In simple terms, the difference between gross vs net income is that gross income refers to a business’s total earnings, while net income is left over after subtracting expenses.
However, gross vs net income is slightly different for tax purposes depending on whether you’re an employer or an employee:
- Employers pay tax on net income
- Employees pay tax on gross income
Because the law requires employers to withhold taxes from employees, business owners need to keep both perspectives in mind.
This article lays out the basics employers need to know to pay taxes on their profit as well as how to correctly withhold employee pay.
Calculating Net vs Gross Income for Businesses
Gross income is all of the money your business has brought in during a period, while net income remains after subtracting the costs of running your business from your gross income.
A crucial prerequisite for calculating net income is proper documentation of business expenses. You need to have a clear picture of what you’re spending on your business, not to mention the IRS requires documentation for all business expenses claimed on tax returns.
Beyond that, certain industries, such as healthcare or businesses receiving government funding, also have legal documentation requirements.
Costs To Subtract From Gross Revenue
To calculate gross revenue, you’ll need to identify the expenses you put toward your business over the course of a tax year.
While this is not an exhaustive list, here are some of the most common expenses businesses use to calculate net income:
- Cost of goods sold (CoGS) – the cost of producing or purchasing what your business sells
- Salaries and wages – not only pay but also benefits, such as 401(k) matches, and FICA taxes
- Rent and utilities – electricity, water, internet, and the cost of the space your business occupies
- Miscellaneous supplies – such as paper, ink, laptops or office furniture
- Marketing & advertising – the cost of promoting your business
- Insurance – including property, liability, or workers’ compensation
- Depreciation and amortization – the cost of using and replacing equipment, vehicles, and other capital infrastructure
- Interest – the cost of borrowing money
- Travel or entertainment – such as plane tickets, meals, or hotels
- Uncollectible accounts – services you’ve provided but, for whatever reason, your customer is unlikely to pay
| Did you know sole proprietorships are the most likely businesses to be audited? Financial experts speculate this may be because they’re the most common source of improperly reported income. If you’d like to submit your taxes with confidence, consider indinero’s business tax services. |
Tax Treatment By Business Type
Now that you’ve calculated your business’s net income, you can calculate the taxes owed. But the way taxes are calculated depends on which business entity you’ve selected.
Sole proprietorships, partnerships, limited liability companies (LLCs), and S-corporations are pass-through entities; owners report their income as personal income on their tax returns and pay regular income tax.
On the other hand, C-corporations pay corporate tax, and their owners pay regular income tax on dividends. It’s uncommon, but LLCs can also elect to be taxed as a C-corporation.
One last thing: If your business doesn’t turn a profit in a given year, you’re not liable for applicable corporate or income taxes. Additionally, you’re able to carry forward net operating losses as tax deductions for future years.
Calculating Gross Pay vs Net Pay for Employee Withholding
As an employer, you’re legally required to withhold taxes from employees paychecks.
Businesses should have a good grasp of the methodology of withholding those taxes from employee wages; otherwise, they or their business could be held liable for the money. Additionally, there are a handful of benefits that, while not legally required, are commonly deducted as well.
If you’re uncertain about this process, indinero accounting services can help.
Taxes to Deduct
| Note: in addition to deducting the following taxes, make sure you understand how to file a Form 941 with the IRS. This is how you’ll report the amount of federal tax withheld. |
Federal income tax – The rate at which your employees’ income is taxed depends on which tax bracket they fall into. The basic brackets are below; visit the IRS website for detailed information about tax deductions and specific edge cases that could save your business money.
| Tax Rate | Single Filer | Married Filers |
| 10% | Up to $11,000 | Up to $22,000 |
| 12% | 11,000 – 44,725 | 22,000 – 89,450 |
| 22% | 44,725 – 95,375 | 89,450 – 190,750 |
| 24% | 95,375 – 182,100 | 190,750 – 364,200 |
| 32% | 182,100 – 231,250 | 364,000 – 462,500 |
| 35% | 231,250 – 578,125 | 462,500 – 693,750 |
| 37% | Over 578,125 | Above 693,750 |
State income tax – rates vary by state, and nine states don’t levy an income tax. Visit your state government website to learn more about your state income tax rates.
Local income tax – varies district by district. Once again, refer to your local government website or visit your local council for more information and guidance.
Social Security and Medicare tax – also known as FICA taxes. Typically the rate is split between employer and employees. You can learn more on the IRS site here, including current rates.
Other Common Deductions
Not all of these deductions apply to everyone; these deductions depend on your company and the specific benefits you provide your employees.
- Retirement plan contributions – such as 401(k), 403(b) or an elective IRA
- Life insurance premiums – employers sometimes contribute to these as well
- Union dues – premiums paid by employees to be members of a union
- Health insurance premiums – employers usually pay some or all of these premiums, but not always
- Wage garnishments – such as child support or back taxes
Calculating Net Employee Pay
Now that we’ve reviewed the most common taxes and benefits, it’s time to calculate what to pay your employees. Use the following steps:
- Start with gross pay. This is either an hourly wage multiplied by the number of hours worked or a yearly salary divided by the number of pay periods.
- Withhold pre-tax deductions. These items lessen tax burdens by being withheld before taxes are calculated. Examples of pre-tax deductions include 403(b) or 401(k) retirement contributions, health savings accounts, and flexible spending accounts.
- Withhold taxes – Federal income, FICA, state, and local
- Garnish wages – per any applicable court orders
- Net pay – is what remains
It’s relatively straightforward to deduct retirement plan contributions or health insurance premiums. They’re either flat percentages based on gross income or flat monthly premiums.
However, knowing exactly how much tax to withhold gets complicated quickly. Speak with a tax professional to get peace of mind about your withholding practices.
Conclusion: Gross vs Net
Since employees pay tax on gross income, and employers pay tax on net income, businesses need to understand the nuanced differences between these terms.
Owners with a good understanding of gross vs net income stand to save money at tax time. If you’d like assistance managing your employee withholdings or business taxes, speak to an inDinero business tax services professional.
