The Art of the WordPress Startup: Part 13

Founder Taxes

This post is part 13 of a series on how to launch your startup on WordPress. Last time I talked about how to close a sale for your startup built on top of WordPress. Today’s post is about a deadline that we all have and it’s April 15. Most of the time you hear about taxes for the self-employed or company founders it’s in a glamorous way from your friends who work in big corporate. They say things like “oh, I wish I had all the tax advantages that business owners like you have” and to some extent they’re right. The retirement options are great, you can deduct some things like your laptop that they can’t, but it’s not all wonderful. In fact, many first-time founders get burned around tax time for a number of reasons. I’ll explain what those reasons are and how to avoid them. This post will assume you’re running an LLC, as if you’re incorporated as a C Corp, you likely have a great advisor or team of experts (CPA + tax attorney) already helping you. If you don’t, then that’s probably something you should work on right now instead of reading this post. The following is not legal or tax advice. Please consult a licensed professional for making your decisions. This is just well researched information.

Bookkeepers Are For Libraries

In the old days if you ran a company each month you’d mail all your receipts and bank statements to a bookkeeper who would then plug your expenses and income into some software program that wasn’t cloud based and hopefully was being backed up somewhere. Some people still use bookkeepers to this day for small companies and I honestly don’t understand why. There are lots of cloud based solutions out there like Outright (recently acquired by GoDaddy) that automatically track your expenses/income since most things are digital these days. Think Mint.com for LLCs. Just like Mint, you simply link your bank account, create some categories for expenses, teach the system a few rules, and each month watch the magic happen. It will even prepare your schedule C and provide you with quarterly estimates so you know what you owe the IRS. If you want to get a little fancier, then you can use something like Xero which is a bit more advanced and allows you to give your CPA access (or they’ll recommend a Xero savvy CPA in your area) so you can both see what’s going on and have access to the data at all times. In the old days your CPA might have a software program in their office and you’d have to request PDFs or printed copies so you could see what’s going on with your business at any snapshot in time. I have nothing against bookkeepers, but their role is primarily data entry and it’s becoming less and less vital because of technology. You need people on your team who sat for exams/bars like CPAs and tax attorneys, not data entry people who are more prone to errors than automation.

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Forgetting About Quarterly Estimates

Speaking of quarterly tax estimates, you are making those right? This is the #2 mistake I see founders make when it comes to taxes. They live off their profits and then tax time comes around and they use TurboTax or H&R Block and realize “holy cow, i owe $XX,XXX in taxes!” This happens more often than you’d think. It’s really easy to forget about quarterly estimates, particularly if you’ve come from the corporate world of W2s and payroll, where the taxes are neatly taken out of your check. Also don’t forget that self-employment tax means you’re paying both haves of Social Security and Medicare, whereas in your former corporate life your employer was covering half.

How to Set Aside Tax Money

To handle setting aside the proper amount for taxes you have two options. You can put yourself on payroll using something like Zen Payroll, Paycor, or Paychex, and have taxes taken out of your check for the proper amount automatically. If you have stable income this is probably your best bet and the least amount of hassle, and well worth the $25-$125 per month it costs per founder/employee. The other option is to have 2 personal checking accounts, and use one to store the proper % of each check for taxes. For example, let’s say that you think your income will put you in the 25% bracket. Knowing that self-employment taxes are approximately 15%, each time you cut yourself a check from your business checking to your personal checking you could set aside (push) 40% from your main/regular personal checking into your “taxes” personal checking. Both are the same type of account at the same bank, you just use one for storing the money you’ll need to pay your quarterly estimates. So let’s say I take a “withdraw/draw” from my business for $1000. I would write the check from my business checking account to my own personal name, and first deposit it in my regular personal checking. Once it showed up in that account, I could push/transfer $400 of it to my “taxes” personal checking and store the $400 there. If I do that each time I pay myself then when it’s time to make my quarterly estimate to the IRS, I could just write a check for the full balance in the “tax” personal checking as I’ve been taking the proper amount each check like a payroll firm would. This prevents me from spending my entire check and forgetting about that wonderful thing called tax, or from having a huge tax bill due in April. Note that it’s better to overestimate a little than to underestimate, as there can be penalties for underpayment.

Self-Employment Taxes = The Whole Enchilada

Since you’re technically the employer and the employee both now, you owe the whole enchilada in terms of taxes related to Social Security and Medicare. Although enchiladas are delicious, this is not something to be excited about. For self-employment income earned during 2013, that means 15.3% (12.4% Social Security + 2.9% Medicare). However the 12.4% for social security only applies to the first $113,700 of income, whereas the Medicare 2.9% applies to all income no matter if you’re pulling in $100MM per year. Keep in mind you’ll be older than 65 some day and will (hopefully) get to take advantage of both of these, which are like forced retirement savings in a sense. No, Medicare doesn’t cover everything but it’s way better than nothing, and Social Security won’t have you living like a king but it’s enough to keep you from being homeless, so assuming you live past 65 you’ll see some benefit from paying these. You calculate your self-employment tax on Schedule SE and report that amount in the “Other Taxes” section of Form 1040. In this way, the IRS differentiates the self-employment tax from the regular/general income tax.

One piece of good news is that when figuring self-employment tax you owe, you get to reduce self-employment income by half of the self-employment tax before applying the tax rate. Say, for example, that your net self-employment income is actually $50K according to your books. That’s the amount you report as taxable for income tax purposes on Form 1040. But when figuring your self-employment tax on Schedule SE, the taxable amount to use is only $46,175. Not paying the 15.3 percent tax on $3,825 difference in this example saves you $586. How did I come to that figure? It’s simple. Since self employment taxes are 15.3%, half of that is 7.65 %. So rather than doing a bunch of adding and subtracting, it’s easier to just take your income ($50K) and multiply it by .9235 (since 1-.0765=.9235) which gives us the $46,175. So your self-employment taxes owed in this case would be $46,175 x 15.3% = $7064. Please note that i’m rounding the numbers to make things easier so we don’t have to deal with change.

Another piece of good news is that you can claim half of what you pay in self-employment tax as a general income tax deduction. For example, a $7064 self-employment tax payment like the $50K earner above reduces total taxable income by $3532 (half of $7064). Let’s say you’re in the 25 percent tax bracket, that saves you $883 in income taxes (25% of $3532). This deduction is an adjustment to income claimed on Form 1040, and is available whether or not you itemize your deductions. If it sounds confusing, just keep in mind that there are 2 taxes we’re talking about above. One is your regular/general income tax which is calculated/found on form 1040, and the other is your self-employment tax which is calculated/found on Schedule SE. They are different forms and different numbers, but yet relate to each other. It all makes sense if you take a look at a sample income tax return for an LLC.

Bonus: If you’re willing to pay the fees (hundreds of dollars, not the end of the world) associated with electing to have your LLC treated as an S-Corp for tax purposes, then you can reduce your self-employment taxes considerably. It tends to make sense for those making over $50K, as anything less than that it’s typically not worth it. That’s because the IRS says the S-Corp must pay you a “reasonable” salary, and anything less than $50K is typically going to be found unreasonable if you’re running a business. However, let’s say you are John Edwards and made $5MM-$10MM per year as a trial lawyer. He paid himself a salary of $360,000 (subject to self-employment tax) which is a “reasonable” salary for a high-powered lawyer, and then paid out the rest of his income as “distributions” (not subject to self employment tax). The NY Times wrote an article about it here. He saved $591K in medicare tax by doing this, because that 2.9% didn’t apply to millions of income beyond his $360K salary. He still paid the 12.4% for social security because that’s on the first $113,700 of his $360K salary, so he didn’t save anything on that part.

There are some additional reporting and accounting headaches and some increased legal/accounting expenses associated with running things this way, but if your income is say $100K and you’re a photographer (using WordPress for your site!), then you might be able to pay yourself a “reasonable” salary of $60K and take the rest as distributions, since photographers on average (yes there are exceptions) aren’t known for making tons of money. If you’re a software engineer, then a reasonable salary might be closer to $100K, in which case you could take anything above that as a distribution. If you’re a software engineer and your LLC makes $100K, then obviously electing to be treated as an S-Corp for tax purposes won’t do you much good.

Schedule C

Remember that thing called a Schedule C I mentioned above? If you’re confused, let me explain. This is not a schedule like a calendar, but rather where you tell the IRS how much money you made from your business. If you have a regular job, you fill out a 1040. If you’re a founder with an LLC and hence self-employed, then you fill out a 1040 and a Schedule C. In the Schedule C you’re basically just itemizing things out and telling the IRS what your income/expenses are from your business and how you came to those numbers. The form is literally titled “Profit or Loss From Business (Sole Proprietorship)” and it’s not terribly complicated if you have been keeping good records all year long. Something like TurboTax can walk you through it and if you’ve been using something like Outright to track everything, you’ll basically be just copying/pasting over the numbers it tells you. If you’re going to use something like a TurboTax to file, then you’ll likely need a “Business” edition or similar, as the standard version will only cover a 1040.

Doing the Deed

Whatever you do with your taxes, just don’t wing it. Don’t rely on a bookkeeper or friends to be your advice channel. Get yourself a CPA and tax attorney in your area/state who are solid, and pay them for their advice as often as you need it. I say one of each because sometimes one will find things the other missed and two heads are better than one. Tax attorneys are better suited to coming up with strategies to maximize deductions, minimize taxes, and hence maximize income, whereas CPAs are better suited to the tactics of filing your return. A lot of people are penny wise and pound foolish when it comes to this, and say things like “tax attorneys are expensive, I don’t want to pay $300/hour for advice” but if you pay them $1K and they end up saving you $10K, you’re still $9K ahead. Start thinking bigger.

It’s okay to use software tools to track your expenses/income, and to use TurboTax to actually file. But it’s important to have someone advising you on deductions you might be missing or red flags that can trigger an audit. Taking a home office deduction? Your chance for an audit just went up, yay. Writing off that Escalade? Oops, unless you drive it only for work (which you likely don’t unless you’re a courier), you’ve not only raised your chances of an audit but also will likely owe back taxes to boot. There are a number of other red flags that increase your chance for an audit but those are the two big ones that first time entrepreneurs tend to misinterpret or take liberty with. Audits and jail time are not fun. Growing your business is.

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