Going Into Business, Part I
Peter VanderWoude, CPA, CGMA
June 1, 2017
You or someone close to you, through necessity or to fulfill a dream, has left employment and gone into business for themselves as a sole proprietor. Congratulations! For many of you there may be misconceptions about taxes that may dampen your enthusiasm come April 15th. Let’s make sure that doesn’t happen.
Setting up a sole proprietorship can be as simple as filing a “Doing Business As” (DBA) with the county clerk’s office or a bit more complex if you create a single member Limited Liability Company (LLC) through New York State. With a new Tax Identification Number from the IRS, one heads to the bank and opens a business bank account. So far so good.
The new sole proprietor gets a subscription to QuickBooks Online or uses a spreadsheet to keep track of income and expenses. Money is flowing in! Wonderful…right? Yes, but not so fast. Your mindset needs to change.
As an employee, the paycheck you received had social security and income taxes withheld from it and the net amount in your paycheck was yours to spend. Now you are your own “employer” receiving revenue, not a paycheck, from which the net earnings on Form 1040 Schedule C (for sole proprietorships) is subject to two taxes: self-employment tax (Schedule SE) and income tax.
Self-employment tax is approximately 15 percent of net business income of $400 and over. As an employee, you paid half of this social security (employment) tax and your employer paid the other half. As a sole proprietor, you pay both halves. If you are in the 15 to 25 percent federal income tax bracket and the five to six and one-half percent New York State income tax bracket, you can see that 35 to 46 percent of the net income earned by your business goes out in taxes. You must pay for these taxes by making estimated tax payments four times a year – April 15, June 15, September 15 and January 15.
Many new business people have not paid in enough through estimated tax payments during the year, either through not knowing how much to pay or they did not have enough cash at the time. When their income tax return is filed, these new business people owe an amount that shocks them. As a small business owner, it’s hard to see money come in and then see a substantial portion of it go out as taxes. Do we need tax reform? Absolutely.
All new businesses absorb cash to start and grow. Make sure that you have access to capital. See your tax advisor before you start your business and throughout your first year to help change your mindset from employee to a disciplined business owner. Set earnings aside to pay your self-employment and income taxes and separate sales tax collected, which we will discuss next month. You don’t want to use the IRS and New York State as your banker!