The April 15 tax deadline has now come and gone, and most small business owners have no plans to think about taxes again until this same time next year. Those taxpayers contribute to the hard truth that 93% of small businesses overpay in taxes.
This statistic was reported nearly a decade ago by a Forbes analyst who supported small business owners. Serving in that same capacity, I’m disappointed to report that the statistic remains true today. The fact is, the IRS and state tax authorities are bill collectors. They are actively working to collect the maximum amount of tax revenue. Taxpayers tend to take a more passive role in tax matters, resulting in overpayment of taxes that are often avoidable. While federal income taxes garner the most attention, the IRS and state tax authorities collect billions of dollars in other tax types that are often overlooked. Learn more about three lesser-known ways you’re paying more taxes than you should.
Overpayment 1: Paying Self-Employment Taxes
There are nearly 31 million small businesses that filed taxes as a sole proprietorship in the US, according to the most recent data published by the IRS. This filing classification means that the business reports its income and expenses on its personal tax return, specifically on Schedule C. This filing status makes the business’s profits subject to self-employment taxes at a rate of 15.3%. Self-employment tax is the payment that self-employed people and small business owners owe the federal government to fund Medicare and Social Security. They represent the FICA or payroll taxes that employees and employers pay when their compensation is reported on Form W-2.
Sole proprietorships account for over 70% of all businesses in the U.S., according to a report from the Small Business Administration (SBA). Each of these are paying self-employment taxes. In short, these businesses granted the IRS a 15.3% profit share in their business. The IRS reports these businesses earned total net income of $544M, resulting in self-employment taxes of over $83 million in the most recent tax year. Again, this represents millions of dollars in overpaid taxes that are completely avoidable.
Avoiding Self-Employment Taxes
You can establish an LLC and elect to have your LLC taxed as an S Corporation with the IRS, and your small business can completely avoid self-employment taxes and reduce their tax bill by 15.3%. It doesn’t eliminate your exposure to all employment taxes, but it reduces them significantly. The IRS requires that owners of businesses taxed as S Corporations draw reasonable compensation that is reported on Form W-2. In short, you must become an employee of your own company and pay yourself a fair salary. This approach will result in you paying employment taxes. However, you will only pay tax on the amount you’re paid as compensation. In contrast, self-employment taxes are paid on all your profits.
For example, the table below shows a small business that elects to be taxed as a sole proprietorship vs an S Corporation. The small business that files taxes as a sole proprietorship pays self-employment taxes on its net income, resulting in a $76.5K tax due. In contrast, the business owner who elects to file taxes as an S corporation only pays payroll taxes of $15.3K on their compensation. This tax classification change reduces the S corporation’s owners’ tax liability for FICA taxes by over $60K.
Connect with your CPA or tax professional to help you assess if electing to be taxed as an S corporation is optimal for your business to avoid self-employment taxes.
Overpayment 2: Paying State Taxes
Most business owners and tax professionals focus all their attention on their federal income tax bill. While this represents the biggest portion of your income taxes, you cannot overlook opportunities to reduce your state tax bill. According to statistics published by the Tax Foundation, state tax rates span from a low of 1.95% in North Dakota to a top rate of 13.3% in California. Additionally, nine states do not have a state income tax.
The Tax Policy Center reports that total state tax revenue from income taxes totaled $545 billion in 2021, the most recent year for which complete statistics are available. This represents billions of dollars remitted by taxpayers, and at least some of it is avoidable.
Avoiding State Taxes
Considering the varying state income tax rates, the state in which you choose to operate your business will play a big role in your state tax bill. For example, a business with a $500K profit operating in California will have a $66.5K tax bill, while the same business operating in Texas will pay $0 in state taxes. Given this difference, it’s important for business owners to consider where their operations should be located.
Keep in mind, income is taxed based on the location where it is earned. If your operations are based in Texas, even if the business is registered in California, the tax on that company’s earnings will be based on the location of its operations. Selecting a tax-savvy operations base could make a big difference in your state tax bill.
Additionally, several U.S. states offer tax incentives to businesses operating within their borders to reduce or eliminate their state tax liability.
For example, New York has an Innovation Hot Spot (IHS) program that provides tax benefits to early-stage companies in certified incubators. Eligible businesses can receive exemptions from state corporate income and sales taxes for up to five years. Additionally, partners in these businesses may deduct income earned from the incubator company. To qualify, companies must be in their first five years of operation (or seven for life sciences ventures), have less than $2 million in annual revenue, and be in the formative stages of development. This program could save eligible business owners 9.65% in state income taxes over a five-year period.
Similarly, the State of Oklahoma offers a 10-year state tax exemption for small business incubator tenants. This means small business owners in Oklahoma who lease office space in a facility that houses a certified incubator are exempt from state taxes for a decade. This exemption remains in effect even after the tenant is no longer an occupant of an incubator facility. In short, if you secure a short-term lease in a co-working space that houses a certified incubator, you will qualify for the exemption for a full 10-year period.
Other states offer their own state tax incentives to small business owners, resulting in millions of dollars in state tax avoidance for up to 10 years. Connect with your CPA or tax professional to help you assess the benefits of making your business operations in a state and office location that offers state tax incentives.
Overpayment 3: Paying Underpayment Tax Penalties
The IRS treats income taxes as a pay-as-you-go requirement. You cannot wait until you file your tax return to meet your obligation; rather, you must pay your tax bill throughout the year. Those payments are typically made per pay period when you receive a W-2, or by making estimated payments throughout the year when you operate a business. If your payments throughout the year still result in over a $1,000 balance due when you file your tax return, you will be assessed an underpayment penalty. Adding insult to injury, the IRS will also charge interest on the penalty it assesses. The 2025 IRS interest rates for underpayment penalties are 7%. This is down from the 2024 rate of 8%. Adding to the impact of this penalty is that interest is compounded daily by the IRS.
To calculate the penalty, the IRS multiplies the unpaid tax by the applicable interest rate for the full period during which the underpayment exists. For example, suppose an individual owes $10,000 as of April 15, 2025. The IRS expected the taxpayer to begin meeting the obligation for that balance as early as April 15, 2024, the due date of the first estimated tax payment. This timing aligns with the pay-as-you-go requirement. Therefore, the taxpayer would incur an annual penalty of $800 (8% of $10,000). Additionally, interest would be applied dating back 12 months to when the underpayment originated. With a 7% interest rate for all four quarters of 2024, compounded daily, $58 in interest will be added, resulting in an underpayment penalty of $858 with interest. The amounts are relatively small, in this example, but while the IRS treats this as an underpayment, it represents an overpayment in your obligation to the IRS, and it is completely avoidable.
The most recently published statistics from the IRS disclosed the number of penalties and the amount of revenue collected for fiscal year 2023. They assessed 14.2 million penalties, totaling $7 million in underreported tax penalties. That’s millions of dollars remitted by taxpayers that are completely avoidable.
Avoiding Underpayment Penalties
You can complete Form 1040ES to calculate what your tax burden will be for the year, and determine the appropriate W-2 withholdings or the amount of estimated quarterly payments due for each period. If you use a CPA or tax professional, they can prepare this form for you and help you plan to ensure you meet the IRS requirements to avoid underpayment penalties.
If your income changed dramatically from the prior year, you may be able to avoid the underpayment penalty if you met at least 100% of your previous year’s tax for individual taxpayers earning less than $75K in the prior year. If your individual income was over $75K, the IRS requires you to meet 110% of your previous year’s tax to avoid penalties.
Connect with your CPA or tax professional to help you ensure you’re not subjected to this penalty and you are adhering to the pay-as-you-go requirement of the IRS.
Be Proactive
Complete a thorough review of your most recently filed tax return to assess if you overpaid in taxes in any of these three ways. Then, make plans to file the right tax elections, select the optimal location, and perform the necessary calculations to avoid overpaying in taxes this year.
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