Tuesday, April 5, 2016

The Vicious Self-Employed Tax Cycle

Picture this:
  • You are self-employed.
  • You are meeting with your tax accountant to complete your taxes by April 18 and are told that you owe a bundle in taxes.
  • In addition to the taxes you owe, your tax accountant advises you to also make your first estimated tax payment for the current year by the same April 18 deadline.
  • You simply do not have the money to cover all these tax obligations. You get set up on a payment plan to pay the balance due, and because you are paying off this amount from the past, you surely cannot make estimates for this year. At this rate, it feels as though you will never catch up. You're stuck in a vicious cycle and it feels like you will never be able to get out of the hole.
With proper discipline and planning, you can get out of get out of the cycle of always being behind on taxes. It may be time to evaluate your self-employed tax structure and whether you are as tax-efficient as you can be. An S-corporation tax treatment may be a viable tax-planning strategy. There may be other options as well. Regardless of tax planning strategies, self-employed individuals need to get in a position where they have the proper withholding or estimated tax payments.
 
Estimated tax payments are due April 18, June 15, September 15, and January 15 (Note: The fourth-quarter payment is due in the following year). If you are self-employed, you should most likely be making estimated tax payments. If you do not and you have positive income you will, with almost 100 percent certainty, owe taxes every year. When you are self-employed, your income has no withholding. You are on the hook for federal tax and state tax, but also, depending upon your tax structuring, the 15.3 percent self-employment tax on your business income.
 
To illustrate, think back to a time when you were a W-2 employee. Your actual pay was $5,000 per paycheck, but by the time you got your check, it felt like only a small portion was deposited into your bank account. The difference between your gross check and net check was the result of taxes being taken out of your paycheck. When you are self-employed you will typically have some or all of your income that is outside a paycheck that has withholdings.
 
We believe that proper planning starting at the beginning of the year can alleviate the illusion that you do not have the available funds to pay taxes at year-end. If your business is profitable, you have generated cash; you just chose to spend it on something other than taxes. If you choose to put aside funds and pay estimated taxes during the year, you will never have such a large balance at year-end. Being proactive and making the estimated payments will keep you from having a large amount due at year-end, and help you avoid associated underpayment penalties
 
We attempt to explain this to clients before they get caught up in the vicious cycle. If you are in the cycle, there is a way out. This will take planning and budgeting, but it will be worth it.