Business Owner Tax Tips - Set Half Aside
Every year I get questions about taxes from friends who have started businesses such as “How is my business taxed?” or “Can you do my taxes for me?” But the most important question I get related to this topic is “I owe how much?!?” right after all the information is put into their return. Today, I’m going to go over a tax tip to help you (the business owner) manage your tax situation: Set Half Aside!
Why Should I Set Half Aside?
Setting aside half of the net income that your business generates is an easy way to make sure that you don't get caught off guard during tax season when you need to file a return and pay your taxes. New business owners are often surprised at the amount that they owe in taxes after their first year in business. This happens for two reasons:
No one is withholding taxes for you anymore. Businesses typically require their employees to fill out a form W-4 at the beginning of their employment so the business can withhold income and other taxes each pay period. Those withholdings are sent to the relevant taxing authorities throughout the year and are used to offset the taxes calculated on their tax return. Some people even get a refund! However, new business owners are typically not thinking about withholding money for taxes and do not send the IRS money multiple times a month. As a result, they have a lot less put away for taxes than they would have previously.
The dreaded self-employment taxes. In a typical employer-employee relationship, social security, and Medicare taxes (collectively known as FICA Taxes) are split evenly between the employer and the employee. With each party paying 7.65% of the total wages as taxes for a total of 15.3%. Because a small business owner is both the employer and the employee, they will need to pay the whole 15.3%. The good news is that half of that amount is deducted from taxable income on the owner’s 1040, but it still needs to be tracked. Ultimately, this extra 7.65% of taxes catches some new business owners off guard when it comes to tax time.
But Why Half?
Half, or 50%, is an easy number for most people to understand. 50% is also an estimate based on the following common taxes and related costs:
Federal Income Taxes - 10%-37% - Many people fall into this category the 22% or 24% tax brackets, where each additional dollar of net income will be taxed at those rates.
State Income Taxes - 0%-12.3% - While the rates will vary from state to state, it’s important to also set aside money for state and local taxes.
Self-Employment Taxes - 15.3% - As mentioned above, business owners will pay 7.65% twice as the employer and employee of their business.
Filing Costs - In addition to all the actual taxes, there can be additional costs related to filing, such as paying for a more advanced tax package, or hiring a CPA to do the taxes. Having extra amounts set aside to support this is always a good idea.
Putting those numbers together will likely put the business owner in the 40%-50% marginal tax range without setting funds aside for those additional filing costs. More often than not, I find this percentage to be a comfortable number to put away that will usually cover both the taxes and the filing costs. While the 50% may be more than enough for those with lower federal and state rates, I find that setting aside half is still the easiest way for many new owners to think about their taxes and not have a huge tax bill every April. If you are making less and just starting out, a 30% or 40% amount may be appropriate. Whatever amount is right for you, make sure you keep it in mind all year long to prepare for tax time!