Practical Considerations When Starting Your Own Business
By Raymond A. Rowntree, CPA/PFS, CFP
One of the least glamorous aspects of running your own business is accounting and taxes, but if you want to be successful it is an area of importance. Whether you want to start your own business or have been running one for years, here are practical tips to consider for the independent contractor.
When you were an employee, someone else did the accounting for you (the W-2 you used to prepare your taxes) and may have provided some non-taxable benefits (retirement plan, health insurance, disability coverage, etc.) that you will now need to provide for yourself. When deciding to become an independent contractor, one of the first things to do is to go through a budgeting process to confirm going out on your own is a good idea.
Now budgeting is not rocket science, but you would be surprised how often a business owner will not go through this process. The starting point is what you expect to collect, as an average, in fees per month. Then you subtract what you need for living expenses and health insurance each month and the taxes on these living expenses and insurance. This is the minimum you will need to earn. You should also subtract any contribution you will make to a retirement plan, though most business owners forgo making contributions until things start rolling. The difference is what you can spend to run your business. To reiterate:
The next step will be to start estimating your monthly business expenses to see if you have covered your need for a professional office, resources and marketing. If you don't like the answer you come to, now is the time to start modifying your expectations. However, a realistic, achievable goal for monthly revenue is the first step.
The final phase of the budgeting process is far simpler. You will need a cash hoard to cover any up front costs you will incur (rent deposits, furniture, office equipment, resources, marketing, etc.) and to provide for the first few months of living expenses until your receivables start turning into cash.
Failure to keep accurate records will reduce your ability to effectively manage your business and will be a source of aggravation at tax time. Keeping accurate track of your business expenses is of obvious importance. More business expenses mean fewer taxes.
Set up a separate business checking account and designate a credit card to be used only for business purposes. Never co-mingle business and personal expenses. Assuming you are not incorporated, when you want to take your earnings out of the business write a check payable to yourself and deposit it into your personal account. By always using a check or credit card, you create another record to help you capture all of your expenses.
Use an electronic checkbook program like Quicken or Money. Although these programs offer many features, you can use them just like a check register. Enter the checks you have written and record your deposits. Designate each check by the type of expense category. Then at the click of a mouse, you can determine how much you have earned and where your money was spent. It also makes balancing your checkbook a snap!
Avoiding spending cash. Unlike a check or credit card charge, a receipt is easily lost and makes documenting the expense harder. For those rare occasions when you use cash for a business expense, set up a separate account on your checkbook software called "Out of Pocket" which indicates amounts paid with cash. This way you will capture your expenses as they occur and will not be scrambling to find receipts at year-end.
Self-Employment Tax (Social Security and Medicare Taxes)
The Social Security tax may be both the best and most insidious tax in our society, depending on whether you are collecting it or paying it. As an employee, you have paid one-half of the Social Security tax. The employer and employee each pay half. As an independent contractor, it is called the Self-Employment tax and you get to pay both the employer and employee's share. The Social Security tax is 12.4% on the first $84,900 of profits in 2002. The Medicare tax is 2.9% on an unlimited amount of earnings. You are allowed to deduct 50% of these taxes when computing taxable income.
The Self-Employment tax is calculated before any itemized deductions or exemptions. After these deductions, you pay income taxes on this same income.
As an employee, this tax was relatively painless because it came out of every paycheck, and you never had your hands on the money. It was never reflected on your income tax return, so you tended not to think about it. As a member of the self-employed, it is painful. Many small business owners pay more in Self-Employment tax than they do in income taxes.
IRS Audit Prospects
Sole proprietors have historically been more likely to be audited than other individuals with similar income and deductions. Why? There is a perceived notion that a business owner has more opportunity to hide income or treat personal expenses as business expenses.
The IRS is completing its reorganization and hired many new auditors. One of the primary divisions formed is dedicated to small businesses and self-employed individuals. Corporations and partnerships with less than $5 million in assets will be the responsibility of this new IRS division. In the past, the functional operation of the IRS separated the sole proprietor from the corporation. In the future, it appears that will no longer be the case. IRS audit rates have fallen during the past few years as the IRS became "kinder and gentler." With budgets increased and the new auditors already hired, the IRS expects audit rates to increase.
Other Tax Items
The United States has a "pay-as-you-go" tax system. When you were an employee, your employer was required to withhold income taxes from every paycheck. When you own your own business you are required to make quarterly estimated tax payments to the IRS (Form 1040-ES) and state authorities (Oregon Form 40-ES). Failure to make timely estimated payments will result in a tax penalty, which is 6% of any deficiency for the first quarter of 2002.
Current guidelines allow you to write-off, in the year of purchase, most equipment up to $24,000 in 2002 (excluding automobiles). This covers the equipment needs of most technical communicators. Leasehold improvements have to be written-off over 39 years, and software usually has a three-year tax life. Software subject to annual renewal can be expensed.
To deduct the cost of automobiles, you can either choose the standard rate ($0.365 per business mile in 2002) or total actual expenses multiplied by the percentage of business use. The newer your vehicle, the more likely actual expenses will yield a greater deduction. If your auto is older and more economical, the standard rate may be a better answer. It is important to document your business travel in the event you are ever audited.
Entertainment and business meal expenses are limited to a 50% deduction. Strict documentation is required to successfully defend entertainment expenses. In order to survive a challenge to your entertainment expenses you must be able to answer: Who did you meet with? What substantial business discussion occurred? When and where did the meeting occur? Why was this meeting substantially business oriented?
As though you did not feel heavily taxed enough, there are a few additional checks you will write to local tax authorities if you start your own business. Personal property taxes are a tax on the value of your office equipment and furniture. In Oregon, for less than $10,000 of equipment value, the tax is typically waived but a tax form is still required to be filed with the county where you work. For those working in the Tri-Met Metropolitan or Lane County Transportation District, there is an additional tax (0.6195%) and report that needs to be filed. For those working in Multnomah County and/or the City of Portland, a combined report form is filed to pay a county tax (1.45%) and city business license fee (2.2% or a $100 minimum), both based on taxable income.
For starting a business in Oregon, a helpful resource is a booklet published by the Business Information Center called "Oregon Business Guide." Call 503-986-2200 for a free copy. For general information on small businesses, nothing beats the Internet. These Web sites have helpful information, checklists and templates for starting or improving small business:
Raymond A. Rowntree, CPA/PFS, CFP is a shareholder in Brown/Armstrong, a Professional Corporation. Ray's practice focuses on tax planning and wealth building for professionals. He can be reached at 503-221-1776.