Article in Summary
- Small business owners are responsible for 15.3% of self-employment tax
- The IRS requires the self-employed to make estimated payments
- Pre-tax retirement contributions will reduce taxable income
In my last article advising small business owners I discussed how to run a small business from a managerial standpoint. While those issues are imperative for success for the business, there is another aspect to becoming a successful small business owner: managing taxation! If a small business owner owns a flourishing business but bobbles personal taxes or business taxes, the business will ultimately suffer and probably die.
Self –Employment Tax
Most folks don’t fully understand the tax implications of being self employed. In a nutshell, you pay more tax on earned income. Here’s why: W-2 wage earners, or folks who work for employers, pay into Social Security (6.2% up to the yearly max income level, which for 2010 is $106,800) and Medicare (1.45%). This is deducted from your paycheck every pay period. Don’t believe me?….have a look at your pay stub. The 7.65% total amount withdrawn from your paycheck for Social Security and Medicare is not the end. Your employer matches that amount as well. The total amount paid into the system for an employee is 15.3%: 7.65% of earned income by the employee and 7.65%by the employer. This withholding does not include the amount withheld for Federal Taxes.
As a self-employed business owner the contribution amount changes. Since there is not an employer to contribute the second half of the required 15.3%, the business owner is on the hook for it. This means the entire 15.3% is the business owner’s responsibility. That’s 7.65% more tax liability than an employee of a company *. These self employment taxes apply to business owners who operate under a pass-through type business entity, such as sole proprietorship. Partnership, S-corp, and LLCs. Corporate business owners pay tax at the personal and corporate level, so this discussion is not relevant to that scenario.
The IRS says pay as you go!
While an employee has the employer to withhold these additional taxes, the self-employed do not. The IRS recognizes this and has a rule. Surprised? I didn’t think so. The IRS has a rule for everything. Our tax system is considered a pay as you go system. This means we have taxes withheld as we earn money, at least for employees. Due of the design of our tax system (pay as you go), the IRS requires the self-employed to make estimated payments throughout the year. Luckily, these payments are only required four times a year: April 15th, June 15th, Sept. 15th, and Jan. 15th.
The payments due on the above four dates are estimates of tax due on taxable income. While called estimated payments and portraying a kind or forgiving tone, the IRS is quite serious. It is the taxpayer’s responsibility to meet minimum payment requirements. If these requirements are not met at year end, underpayment penalties will result. Again, surprised? I didn’t think so.
Managing Tax Liabilities of the Small Business Owner
Now that we understand the importance of taxation for the small business owner, how can we properly manage this liability?
1. Proactively view your tax liability.
Most Americans will not know their tax liability until after their return is prepared. This reactive approach can be financially devastating. As a small business owner it is vital to perform tax projections several times a year and coordinate those projections to determine quarterly estimated payments. Accepting the estimated payment voucher your tax preparer provides you may be risky. Usually, these vouchers are based on last year’s data. If your SE income and expenses will mirror last year, you will be fine, but most companies have a fluctuation in income and expenses. Proactively manage your business tax liability by incorporating tax projections and you will eliminate a tax-time surprise.
2. Maximize expenses.
So many small business owners blur the line between business and personal expenses. While migrating personal expenses to the business is wrong, utilizing all qualifying business expenses is a valid piece of the tax reduction strategy. If a business owner pays a $1000 expense out pocket and doesn’t claim the expense through the business, the taxpayer will lose significant dollars. A taxpayer in the 25% tax bracket who pays a $1000 expense out of pocket and doesn’t claim it through the business is losing close to$400 in taxes (25% marginal rate + 15% SE tax). The key to this tip is keeping diligent records to substantiate expenses. This is where a conversation with the tax preparer should be relied on to dispense advice on qualifying expenses. Also, don’t forget to track business mileage, another area which can create a great tax savings.
3. Utilize effective incentives and available tax savings options.
Our tax code does create benefits to a small business owner, but often the owner is not familiar with the available options and the breaks go unused. Retirement contributions are a great place to start. Pre-tax retirement contributions will reduce taxable income and are a wonderful, yet simple, strategy to reduce tax dollars. Some of the other available options for business owners are: section 105 health reimbursement accounts, office in home deduction for those that work out of their home, health savings accounts, section 179 expense deductions, and employing minor children of the business owner. Although, some of these strategies are quite complicated and required the hand of a professional to implement and administer, they are great tax saving strategies.
Understanding self-employment taxation, meeting quarterly estimated tax payments, and maximizing tax saving strategies for the self-employed are a vital component to a successful small business. These issues usually require the assistance of a professional. If your small business is struggling with taxation and would like someone to discuss these issues with, The Alliance of Cambridge Advisors (ACA) is a great place to start. ACA is a wonderful organization made up of roughly 150 comprehensive, fee-only advisors who specialize in integrating financial planning with taxation. You can learn more at www.acaplanners.org .
*While federal tax code does give some relief to the self- employed and true SE tax due does not actually total 15.3% (it is closer to 14.13%), the complexity of the calculation is beyond the scope of this text. The design of this text is to illustrate the tax burden to the self employed.
The opinions expressed in this article are intended as general guidance only and are not intended as recommendations for specific situations. Internal Revenue Service (IRS) rules of practice require me to inform you that any tax advice included in this communication is not intended to be used, and cannot be used, for the purpose of avoiding any tax penalties imposed by the IRS.