It may surprise you to learn there are two separate sets of rules buried within the US tax code. One set of rules is for “wage earners”, while the other set is for business owners. The disparity between the two spans well beyond the applicable tax forms to be filed. The difference is at the core of the tax system: businesses (and business owners) are taxed completely differently than employees.
If you’re an employee, your taxes are pretty straightforward. The government takes a percentage of your gross pay before you ever see it. You never get to put your hands on it. Your paystub will show the deductions simply as federal income tax withheld, state income tax withheld, and Social Security withheld (FICA). Employees have a very limited ability to itemize deductions. They pay the most in taxes and have the least control in mitigating their tax burden. If you are an employee who receives a W-2 at the end of the tax year, you are taxed on your gross income.
Businesses, on the other hand, are not taxed on gross earnings. They are taxed on their net earnings (after expenses). Does this really make a significant difference in the amount of taxable income? Absolutely.
Hypothetical Example Comparing Personal vs. Business Taxes
Let’s assume, for example, there are two individuals: one is a W-2 employee, while the other files a Schedule C as a sole proprietorship business owner. All other things considered equal, we’ll assume they each earned $100,000 during the year. We’ll use the same (roughly estimated) tax rate of 30% for each person. And finally, we’ll assume that their expenses (mortgage, food, gas, living expenses, dining out, etc) are $70,000 for each.
Using this (over-simplified) example, the employee would earn $100,000, pay $30,000 in taxes, and of the remaining $70,000 end up paying all of it throughout the year for his or her cost of living. At the end of the tax year, there would be $0 remaining.
The Business Owner
The business owner, however, applies a different formula to their tax picture. He or she likely has a cell phone, internet access, a vehicle, a home-based office, etc. (The employee has all of the same expenses, but they’re considered “personal” expenses rather than “business” expenses).
Let’s say the business owner can attribute $45,000 of expenses to their Schedule C (business) tax form. Of the $70,000 in total expenses, that leaves $25,000 of personal cost-of-living expenses. Additionally, we’ll say they have a depreciation deduction of $15,000 (a memorandum expense, not an out-of-pocket expense) for their business assets, amounting to a total of $60,000 in total business deductions. For taxation purposes, the $100,000 of gross income would be reduced by $60,000 to be a net income of $40,000. They would pay just $12,000 in taxes (30%) on the $40,000. Keep in mind, the depreciation deduction isn’t out of pocket, so in actuality, they’d still have that $15,000 in the bank. Their financial picture at the end of the year would look like this:
$100,000 (income) minus ($45,000 actual expenses attributable to business); minus $12,000 (taxes paid on actual business expenses WITH depreciation); minus $25,000 (remaining personal cost-of-living expenses) … amounting to $18,000 remaining in their bank account.
In a nutshell, the two hypothetical individuals above could be neighbors. They might drive the same model of car, have the same type of house and matching mortgage payments. They use the same phone, shop at the same stores, and in every other way are essentially twins. The only difference is that one is an employee, playing the game of life under “employee rules”, and the other is a business owner who files a different form with their personal tax return.
The employee is penniless at the end of the year. The business owner has $18,000 remaining. Which looks better to you?
Avoiding taxes by taking advantage of provisions within the US Tax Code is not only legal but expected. Tax evasion (or fraudulently circumventing or violating US Tax Code), on the other hand, is against the law. Business owners can often legally avoid paying as much income tax as their employee counterparts in the workforce.
(DISCLAIMER: The scenario above does not represent any actual individual or tax scenario. It is for illustration purposes only, to convey the concept of tax advantages of business ownership. It is not intended to provide tax, financial or legal advice. Likewise, the content of this article is for educational purposes, not advisory in nature. For tax, legal, or financial advice with your actual financial situation, see your accountant, attorney, or tax preparer as applicable).
The Role of Your Tax Preparer
Did you know that it’s not your tax preparer’s job to find you all of the deductions you might be entitled to? Sure, they will document the expenses and take the deductions you present to them. But their role is not to pry into your business to explore all the possibilities. Some of the better ones will do so, but their job is to take what you give them (at face value), fill out the forms correctly, and submit your tax returns for processing.
If you have entered their office around tax time, you’ll see that the typical tax preparer’s office is a combination of chaos and mayhem at that time. They’re too busy producing 1099’s, W-2’s, K-1’s, etc. and sorting through boxes and folders of dozens of other people/businesses. They don’t have the time to do your due diligence for you. If your organizational system amounts to “shoebox accounting” (where you just cram receipts and statements into a box to hand to them), you’re almost certainly leaving money on the table with your tax return. In other words, if you don’t document it, you can’t deduct it.
Getting Prepared for Business Taxes
You’ve probably heard the expression, “It’s not what you make that matters. It’s what you get to keep.” To keep the most you’re allowed to, you need to maintain good records and communicate effectively with your tax preparer. The Financial Acumen Course® teaches a simple organizational system that assures that your records are complete. At tax time, your preparation time should be less than an hour and your tax preparer will love you for it. Likewise, if you want to explore potential business tax deductions to discuss with your tax preparer, schedule a consultation with a PSG Certified Debt & Wealth Coach™ to help you.
The Legalities – As Quoted by Judge Learned Hand
The Honorable Learned Hand, a judge who is famous for tax cases, is quoted as follows:
“Anyone may so arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.”
Judge Learned Hand is also quoted as saying:
“In America, there are two tax systems; one for the informed, and one for the uninformed. Both are legal.”
The two systems that he refers to, above, represent the one applicable to employees, and the one applicable to business owners. So you may want to give some consideration to starting a business of some kind, whether it be something simple and small as an eBay business, a consultant, an Amazon.com store, etc.; or something more traditional like a brick-and-mortar store, a restaurant, real estate, etc. It costs nothing to explore your options. The difference it can make to your bottom line, however, is potentially life-changing!