I know what you’re thinking: “Come again? You must be out of your head! Don’t I always want to reduce my income for tax purposes?” Sometimes, the answer is no. Actually, I got the idea for this post from Howard, one of my readers with an accounting background and an owner of a struggling restaurant.
I’m walking on a tight rope here so I want to make sure that I explain this carefully. Under tax law, a small business owner is required to report all of his income and expenses accurately. I’m always telling people “don’t make stuff up” – that’s my rule and I stand by it. That said, there’s some leeway, like prepaying expenses at the end of the year to reduce your business income and stuff like that.
Where I’m going with this is there are some people who don’t want to reduce their business income for the tax year. One category is people who are applying for a home loan—you want your net income to be as high as possible, even if you’re paying self-employment taxes because the bank will be looking at your net income. The other category of folks who might not want to reduce their business income is people who may qualify for an Earned Income Credit (EIC).
Since leaving the big box tax company, I haven’t filed a lot of EIC returns; most of my clients are small businesses owners and have incomes that are too high to qualify. But last year, I had 5 EIC returns for people who had never even heard of EIC before, basically small businesses that had hit a rough spot with this economy. (I do lots of returns for people who don’t own businesses too. But I’m on a business roll right now.)
So here’s the thing: as a small business owner, you’re taxed 13.3% for your self-employment tax for 2011. If you make a net profit of $10,000 your self-employment tax is about $1,330. (Not exactly, it’s a funky equation, but that’s pretty close.) If you’re single with no children, the Earned Income Credit would be about $278, so it would make sense for you to lower your net income if you can so that you reduced the self-employment tax. But, let’s say you’re filing as head of household with 2 children – in that case your Earned Income Credit would be around $4,010 so reducing your net might not be such a good idea.
Bottom line: the tax strategies for a business owner who is a parent may be different than the strategies of a business owner with no children.
The IRS website has an Earned Income Tax Credit Calculator to help you determine how much of an Earned Income Credit you can receive if you qualify for one. Here’s the website: http://apps.irs.gov/app/eitc2010/SetLanguage.do?lang=en.
Remember, that’s just the EIC and it is an estimate. Remember that for your-self employment income, there’s also self-employment tax – the quick and dirty calculation for that is 13.3%. It will help you figure out where you stand with the EIC compared to self-employment taxes.
If you’re married and your spouse has income, that income will be included in the overall calculations, so EIC may not be a factor for you.
There are so many things to think about when you own your own business. It’s a good idea to get some professional help at least once every three years to make sure you’re on track and getting every deduction and tax credit you deserve. If you have made mistakes in the past, a professional can amend your prior year returns and get you refunds for what you’ve missed as long as you’re within that three year time limit.