Business owners face a lot of uncertainty. Will your product or service be a hit? Have you targeted the right audience? How do you build better engagement with customers through social media? These are all common questions, but one of the most frequently asked, particularly by new business owners, is how much they should set aside for business taxes. Understanding and familiarity come with experience, but if you’re just starting out, it can be daunting and confusing.
More Big Companies Using Reserves
While we mentioned that larger companies weren’t all that dismayed by their tax bill, that’s not entirely true. In fact, it’s becoming less true with every passing year. Today, most large corporations than ever before are setting aside a reserve to meet their tax obligations, and more of them are saving larger amounts than they actually pay in taxes.
The reason? Increasing uncertainty surrounding what they’ll owe and when they’ll owe it. In fact, the difference between what’s collectively paid to the IRS and what’s collectively kept in corporate reserves is measured in the billions of dollars. As a small business owner, you won’t need to worry about that quite so much, but you will need to know a few things.
When Should You Pay?
When should you pay your taxes as a business owner? The answer, despite the many different interpretations out there, is quarterly. This is particularly true for those who don’t fall under the heading of a traditional small business owner. For instance, freelancers, consultants, subcontractors and the like.
These professional will benefit greatly from ensuring that they’re paying their tax bill on time, all the time. Of course, that still leaves the question of how much you should pay, but we’ll cover that momentarily. For now, suffice to say that you need to account for your taxes quarterly, particularly your employment taxes (Social Security and Medicare).
What Do You Mean By “Reserve”?
When it comes to paying business income taxes, it is important to realize that only the largest firms can afford to pay their tax bill all at one time. Most companies need to save for the event. As a small business owner, you’ll need to save for it, too. This term for this is a “reserve”. Essentially, it’s the portion of your earnings that you reserve in order to meet your tax liability with the IRS.
How Much Should My Reserve Be?
Sadly, there is no one size fits all answer here. Too much depends on the variables in the situation. Some advisors recommend that you take 10% of every single payment you receive and sock it away against the need to pay business taxes during your first year. Why only 10%? Is that enough to cover your actual tax bill? No, it’s not. However, it gives you the means to build a sort of nest egg against the day that you do start paying taxes.
Here’s how things work. New businesses generally aren’t profitable. If you don’t make a profit, you don’t owe any income taxes (no income equals no taxation). However, you still take 10% of your income and put it away against future needs.
The second year of your business is also unlikely to be profitable. However, you still keep putting away 10% of your earnings. This ensures that if you suddenly do turn a profit, you have the cash to pay what you owe Uncle Sam. If you don’t become profitable overnight, then you have additional cash reserves for the third year.
Each year that your business fails to turn a profit, you show a loss on your taxes and write everything off as a wash. You keep whatever monies came your way. Here’s the thing – if your business is not profitable for too many years, the IRS may decide to step in. They’ll declare your “company” a hobby instead of a business. Guess what happens then? All those write-offs that were perfectly legitimate when you were running a business must now be paid back to the government because you owe money. If you still have that nest egg built by saving 10% of everything, doing so will be much easier.
When Do You Reserve More?
You will eventually start to put more money into your reserve. One your business is running smoothly and things have settled a bit, it will be time for you to save more. For instance, once you’ve accounted for your operating expenses, you’ll need to begin reserving around 40% of your profit for tax purposes (15% for your self-employment tax, and the rest for income taxes). Of course, the actual amount reserved will depend on a couple of factors.
Your tax bracket is the most important. For instance, the 40% is only applicable if you’re in the 25% tax bracket. You could earn more or less, which will change that. You also need to consider whether or not your state requires you to pay state income tax. While you can claim that on your federal income taxes, you’ll still need to pay it out to the state, which means you need to save it in the first place.
What If You’re Profitable Off the Bat?
Some businesses are profitable immediately – freelancers, contractors and consultants come to mind. The 10% rule discussed previously will not apply here. Instead, you need to reserve around 30% of your income for business taxes. This ensures that you have ample money to cover both income taxes and self-employment taxes.
Finding the Right Path
Charting the right path for your business can be difficult, particularly if you’re new to the whole process. Working with a tax professional can help ensure that you’re able to save an ample amount of money for Uncle Sam while also making sure that you have enough for operating costs. As a note, make sure you’re working with a professional with plenty of experience helping small business owners reserve money for tax purposes.