The #1 Pitfall New Business Owners Face
We all know starting and running a business is hard work. You believe you can create a positive change in the world through your service or product. You give up a well paying job to go out on your own. You sacrifice family time to pour your heart and soul into something you believe in. You learn firsthand why roughly half of all business start ups don't exist after 5 years. But you're different. All your blood, sweat, and tears culminate to a nice profit at the end of the year because of your savvy business skills.
Boom! boom! boom! Someone is pounding at the door. You open the door and see a person with an envelope in their hand. You open the envelope - it's your tax return. "Alright, time to see how successful I was this past year… I shouldn't owe that much tax" you think to yourself. Because after all, you're just a small new business owner with LITTLE income. Looking through the (2020) tax return you flip through and stop on Page 2 line 23 (Other taxes) and line 24 (Total tax). Your heart skips a beat and your stomach drops. "How can this be?!" You ask yourself. You quickly flip to Schedule 2 and you see line 4, Self-employment tax. Confusion and agony quickly flood your emotions while the room seems to start spinning. The person at the door has been watching you the whole time with a smirk. They rip off their jacket and underneath there is a shirt with "IRS" on it. The IRS employee yells "Gotcha!" in a creepy whisper yell.
Now that isn't exactly what happens in real life. There is no IRS boogeyman that enjoys watching you suffer the first time you see how much tax you owe as a small business owner. However, if you've experienced this before the illustration above is similar to how it feels. As a CPA that prepares tax returns for many small business owners, I see this all the time (the disbelief, not the IRS person knocking on your door). So what is the#1 pitfall for new business owners? Self-employment tax.
You are subject to Self-employment tax (SE Tax) if you are one of the following and have net self-employment (SE) earnings (profit) of $400+:
A sole proprietor business owner that files a Schedule C
LLC owner
1099 contract/commission worker
Partner in a partnership
Church employee who is exempt from Social Security and Medicare taxes (only have to be paid $108.28, not $400 for church employees)
What is SE tax?
15.3% which is a combination of Social Security tax and Medicare tax on SE earnings
12.4% for Social Security, capped at $132,900 for 2019 for each taxpayer.
2.9% for Medicare
Net SE earnings are not only subject to self-employment tax. Net SE earnings are also subject to ordinary income tax rates. All of a sudden your effective tax rate is in the 30-40% range and you only make $50,000 in net income! You can just picture the IRS person smirking right now, can't you? We see some clients that have higher effective tax rates than other clients with a W-2 and twice as much income.
How can this be and how is this fair? Let's go back to your employee days where your salary was reported on a W-2 (W-2 example below). See box 4 & 5? That's your portion of payroll taxes owed to the government. Your employer is paying the same amount and they get to deduct it against their income. When you have SE income as a business owner you are paying the "employer portion" and your portion. Double your pleasure double your fun, double the payroll tax gum! Oh, that's not how the Doublemint Gum jingle goes?
In a way that seems fair because you are now a business and the government is going to get that 15.3% one way or another. However, I don't think that's fair. I don't think that's fair for business owners with net SE earnings to be taxed at 15.3% on top of their ordinary income tax rate because it can be mostly avoided by simply checking a box. Ok it's not that simple but it kind of is. Enter S-Corporations. Net earnings on S-Corporations are (usually) only taxed at ordinary income tax rates, not SE tax rates + ordinary tax rates like your typical Schedule C business.
S-Corporation owners are an employee and a shareholder. The owner pays themselves a salary - which is subject to payroll taxes, payroll taxes are deducted against net income, and the rest of the income is only subject to ordinary tax rates. Instead of all your net income being subject to SE tax, only the amount you pay yourself is subject to SE tax. Filing your small business as an S-Corporation has the potential to save you thousands in SE tax by adding a manageable administrative burden - having to file an S-Corporation return (1120-S) and file payroll through the S-Corp. If you're interested in S-Corporations then we are interested in talking to you. Please schedule an New Client Initial Consultation Meeting with us and we can evaluate if an S-Corporation would be worth your time.
