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Wait a minute… didn’t tax season just end? Well yes, it did, but this is actually the best time to start preparing for next year!
A lot of people start off by saying, “Now, I know this is a boring topic…” If there were any topic to do that with, it would be taxes.
But I don’t want to do that. Remember, people feed off of your energy! They’re looking to you for how to feel.
That’s why I’m going to make this fun. This is going to be an exciting episode about taxes that will help you feel a lot more prepared for next year.
This is an ideal episode for freelancers, small business owners, and any kind of entrepreneur.
If you’re looking to understand taxes better, feel a little more prepared, learn to categorize expenses easily, reduce self employment tax, and get a handle on things, this episode is for you.
Highlights, Takeaways, & Quick Wins:
- Right now is the beginning of next year’s tax season and you need to start preparing now.
- Pay a CPA now for 2016 and find one sooner rather than later.
- The first year I paid a CPA $800, it hurt. But I ended up paying $10,000 less in taxes than I expected.
- When you get to tax time and you owe an extra $2,000 because you did something wrong or you didn’t prepare—that’s when you realize how smart it would have been to spend $300–$1,000 on a CPA.
- Set aside 25% of everything you make——if you made $400 or more, you have to pay self-employment tax.
- Have a buffer: self-employment is an additional 15% tax on top of what you make.
- Use Freshbooks for automatic expense categorization.
- Make sure to use a separate card for your business expenses.
- Reduce self employment taxes by looking into setting up an entity, LLCs or S-Corps, to create liability protection.
- If setting aside tax money is difficult for you, to consider making quarterly estimated tax payments.
- Don’t get to the point where you don’t have the money you owe the government.
- If your intent is to run a business, don’t be dishonest and call it a hobby to avoid taxes.
- 03:36 Sean: Disclaimer: this isn’t personalized legal advice. Don’t take this at face value. Rules are going to be different everywhere and I’m speaking from the standpoint of paying taxes in the United States. A lot of these principles can apply outside of the US but things are going to be different from country to country, and even state to state, so make sure to consult with an accountant. You’re probably thinking, “Sean, we just paid taxes!” It might seem like a weird time to do an episode on reducing stress for tax season, but:
Right now is the beginning of next year’s tax season and you need to start preparing now.
- 04:54 Ben: You mean I should have started preparing last year at this time instead of February?
- 05:07 Sean: That’s something I’ve been getting better at in the past few years but before that, I thought, “April is when you do taxes.” No! Now is when you want to start thinking about keeping records, tracking mileage, and categorizing expenses.
1. Pay a CPA Now
- 05:46 Pay a CPA ahead of time to consult for next year because that’s going to be the most valuable time to get their insight. When I hired a CPA for the first time, it was a big investment for me because I was comparing Turbo Tax for $50 to what I ended up paying the CPA, which was $800. It seemed huge and I didn’t want to do that but they helped me. CPA’s have lots of clients so you can’t go on April 1st and expect them to file your taxes on the 15th. They had to file several extensions to be able to work with me that year, then it was all about preparing for the next year. If you’re going to work with a CPA, which I think you should, start early—start now for 2016.
- 07:03 Ben: My wife and I had been doing taxes on our own but we started getting busier with freelance work and the band we were in. We thought we could do our own taxes that year and we were going to owe $800. It freaked us out because we had never had to pay before, we had always gotten something back. If your work is coming in the way it should be, you can expect to be paying instead of receiving a tax return. We felt desperate and decided to try out a CPA to see if we had done this correctly and that year we ended up getting back $7,500 dollars. That was also in combination of freelance work and employment so that was probably a big part of it. Plus, children make really good tax deductions.
- 08:40 Sean: A CPA seems like a really big thing to invest in. In case you’re not familiar with the acronym, CPA stands for Certified Public Accountant and they’re people who will file your taxes to the government on your behalf.
- 09:02 Ben: If you’ve given them all your records and you’ve been keeping your own books well, then you pass it on to them, don’t they take some of the legal liability on?
- 09:24 Sean: I don’t actually know how much liability they take on. I know you have to sign off permission for them to file on your behalf but I imagine that’s for their protection.
- 09:43 Ben: If they were misinterpreting or misusing one of the tax laws and you’re unaware, aren’t they liable for that?
- 10:01 Sean: Along those lines, in the chat room, Keshna is asking, “What do you want to look for in an accountant?” I honestly didn’t know who to go to. I didn’t want to go to the cheapest one so I looked around for someone a step up from that. I found a CPA that was more for a level above where I was. They worked mostly with larger businesses, so it seemed weird when I went in but they were willing to take me on. It was a little more expensive but I purposefully did that because that’s where I saw myself going. I wanted to grow into that.
- 10:48 They asked me what my projections were for the following year and that was a challenge to me. I had to make a statement about what I was going to make instead of just letting whatever income comes my way. I didn’t want someone who did only my level of taxes, I wanted someone that was above me—in the place I wanted to be—so I could grow into that. I wanted to get their advice on proprietorship vs. an S-Corp or LLC and they helped me grow into that. Paying them was an investment but it ended up being very worthwhile. The first year I paid a CPA $800, I ended up paying $10,000 less in taxes than I expected when I was going to do it on my own.
- 12:08 Ben: The reason people pay them so much is because they keep up with all the tax laws, policies, and new information coming out each year. If you sat down and devoted time to keeping up with that stuff, you could figure out how to work that information into your taxes, but think about how much that time is worth to you. These people are spending 40+ hours a week focusing exclusively on tax stuff. In order for you to be able to do the same level of work with your taxes, it would take you away from what you love doing. That time is worth way more than $800. Albert asks, “Would a CPA be a wise investment for someone who’s just starting out, as in the beginning stages of the Overlap Technique, or hold off until there’s more money coming in?”
- 13:19 Sean: At that time, I had a partnership web firm that was my day job and I owned a computer repair business, which I had contractors for, and I also had my lettering work on the side. My wife was also working a job. I didn’t know much about focus then and it got to the point where I really couldn’t do it with Turbo Tax. It was too complicated to put all those things into the Turbo Tax boxes.
- 14:08 For someone just starting out, if you have a day job and you’re just starting to make a little bit of money on the side and that’s it, you might be fine using Turbo Tax. You should play to your strengths. The fact that everything is so complicated that you need to hire a professional what you owe is a whole other topic, but it’s also the reality. You can either invest all of your time learning the different tax codes and complications, or pay someone else to handle that so you can focus on your strengths and making more money.
Time you’re spending on taxes is time you’re not spending doing what you’re good at that will make you more money anyway.
- 15:32 Ben: It’s not just an investment in what you might save in paying the government, but it’s an investment in what you’re going to save in terms of the time you can spend doing the things that make you money.
2. Set Aside 25% of Everything
- 15:44 Sean: A good rule of thumb if you’re bringing in a lot of self-employed income is to save 25% of everything you make. You might end up paying a higher percentage than 25% of the taxable income you bring in, but it depends on what tax bracket you’re in. You’d have to be in a pretty high bracket to be paying more than that. We’re also assuming if you’re hiring a CPA, you’re taxable income isn’t going to be your gross income. What I mean by that is: you bring in $1,000 for a project, set aside $250. More than likely, because of different expenses and deductions, your taxable income might come down to $600 to $800.
- 16:35 $250 out of $600 to $800 is a significant percentage and that will more than likely cover what you owe. Hopefully, you end up with a little bit more. 25% is a good number to set aside. You might be wondering, “How much do I need to be making to start setting aside 25%?” According to the IRS, if you made $400 or more, you have to pay self-employment tax. You’ll receive a 1099 in the mail, which will show the government you received miscellaneous income, a.k.a self-employed income. You’ll have to submit that document when you do your taxes and then the government is going to expect you to pay taxes on that.
- 17:59 Ben: That sounds like a lot when you’re thinking about your income as far as what you need to make to cover you bills. It’s a challenge to shoot beyond that. If you know your expenses for the year—rent, food, mortgage, etc.—will total a certain amount, then you need to shoot for something higher than that so that if you take 25% away from it, you’ll have enough leftover to cover you bills. I like how it makes it necessary to think bigger than the regular bills. When you have a job and they offer you a salary, you know taxes will be taken out of that. Think about it in those terms—what kind of salary do you need to make in order to still have what you need after taxes are taken out?
- 18:59 Sean: Justin says, “As a point of comparison, I set aside 40% of my business income for taxes.” Have a buffer—I’m saying 25% as a rule of thumb. At least put aside 25% if you want to be smart and you can do more than that to be safe. Self-employment is an additional 15% tax on top of what you make.
- 20:20 Ben: I wanted to talk about the mindset and attitude toward taxes. Part of what makes it so stressful is this idea that, “This is my money and now it’s being taken away from me.” On the last Lambo Goal episode, Matt was talking about his attitude toward taxes, which is very positive. When you go down the list of what the government uses tax money to fund, you might have a negative attitude toward it because you disagree with what they use it for, but you’ve got to deal with the reality.
- 21:15 There are several things you enjoy as a citizen that, were people to stop paying their taxes, you would have to furnish yourself or it wouldn’t be possible because of the amount of infrastructure it takes to support. I prefer the attitude of appreciation toward having the benefit of the things taxes afford, regardless of how many I agree with or not. You can also give to charity or government funded programs to bring your taxable income down, which can be a tool for shifting your attitude. If your attitude isn’t, “This is my money and they’re taking it!” then it becomes less stressful. You’ve expected it because you enjoy the benefit of certain things.
- 23:18 Sean: Brent asks, “Should I look into a CPA that specializes with my line of work? That being a self-employed freelance graphic designer. Also, does your CPA have to be local to you and would you recommend it?” I don’t see any harm in having a CPA specialized to your line of work, they’re going to know very specific things that can be helpful. I wasn’t concerned about finding a specialized CPA, I was more concerned about finding one that could help me grow to the next level. In the past 6 months, I’ve gone from a solo-entrepreneur to five employees.
- 24:06 That’s not a situation where I needed someone tailored to my line of work. I needed someone to help me grow, pick the right entity, and help me with employees/contractors. If you can find someone who specializes, that’s great, but don’t stress about it. Find a CPA sooner rather than later and just go with one if it’s taking too longer to find a specialized one. He’s also asking if they need to be local and for me, I don’t always need to go into my CPA’s office but for the initial consultation, it was valuable being in person. It was valuable to eventually talk with the partners there and discuss where I’m going and get questions answered. We can get questions answered over email but there’s something freeing about being in person, getting all of your questions answered, having them reassure you, and show you what’s next, especially initially building a relationship with them. If you do want to work remotely with someone, I would say it’s worth the trip to have that initial consultation with them in person.
- 25:51 Ben: When we’re talking about easing the stress of tax time, if you feel the person doing your taxes for you is professional and competent, you’re going to feel a lot better. When I’ve sat down with a professional and saw their demeanor, I realized I didn’t have to stress because this person knows what they’re talking about. I’ve never had that same kind of experience with someone over the phone or email. Experiencing them in person translates to every other interaction you have with them thereafter.
- 26:57 Sean: Having met someone in person can be applied to texting, emailing, or calling them. Steph says, “If you set aside 40% for taxes, how much do you increase what you charge to accommodate that?” First of all, there’s also state taxes for the poor unfortunate people who don’t live in Texas, you’ve got to set aside even more of your money. If you’re setting aside 40%, in theory, you’re also making quite a bit of money too, so you won’t have to charge more to accommodate for that.
- 27:53 Justin has a better answer than I do, he says, “The way I do that is I have an internal hourly rate that’s not shared with clients. It’s designed to cover living expenses and I use that as a baseline to ensure I’m not undercharging. For example, if I’m considering a project that’s going to take me an estimated 100 hours, I multiply that 100 hours by my internal hourly rate to get the minimum amount I need to charge to pay bills, taxes, buy food, etc.” We talk about this in our Value-Based Pricing series (Related: e145 Getting Started With Value-Based Pricing, e146 Attracting Clients and Positioning the Conversation Around Value, & e147 The Nuts and Bolts of Value-Based Pricing). There’s an internal baseline rate that covers your expenses, which is not what you charge, but what you account for when you’re pricing a project. We talk about how to go into discovering the value to the client that’s priced in addition to your expenses. You start with being able to cover your expenses so anything else you make from clients is profit, that’s how you can afford setting aside 25% to 40%.
- 29:15 Ben: You do charge sales tax on top of the full value of the project, right?
- 29:22 Sean: You do if they’re in the same state, but if they’re not in the same state, you don’t. The laws are changing a lot and they’ve tried to make it to where you sell to a customer in Indiana, but you live in Texas, you would have to collect Indiana state sales tax to pay quarterly. Can you imagine doing that in all 50 states? It would put everyone out of business, yet there’s people pushing for that. You have to charge sales tax in whatever state you have a business presence in.
3. Use Freshbooks for Automatic Expense Categorization
- 30:52 I use a free Freshbooks account for automatic expense categorization. I used to use Freshbooks to invoice people but I’m no longer doing client work. You can apparently still use the expenses feature, even after you down grade to the free account. I tie that account to my business credit card so that all of my automated expenses go onto the card—which gets paid off every month—and gets tracked by Freshbooks. You want to make sure to use a separate card for your business expenses. If you use your personal card, you’ll make it a nightmare for yourself and your accountant. In Freshbooks, you only have to categorize them once—postage, office supplies, contractors, etc.—and every time those charges come in, it’s automatically categorized going forward. At the end of the year, you can export a report in PDF format that has all the categories. Your CPA wants to know every single category itemized and this does it automatically.
- 33:21 Ben: What you’re describing would save us so much time. I would pay for that, but you’re telling me this is free.
5. Reduce Self Employment Taxes
- 33:52 Think about how amazing it is to start you’re own business somewhere. People rode on disease ridden ships for weeks eating awful food and watching their children die, just so they could have the opportunity to start their own business and pay a bunch of taxes. It’s a privilege. If we can think of it that way instead, we’ll be a lot better off.
- 34:39 Sean: That’s a good perspective. It can be really hard when you’re trying to start out and you’ve got an additional 15% on top of everything else. Not that we should have a bad attitude, but being realistic, I wanted to talk about how to reduce self-employment taxes. If you make over $400, you pay self-employment taxes. There are different entities or corporations you can create where you, yourself, are an employee of the business. The business becomes an entity instead of just you. In years past, seanwes has been a DBA—a name I do business as—but the government sees all of my income as Sean McCabe, which is self-employed income. If you have a DBA or are a sole-proprietor, everything you make is self-employed income and you’re going to pay a lot of taxes on that.
- 36:03 There’s LLCs, S-Corps, and Corporations, but you probably aren’t going to need to worry about a Corporation. A single member LLC is really easy when it comes to the paperwork for establishing your work as a business, not just as a sole-proprietor. When you have a single member LLC, it’s what’s known as a “pass through entity.” It affords you some liability protection. Everything that comes through will be treating as self-employed income, but you get liability protection and deductions are taken at a personal level.
- 37:00 If you have an S-Corp, you’re an employee of your business so you get paid a “reasonable salary.” The S-Corp pays you and deductions are taken at a business level. You personally only pay taxes on your salary, like a normal employee and then the business gets taxed. It removes you a little bit. The downside is that there’s more paperwork, it’s more expensive, you can only have 100 shareholders, and you must be a US citizen. It can cost a couple thousand dollars to set up an S-Corp vs. an LLC, which you can do for a few hundred dollars.
- 38:06 Ben: Is setting those up a one time expense?
- 38:14 Sean: It depends on how you look at it. Setting it up is a one time expense but there might be renewals every 10 years or so but you also have to file quarterly paperwork. That’s either your time or you’re paying someone else, either way is money. It does cost more money but when you’re making six figures or more, a few thousand dollars of expenses there could end up saving you tens of thousands of dollars, because it’s no longer you being personally taxed on all the income. We ended up going with an S-Corp because it made more sense for me. I’m essentially an employee and the business is it’s own thing. It depends on what level you’re at and how much you’re making if those kinds of expenses are worthwhile.
- 39:23 Essentially, if you’re doing things on your own, you’re going to be paying a lot more because you’re self-employed. If the government sees you, personally, making a bunch of money, then you’re going to owe a bunch of money. If you’re paying a lot in taxes and $3,000 for the paperwork cost is the difference between paying $20,000 or $30,000 in taxes, it’s going to be worthwhile to you.
- 40:42 Ben: Was the valuable information you just shared research information you did on your own? Did the CPA play a role in which was the best route to take?
- 40:58 Sean: All of that is stuff I learned on my own. Then, I went into the meeting with the CPA with the best understanding I could get from self-education and I asked even more questions. I said, “It’s my understanding that an S-Corp works like this and an LLC works like this. I’m learning toward this being the best option but I wanted to make sure I have the right understanding and that you would recommend this,” and they did end up recommending it. I went in with a decent idea of what it was.
- 41:48 Ben: For those that feel overwhelmed at the prospect of learning how businesses work, it’s definitely a good idea to learn as much as you can but some people need to be guided through that. The business types Wikipedia page might look like a foreign language to you. It might be a worthwhile investment to pay someone to coach you through it in the beginning. You want to go with the thing that’s going to be right for where you are now and where you’ll be in the future. If you can determine that on your own, that’s good but it comes back to the question: is it worth my time to research this on my own or would it make more sense to pay someone else who has that expertise, so I can spend that time working on other things?
- Estimated Taxes
- 43:07 Sean: Don’t just pay a CPA for the things you know but pay them for the things you don’t know. One of those things for me was estimated quarterly tax payments. I’m busy building and growing my business, I wasn’t learning much about taxes. They told me I should be paying quarterly estimated tax payments. When I was first going out on my own, I owed $6,000 or so and the next year it was $16,000, which I had set aside. You can be pretty disciplined but it can be difficult for a lot of people to set aside $16,000, or eventually $60,000, that you’ll owe the government in one lump sum. It can be hard to set aside and not treat it like your own personal lending bank.
- 44:28 If setting aside tax money is difficult for you, to consider paying quarterly. Estimated payments are based off of the previous year’s return. Say you owe the government $20,000 last year, this year you’re quarterly estimated payments are going to be $5,000, paid quarterly. This is if the CPA looks at your situation and they don’t expect anything to change in the next year so you’ll hit it pretty close. The goal is not to overpay, because that’s money sitting in the government’s bank account you could be making interest on. Some people will incur fees from not paying quarterly estimated payments but if the fees are $20, and the interest you made on a lot of money over the year was more than that, it might make more sense to keep it in your bank account.
- 45:44 Ben: What you don’t want to do is get into legal trouble, but if you’re talking about fees it’s a good question to ask. If I overpay and I don’t have this money available to me, what opportunities am I missing out on that could produce much greater returns? I like the idea of not thinking of it in a solid, black-and-white thing, but being creative with it so you can experience the most benefit from your money.
- 46:31 Sean: It’s a good idea for just about everyone to pay estimated quarterly payments. It helps me remember that I owe the government a part of what I’m making. When it’s self-employed and it’s not just taken out of a paycheck you get, you’re going to remember at one point or another. If you wait until the end, it could be really bad and messy.
Don’t get to the point where you don’t have the money you owe the government.
- 47:04 You would have to go make money and pay it all back and somehow pay bills, meanwhile racking up late fees. I was reminded just this year that all the taxes for last year and the first quarter estimated payment were both due on April 15th. I had paid estimated payments last year, but they’re based off the year before and since my business is growing every year, I keep owing more than the estimated payments.
- 47:57 I ended up paying them everything I owed for 2014 and 25% of what I’ll end up owing them this year all on the same day. I wasn’t completely ready for that and I had to move some money around. I should have been thinking about this and setting aside enough to pay the government everything I owe at the end of this quarter since the beginning of this year. You don’t really feel when you’re putting it off but you don’t want to wait until the last minute. That was a reality check for me. Now, for the second quarter, I need to make sure I have everything set aside so I can pay it.
- 48:57 Ben: It feels like you have to just keep taking money out of your pocket and give it to the government but I want to encourage a shift in attitude toward paying taxes. Recognize the benefits you’re receiving and that you enjoy because of this infrastructure that already exists. Where you feel frustrated, do something about it—vote against it, organize groups, talk to people about it—otherwise, go with it and you’ll be way less stressed out about it.
Hobby or Business?
- 50:47 Sean: I’ve noticed a lot of people in the chat room talking about hobby income, but if you’re asking the question, then you’re probably in a business. Most people with hobbies aren’t worried about it but it’s often where you’re trying to blur the line—“I’m making some money but can I call this a hobby so I don’t have to pay self-employment tax?” You have to realize the government’s goal is to make sure you’re not trying to get out of paying taxes that you should be paying. If you’re running a business, realize what your intents are and just pay the taxes. Don’t look for a loop hole to see if you can make it look like a hobby..
If your intent is to run a business, don’t be dishonest and call it a hobby to avoid taxes.
- 52:03 Ben: If you’re making six figures a year and you’re still calling it a hobby, something is probably off.
- 52:18 Sean: Here’s the questions the government wants you to ask yourself:
- Does the time and effort put into the activity indicate an intention to make a profit?
- Does the taxpayer depend on income from the activity?
- If there are losses, are they due to circumstances beyond the taxpayer’s control or did they occur in the start-up phase of the business?
- Has the taxpayer changed methods of operation to improve profitability?
- Does the taxpayer or his/her advisors have the knowledge needed to carry on the activity as a successful business?
- Has the taxpayer made a profit in similar activities in the past?
- Does the activity make a profit in some years?
- Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?
- Freelance & Day Job Taxes
- 55:42 In the chat room Jake says, “I’m curious, does anyone have to manage both freelance and day job taxes? This is something I anticipate having to do and I’m worried about common pitfalls.” I think a lot of people are in that situation and if you can plug things into the Turbo Tax boxes, just go for it. If you want to shift to having the freelance work become your full-time job, you’re anticipating growing, or there are things you’re unsure about, hire a CPA now for 2016.
- 57:46 When you get to the point where it’s tax time and you did something wrong, you didn’t prepare, or you don’t have answers to the questions you have and now you owe an extra $2,000—that is when you realize you should have paid a CPA $300 to $1,000. It starts to look smart and I was in this position, that’s why I was hammering on it so much. I didn’t do it for too long, and once I did it, it was the best thing I ever did.