Who pays a greater share of their income in taxes — Warren Buffett, or his administrative assistant?
Obviously, posing the question implies its answer.
Politicians may tout the virtues of our “progressive” tax system, but it doesn’t really favor the poor over the rich.
Nor does it favor the rich over the poor, not when 40% of federal tax receipts come from 1% of the population. Fairly or otherwise, the tax system favors the diligent over the unprepared. Specifically, the system favors independent businesspeople over salaried workers.
This topic requires a book-length explanation, but to summarize, starting your own business lets you enjoy tax advantages wage slaves only dream of. Take two people in the same field, making like incomes, living in the same city — the only exception being that one owns his own business and the other works for someone else. It’s eminently possible that the latter person’s tax bill is nine times the former’s.
Declare your independence today, if your career lets you make a horizontal shift to entrepreneurship. If you’re an anesthesiologist, it’ll be hard to rent out an office and put up a sign that reads “Mepivacaine Administered Here — Happy Hour 4 – 7.” But if you’re an accountant, real estate agent, home inspector, engineer, attorney* or in any kind of creative profession, you can take advantage of complex tax laws.
I’m not talking about the kind of entrepreneurship that requires you to open a physical storefront and spend years building a customer base. I’m talking about changes you can make now that will immediately impact your bottom line.
I tried to go as long as I could without using the first-person pronoun, but my story illustrates the point. Many years ago I was working for a decently-sized advertising agency as a senior copywriter, making somewhat more than the nation’s per capita income. One day I ran the numbers and realized I could make more money going out on my own.
I collected most of my new clients, other ad agencies, via word-of-mouth. But most importantly, I took on the very agency I’d left as a client — and charged them about 30% more than they paid me as an employee. There are two components to that: 1) they were underpaying me to begin with, but had to cough up once I exercised my leverage and threatened to walk and B) the daily rate they paid me after the switch was just for the services I rendered nothing else. It included no employee benefits, no capital expenditures for a workstation, no space reserved for me at the office Christmas party, no food allowance, no 6.2% Federal Insurance Contributions Act tax, no unemployment insurance premium. The responsibility for all that now fell on me.
Which is wonderful. It meant that instead of my former employer enjoying all the possible tax deductions from my labor, I got to take advantage of them. My taxes got a little more complicated — I now had to keep more detailed records, and file quarterly instead of annually — but the benefits grossly outweighed the costs.
It’s easy to get started, but also easy to make mistakes. You don’t want to be a single proprietor. You want to found an S Corporation, a legal entity that protects you from creditors who are forbidden from coming after certain classifications of income. An S Corporation lets you separate your money between salary and capital gains, the latter of which is taxed at a lower rate.
Find a company that specializes in entity formation. It’ll cost maybe $500 for them to register you with the relevant state’s Secretary of State office. You don’t have to register in your home state, either. If you live in California or New York, you don’t want to — those states’ laws don’t protect you enough from creditors. Register in Delaware or Nevada or, failing that, your home state.
Once you incorporate it starts forcing you to think like a businessman. Income will now be tabulated on IRS 1099 forms, rather than those infamous W-2s. The former is where you want most of your income to come from. As a practical matter, once you incorporate you’ll pay (correction: your company will pay) you a salary. What’s a reasonable amount to cover your annual living expenses; maybe $40,000? Then that’s what Employee #1, you, will receive and pay taxes on. After deductions, your effective tax rate on the salary will be close to zero.
But what about the rest of your company’s income? Legally speaking, the rest of the revenue your S Corporation takes in is not salary, but shareholder dividends. Which are taxed at a lower rate than salaries are. And you can now deduct all sorts of business expenses before calculating the net shareholder dividends you’ll pay taxes on. Go to IRS.gov and check out Form 2106. Your employer fills one of these out every time you go on a business trip, or eat a meal on company time, or buy anything related to your job. And your employer then enjoys the tax deduction.
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* It tears me inside to know that by writing this post, I’m giving you leeches an economic edge.
About the Author: Greg McFarlane is the author of Control Your Cash: Making Money Make Sense, a financial primer for people in their 20s and 30s who know nothing about money. You can reach Greg at greg@ControlYourCash.com.
Photo Credit: Bre LaRow
Maybe in your situation yes, the employed are smarter.
But what about the trader in Morgan Stanley who has been racking in $5mm a year (let’s just use this as an example). Sure he will pay perhaps close to 40+%, but he will still net out better than “business owners and self employed who do not earn as much”!
Every CEO of a fortune 500 company pays taxes as employees (yes they do have stock options etc). Bet they are smarter than many “self employed”.
Just as you can make use of the advantages in taxes, it can be overcome by simply making a lot of money as an employee.
Mr. Card (or can I call you “Credit”?):
Uh, I was trying to be practical.
Here’s another easy way to get rich: be a Major League Baseball player. (There, wasn’t that helpful?) However, MLB only has about 800 openings. Add that to the 500 Fortune 500 CEO jobs, and that still leaves hundreds of millions of us unaccounted for. And it’s those of us remaining who have to maximize whatever situation we’re in.
“Just as you can make use of the advantages in taxes, it can be overcome by simply making a lot of money as an employee.” I don’t know what adverb I would have used in your sentence, but it wouldn’t have been “simply.”
I’m advocating a full-on lifestyle change for people who are already on the fence about staying in their current positions, and wouldn’t mind hearing a little more about some of entrepreneurship’s quiet and immediate benefits.
Greg – my point is that the problem is that some folks are just not cut out to be entreprenuers and are better at being employees of a corporation.
It’s not just MLB players or being a CEO. It is about being the best in your profession, whether one is a surgeon, attorney, chef or whatever.
Someone who is making say $300,000 a year as an employee is financially better off than a person who does not have the skills to run his or her business and taking home only (say) $60,000 after all the tax advantages. Who is smarter? Plus, most businesses fail after 5 years anyway?
There is no doubt that there are tax advantages to owning a business. But to say that business owners are smarter than employees (am not so sure).
I used to work for major corporations as well – so I guess I was dumbmer back then!!!! And trust me, I know lots of employees who make more than me..perhaps more than all of us here combine..so I guess I’m really not too bright as well!!! And that makes 2 of us!
@Bret: Most states only tax you on the income you produce within their state. That’s why over 50% of Fortune 500 corporations incorporate in either Delaware or Nevada. They get all the benefits of those 2 state’s corporate friendly laws without the cost of double taxation.
Note I did use the weasel word *most* for a reason. Just about every state is running a deficit and who knows what kind of crazy laws the legislators might think up to raise money.
@Susan Of course, everyone should consult with his accountant or attorney for the best corporate set-up.
Darn it Greg, you forgot the obligatory we hate attorneys disclaimer!
Back to the debate:
Entrepreneurs (of every size and shape) have an attitude of abundance and a almost fatalistic ability to roll with the punches. Lifelong wage slaves are worried about the scarcity in their life and an almost crippling fear of change and/or loss.
Greg’s post will excite the former and bring out the cynic in the latter.
I’ve been a freelance designer for the last 5 years. I do pay less taxes overall than when I was employed by a company, but I miss those regular paychecks.
BTW, I never formed a corporation or anything. I’ve always just did my taxes based on my 1099 that I get at the end of each year, pay my self-employment tax, and take the allowed deductions (ie, “home office space”, “supplies”, “business lunches”, etc.)
Is there a benefit to having a corporation? I usually don’t have more than 2-3 clients in a year (Most of my freelance business comes from my former place of employment).
Yeah if they are so smart, why are they calling me to configure their wireless internet. Perhaps smarter isn’t the correct word.
@Sam: A lot of benefits to be sure. The one area where working for a corporation has an advantage seems to be health care benefits. Then again, if you write off enough trips to Hawaii and Mercedes when you are self-employed, I guess it doesn’t matter.
@Susan:
Dividends are taxed here too, so it isn’t any different from the States.
They’re taxed once as the corporation (19%) and then taxed again when I pay myself as a shareholder (I am not an employee of my company, because of the extra paperwork).
I just live on very little — $20,000 – $30,000 a year, and I only pay about $300 – $400 in taxes for that amount, which is peanuts.
If I wanted to take out $60,000 for example, it’s $2000.
Which is peanuts to me, considering it’s $2000/$60,000 = 3.33%
I can’t have any other income for the year either. Just dividends.
I’d personally leave all the money in the company and just take it out ad hoc as you need it.
I don’t need $60k to live. So I just take out less.
In New Jersey, the cost to set up and then maintain an S-Corp is about ten times that of setting up an LLC: LLCs are charged $50 per year to file their mandatory annual report while S-Corps are charged $500. Assuming that I don’t have clients who are going to sue me, is there still a benefit to having an S-Corp over an LLC?
I have been on my own with an LLC for about six years; ever since I told the CEO’s son that he had a bad case of analencephalitis. 😉
I love being self-employed. I have gotten used to a varying monthly income (sometimes good, sometimes not so good) and finding new work. There have been lean times… but then again, when I am making money, I am making more than I did as an employee.
WhatACutUp:
From a tax standpoint, theres no difference between an LLC and an S corporation. The biggest difference between them is how the IRS treats excess profits, a/k/a “distributions”. If you own and operate an S Corporation and pay yourself a reasonable salary out of the profits, the remaining profit is distributed to you at the end of the year and isnt subject to self-employment tax. Not so with an LLC.
Theres an exception. You can tell the IRS you want your LLC to be treated like an S Corporation for tax purposes. Form 2553. File it before the 16th day of the 3rd month of the (relevant) tax year. If you pay salaries, youll file quarterly returns (Form 941) showing what you paid per employee along with what you deducted for federal taxes and FICA. Depending on the size of your payroll, youll pay those taxes biweekly, monthly or quarterly.
And as I’m sure you know, there’s no cure for analencephalitis.
Yeah,I used to work as a freelancer and I love my work.
Got to tweet this one.
Greg,
While I agree with your overall theme, you are wrong, I believe, on a couple of key points. You say that a subchapter S corporation’s income in excess of the salary paid will be dividends and taxed at a lower rate. That is not correct. The excess income is not dividends, but rather a distribution which will “pass through” to the owner and be treated as regular income. That’s why subchapter S corporations are called pass through entities because the income “passes through” to the owners.
That’s not to say that there are no potential tax savings with this approach. The savings, however, are in the form of lower social security/ medicare payroll taxes. The salary paid will be assessed about 15% for these taxes (7.5 by the company, plus 7.5 by the employee). However, the amount distributed (income in excess of the salary) will not be subject to payroll taxes. So there can be a savings there. However, the IRS is cracking down on this approach and the salary paid to the employee must be reasonable, otherwise the distribution will be re-characterized as a salary and taxed accordingly.
The IRS has no guidelines as to what is reasonable so rarely does the IRS audit for reasonableness unless the corporation has many employees and reasonableness is measured by determining the salaries that employees receive.
Also, the shot about lawyers was cheap and uncalled for.
You didn’t use the International Sarcasm Font there (Calibri Bold, 16 point, #FF0000), so I can only assume you’re serious.
I was always afraid of taking the freelancing route because of the lack of insurance but it has not been as scary as I thought and it leads to more freedom which I would never trade for anything.
Well said, Len!
I adore being a freelancer under my own corporation exactly for that reason — all the tax breaks and in some cases, tons of write offs.
It really helps lower your taxable income for the year.
Even better, is that I just take out $20,000 net as dividends from my company each fiscal year, and pay NO taxes on those dividends, and just live off it.
I keep the rest of the $$ in the business and take out another $20,000 next fiscal year, and so on
Kind of like a savings account.
Eventually, I will have to drain the account when we move to the States, but that’s what we’re doing for now.
@FabulouslyBroke: Thanks, Me! But I didn’t write this little gem – Greg McFarlane from Control Your Cash did. 🙂
Greg’s article and your experience is good info for me to remember when I finally decide to throw away my corporate gig – or get laid off.
@Mr.CC: The provocative headline was all my idea. Greg begged me not to do it! Probably a bad idea, but what else did you expect from a dummy who works for a major corporation? LOL
Oh and the other point you made near the end about living through your corporation is true.
This is an odd example but I am traveling on contract now. So my corporation pays for my food, living expenses and whatnot. That all deducts from my taxable income and whatever I want to buy for the company — new laptop, etc.. all comes out of the account as well, and I don’t pay the taxes (sales tax, or income tax, as it’s an expense)
There are so many tax advantages to owning your own business. But, one thing that people need to be careful of is spending money just to take advantage of tax breaks. This can really hurt your business.
Good article that brings lots of thoughts to the surface as evidenced by the nice lil debate going here. I agree with both of you. There are executives that do really well as “employees” and also self-employed people who have become financially free. I guess it depends on the strengths and skill sets of an individual.
Greg,
Nice post. Thanks for the information.
According to the research supporting the book The Millionaire Next Door, someone is four times more likely to become a millionaire if they are self-employed.
I have a questions about incorporating out of state. Do you have to file income taxes in both states?
I have to agree with Greg and Fabulously Broke re: the many tax benefits of being self-employed, but in the US, C Corp dividends are taxed, and you can only take S Corp distributions if you’ve paid yourself a reasonable salary, so it would be pretty hard to duplicate Fabulously Broke’s fabulous situation in the US. Also, Greg’s point that S Corp is the way to go is a pretty broad generalization. In some cases it’s not the best entity.
Len, I was gonna say well done too, but then I realized you didn’t write it either. So, well done getting greg to write it for you! 🙂
Being self-employed is what it’s all about. Two tickets to Hawaii? Write it off! Mercedes S550? Write it off! lol. Gotta love it.
Self employed all the way! 🙂
Gosh, the US system seems a lot more favourable to the self-employed / service company vehicle than here in the UK. We do get benefits in the tax system as is only right given the extra overheads of being self employed or a small company, but you’d have trouble declaring tickets to Hawaii or all your living expenses in Canada as an expense — unless you could / were prepared to prove exactly why you needed to be there.
Whatever the tax reasons, I’d recommend self-employment for 100 other motivations, too.
Investor, while it is done all the time, you still need to justify those trips to Hawaii. I have a coworker who has a side job and he tells me he continually has to answer to the IRS with justifications (including proof that the trips are business related) for his Las Vegas business-trip write-offs. I’d imagine it would be the same thing for Hawaii and other similar expenses.
I should also note that is including the fact that I pay a lot of cash into my retirement savings, which I think you call a 401k in the States, and that takes away from my taxable income as well.
I also greatly reduce my taxable income as well through retirement contributions – and my flexible health spending account, too!
I think this is just one of the adv advantages of being self-employed. Less taxes, if you know what you are doing. Another advantage is, you are your own boss.
It’s true, not everybody has the guts or the courage to be self-employed and would rather be on the safe side and remained employed. How about if you do both, don’t let go of you employment yet until your corporation is doing okay already.
The article’s title itself speaks out loudly. Indeed self employed people are way much smarter than those who just work out 8 hours a day.
Cheers to a good post, really good for starters who wants to be self employed.
Now, it feels like I have to pursue self-employment as soon as possible to enjoy these benefits and advantages.
Interesting debate raging in the comments! Here’s a non-US view.
One of the biggest benefits that I see, as a self employed ‘sole trader’ is that I get to pay my expenses *before* I pay tax. That gives me a lot more control over how much tax I ultimately pay.
If you’re an employee earning roughly the same amount, you’ll have far fewer options for claiming tax deductions, and all those expenses you pay just to show up at your job are paid for with post tax dollars.
And don’t forget, not everyone is earning mega bucks, regardless how they earn it, sometimes lifestyle is the biggest perk of being self employed.
Great comments, Diane!
Thanks for stopping by and sharing them.
“But if youre an accountant, real estate agent, home inspector, engineer, attorney* or in any kind of creative profession, you can take advantage of complex tax laws.”
Also, farmers – and their tax breaks are simpler to take advantage of than going the Subchapter S route, and the like.