Expert Articles

The Rebirth of an Entrepreneurial Nation

Sherri Mahoney-Battles

Enrolled Agent

Taxing Matters

Most entrepreneurs start businesses with stars in their eyes unaware of the slippery slope ahead of them.  There are so many things to do:  Find a location, design a logo, setup a website and put together advertising.  The list, it seems, it is, endless. Most people wait until the tax filing deadline to grapple with the tax implications of being self-employed.  Unfortunately, taxes are inevitable and a small business owner can get hit particularly hard. 

Let’s start with the basics of how a small business owner is taxed.  Most taxpayers are taxed at an average rate of 15%.  Self-employed people pay an additional self-employment tax of 15.3%. This is because an employee has 7.65% withheld from their wages for social security and Medicare taxes.  Their employer then matches and sends in the other half of the social security and Medicare for a total employee and employer contribution of 15.3%. A self-employed person in a 15% tax bracket will pay 15% federal tax, 15.3% self-employment tax (which is total social security) and approximately 5% in state income taxes.  This represents a total tax of approximately 35%.  A self-employed person in a higher, 25%, tax bracket will pay 25% federal tax, 15.3% self-employment tax and 5% in state income taxes for a total tax of approximately 45%. 

A critical part of being in business is tracking business expenses as this can significantly lower a business owner’s tax liability.  A business owner that takes in $50,000 in gross income, but has expenses of $20,000 will only pay tax on $30,000.  Thus, $20,000 in business expenses will reduce a tax liability by $7,000 to $9,000.  The Internal Revenue Service definition of a business expense is that it must be “ordinary and necessary” for your trade or business. The list of potential deductions is extensive, but some examples include:  Advertising, commissions, materials, labor, office expense, legal and professional fees and vehicle expense. Some expenses can be partly business and partly personal.  For example, a computer could be used both personally and for business so you would divide the cost between the two and deduct the business portion.  A business owner with a legitimate home office will deduct a percentage of home related expenses such as mortgage interest or rent, real estate taxes, homeowner’s insurance, repairs and utilities against business income.  The balance of the mortgage interest and real estate taxes not deducted as a business expense will be deductible as an itemized deduction, but the benefit of deducting a portion as a business deduction is that it will reduce the self-employment tax in addition to the federal income tax whereas an itemized deduction will only reduce the federal income tax. 

The benefit to monitoring the tax situation during the year is two-fold.  A self-employed person who anticipates a tax liability should make estimated payments during the year rather than waiting to come up with a large sum months after the money has come and gone.  Another valuable benefit is that a taxpayer who reviews their tax situation before the end of the year has an opportunity to make business expenditures that will reduce their tax liability.  For example, a business owner with income climbing into a higher bracket might make the decision to purchase a new vehicle before the year end to lower their tax bill.  Effective tax planning empowers business owners, and provides them with the option of legitimately lowering their tax liability.

The road a business owner travels is often a scary and lonely journey with many twists along the way. It may not be possible to anticipate all of the bumps that may interfere with your journey, but an entrepreneur that addresses their tax issues will find the traveling that much easier.

Sherri F. Mahoney-Battles, EA started the firm, Taxing Matters, in 1987. She is licensed by the U.S. Treasury Department as an Enrolled Agent to represent taxpayers before all administrative levels of the IRS. As an Enrolled Agent, Sherri has represented clients in cases of audit, collections, and appeals and is a member of the National Association of Enrolled Agents and the National Association of Tax Professionals.

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