare tax for all employees:
$725 + $580 + $435 = $1,740

3. Calculate federal unemployment tax act (futa) taxes

• FUTA tax rate: 6.0% (before state credits)
• FUTA wage base: $7,000 per employee

For each employee:

• Employee 1: $7,000 x 6.0% = $420
• Employee 2: $7,000 x 6.0% = $420
• Employee 3: $7,000 x 6.0% = $420

Total futa tax for all employees:
$420 + $420 + $420 = $1,260

Note: after state credits, the effective futa tax rate is typically reduced to 0.6%, but we’ll use the standard rate here for simplicity.

4. Calculate state unemployment taxes (suta)

Assume the state unemployment tax rate is 5.4% on the first $7,000 of wages per employee.

For each employee:

• Employee 1: $7,000 x 5.4% = $378
• Employee 2: $7,000 x 5.4% = $378
• Employee 3: $7,000 x 5.4% = $378

Total suta tax for all employees:
$378 + $378 + $378 = $1,134

Total payroll tax liability

• Social security tax: $7,440
• Medicare tax: $1,740
• FUTA tax: $1,260
• SUTA tax: $1,134

Total payroll tax liability:
$7,440 + $1,740 + $1,260 + $1,134 = $11,574

3. Capital gains tax liability

When you sell a property, an asset, or any other investment and make a profit, you’ll need to pay taxes on those gains. However, if you sell at a loss, you won’t owe taxes, but you will need to report it as a capital loss.

Capital gains are categorized in two ways: long-term and short-term. 

• If you sell an asset you’ve owned for less than a year, it’s considered a short-term capital gain. 
• If you’ve held it for more than a year, it’s a long-term capital gain.

Just like different income tax brackets, there are different brackets or thresholds for capital gains that determine how much tax you’ll pay.

How to calculate your capital gains (Step-by-step guide)

Assume you purchase 100 shares of XYZ common stock for $10,000 in 2022 and sell them five years later for $18,000.

The $8,000 gain is a taxable event. Because you held the stock for more than one year, the gain is a long-term capital gain.

Using the previous example, if your adjusted gross income was $60,000, your capital gains bracket is 15%. So, you’d need to pay 15% of $8,000 in taxes, or $1,200. If you had held the stocks for less than one year, you’d include the $8,000 in your gross income before subtracting your standard deduction.

So, if you earned $72,950 and had $8,000 in short-term capital gains, your total income is $80,950. If your filing status and other deductions were the same as in the previous example, you’d still be in the 22% tax bracket and would work through the calculations the same way with the new income amount.

4. Sales tax liability

State and local governments impose sales taxes on businesses on almost every good or service they sell. The amount is collectively known as the business’s sales tax liability. All businesses are mandated to pay the taxes in a timely manner to the respective authorities.

How to calculate your sales tax liability (Step-by-step guide)

Imagine you own a small retail business in Massachusetts that sells home decor items. In 2023, your total sales were $150,000. The state sales tax rate in Massachusetts is 6.25%. Here’s how you can calculate your sales tax liability:

Step-by-Step Sales Tax Calculation:

1. Determine the Total Sales Amount Subject to Sales Tax:

• Total sales for the year: $150,000

2. Calculate the Sales Tax Rate:

• State sales tax rate: 6.25%

3. Calculate the Sales Tax Liability:

• Sales tax liability: $150,000 x 6.25% = $9,375

So, your total sales tax liability for the year is $9,375.

Detailed Breakdown:

1. Total sales amount:

Assume all $150,000 of your sales are subject to the Massachusetts state sales tax. If you had non-taxable sales, you would subtract that amount from the total sales before calculating the tax.

2. Sales tax calculation:

The state sales tax rate in Massachusetts is 6.25%. To find the sales tax liability, multiply your total taxable sales by the sales tax rate:

• $150,000 (total taxable sales) x 0.0625 (sales tax rate) = $9,375

Additional considerations:

Collecting sales tax: As a business owner, you must collect the sales tax from your customers at the point of sale. This amount is then held in trust until it is remitted to the state.

Filing sales tax returns: Typically, sales tax returns are filed either monthly, quarterly, or annually, depending on your state’s requirements and the amount of sales tax you collect. In Massachusetts, you would remit the $9,375 in sales tax to the state according to your filing schedule.

Local sales tax: If your business operates in a jurisdiction with additional local sales taxes, you would need to include those rates in your calculation. For example, if your city had an additional 1% sales tax, your total sales tax rate would be 7.25%, and your liability would be calculated as follows:

• Total sales tax liability: $150,000 x 7.25% = $10,875

Final sales tax liability:

Based on the Massachusetts state sales tax rate:

• State sales tax liability: $9,375

If there were additional local taxes, adjust the rate accordingly:

• Potential local tax liability (example): $1,500 (assuming an additional 1% local tax)
• Total sales tax liability: $9,375 (state) + $1,500 (local, if applicable) = $10,875

For this example, assuming only the state rate applies, your total sales tax liability for the year would be $9,375.

5. Self-employment tax liability

If you’re self-employed, you’ll need to pay Social Security and Medicare taxes, collectively known as self-employment tax. This tax totals 15.3% of your earnings, out of which 12.4% goes towards Social Security and 2.9% is added to your Medicare tax. You can calculate these taxes using Form 1040^[4] or 1040-SR^[5].

How to calculate self-employment tax liability for businesses (Step-by-step guide)

Imagine you are a self-employed graphic designer filing as a single taxpayer in 2023. Your gross business income for the year is $120,000, and your business expenses amount to $25,000.

Here’s how you can calculate your self-employment tax liability:

1. Calculate gross income:
   • Sum up all sources of revenue for the business.
   • Example: Total revenue = $120,000
2. Calculate deductions:
   • Identify and total all business expenses that qualify as tax-deductible.
   • Common deductions include employee salaries and wages, office supplies, depreciation on business assets, rent or mortgage interest, utilities, and travel expenses.
   • Example: Total deductions = $25,000
3. Calculate taxable income:
   • Subtract the total deductions from your gross income.
   • Example: Taxable income = $120,000 – $25,000 = $95,000
4. Calculate qualified business income (QBI) deduction:
   • The QBI deduction is 20% of your net business income.
   • Example: QBI deduction = $95,000 x 20% = $19,000
5. Determine adjusted gross income (AGI):
   • Subtract the QBI deduction from your taxable income.
   • Example: AGI = $95,000 – $19,000 = $76,000
6. Apply federal tax rates:
   • Use the progressive federal tax brackets to calculate your tax liability.
   • For 2023, the tax brackets for a single filer are:
     • 10% on income up to $11,000
     • 12% on income between $11,001 and $44,725
     • 22% on income between $44,726 and $95,375
7. Federal tax calculation:
   • First $11,000 at 10% = $1,100
   • Next $33,725 at 12% = $4,047
   • Remaining $31,275 at 22% = $6,880.50
   • Total Federal Tax = $1,100 + $4,047 + $6,880.50 = $12,027.50
8. Calculate self-employment taxes:
   • Self-employment tax rate covers Social Security (12.4%) and Medicare (2.9%).
   • Self-employment tax = $95,000 x 15.3% = $14,535
   • Deduct half of the self-employment tax from your AGI for calculation purposes.
   • Half of self-employment tax = $14,535 / 2 = $7,267.50
   • Adjusted net business income for AGI = $95,000 – $7,267.50 = $87,732.50
9. State tax rates:
   • Depending on your location, state taxes may also apply. Each state has its own tax rates and rules.
10. Credits:
    • Subtract any tax credits your business qualifies for. Tax credits directly reduce your tax liability.
11. Quarterly payments:
    • If you have made any estimated tax payments during the year, subtract these from your total tax liability to determine what is still owed.

Example calculation summary:

• Gross Income: $120,000
• Deductions: $25,000
• Taxable Income: $95,000
• QBI Deduction: $19,000
• Adjusted Gross Income (AGI): $76,000
• Federal Tax: $12,027.50
• Self-Employment Tax: $14,535 (with half, $7,267.50, deductible)
• Adjusted Net Business Income: $87,732.50

Your total self-employment tax liability, before considering any state taxes or additional credits, is the sum of your federal tax and self-employment tax.

• Federal tax liability: $12,027.50
• Self-employment tax: $14,535

Total tax liability = $12,027.50 + $14,535 = $26,562.50

The bottom line

Remember, the U.S. tax code is complex and constantly changing. Whether it’s managing payroll taxes for your employees, calculating capital gains on investments, or handling sales tax for your retail business, knowing your tax obligations can help you avoid costly mistakes, ensure compliance with tax laws, and minimize your tax burden. 

At CoCountant, we offer comprehensive tax filing and advisory services that simplify your tax obligations and provide strategic tax planning tailored to your business needs. With services ranging from accurate and timely tax returns to continuous year-round support and audit representation, our expert advisors help you navigate the complexities of tax laws.

Our advanced tax solutions address complex challenges, including international taxation for businesses operating across borders. We seamlessly integrate our tax services with your financial reporting, maintaining consistency and accuracy across all financial documents. Stay informed and prepared with our proactive approach to legislative changes, ensuring your business adapts swiftly to new tax laws and regulations.

Ready to minimize your tax liabilities and keep your business compliant and successful?