A Small Business Tax Crash Course
Taxes are, far and away, the biggest excitement-sucking, demoralizing, make-me-want-to-cry, soul-crushing expense that I experience as a small business owner.
Me: Wow! Things are looking really good! I think we should maybe hire a developer to build YNAB for the [insert your favorite device] platform.
My Accountant: Yeah…about that. Quarterlies are due.
Me: Oh. I’ll go get the checkbook. YNAB on the [insert your favorite device] platform will have to wait.
I could cry and whine here for the rest of this post, or we could talk about how you can handle the cash flow ramifications of what is likely your single largest expense.
In this little Small Business Tax Crash Course, we’ll cover a few very important topics:
- Quarterly taxes
- Profits vs. Distributions
- The Self-Employment Tax (FICA) (and how to minimize it a bit)
If you’re familiar with the YNAB Way, then you know that Rule Two calls for us to “Save for a Rainy Day”. Oh what a rainy day it is on January, April, June and September 15th!
If you’re an employee, your employer withholds your taxes from your paycheck. You determine how much is withheld by filling out the W4. At the end of the year, you get your W2 that tells you how much you were paid, how much you had withheld, etc.
If you’re a self-employed small business owner (ranging from an Avon rep to a Zebra Whisperer), you don’t have an employer to withhold the taxes for you. You’re required to withhold them yourself. You do this with quarterlies. Quarterlies are basically estimated tax payments. You figure out what you’ll owe for the year, divide that by four…and then pay that amount when the quarterlies come due (on the 15th of January, April, June, and September).
YNAB saves the day here, because we know exactly what to do with those larger, less-than-monthly expenses. I don’t want you realizing suddenly that quarterlies are due and you have virtually no funds left in your checking account!
At the beginning of each month, you’ll do your monthly bookkeeping. One of those tasks absolutely must be to make sure you’re squared away with your quarterly filing. Here’s how:
1) Go to Reports -> Net Income/Net Worth and find the month’s Net Income.
2) Multiply the month’s Net Income by your average tax rate (Total Tax / Gross Income from last year…you could also let your CPA figure this out).
3) Budget the answer from #2 into your Quarterlies category.
4) When quarterlies are due, pay the balance of your Quarterlies category.
If you follow this, you’ll be well-equipped to handle the acid tax rain that comes four times per year. Do things this way and your cash flow will be zipping right along without any issues.
Profits vs. Distributions
If you’re a sole proprietor, you are the business. Whatever profits the business makes, those are your profits. Done. A piano teacher is paid $80,000 and has $20,000 in business expenses. The teacher’s profits are $60,000.
If you’re running things as an LLC, you’re not the business. You’re a member/owner. If the LLC makes $80,000 and has $20,000 in business expenses, the LLCs profits are $60,000. What if you decide to live frugally and you only pull $30,000 of the $60,000 out of the business as a “distribution”? You still pay tax on the $60,000 in profits. The business passes through its profits (all of its profits), to you.
You’ll hear people who don’t know, acting like they do know, and they’ll say something like, “Yeah, just don’t take as much of a distribution and you can keep your taxes low.” Wrong. When you’re dealing with a pass-through entity such as a LLC, you’re taxed on profits. The IRS doesn’t care about what you took out of the business.
The Self-Employment (SE) Tax
At the time of this writing, the Social Security tax is 12.4% and the Medicare tax is 4.9% — 15.3% in total. The employer pays half, and the employee pays half.
Remember: this tax is above and beyond the income tax. If your income tax rate is 15%, and you’re self-employed, you’re really looking at 30% (give or take, it’s not quite that exact because you can deduct half of your self-employment tax)!
The profit from your LLC has the SE Tax levied against it. If you’re a sole-proprietor, you pay the SE tax on your profits as well. However, if you’re an S Corp (or a LLC electing to be taxed like an S Corp), your profits are not subject to the SE tax. This is a big deal. Here’s why.
Let’s compare two scenarios where the only difference is on paper:
How’d we suddenly save $7,650 in SE tax? We took 50,000 of the 100,000 in profits from the S Corp (or LLC taxed like an S Corp) and made them a wage–the kind you’d get on a W2–for you, the owner. The other 50,000 we left in there to pass through (from above, remember Profits vs. Distributions…) to your tax return as self-employment income.
This is just a reclass of income when it comes down to it. Your taking $100,000 of general income and classifying $50,000 of it as a wage (subject to the SE tax) and the other $50,000 leaving as profits that simply pass through. This is where the difference between a distribution and profits really matter.
Now imagine that! You save $7,650 because you change things on paper just a little bit! (You actually need to run payroll — that is, pay yourself as an employee of your own business).
What will the IRS look for? Excessively low wages. You can’t have $100,000 in S Corp profits and pay yourself a wage of $10,000 unless that’s considered “reasonable”. Whatever’s reasonable is your call.
What We Covered
Quarterlies. Use YNAB as it’s intended and plan for those large, soul-crushing outflows in advance!
Profits vs. Distributions. They’re likely the same when it comes to taxes…unless you’re operating as an S Corp.
Self-Employment Tax. This is a big kahuna. Minimize it if possible by making yourself an employee of your S Corp and managing your wage (subject to SE tax) there.
If you want to get a better grasp of taxes overall (high-level, fairly entertaining stuff), check out YNAB’s Tax Insight course. (Free & Fun).