Tips for the Small Business Owner (Part II)

In my last article regarding small business owners I discussed how to run a small business from a managerial standpoint. While those issues are imperative for success for the business, there is another aspect to becoming a successful small business owner: managing taxation! If a small business owner owns a flourishing business but bobbles personal taxes or business taxes, the business will ultimately suffer and probably die.

Self –Employment Tax

Most folks don’t fully understand the tax implications of being self employed. In a nutshell, you pay more tax on earned income. Here’s why: W-2 wage earners, or folks who work for employers, pay into Social Security (6.2% up to the yearly max income level, which for 2010 is $106,800) and Medicare (1.45%). This is deducted from your paycheck every pay period. Don’t believe me?….have a look at your pay stub. The 7.65% total amount withdrawn from your paycheck for Social Security and Medicare is not the end. Your employer matches that amount as well. The total amount paid into the system for an employee is 15.3%: 7.65% of earned income by the employee and 7.65%by the employer. This withholding does not include the amount withheld for Federal Taxes.

As a self-employed business owner the contribution amount changes. Since there is not an employer to contribute the second half of the required 15.3%, the business owner is on the hook for it. This means the entire 15.3% is the business owner’s responsibility. That’s 7.65% more tax liability than an employee of a company *. These self employment taxes apply to business owners who operate under a pass-through type business entity, such as sole proprietorship. Partnership, S-corp, and LLCs. Corporate business owners pay tax at the personal and corporate level, so this discussion is not relevant to that scenario.

The IRS says pay as you go!

While an employee has the employer to withhold these additional taxes, the self-employed do not. The IRS recognizes this and has a rule. Surprised? I didn’t think so. The IRS has a rule for everything. Our tax system is considered a pay as you go system. This means we have taxes withheld as we earn money, at least for employees. Due of the design of our tax system (pay as you go), the IRS requires the self-employed to make estimated payments throughout the year. Luckily, these payments are only required four times a year: April 15th, June 15th, Sept. 15th, and Jan. 15th.

The payments due on the above four dates are estimates of tax due on taxable income. While called estimated payments and portraying a kind or forgiving tone, the IRS is quite serious. It is the taxpayer’s responsibility to meet minimum payment requirements. If these requirements are not met at year end, underpayment penalties will result. Again, surprised? I didn’t think so.


Managing Tax Liabilities of the Small Business Owner

Now that we understand the importance of taxation for the small business owner, how can we properly manage this liability?

1. Proactively view your tax liability.

Most Americans will not know their tax liability until after their return is prepared. This reactive approach can be financially devastating. As a small business owner it is vital to perform tax projections several times a year and coordinate those projections to determine quarterly estimated payments. Accepting the estimated payment voucher your tax preparer provides you may be risky. Usually, these vouchers are based on last year’s data. If your SE income and expenses will mirror last year, you will be fine, but most companies have a fluctuation in income and expenses. Proactively manage your business tax liability by incorporating tax projections and you will eliminate a tax-time surprise.

2. Maximize expenses.

So many small business owners blur the line between business and personal expenses. While migrating personal expenses to the business is wrong, utilizing all qualifying business expenses is a valid piece of the tax reduction strategy. If a business owner pays a $1000 expense out pocket and doesn’t claim the expense through the business, the taxpayer will lose significant dollars. A taxpayer in the 25% tax bracket who pays a $1000 expense out of pocket and doesn’t claim it through the business is losing close to$400 in taxes (25% marginal rate + 15% SE tax). The key to this tip is keeping diligent records to substantiate expenses. This is where a conversation with the tax preparer should be relied on to dispense advice on qualifying expenses. Also, don’t forget to track business mileage, another area which can create a great tax savings.

3. Utilize effective incentives and available tax savings options.

Our tax code does create benefits to a small business owner, but often the owner is not familiar with the available options and the breaks go unused. Retirement contributions are a great place to start. Pre-tax retirement contributions will reduce taxable income and are a wonderful, yet simple, strategy to reduce tax dollars. Some of the other available options for business owners are: section 105 health reimbursement accounts, office in home deduction for those that work out of their home, health savings accounts, section 179 expense deductions, and employing minor children of the business owner. Although, some of these strategies are quite complicated and required the hand of a professional to implement and administer, they are great tax saving strategies.

Understanding self-employment taxation, meeting quarterly estimated tax payments, and maximizing tax saving strategies for the self-employed are a vital component to a successful small business. These issues usually require the assistance of a professional. If your small business is struggling with taxation and would like someone to discuss these issues with, The Alliance of Cambridge Advisors (ACA) is a great place to start. ACA is a wonderful organization made up of roughly 150 comprehensive, fee-only advisors who specialize in integrating financial planning with taxation. You can learn more at www.acaplanners.org .

*While federal tax code does give some relief to the self- employed and true SE tax due does not actually total 15.3% (it is closer to 14.13%), the complexity of the calculation is beyond the scope of this text. The design of this text is to illustrate the tax burden to the self employed.

The opinions expressed in this article are intended as general guidance only and are not intended as recommendations for specific situations. Internal Revenue Service (IRS) rules of practice require me to inform you that any tax advice included in this communication is not intended to be used, and cannot be used, for the purpose of avoiding any tax penalties imposed by the IRS.

Prioritizing and Eliminating Debt

One of the many questions I receive from new clients involves the elimination of debt. Should I pay off my credit card or my mortgage first? Should I make extra payments towards my student loans? What about that nagging car payment? The answer lies in understanding the question of how to prioritize debt.

Essentially, there are two types of debt: good debt and bad debt. Understanding the difference between good and bad debt will allow for prioritization and systematic elimination of debt.

Good Debt

Good debt is debt that utilizes some type of positive leverage. Good debt also has a component of longevity. For example, borrowing to pay for a college education is certainly good debt because there are tax benefits to the student loan interest, as well as, the education will outlast the debt. That pizza you put on the credit card six months ago is long gone, while the debt may linger. Another example of good debt would be mortgage debt. A mortgage (especially a 30 year fixed rate) will allow for leverage while utilizing the tax benefits of the mortgage interest deduction.

Bad Debt

Bad debt can be categorized as consumer debt. This would include credit cards, revolving debt (store debt, such as a furniture purchase), auto loans, personal loans…etc. These debts offer no tax benefits and usually lead to negative financial momentum. For example, a consumer purchases an expensive car and borrows the money to do so. The payments put a strain on monthly cash flow requiring the consumer to use credit cards to purchase needed items such as food and clothing. The spiraling downturn can become overwhelming and eventually lead to financial ruin.

Attacking Debt

Once the debt is categorized, the picture becomes much clearer and debt elimination can begin. Focusing on bad debt should be the priority. List the debt balances, as well as the interest rates associated with each debt. While some so called “experts” recommend eliminating the smallest debt first, as a comprehensive planner I feel everyone has a unique situation and the debt elimination plan should be individualized. A holistic CFP® (Certified Financial Planner) specializing in cash flow and debt elimination can be a big help when it comes to mounting a charge against debt.

Debt Reduction Tips

1. Understand Cash Flow!
Debt is a by-product of poor cash flow management. Most folks don’t truly know where their money goes every month. It’s important to see in black and white the spending choices that are made. Tracking income and expenses will allow one to see where their money goes. It will also show what is left over at month’s end. What’s left over can be applied to debt, so it’s imperative to keep a close eye on cash flow.

2. Make a Commitment!
If married or in a committed relationship, it is important that all parties are working together to eliminate debt. If one spouse is savings and paying off debt while the other is frivolously spending, little or no progress will be made. Debt reduction requires thought and action, so commitment is essential.

3. Don’t Rush to Eliminate Good Debt!
The good debt discussed above can actually have financial benefits, so don’t rush to eliminate that debt, especially mortgage debt. For example, a 30 year fixed-rate mortgage is a debt I recommend to most of my clients. This mortgage creates a great inflationary hedge. A long term fixed debt will allow the homeowners to make tomorrow’s mortgage payments in today’s dollars, so don’t rush to eliminate this debt. There may be better use of your dollars.

4. Know How Much You Can Afford!
While good debt has benefits, it is important to utilize this debt properly and not overspend. This is especially true in purchasing a home. While I am an advocate of 30 year fixed rate mortgages, I am not an advocate of over-buying real estate. Knowing how much to buy is imperative. Creating an inflationary hedge and utilizing the tax breaks offered from a mortgage will do no good if the homeowner buys a house they cannot afford.

Debt usually stems from behavioral choices, so before any debt reduction can begin the behavioral issues need to be resolved. In essence, living within your means is the first step. Another key component to debt reduction is understanding personal finances from a big picture view. Financial planning is equivalent to a giant puzzle and all pieces should work together to meet the end result, so a synergistic approach should be taken. Taxes, cash flow, interest rates, type of debt, and other issues should all be considered before a debt reduction plan can be put to work. A qualified financial advisor may be needed to tackle debt reduction with a synergistic approach. The Alliance of Cambridge Advisors (ACA) is a great organization of comprehensive planners that can assist is debt reduction strategies. More information can be found at www.acaplanners.org.