The biggest problem new businesses encounter is paying unexpected taxes when you file your first income tax return after starting your new business. The result can be a serious cash flow/debt problem. How does this happen and how can you avoid it?
Starting a New Business: Plan Ahead and Prepare Yourself:
Joe starts selling widgets or his wife starts doing shows and they are shocked at how much they owe when do their income tax return. When you operate a business on your own, without forming a corporation, your profits are subject to income tax plus self-employment tax. Self-Employment Tax is basically the equivalent of medicare and social security taxes but both the half that was deducted from your paycheck plus the half paid by your employer that you never saw. Yes, the self-employed pay both halves of these taxes because you are the both the employee and the employer. While the income tax on your profit should be expected what surprises people is the self-employment tax. The self-employment tax, in the past has been 15.3%, now is 13.3% but you can probably expect it to return to 15.3% eventually. So if you are in a 25% tax bracket you could be paying about 38.3% in income and self employment taxes on the profit of your business. So if your profit is $100,000 you will be paying about $38,300 of that back to Uncle Sam. You could be expecting to pay about $25,000 and so you saved that amount during the year, OK maybe you didn’t, and now where is the $13,300 going to come from? You have spent it already and you are investing in your growing business so now you are also going to be making payments to the IRS trying to catch up for last year. In the meantime now your taxes for the current year are going to be more than you expected. This is a big reason why many new businesses fail and why you should have a conversation with your CPA before you start your business.
Preparation and Actions to Take to Minimize Your Taxes:
An unexpected tax bill can be a real ‘kick in the gut’ and if you’re not careful it can cripple your business financially and it can steal your enthusiasm for your business. It helps so much as a business person to be positive and to be one who gives energy to others. If your tax bill hurts you emotionally you it can adversely affect your relationships with others. So first, know upfront, before you start the business, what to expect in regard to taxes and everything associated with your business. The successful are prepared for what is coming. By being prepared for how much tax you will pay you can save during the year and make estimated quarterly payments to the IRS to avoid having a large unexpected tax bill at the end of the year.
There are other things you can do as well, like timing expenses to minimize your profit for the year. You should always have conversations with your CPA during the year so you can be planning for the success of your business. You especially want to have a conversation about a month before the end of your tax year to have a strategy for timing expenses and investment decisions. To reduce your profit and hence taxes for the year you can pay for business expenses or invest in assets before the year-end. You may even be able to put them on a credit card and deduct the full purchase amount even though you do not pay the credit card until the following year. You will want to discuss this with your CPA, and I would be happy to serve you in this regard, but you also need to know that while moving up expenses or investments in assets into the current year could lower your profits and taxes for this year it probably also means higher profits and taxes in subsequent years. You also want to be careful to avoid spending dollars just to save pennies. This is why you need a good CPA who you regularly have business discussions with.
One more action to consider is forming a different entity type to use to reduce taxes. If you are my client and you tell me you expect to have a profit of $100,000 we are going to discuss forming an S-Corporation to lower your taxes as well as to provide some protection for your personal assets. This will be the subject of coming blog post.
Here are some other business related posts you should read:
6 Things You Should Know About Business Expenses – What Can You Deduct?
6 IRS Tax Tips About the Home Office Deduction
6 IRS Tax Tips for Self-Employed Individuals
IRS Top Six: Tax Tips For Making Estimated Payments + 1 free bonus
I am happy to take on new clients and help you prepare for success. Feel free to contact me using my information below.
Jeff Haywood, CPA
This article was written by Jeff Haywood, CPA.
Jeff is a licensed CPA in both Texas and Illinois.
He has prepared income tax returns for the public for over 10 years.
He also has an MBA in Finance from Loyola University in Chicago and he has 24 years experience in Corporate Finance and Business Analysis.
I prepare the following types of tax returns:
Federal and State Returns
I especially enjoy discussions about you, your business, your dreams and goals.
In addition here are links to a few of my articles about income taxes for expatriates:
For a full list of prior posts see the CPA Tax Blog.
As always keep in mind that the content provided on this site is general in nature and may or may not apply to your particular case. It is best to check with a tax professional about your circumstances and what is best for you personally. Also, IRS regulations and tax laws are constantly changing and the information on this site is not constantly updated. Again please check with me about your particular circumstances and what will be best in your situation at the given time and law.
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