Updated: Sep 19, 2022
A misconception we see in tax planning with taxpayers is self-employment (SE) taxes (social security and Medicare) and income taxes are calculated on the same line of the tax return. The thinking of the taxpayer can be: “If I have a $5,000 tax bill, I can just spend $5,000 on my truck as a business expense and pay no taxes!”
That’s incorrect. A business cost is not an equal deduction in tax due.
In reality, business expenses only reduce your tax liability by .15-.30 cents on the dollar (see effective tax rate below). SE (Self Employment) tax and income taxes are the two forms of taxes sole proprietorships and single member LLC’s pay on a Federal 1040 with Schedule C return, as far as business income goes.
W2 employees pay these same taxes with no choice each time they get their net paycheck. Sole proprietorships and single member LLCs have the freedom to pay these same taxes quarterly, the freedom to pay quarterly comes with the responsibility “solely” on the Sole Proprietor/Single Member LLC to pro-actively pay their taxes each quarter. Understanding and budgeting this tax payment each quarter is a critical part of being a successful independent contractor.
IRS considers these forms of business as “flow-thru” entities; meaning all income from the business filters down to your individual tax rates and are not be subject to “double taxation” at a corporate/business level.
Calculation of SE Tax and Income Taxes
Let’s compare four owner-operator scenarios for 2018 rates:
Alvin: Single Sole Proprietor who made $40,000 net income after business expenses and paid $3,500 in health insurance.
Simon: Married Sole Proprietor making same as Alvin and paying same in health insurance and no spousal income.
Theodore : Same as Alvin but no health insurance
Dave: Same as Simon but no health insurance
*Assuming no state income taxes such as TX or FL (Calculated income tax is based on 2018 tax tables issued by the IRS from taxable income line. Tax Nerds: for simplification, we are leaving out other credits that would apply to all, such as QBI.)
The above diagram is in chronological order just like a 1040 Tax Return to show how the calculations flow. Simon and his spouse will pay the least due to the health insurance and married filing jointly standard deduction. But all four owner-operators pay the same SE tax because it’s calculated solely off of business income, not adjustments, exemptions or any qualifying credits.
Remember business expenses are not one-to-one write-offs!
Theodore just got off the phone with his tax preparer in late December 2018 and the preparer estimated he should expect around $9,845.00 (see above example) in taxes to be owed. Theodore is considering ways to ‘wipe out’ his tax liability that will be due April 15th. Without reviewing with his tax preparer, he decides to go out and spend $10,000 on December 31st on a chrome kit, new seats, tires, new paint job, etc. He figures, “I might as well put the money in the truck rather than in Uncle Sam’s hands!” Theodore submits his receipts for these purchases to his tax preparer. Come early April, Theodore gets a call from the preparer and is notified of the results as shown in the chart below:
The preparer explains to Theodore that the business expenses effectively reduced his tax liability 27 cents for every dollar he put into the truck remodel. So instead of Theodore paying the $9,845 in taxes for the year, he is out of pocket for a total of $14,239 ($4,239) for taxes and ($10,000) for truck remodel.
For 2018 Theodore would have been better off using his income to purchase health insurance rather than spending his income on business expenses to lower his tax liability. Why, you may ask, if there is no more health penalty, however, next year in 2019? It’s still a one to one write off. He should go after one-to-one write offs that reduce his adjusted gross income such as health insurance, 50% SE tax, self-employed IRAs, student loan interest, and health savings accounts to name a few. Health insurance is not a business expense (as a Sole Proprietor/LLC) and for good reason, otherwise, it wouldn’t be as valuable of a deduction as it is now. So it is in Theodore ’s best interest to purchase health insurance for its dollar for dollar tax incentive vs. the .27 cents on the dollar remodel of the truck in this example.
Tax Planning for Future Years
Usually, good tax methods can help save 20-25% of your income to satisfy tax liability (depending on your situation). Paying quarterly taxes on time will ensure no penalties or interest accrues on your tax liability. Take Alvin’s scenario for example if he didn’t pay quarterly:
*$2,273.75 is Alvin’s 2018 tax liability divided by four. He should pay these for 2019 (safe harbor estimates) if he estimates income will be consistent with 2018.
The key is to be vigilant in planning, budgeting and paying for taxes, identify what types of expenses you can leverage as one-to-one tax deductions to lower your tax liability, and pay quarterly estimates to minimize penalties. Before you spend, talk to us.