Income tax
Learn what income tax is, the types that apply to your business, and how it's calculated.
Published Monday 22 June 2026
Income tax is a government levy on the earnings of individuals and businesses, collected to fund public services like roads, schools, and national defense.
Table of contents
Key takeaways
- Income tax is a government levy on the earnings of individuals and businesses, collected to fund public services and infrastructure.
- The US uses a progressive federal income tax system with 7 brackets ranging from 10% to 37%, so you pay higher rates only on income above each threshold.
- There are several types of income tax, including personal, sole proprietor and partnership, corporate, and state or local taxes, each with different rules and rates.
- Tax deductions lower your taxable income while tax credits directly reduce the amount of tax you owe, so understanding both can help you keep more of your earnings.
Types of income tax
The type of income tax you or your business pays depends on your legal structure and how you earn your money. Here's a look at the main categories.
Personal income tax
Individuals pay federal income tax on wages, salaries, tips, investment gains, and other earnings. The US federal system is progressive, meaning you pay higher rates as your income rises through each bracket.
Sole proprietor and partnership income tax
If you run a sole proprietorship, your business profits flow through to your personal tax return. You report them on Schedule C and pay personal income tax on the total amount. For a step-by-step walkthrough, see the guide on how to file business taxes for your limited liability company (LLC).
Partnerships work similarly but file a separate informational return (Form 1065). Each partner then reports their share of profits on their personal return. In both cases, you're also responsible for self-employment tax to cover Social Security and Medicare contributions.
Corporate income tax
C corporations pay federal income tax on their net profits at a flat rate of 21%. The dividends or salaries the company pays its owners are then taxed again as part of the recipient's personal income.
S corporations and limited liability companies (LLCs) can choose to be taxed differently. S corporations pass profits through to their owners, who declare the income on their personal returns. LLCs can elect to be taxed as a sole proprietorship, partnership, or corporation.
State and local income tax
Most states also levy their own income taxes on top of federal taxes. State income tax rates and structures vary widely: some states use a flat rate, while others have progressive brackets. A handful of states don't charge income tax at all. Some cities and municipalities impose local income taxes as well.
How federal income tax brackets work
The US federal income tax system is progressive, which means your income is divided into portions and each portion is taxed at a different rate. You don't pay the highest rate on all your income; you only pay it on the amount that falls within that bracket.
For the 2025 tax year, there are 7 federal income tax brackets with rates of 10%, 12%, 22%, 24%, 32%, 35%, and 37%. The income thresholds for each bracket depend on your filing status (single, married filing jointly, head of household, or married filing separately). You can find the current bracket thresholds on the Internal Revenue Service (IRS) website.
The difference between your marginal rate and your effective rate matters. Your marginal rate is the rate on your last dollar of income. Your effective rate is the overall percentage of your total income that you actually pay in taxes, and it's always lower than your marginal rate because of how the progressive system works.
How to calculate income tax
Calculating your income tax starts with figuring out your taxable income, then applying the right rate. Here's how the process works step by step.
Adjusted gross income and standard deduction
Start by calculating your adjusted gross income (AGI). This is your total income from all sources minus specific adjustments like retirement contributions, student loan interest, and self-employment tax deductions.
From your AGI, subtract either the standard deduction or your itemized deductions (whichever is greater). The standard deduction amount varies by filing status and can change year to year; check the IRS website for current figures. The result is your taxable income.
The basic formula
The basic formula to calculate income tax is:
Income tax = Taxable income x Tax rate
You may need to use several tax rates when calculating progressive income taxes. See the examples below.
Example: flat rate income tax calculation
A company with revenue of $240,000 and expenses of $140,000 is subject to a flat rate tax of 21%.
Taxable income (revenue minus expenses) x Tax rate
($240,000 minus $140,000) x (21/100)
= $100,000 x 0.21
= $21,000
The company owes $21,000 of income tax. If it distributes after-tax profits to its owners, they'll need to declare that income on their personal tax return as well.
Example: progressive income tax calculation
An individual earns $70,000 in wages and makes $30,000 in profits from a sole proprietorship. Their total income of $100,000 touches multiple tax brackets.
After subtracting the applicable standard deduction, their taxable income is reduced. This amount is then split across the applicable brackets, with each portion taxed at its corresponding rate. The total tax owed is the sum of the amounts from each bracket.
Tax deductions and credits
Tax deductions and credits both reduce how much you owe, but they work differently. Understanding the distinction can help you take full advantage of both.
Tax deductions
A tax deduction reduces your taxable income. You can choose between taking the standard deduction or itemizing your deductions, whichever gives you a bigger benefit.
Common itemized deductions include mortgage interest, state and local taxes paid (up to $10,000), charitable contributions, and medical expenses above a certain threshold. Business owners can also deduct eligible expenses like office supplies, software, and travel costs on Schedule C.
Tax credits
A tax credit directly reduces the amount of tax you owe, dollar for dollar. Credits are generally more valuable than deductions because they lower your tax bill rather than just your taxable income.
Common credits include the Earned Income Tax Credit (EITC) for lower-income workers, the Child Tax Credit (CTC), education credits like the American Opportunity Credit, and small business health care credits. Some credits are refundable, meaning you can receive money back even if the credit exceeds what you owe.
Income tax rates
Tax rates can change from year to year, so it's always best to check the official source for the most current information.
- Individual tax rates on the IRS website (also check if your state levies income taxes)
- Corporate tax rates on Trading Economics
- State income tax rates on Tax Foundation
Reporting and paying business income tax
All forms of businesses pay income tax only on their net profit (before taxes). When filing a return, you're expected to report revenue and expenses, and you may need to provide copies of the corresponding invoices and receipts.
Your business may also need to prepay taxes in installments throughout the year to avoid big end-of-year bills. These estimated tax payments are often based on projected earnings or the previous year's profits. The IRS requires quarterly estimated payments if you expect to owe $1,000 or more when you file your return. Getting your tax preparation started early can help you stay organized.
What info does a business need to calculate income tax?
To calculate your business income tax accurately, you'll need a few key pieces of financial information from your accounting records.
- Revenue and expenses, found on your income statement (also known as a profit and loss report)
- Depreciation claims for assets owned by the business
- Tax credits, if applicable, which can be subtracted from the taxes owed
Accounting software like Xero can simplify your income tax process by capturing transaction data (including copies of invoices and receipts), automating depreciation calculations, and generating the financial reports you need at tax time. It's also a good idea to get support from a tax professional. You can find one in the Xero advisor directory.
States without income tax
Not every state charges income tax. If you live or operate your business in one of these states, you won't owe state income tax on your earnings.
The 9 states with no state income tax are Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming.
Keep in mind that even in states without income tax, you may still face other business taxes like sales tax, franchise tax, or gross receipts tax. Always check your state's specific requirements.
Simplify your income tax with Xero
Staying on top of income tax doesn't have to eat into your time. Xero's cloud-based accounting software helps you track income and expenses in real time, automate bank reconciliation, and generate the financial reports you need for tax season.
With Xero, your transaction data is organized and accessible from anywhere, making it easier to work with your accountant or tax professional when it's time to file. You can also connect payroll through Gusto integration and manage expenses with Xero Expenses. Ready to spend less time on your books and more time running your business? Get one month free.
FAQs on income tax
Here are answers to frequently asked questions about income tax.
What percent of income is taxed?
The percentage depends on how much you earn and your filing status. Federal income tax rates for 2025 range from 10% on the lowest bracket to 37% on income above the highest threshold.
What is the difference between a tax deduction and a tax credit?
A tax deduction reduces your taxable income, while a tax credit directly reduces the amount of tax you owe. Credits are generally more valuable because they lower your bill dollar for dollar.
Which states have no income tax?
9 states currently have no state income tax: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming. However, these states may still levy other business-related taxes.
Do all types of income get taxed the same way?
No. Different types of income can be taxed at different rates. For example, long-term capital gains are typically taxed at lower rates than ordinary income, and qualified dividends receive preferential tax treatment as well.
Related terms
Explore related financial terms to build your understanding.
Learn more about income tax
Dig deeper into tax topics for small business owners with these Xero guides and resources.
Handy resources
Advisor directory
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Income statement template
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Disclaimer
This glossary is for small business owners. The definitions are written with their requirements in mind. More detailed definitions can be found in accounting textbooks or from an accounting professional. Xero does not provide accounting, tax, business or legal advice.