Federal effective tax rates average 20% for small businesses

April 15, 2009

A new report out from the Small Business Administration reveals the effective tax rates for small businesses when it comes to federal income taxes. Average rates range from 13.3% for small sole proprietorships to 27% for small S corporations. And remember, the effective tax rate is the actual amount of taxes paid by a firm as a percent of its net income. This is important because these rates reflect the statutory benefits aimed at lowering a business' tax liability. In essence, the 13-27% is lower than what the rate would otherwise be without legislative deductions, exemptions, credits, et al.

And keep in mind that the SBA defines a small business as a firm with less than 500 employees. In my mind, a firm with 499 employees is a pretty large enterprise. I do appreciate that the state government defines a small business as one with 20 or fewer wo!
rkers and earn less than $3 million or less in annual gross income. 

As the economic downturn interminably lags on, the importance of supporting small businesses is more important than ever. Looking at data from the last recession in the early 2000s (granted a different type of slowdown, but a strong one nonetheless), sole proprietorships and LLCs see strong growth during the downturn. Even going back to the early 1990s recession -- and before LLCs were available in Washington -- sole proprietorships skyrocketed while corporation registrations floundered. This also happened during the recession of the early 80s.

When unemployment takes off during a recession, budding entrepreneurs who have been laid off are almost forced to finally start that small business they have been thinking about for so long. In fact, according to the t="_blank">census bureau, during the 2001-2002 period, firms with between 1-4 employees saw a 14% increase in employment while firms with 5 or more employees saw an average employment percentage decrease of 5.3%. As the economy turned around over the next few years, and the unemployment rate improved, some of those small business owners went back into the fold of a large employer and steady paycheck.

Policymakers on both the state and federal side should recognize that right now there are a lot of laid off workers who are also budding entrepreneurs looking for their next opportunity. Washington's unemployment rate for March is now a startling 9.2% and is forecasted to get worse over the next year. The Small Business Survival a> report linked to earlier also mentions that, even with Washington's supposedly friendly small business climate, "Washington businesses pay a higher initial share of taxes than individuals compared to other states."

So, as policymakers in Olympia debate what (not if) kind of tax increases should be leveled on businesses, they should remember that any kind of tax increase will come on top of the 13-27% federal income tax.