One question I hear all the time is: How much should I put away to pay my business taxes? If you’ve been in business for a few years, you probably have a good feel for how much you take in versus how much your expenses are and what your overall tax bracket is. After a while, you’ll be able to make estimated tax payments with fairly good accuracy. But if you’re just starting out and you don’t have a lot of experience, it’s really hard to guess. This post is for you.
Starting with the very first payment you receive, put away 10% of your revenue. Ideally, you will set up a special savings account at a bank to escrow your taxes, but you can use a piggy bank at home for all I care. Set aside 10% of your revenue.
But I thought my self-employment taxes were more than that? They are. Generally, self employment taxes are 15% of your income, and then you pay your regular tax rate on top of that. If you’re in the 25% tax bracket, the taxes on your business are 40%. This puts people into a panic—most people don’t pay 40% of their revenues, you have to back out your expenses first.
So shouldn’t I put away 40% of my profit? Yes, after you’ve got your business settled in and running smoothly. In the beginning, most start ups lose money, so your business taxes might be zero. You could even reduce your other taxes by reporting a business loss. Setting aside the 10% is your safety net. 10% is easy. 10% is a number you can live with. Most importantly, 10% might save your life.
You were right, I had a loss my first year. Can I spend the tax money that I had set aside? No. You’re going to add to it the next year so that you’ll have enough money to pay taxes then.
What if I have a loss for my second year of business? Keep setting aside 10%. There are basically three things that could happen:
Eventually your business will start making a profit and you’ll be glad that you set aside some money to pay your taxes.
Your business will never make money, so the IRS will decide to call your business a hobby and you’ll have to pay back the taxes you avoided by claiming business losses. We don’t want that to happen! But again, you’ll be glad you have that money set aside.
Your business doesn’t make any money and you’re smart enough to get out before the IRS declares you to have a hobby. Now you’ve got a nice little savings account started.
The 10% rule is a win/win situation for you no matter what.
I make really good income as a contract laborer and I don’t have any expenses. What if I expect to definitely make a profit my first year? A good example of this situation would be an independent IT contractor; a lot of these folks are profitable from day one. If you’ve got a similar situation, I’d hold back 25% at a minimum, 30% is better. If you’re married and you’re adding your income onto a spouse’s earnings, I’d put away 40% right from the start. If you anticipate over $100,000 of income your first year, you should sit down with a professional and do some strategy planning. Your self-employment taxes will actually go down after $106,800 but you could be in a higher overall tax bracket.
Face it, if you’re making over $100,000 a year, you can afford to pay the consulting fee to an accountant. By the way, you’ll write that off as a business deduction.
Okay, so I set aside 10% of my revenue for my business taxes the first year but it wasn’t enough. Now what do I do? First, be glad that at least you had the 10% set aside. Now you’ve got some figures to work with for next year. Based upon your tax return, you can now compute a percentage for you to set aside. Maybe it’s 20%, maybe 30%. Once again, you’ll set aside a percentage of your revenues. You’ll make estimated tax payments every quarter based on what you owed last year. Let’s say you had a balance due of $4,000 last year, then you’ll make quarterly estimated tax payments of $1,000 each this year. You’re still putting money in the bank for your taxes and you’ll pay the estimated taxes from your set-aside fund.
I see a lot of people with small businesses get into tax trouble. They scrape to get ahead and then when success finally comes, the tax bill is a big slap in the face. Success is sweet, but there’s a price. If you start from day one setting aside a portion of your revenue for taxes, you’ll be prepared.
About the photo: it comes from a website called TaxBrackets.org. If you’d like to learn more about income tax brackets–which they’ve got some really good information, or if you’d just like to check out their images of money, click on this link: http://www.taxbrackets.org/
One of the quirky things I enjoy about doing taxes is that when I get someone’s Social Security number, I can tell where the person is from. The first three digits of your Social Security number are tied to a geographic area. The second two digits are a group number and the last four digits are a serial number. Social security numbers that were issued since 1972 can be tied directly to a state and is determined by the zip code on the address of the application. I can tell you 012 is Boston and the numbers go higher as you head west. (I can tell you a lot more, but it’s kind of embarrassing to admit that I know what the social security number codes mean.)
That’s all going to change now. On June 25, 2011, the Social Security Administration (SSA) adopted a new randomization program. It’s going to eliminate assigning the numbers based on geography. Part of this is due to the lack of new numbers available for use. Currently, there are approximately 420 million numbers available to be issued, but because the numbers are restricted by state, the numbers available were greatly limited. Randomizing the Social Security numbers opens up all of the available numbers for use, and keeps the SSN at nine digits instead of changing it to a larger number.
Another benefit to the randomization process is privacy. It will be more difficult for an identity thief to reconstruct someone’s Social Security number based on public information once the numbers are randomized.
Some numbers that still won’t be in use are 000, 666, or anything from 900-999. Only new social security numbers will be under the randomization process. You do not have to do anything about your Social Security Number if you already have one.
For more information about the Social Security randomization program, you can click this link: http://www.socialsecurity.gov/employer/randomization.html
You’ve probably heard the story about Christian Lopez, the guy who caught Derek Jeter’s 3,000 career hit ball at Yankee Stadium and then was classy enough to return the ball to Mr. Jeter. He was rewarded handsomely by Yankee management with box seat tickets for the rest of the season, autographed balls and other merchandise. There’s been a lot of talk on the radio and in the media about the IRS going after Mr. Lopez for taxes. And while there are some really good articles out there already about the tax issue, I’ve decided to answer some of the actual questions people have been asking me because not all the stories running around out there are accurate.
I’ve heard that the IRS has already issued a bill to Christian Lopez for $10,000, how can they do that? That rumor isn’t true. There’s some speculation about how much tax Lopez will have to pay, but no bill has been issued by the IRS-they just can’t do that. The IRS will have to wait until April 15, 2012 to see any money from this event.
I’ve heard that Christian Lopez will have to pay a gift tax to the IRS for giving the ball to Derek Jeter. Why? First, that’s not true. But this is why people are talking about that: You can give a “gift” to someone with a value of up to $13,000 and not have to deal with any gift tax issues. People estimate that the ball Christian Lopez caught is worth between $275,000 – $300,000. Since Lopez gave it to Jeter, some people are erroneously calling that a gift. Even if they would be right about the gift, you can gift up to $5 million in your lifetime without paying tax on it—it just requires paperwork.
But I say it’s not a gift at all. Christian Lopez caught the ball and gave it back right away. Kind of like turning down a prize at a game show, he just gave it back so there’s no taxable transaction there. I’m from St. Louis. In 1998 when the fan returned Mark McGwire’s ball when McGwire broke Roger Maris’ single season home run record, the IRS did not require a gift tax return. That gives Lopez legal precedent.
But what about the tickets and stuff the Yankees gave him? Will that be taxed or is that a gift too? It would be nice if it could be considered as a gift, but it won’t. I’m pretty sure that the Yankees will issue a 1099 to Christian Lopez for the value of the tickets and merchandise he was awarded.
So he’s screwed no matter what? Not completely. One option is for Christian Lopez is to sell some of his tickets.
But if he sells the tickets, then won’t he have to pay tax on that money too? Only if he makes a profit. You see, because he’s paying tax for receiving the tickets then he has what’s called basis in the tickets. Say for example one of the tickets is worth $100 (I know it’s worth more than that, but let’s make the math easy.) Christian Lopez is getting taxed on receiving the full fair market price of the ticket, right? So it’s like he paid the full $100 for the ticket. So if he sells that same ticket for $100, he hasn’t made a profit on it, so there’s no tax on the $100 (because he’s already paid the tax on it). For you tax geeks, it would go on a Schedule D, just like selling stock.
Now it’s possible that Christian Lopez could sell his $100 ticket for $125. (Come on, really. Wouldn’t it be kind of cool to sit in Christian Lopez’s box seat? I think people would pay extra for that.) If he sells his tickets for more than their face value, he would be stuck paying taxes on the profit. That’s cool, make a profit and smile. If I were Mr. Lopez, I’d sell enough tickets to be able to pay the taxes and have fun going to as many baseball games as I could.
For more tax information about the Jeter baseball, this article at Accounting Web.com makes the most sense: http://www.accountingweb.com/topic/tax/jeter-baseball-fan-catches-bad-tax-advice
According to reports from Washington, instead of raising taxes or cutting spending we could solve America’s debt crisis simply by going after uncollected taxes. It’s claimed that over $400 billion dollars a year go uncollected. The difference between what is actually collected on time and what the IRS believes should be collected is referred to as the “tax gap.”
While I am quite certain that there is a gap between what is owed and what gets paid, I am equally certain that the tax gap is significantly under $400 billion per year. Working from the other side of the table, I find it very rare that the amount the IRS claims someone to owe in debt is accurate.
One case I worked on involved a young woman who received an IRS notice stating that she owed over $2 million in taxes. Yes, two million dollars! Clearly, there was a mistake. Once we sorted the whole thing out, it turned out that she owed $13. That’s not a typo; the IRS said she owed $2 million when she really owed $13. How many more mistakes like that are out there?
Although the $2 million case is an unusual example, the taxpayers I work with who receive collection notices from the IRS often wind up receiving refunds after I’ve finished processing their paperwork. This is not because I’m some kind of master tax genius (although I‘d like people to think so), but merely because I’ve done the paperwork correctly.
The tax code has become so complex that even college educated professionals have trouble navigating the tax code. This is my job, I have training and experience, and it’s not always easy for me to interpret the tax code. Sometimes, even IRS personnel have trouble interpreting the tax code. I recently represented a taxpayer at an audit that was very focused on one item on the tax return. Although it was implied that the taxpayer had prepared the information “wrong,” there were no guidelines as to how to do it “right.” I asked the auditor, “Tell me how you want this done. I will do it.” She couldn’t answer me. Not because she was stupid or incompetent, but because there are no IRS guidelines for that particular issue (Yes, we won that audit).
One particularly galling point in the “tax gap” argument is a claim made by Benjamin Harris, a research economist at the Brookings Institution. He was recently quoted in an article in the St Louis Post Dispatch, “You kind of feel like a sucker as a wage earner. Here you are paying taxes because someone else is paying you, but if someone else is getting paid on their own, they pay taxes at half the rate.” As a self-employed business owner, this makes me furious. First, I pay taxes at a higher rate than Harris because I have to pay my self- employment tax over and above my regular tax rate. Additionally, as an employer, I pay my share of my employee’s FICA taxes, a benefit that Mr. Harris receives but appears to be blind to. To see the entire article, here’s a link: http://www.stltoday.com/news/national/article_890fa85f-c788-5a96-978c-d90edae37593.html?print=1
Are there people who cheat on their taxes? Certainly, and they should be caught and prosecuted to the full extent of the law. However, do not assume that all business owners cheat on their taxes. They probably don’t owe what the IRS says they do.
If you’ve claimed a home office deduction on your tax return, you’re familiar with the form—they ask you for the square footage of your home office and then they ask for the square footage of your home. Let’s say that your home is 2,000 square feet and your home office is 100 square feet, then your home office percentage is 5%. If your home operating expenses were $10,000 then you’d get to claim $500 for your home office deduction before claiming depreciation (because $500 is 5% of$10,000).
But did you know that if the rooms in your home are roughly the same size that you can figure the percentage based upon the number of rooms in your house? Say you had 8 rooms in your house, a kitchen, living room, dining room, family room, three bedrooms and your office. That would change your percentage to 12.5%, and now your deduction would be $1250—that’s more than double the difference.
Now if your home is like mine, your rooms aren’t all the same size and you can’t use the ‘number of rooms’ formula. But—the ‘number of rooms’ formula does help those of us who must use the regular square footage formula. You see, when you use the ‘number of rooms’ formula, you’re leaving out things like hallways, staircases, and bathrooms. When you’re determining the square footage for your whole home, you are allowed to deduct the following items from your total square footage:
o Space occupied by heating and air conditioning units, and water heaters
o Outside walls
By reducing your overall square footage, you increase the percentage that you can use for your home office expense. Using the office mentioned above, let’s say the taxpayer measures out his stairs, foyer, hallways, etc. and finds that it reduces his overall square footage by 500 feet. Now his percentage would be 6.67% raising his deduction to by $167 to $667.
This might not seem like a huge savings, and certainly it will vary depending upon the size of your home and your expenses. The important thing here is that its extra tax savings to you without spending any additional cash. You’ve done nothing extra except re-measure your house.
Let’s add depreciation into the mix. Let’s say, for this same house, the owner’s purchased it for $250,000. $50,000 of that was attributed to the cost of the land so we’re depreciating $200,000. If 5% of the home were depreciated, the deduction would be $256 (200,000 x 5% x 2.54% depreciation rate). By increasing the percentage used to 6.67%, then the depreciation would be $342, an increase of $86.
So now, by doing nothing more than re-measuring your house, you’ve increased your home office deduction by $253 and, if you’re self employed and in the 25% tax bracket, you’ve just saved yourself $101 in taxes.
This is one of those cases where everyone’s results will be different, but the example that I used was pretty conservative. It’s highly likely that you can save even more than this example does, especially if your expenses are higher or your home office is larger to begin with.
You always want to take advantage of any tax issue that puts money in your pocket without you putting money out. Re-measuring your home for the home office deduction is like a little gift from the IRS to help you save money on your taxes.
Did you get an email from the IRS? Maybe it said they owed you more money and they wanted your bank account number so they could direct deposit it. Or maybe it said that there was a problem with your return and they needed your social security number to verify they reached the right person.
Those emails are SPAM. Don’t open them, don’t click on the links, don’t open the attachments, and whatever you do, don’t send them any information.
The IRS is not going to send you an email asking you for information. If the IRS needs something from you, you’ll get a letter the old fashioned way. The only IRS e-mail that you might possibly receive is a form letter that says your electronic return was received (or rejected). It won’t say anything else.
The IRS will never ask you for your social security number by email; they already know it. They also know your bank account number, your date of birth, where you work, and a lot of other things. If you call the IRS, they might ask you those things—not because they don’t know the answers, but to confirm that they’re really talking to the person you say you are.
These fake emails may look very official. They often have the IRS logo on them. The links can be very deceiving. You’ll see something that says www.irs/importantmessage.com But if you click on it, it will take you someplace totally different. (Did you try clicking on that link? It took you to my Facebook page. Spammers can set up links to look like they’re real, but they’re not).
If you receive IRS spam, and have the presence of mind to do so, forward it to the IRS at email@example.com That’s a real IRS email address. This will give the IRS the opportunity to hunt down the criminals and put a stop to them. Don’t be mistaken: these phishers are criminals and they’re dangerous. If you don’t have the presence of mind to forward it, just delete it. It’s probably a good idea to run a virus scan on your computer too. Sadly, many of those IRS scam emails are booby trapped with computer viruses, some of them can even wipe out your hard drive.
I hate to sound so much like Chicken Little with the “sky is falling” routine, but I’ve gotten asked about these emails twice in two days. One person forwarded his email to me, fortunately my virus protection program picked up the problem before I opened it.
Remember, no matter how real it looks, no matter how official it seems; the IRS will never send you an email asking for personal information.