This is your first year in business and it has just dawned on you that there is nothing coming out of your paycheck. You know that you have got to pay taxes somewhere along the way, but you have been spending the paychecks like 100% of it is net income to you. This frequently happens to people the first year that they get in business as it can be very confusing on how to estimate your income taxes so you don't run into hot water come tax time. I'm often asked by small business owners and individual 1099 earners about the best way to plan for estimated taxes, so here are some tips that should help you manage this in the best way possible.
As a business owner, you have a litany of options on how to set up your business. You can choose to stay as a sole proprietor, set up an LLC, set up an S-Corporation, or choose to elect to become a C-Corporation. Most of you who start a business will either choose to be an LLC (likely taxed as an S-Corporation) or just elect to become an S-Corporation. Within that structure, there can be two ways you think about setting aside money for income taxes.
The first way would be to pay yourself a salary which you are going to need to do anyway. The salary should represent whatever amount of income that would be commensurate for hiring that specific position at whatever rate the company can truly afford. If you pay yourself a salary of $50,000, for example, you can elect to withhold as much federal and state tax as you want through your payroll system. In this case, the salary can be a forced way to set aside money for taxes.
The other way to set aside estimated taxes can be far more difficult because your liability will be dependent on the net profitability that passes through to you as the owner. Since a business can have unpredictable cash flow and overall profitability in its first year or two, it can be challenging to determine how much tax money to put away because you are, in essence, making a guesstimate. At the same time, you would like to have as much use as possible for your cash flow so you don't necessarily want to put away more than you need to during the course of the year. The last factor to consider is whether you have a partner or spouse that is working because their income, in addition to your salary and net profit in the business, may put you into a higher tax bracket.
One recommendation is to set up two accounts when you open up your new business venture. Have a main operating account where deposits are made and bills are paid. Then, set up a second account where you put 25% of every distribution you make when you move money from your business checking account to your personal account so you don't distort you real personal cash flow on a monthly basis. Far too often, I see business owners who feel cash rich because they make distributions to themselves without factoring in the tax liability on that money. Unfortunately, this can make for a very ugly situation when it comes tax time. While 25% may not be the exact number you need to set aside to cover federal and state tax liability, it is a good start for estimating overall income tax until you are more certain about the net income you'll earn from the business.
Owning your own company can be one of the most freeing and exhilarating things you do in your life. You have all of the freedom in the world to go out and create your own destiny. However, it won't be too much fun if you are saddled with an unexpected $20,000 tax bill when you file that extension and complete your taxes in October. With more and more 30's, 40's, and 50 something's leaving corporate America to start their own venture, doesn't it make sense to figure out how tax liability will work so you can measure twice and cut once?
Visit www.oXYGenFinancial.net to request a consultation on how to make smart money moves for your future.
Ted Jenkin, CFP®, AAMS®, AWMA®, CRPC®, CMFC®, CRPS®
Co-CEO and Founder of oXYGen Financial, Inc - The Leaders in Gen X & Y Financial Advice and Services
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