This post is part of a larger series.
In my last post, I covered property taxes. This post will explore business taxes.
There are several types of business taxes in Philadelphia. Like with other types of taxes, there are taxes levied at the local, state, and federal levels. Let’s start with the local level and work our way up.
Business Income and Receipts Tax
This tax is currently 6.25% on profits and 0.1415% on total revenue (before profits). The tax on profits is scheduled to decrease slightly each year, until remaining at 6% after 2023. There is an exemption on the first $100,000 in gross receipts, and a proportionate amount of net income is exempt.
Net Profit Tax
This is in addition to the Business Income and Receipts Tax, and it is 3.8809% of net profits for residents, and 3.4567% for non-residents. Essentially, this is the wage tax, but for businesses. Note that corporations are exempt from this tax. Also, businesses can receive a tax credit of 60% of the amount paid on the net income portion of BIRT.
Real Estate Tax
Businesses that operate out of real estate in the city that they own must pay a real estate tax of 1.3998%. This is exactly the same tax that homeowners pay for their homes. Pennsylvania’s constitution prohibits issuing different tax rates for the same kinds of things, and the state courts have ruled that this means that all property taxes must have the same rate. Therefore, the city cannot charge a different property tax rate for businesses, households, or any other category.
Use and Occupancy Tax
Even though the constitution and the court’s rulings prevent new types of real estate taxes, lawmakers have wiggled around these requirements. The Use and Occupancy Tax is 1.2% of the assessed value of the property a business occupies. There is a $165,300 exemption from the assessed value for this tax.
There are various other specific taxes, such as tobacco, car rental, hotel, vending machine, parking, and sugary drink taxes. You can find a full list of the types of taxes and their amounts here.
Next, let’s take a look at the state level.
Corporate Net Income Tax
This tax is 9.99% on net income (profits) of corporations that operate in Pennsylvania. Only C corporations are required to pay this tax. All others pay the state income tax of 3.07% on net profits that each individual takes in.
This tax has several layers to it. The employee is responsible for 0.6% of gross wages per year. The employer’s tax is more complicated. If you are a new employer (within two to three years), you pay 3.689% on the first $10,000 of gross wages each year for non-construction employees. If the employee is in construction, the rate is 10.2238%. After the new employer stage, an employer can qualify for a standard rate or a computed rate. The standard rate is 7.2916% for employers with a positive reserve balance, and 11.2968% for employers with a negative reserve. The reserve balance is how much you’ve paid into the unemployment fund versus how many benefits have been paid out for your employees. The computed rate is calculated based on the impact that the employer has on unemployment in Pennsylvania, and it can vary from 2.3905% to 11.033%.
Like the City of Philadelphia, Pennsylvania has a host of very specific taxes on certain items or activities. These include various types of fuels, cigarettes, hotels, utilities, and more. See the link in the corporate net income tax category for more information. The most significant of these is the sales tax of 6% throughout the state, and 8% in Philadelphia. Some categories of items are exempt, such as unprepared food, candy and gum, clothing, textbooks, computer services, pharmaceutical drugs, sales for resale, and residential heating fuels.
Finally, there is the federal level.
Federal Income Tax
Federal income tax on businesses depends on the type of business. Sole proprietorships, partnerships, limited liability companies, and S corporations don’t actually pay any income tax. Instead, the profits that the owners, partners, or shareholders receive are taxed at the normal income tax rates for individuals. Only C corporations pay a separate tax on profit, and, as of the 2017 tax cuts, this is a 21% flat rate. The share holders must then also pay a tax on the dividends they receive.
Federal Unemployment Tax (FUTA)
This tax is 6% on the first $7,000 paid to each employee per quarter. Most employers are eligible for the maximum tax credit of 5.4%, so they really only pay 0.6%.
Social Security and Medicare Taxes (FICA)
As mentioned in my prior post, employees typically only pay for half of their FICA taxes. The employer pays the other half, or 6.2% of gross wages for Social Security taxes and 1.45% for Medicare. The Social Security tax caps at a gross wage of $132,900, but the Medicare tax remains the same regardless of the employee’s wage. The employee is responsible for another 0.9% on gross wages over $200,000 for the Medicare tax. If the business is a sole proprietorship, partnership, or limited liability company, then each individual within that organization must pay both halves of the tax when they take the profit as pay.
Like Philadelphia’s assorted other taxes on specific items, the federal government has excise taxes. These are on things like fuel, certain types of vehicles, gambling, and a long list of other activities or items. You can find more information about excise taxes here.
The federal tax cuts in 2017 created something called Opportunity Zones, which are census tracts that offer tax incentives to businesses that operate there. Qualifying businesses can pay heavily reduced federal taxes or even receive a 100% tax break. It is still too early to tell how these will be used and what their impact might be, but take a look at the regions in Philadelphia designated for these tax breaks:
Even before the federal tax-free zones, Philadelphia has had several similar zones under Pennsylvania’s version of this law—called Keystone Opportunity Zones. Businesses operating in these areas can pay reduced to zero taxes at every level of government, not just the federal level. You can see a map just like the one above in the link for KOZs, but here’s an image, just in case:
Real Life Examples
Like with everything, business taxes in Philadelphia are complicated. In sum, there are:
- Taxes on profit;
- Taxes on real estate;
- Taxes to support unemployment;
- Taxes to support Social Security;
- Taxes to support Medicare;
- Various taxes on sales and specific items, like fuels; and
- Various tax-free or reduced tax zones.
Because of these layers of taxes, it’s really difficult to give a typical tax rate on businesses. But, let’s try to imagine a “normal” small business, like an LLC or a sole proprietorship. Let’s call it “Mom-and-Pop Business.”
Mom-and-Pop Business Taxes in Philadelphia
Let’s imagine a small cafe near Center City. It isn’t in one of the tax-free zones, and it’s just started about a year ago. The owner lives in the city.
Total expenses in one year: $395,525.23 (including $42,000 in wages for two part-time employees and payroll or pre-profit taxes of $5,525.23)
Total revenue in one year: $435,000 (assuming a generous 10% profit)
Total profit in one year: $39,474.78
Value of real estate occupied: $250,000
That comes out to a total tax obligation of $11,836.59, or 29.99% of profits. Here’s the breakdown by taxes owed on profit to each level of government:
This is just to give an idea of what it would be like to pay business taxes for a small business in Philadelphia. Obviously, there are many factors that would affect a business’s final tax obligation, and I am sure there are many deductions I am not including. Regardless, it seems that the taxes on small businesses are quite high. Interestingly, most of this tax burden comes from the federal government, especially from the FICA tax. Still, without city taxes, the effective tax rate on profit is 24.18%, and without state taxes, it’s 21.11%.
I’ve attempted to graph the effective tax rate on business profits in Philadelphia. However, this is a bit more complicated than the effective tax rate on personal income, since there are a lot more variables. To make this, I had to remove the deductions that depend on variables outside of profit, and I assumed this is one person attempting to take home the profit of their non-corporation business. So, this is nowhere near a perfect picture, but it is close enough to get an idea of the tax rate.
First, here is the effective tax rate with all of these assumptions, up to $1 million in profit. You can see clearly that the rate begins at around 27%, sharply increases, then flattens out closer to 50%.
Since most people are probably closer to the $0-100,000 range, I zoomed in on this portion for a closer look. Here, you can see that the rate climbs quickly and steadily from about 27% to 43%.
As profit increases to dramatically higher numbers, the effective tax rate on profits will approach, but never reach about 51%. Because of the federal standard deduction, the minimum will be about 27%.
It seems like it’s fairly tough to be a small business owner in Philadelphia. Interestingly, though, this seems to mostly be due to the FICA tax. This is because business owners pay the so-called “self-employment” tax, which is just the employer’s portion of the Medicare and Social Security taxes of FICA. Additionally, FICA is a flat tax, and it’s on gross wages before profit for employees. So, it is true that the city levies several taxes that make it comparably more expensive for businesses than in areas with no such taxes—but this is only a small portion of taxes paid. Federal taxes by far eclipse local and state taxes.
Additionally, business taxes follow the same general structure of income taxes. This is, of courses, because a huge portion of business taxes are exactly the same as personal income taxes. In sum, business taxes begin at about 27% of profit, increase dramatically, and then steady out above 45%. The tax is progressive, but it’s a very weak progressive tax.
Finally, there’s the added complication of the recent tax-free zones. The Keystone Opportunity Zones have existed for a while, but are small and dispersed. The new tax zones at the federal level span a large portion of the city, mostly in areas with the highest poverty rates. It is still too early to tell what exactly their impact will be, but their far-reaching placement is concerning. Right now, it seems likely that businesses in some of the wealthiest areas of the city will be able to benefit, such as in University City and the perimeter of Center City. New businesses taking advantage of these zones could completely ignore large swaths of tax-free zones that are outside of these prosperous regions. Additionally, it seems that most of the tax benefits will be for investments, and not necessarily for income, property, or payroll taxes.
Next, I’ll research total tax revenues, in addition to the process for issuing taxes and who holds taxing authority over what.