Why Tax Planning is Important for the Self-Employed

Taxes are the single largest expense a self-employed person pays year to year.  In your lifetime, you will almost certainly give more of your money to the government than you will spend on any other single endeavor.  Last year alone, the government collected $2,268,000,000,000 in taxes.  That’s a lot of zeroes!

The increase in government tax collections between 2004 and 2005—just the increase—was 2.74 times more than the total tax collected in 1960.  So, getting every dollar you can in business tax deductions has never been more important.

Moreover, because you are self-employed, you cannot ignore the need for tax planning when you start your business, when you make little money, or when you make lot of money.  The self-employment tax starts almost immediately, and that puts you automatically at the starting gate of taxes.

Think of this: For the single taxpayer earning $50,000, one new dollar in deductions saves 39% of that dollar from taxes.  If this taxpayer lives in a state with income tax, he or she might save up to 48% of that one dollar in new deductions.  Wow!  That’s a lot, and it goes right to the bottom line.

Example.  Harriet Miller, a subscriber, found $47,000 in missed deductions on her standard mileage car after reading the Tax Reduction Letter article on that subject.  Because of her tax bracket and the state in which she lives, she pocketed $22,560 in tax money on the day she sold this car.

Her total effort for this savings was less than two hours of work.  She just had to know what to do, and then do it (which was to sell the car and not trade it—Harriet would have traded cars until she died had she not read the article).

The Self-Employed Married Taxpayer

Just as the single taxpayer can save big on taxes by finding business deductions, so can the married self-employed taxpayer.  Business deductions are the very best deductions, because they escape most deduction impediments, like the alternative minimum tax.

The Married Myth

You often hear that the spouse should not work because all the spouse’s earnings go to taxes.  It would be very easy to make a hasty generalization that the increase in tax bracket from 15% to 39% makes it undesirable for the spouse to work.  That would be incorrect thinking.

First, the cash from the original $75,000 of W-2 income is untouched by extra taxes caused by the additional earnings.  The tax bracket affects only the additional earnings.  After taxes, the taxpayer’s $25,000 in additional earnings over the $75,000 of the W-2 spouse adds $15,746 to the couple’s bottom line.

You can look at this as the glass half-full or the glass half-empty.  Half-full gives you $15,746 in new cash; half-empty is that the government took $9,254 of the $25,000, a hefty 37%.  We like the half-full approach.  Why?

Two reasons: First, you have the after-tax income—nothing to sneeze at.  Second, you now have more tax-planning opportunities, meaning that you can find deductions that put cash in your pocket at rates of up to 39% without even considering your state income taxes.  For example, if you live in California, you can save an additional 9.3%, which means combined federal and state tax savings of 48.3%.  Good grief!  That’s a lot!

Further, if you are self-employed, you can identify deductions for fun that you are already having, vehicles you are already driving, and medical expenses you are already paying.  With no self-employment, you probably pay for these things with after-tax dollars.  But with self-employment, you can get deductions for your business car, business golf, and business medical expenses.

Example.  Your new self-employment generates $25,000 of gross income.  Because you know what you are doing, you identify tax deductions of $25,000 from expenses that you pretty much incurred before self-employment (for example, your car).  With $25,000 of income and $25,000 of deductions, you have zero taxable income, but you really have $25,000 in new cash in your pocket.

Regardless of what you make, you come out ahead with business deductions.

Sure-Fire Way to Tax Planning

For the most part, your business deductions do not suffer the alternative minimum tax (AMT) or the passive loss rules (assuming that this is your business and you are the main worker).  Moreover, business deductions offset business income and don’t get hung up by the portfolio bucket or the passive loss bucket.

In other words, with minor exceptions, business deductions do what you expect deductions to do: They offset your business income.  Further, and again for the most part, business deductions benefit your entire return and reduce all your taxable income.

Deductions trapped in the passive category can produce no tax benefit whatsoever in the current year.  Deductions nailed by the AMT can be lost forever.  That’s disgusting.  The alternative tax robs you of the tax deductions authorized by the tax law for your regular tax return.  Again, for the most part, none of your business deductions suffer from these rules.

When you run a business, you have myriad expenses.  When you recoup those expenses as business tax deductions (and you almost always can if you pay attention by reading your Tax Reduction Letter), you are making more money without having to do more work.

Example.  You have two children who are going to college in seven years.  You are self-employed and have some work that your current part-time employee is not doing as well as your children could do it.  You fire the part-time employee and hire your two children.  You pay them $5,000 each per year during this seven-year period.  At the end of seven years, here are your results:

• You have paid the children $70,000.
• The children have the $70,000 (and they paid zero taxes on it).
• The children are going to use the $70,000 for college (meaning you are not paying for college with after-tax dollars).
• You have $27,300 net cash in your wallet from your federal tax savings at the 39% rate (assuming you live in a state with no income tax).

In other words, by knowing what you are doing, you have $27,300 more cash without doing any more work.

Because you are self-employed, you have access to the business tax deduction.  You can use it as a weapon to fight taxes.  How much you save (which is really less like saving and more like earning) is entirely based on your good judgment, self-discipline, and how much attention you pay.

Summary

Realize that you start every year with a huge chunk of your income going to taxes.  Know that you save taxes in your tax bracket, which at the federal level is probably 30%-40%.  (You might have to add some for your state income tax.)  When you look at it in this light, every deduction you keep is more like extra money you have earned.  Small business owners are both blessed and cursed in the way the government sets up their taxes.

Cursed because they pay a larger percentage of their net income in taxes than anyone else in the country.  Blessed with business deductions that, when used properly, not only balance their taxes with those of the average employee, but actually mean (if they are paying attention) that they pay a whole lot less.

In a real sense, your self-employment enables you to control the taxes you pay.  If you know the rules and spend the time to use them properly, you can significantly reduce the largest expense you pay during your lifetime.

Information provided by Tax Reduction Letter, Volume 15, Number 6, June 2006

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