Small Business Owners’ Tax Rates Top 62% … Wait, What?

Taxes: The albatross of you, me and every business owner on the planet. Most business owners are tasked with paying taxes quarterly, paying payroll taxes, paying people to prepare taxes and defending ourselves when audited for taxes—it never ends. But what most people don’t realize is how big that effective tax rate gets for an entrepreneur trying to make a living, and that’s something I aim to clear up here. Take your average small business owner. Let’s call him Joe. Now, Joe has a company he started himself and he makes a decent living. Let’s assume Joe makes $150,000 per year that he takes as salary and that this amount was basically all his company net during the year.

Joe, like many homeowners in America right now, is unfortunately doing a short sale on his house. So, back in early 2011, he stopped paying his mortgage payment and therefore he can no longer take itemized deductions. Joe is single and has no kids. Joe is going to pay about $40,000 in income taxes. And it gets much, much worse…

Joe is also going to pay over $4,000 in Medicare and about $13,000 in Social Security because he is self-employed. Joe lives in a $300,000 house that is now worth $150,000, but he will pay about $9,000 in property taxes on the old value. He is going to pay about $800 in “luxury tax” on his vehicle. He eats out a lot, and so he is going to pay about $2,000 in sales tax on meals. He buys some clothes and other household items now and again, which will take him for another $3,000 in sales tax. Joe is also going to pay excise tax on his cell and house phone, fuel tax on the gas he buys for his vehicle and unemployment tax on his salary. These miscellaneous taxes together will cost him up to another $2,000

None of what we’ve itemized thus far takes into consideration that his salary would have been higher in the first place if his company didn’t have to pay business license fees (tax), capital gains tax, industry specific tax (like gaming or entertainment tax), personal property tax, and on and on to the tune of several more thousand dollars.

But, in one area Joe is lucky. He lives in Reno, Nevada and doesn’t pay state income taxes. If Joe lived in California, he’d be facing another $12,000 for state income taxes.

If you include the state income tax, all of these add up to about $92,000 leaving Joe a net paycheck of $58,000 for the year. That’s right folks—that is an effective tax rate of 62%! Now, can Joe change his behavior—drive less, eat at home more? Maybe. But really, 62%? The reality is that all business owners pay an exorbitant combined amount of tax, and we can all end up in this spot if we’re not careful.

Our country’s tax structure will not be fixed overnight. It is unfortunate the burden that this myriad structure places on a business owner. By not educating ourselves on the large tax liability that business owners are expected to shoulder, we can set ourselves up for failure and devastating tax consequences. However, by being proactive and learning how these affect us, we can lessen this burden—at least enough to make it a little more palatable.

Here are four myths about taxes that are a good place to start in facing your own tax situation:

An audit is not the end of the world and it will most likely not kill you.

Is an audit unpleasant? Most definitely. But, just because you are facing an audit, do not just assume that you will ultimately be facing a big tax bill. If your tax return is reasonable and you are taking legitimate deductions, then the audit will most likely not result in changes to your return. You can even be aggressive and still not have additional tax bills. The key to an audit is ensuring that you are documenting your stance on tax positions, taking deductions that are truly deductible and allowed under the tax laws and that you are claiming your taxable income.

All of my deductions should fall within a range that the IRS says is reasonable.

Balderdash. Deductions are reasonable if they are truly business deductions. Not because they fall within a common percentage of your income. Your business is different than any other business. Your deductions will also be different. Here are some examples of deductions being relative to a business. First, say you own a restaurant and you are thinking about adding Eggs Benedict to the menu. You go to other restaurants to try their Eggs Benedict and that is a legitimate business expense. In many cases, I would even venture so far as to say this is marketing expense rather than meals expense. Another example would be a model or spokesperson. These are two of the rare positions that can deduct things like drycleaning and getting your hair done. Not a common deduction for the rest of us!

My Itemized Deductions (for example, mortgage interest and charitable deductions) will always be deductible.

Wrong again. Starting in 2013, the phaseout of itemized deductions is coming back to rear its ugly head. That means that when you make more than a certain amount (depending on your filing status) then your itemized deductions start to vanish. So at higher income levels, you can pay your mortgage and make donations and not get to claim any of it as a deduction on your tax return. Now, this doesn’t necessarily mean that these payments aren’t still a good idea, but if you are planning on the tax benefit, make sure you know what that is.

If I run it through my business or if my business loses money, then it must be deductible.

Wrong again. A typical business structure for a small business is either an S corporation or an LLC. Just because you take your kids to Disneyland and have your business pay for it, does not make it a business expense. Business expenses differ for every business. Yours should include items that are related to your business. But, that said, you can include expenses that maybe you didn’t deduct before you started your business like your cell phone and home office internet.

On the flipside, business losses come in many shapes and forms. In many cases, if your business shows a loss, your tax preparer could add insult to injury by telling you that you can’t deduct it on your taxes. There is a term called basis that determines if a loss can be deducted. Think of basis as your skin in the game. Basis can be very complex, but be sure to check with your tax preparer to ensure you have enough basis to deduct losses before counting on it.