It’s October 21st and many of you just completed your 2018 taxes. There might be a few who managed to get their documents to their tax preparer in plenty of time to file by the April 15th deadline, but for the most part, if you just filed, it was because you needed the time to sort out your records. Frustration and stress followed by likely disappointment because of how much you had to pay in taxes and how much you had to pay your tax preparer to tell you how much you owed. And here comes the end of 2019, just around the corner, raising a curious eyebrow at you to see if this year will be any different. It’s a vicious, debilitating cycle and it often steals the joy out of what business owners manage to accomplish from year to year.
If you’re just starting your business, please do yourself the biggest favor of your professional life right now. Call the bank that has your personal checking account, open a savings account, and transfer 15% of your checking balance to the savings account. From now on, do not spend a penny of the money you pull out of your business until you’ve transferred 15% of it in the savings account. Because here’s the deal: If you’re a sole proprietor, then 15% of every dollar you take home, every dollar you spend on personal expenses, will have to be paid back in federal self-employment taxes.
If this comes as a shock to you, please consider the fact that you no longer have an employer who is withholding taxes from your check. As a self-employed individual, you will have to withhold and pay your own taxes (social security and medicare). This simple fact, I am convinced, is the bane of the sole proprietor’s existence, and it can be defeated with some basic cash flow planning. That savings account you just opened is your new best friend. It’s going to ensure that you have enough money to pay your tax estimates throughout the year. It’s also a friend you’ll never see or talk to except four times a year when it’s time to pay taxes. Don’t check the balance. Don’t wonder how much is in there. Don’t tempt yourself to use it for an emergency and pay it back. If you need to nickname the account “The Government’s Money” or “Don’t Even Think About It,” to help yourself out, you should go ahead and do that.
I actually ended up separating my funds entirely. My tax savings account is at a different bank entirely from my personal checking account which is a different bank from my business checking. I linked the tax savings account to my business account so I can transfer funds, but there’s no fast way for me to move funds from my tax savings to my personal checking. In fact, I never do. Once it’s in my tax savings account earning interest, I don’t touch the funds until it’s time to pay my estimates. Then I transfer the balance directly from the savings account to the IRS. It never hits my personal checking account. It’s like the funds don’t even exist except for the bit of interest it accumulates, thanks to Alliant Credit Union‘s 1.884% interest rates on their savings accounts. Other than the few dollars a month it earns, the funds just sit around looking pretty for no one to see for most of the year. It’s the practice that’s kept me and my firm stress-free when it comes to tax planning.
Many owners I work with will kick the tax plan down the road as far as possible and hope to God that their tax preparer will be able to work some magic when it comes time to file. I have to tell you though – that magic usually comes in the form of your purchasing an expensive, depreciable asset. If you go out and buy a $75 thousand truck, your tax preparer will be able to write off a majority of that truck under section 179 and wallah! No taxable net income. But now you have five years of paying $1400 a month on a truck payment and an insane gas expense and insurance bill to go with it and guess what? You’ve already written off all five years of those truck payments to avoid paying taxes. Next year, your tax preparer will likely tell you to buy some new equipment so they can write it off and save you on taxes again. Genius, right!? But now you have another monthly payment and your cash flow takes another giant hit.
It absolutely kills me that tax preparers advise their clients to buy assets they can’t afford in order to avoid taxes. It makes the tax preparer a hero in the moment, but it often signs the death warrant of the client’s business. You cannot sustain a healthy cash flow with that kind of planning. It should be illegal, punishable by fines and prison time for a tax preparer to tell you to take out a loan for a vehicle or equipment or a building so you can avoid income taxes. It’s asinine and irresponsible and short-sighted. By minimizing your tax bill, they have insured that your take-home cash is virtually non-existent.
Instead, your tax preparer should estimate the total taxes you will owe each year, divide that by the amount of revenue you expect to earn and give you a percentage of your revenue to set aside. Mike Michalowicz’s Profit First is the absolute king for describing this method in detail. This calculation should be completed quarterly to ensure that you aren’t setting aside too much or too little. You want to maximize your take-home cash, not minimize your tax bill.
Taxes are inevitable. What I witness in the form of avoidance and frustration and aggravation every year far surpasses the alternate reality business owners could live in if they could just take a deep breath and talk to someone about how to maximize their take-home cash rather than worrying about how to minimize their tax bill.
