Posted by Joseph Gaudio, CPA
If you are self-employed, you probably spent some time in your career working as an employee for someone else. When that transition from employee to employer occurs, tax implications change drastically.
I’m a big fan of examples, so let’s get right to it:
Meet Bob. Bob is a 35-year-old IT professional. He has been working as an employee for the same company since graduating college. Bob has a certain comfort level in knowing that his employer is handling federal/state withholdings and payroll taxes with each payroll run. In fact, he rarely thinks about taxes at all. From time to time, he may take a look at his paystub and figure out the differences between the gross pay and the net check that was direct deposited into his bank account, but that doesn’t feel important to Bob. After all, he manages his personal bills based on the net check in his bank account.
Bob has grown weary of the IT profession, follows his passion, quits his job, and plans to open the best taco stand in town.
Bob engages an attorney and a CPA for advice regarding start-up and operating his taco stand. The attorney and CPA collaborate with Bob to determine his most advantageous entity structure is a single member limited liability company (Bob’s Tacos LLC).
Fast forward a few months – Bob’s Tacos LLC is a huge success! The LLC checking account has a $110,000 balance. No bank or personal loans were made that would have increased the cash position; the balance is purely the result of profitability. Bob knows he needs $10,000 in the LLC account to cover expenses and transfers $100,000 to his personal checking account. This is where the problem begins. The profit Bob transferred to his personal bank account is not net of taxes as when he was an employee. As an employee, Bob had virtually no tax responsibility. As a self-employed individual,he has the responsibility. All of the withholdings and tax remittances previously done by his employer now most are achieved through quarterly estimated payments. Bob will write checks quarterly to the U.S. Treasury, which are intended to cover his income tax liability based on his tax bracket (10%-39.6%). In addition, the payment will cover another tax category called self-employment taxes (i.e., Social Security and Medicare). Bob is considered an employer and an employee of Bob’s Tacos LLC for self-employment taxes. That means he is effectively responsible for Social Security taxes (6.2%) and Medicare taxes (1.45%) both as an employee and as an employer (15.3% in total). In addition, quarterly estimates will be due to the state in which Bob is domiciled and conducts business.
It should be noted that under the above scenario the income and self-employment taxes are based on business profit, not the distribution of the earnings from the business account to a personal account. In other words, Bob will owe the same amount of tax whether he leaves the earnings in the business, or distributes the money to his personal account.
This cycle of profit distribution is psychologically deceiving for a self-employed person like Bob. There’s a sum of cash in the personal bank account due to business profit but an undeterminable amount isn’t available for personal expenses and should be earmarked for paying estimated taxes. We generally recommend opening a separate checking account to hold the earmarked cash. Physically moving the cash into a checking account set up to pay taxes can remove the temptation to use this money for personal purposes.
Income brackets, mix of deductions, retirement contributions, forecasted earnings, spouse’s income and withholding as well as endless other factors drive your tax position. How much money should get moved to the separate tax checking account and the amount to pay with each quarterly installment is unique to each individual.
Failure to properly strategize can result in very expensive tax problems which can harm individuals and their business ventures. Utilizing the skillset of a CPA can be extremely valuable for the tax and cash flow planning needed to avoid unwanted surprises.