93% of the taxpayers I have helped with back taxes in the past 4 years were self-employed. Over half of those people were also first-generation business owners. They all have one thing in common. The struggle of transitioning from employee to entrepreneur.
My heart goes out to these entrepreneurs because often there is no one to guide them through tax law. The main contributing factor to their struggle in transitioning is the lack of understanding. They are phenomenal at what they do. The tax side trips them up though. They just don’t know what they don’t know.
This results in analysis paralysis, stagnation in sales, and tax debt they can’t get out of. So in the next 5 minutes, I’m going to explain 3 things I have observed about the business owners I have helped. I hope this helps you avoid a tax bill of $100,000 that you can’t pay today.
#1 – The United States has a pay-as-you-go tax system.
The IRS wants you to pay income taxes as you earn money. Taxpayers are familiar with this concept when they work a W-2 job. Your employer withholds taxes each time you’re paid. Then they are responsible for making those payments on time.
For some reason, the same concept is foreign to first-generation business owners. As a business owner, you are now responsible for your own taxes. This includes making sure the right amounts are set aside but paying them on time.
If you had a tax liability of $1,000 or more than you the IRS requires you to make quarterly estimated tax payments. Please note that even if you received a refund in the prior year that does not mean you didn’t have a tax liability. It means you overpaid your tax liability and the IRS refunded the amount you overpaid.
Also, if you do not have at least 90% of the tax liability paid by tax day you will be subject to underpayment penalties.
#2 – You now have to pay self-employment tax.
Self-employment tax is a very unpleasant surprise for new business owners. So what is self-employment tax? It is your share of social security and medicare tax.
When you’re an employee you may notice on your W2 that money is withheld for these items. It’s non-negotiable. What you don’t see is that your employer pays the same amount that you do.
When you become a business owner guess what happens. You have the privilege of paying both halves, which ends up being roughly a whopping 15.3% of your net income. You pay this tax with your Federal quarterly estimated tax payments. This 15.3% does hurt if you are not prepared for it. Who am I kidding? It hurts when you have prepared for it.
If you would like to learn more about self-employment tax I cover it in greater detail on my podcast, Tax Relief with Timalyn Bowens. You can catch the episode on self-employment tax here: What is Self-Employment Tax?
#3 – Business expenses must be ordinary and necessary.
It is common knowledge that business owners can deduct a lot of things for their business. However, a lot of people think that means they can deduct anything for their business. That is not how this works. That is not how any of this works at all.
Attempting to deduct frivolous and or unnecessary things will put all types of flags on your back. Thus, signaling the IRS to audit you. When purchasing something you have to ask, “is this necessary to run my business? Is it something ordinarily used to run this type of business?”
So yes, a G-wagon may qualify as a tax deduction for certain businesses. But does it qualify for your business?
- Is it necessary?
- Is it ordinary for your type of business to even have a vehicle?
But also, what they aren’t telling you is that in order for you to write a car off 100% you have to use it exclusively for business.
Is that going to be the case or will you be picking up all your friends and family? The IRS will ask for proof of this exclusivity.
Let’s look at a more practical example, a business suit. Yes, you do need to look nice to make sales. However, as soon as you wear that suit outside of work it then takes on personal use. This is a personal benefit and therefore not a business expense.
Now if you work in construction and purchase steel-toed boots to wear on-site, that is different. The purchase is both ordinary and necessary for you to generate revenue.
I hope you find these helpful. These 3 things are not all-inclusive but they are a good start. If you have found yourself in a bit of tax trouble already don’t let that stop you from growing your business. A tax bill that you can’t pay today still has a solution that will satisfy the IRS and not bankrupt you.
Check out episode 10 of Tax Relief with Timalyn Bowens. I explain IRS installment agreements, how to qualify, and how to set one up. Listen to it as soon as possible because back taxes shouldn’t ruin your life.
What was your biggest surprise about taxes when you became a business owner?
