Originally published on: 3/14/2010 6:42:58 PM
However, it's tax season in the USA. If you work as a W-2 employee, you still have a month to get the old 1040 filled out. For those of us who own corporations, even the single-owner "S" corporations like mine, we have to get the corporate taxes filed by March 15.
The result of that whole process turns into one number representing the profit or loss for my consulting company. And, in turn, that's the amount I pay federal and state taxes on.
Planning for that is one of the biggest concerns people have when they ask me questions about being self-employed for consulting/contracting work (along with "stability" and what to do about health insurance). I have a very basic approach to the whole thing that ensures I always have enough funds to pay the taxes comfortably.
First, since I do run my consulting as an "S corporation", the finances are completely separate. If you hire me to do some work, you'll be paying my company. I have checking accounts and credit cards specifically for the business and never, under ANY circumstances, use those for personal use.
When it comes to business expenses, I only ever spend in completely above board ways. I will stand behind every business expense as being ethical to anyone who needs to care. That's a much higher standard than is generally required, but it means I never have to worry about it.
I'm sure I'm missing out on some things I could expense, but as far as I'm concerned it's not worth it. So, when money comes into the company, I pay for things like the web hosting, hardware (laptops, etc.), MSDN subscription and other software expenses, cell phone, etc.
What's left over is destined for our household. Here's where you've got to be careful. I've seen more than a few people just write themselves a check for everything and move on, only to seriously regret it come tax time.
The basic rule here is that every single dollar that goes from your company to you needs to go through one of 3 channels and taxes set aside. Either you pay it to yourself as a salary, you reimburse yourself for expenses or you pay it out as profit.
For the salary payments, regular payroll taxes will apply and payroll services are usually the best way to handle it. The IRS requires that for businesses like mine you pay yourself a "reasonable salary". I know of people who do software consulting and pay themselves $12,000 a year. That's not "reasonable" and, while they may have gotten away with it, it's not something I'm willing to risk.
However, dollars paid out as profit aren't subject to Medicare/Social Security withholding, so there's an incentive to minimize the portion that goes through as salary. I base my own salary on whatever a developer here on an H1B Visa would get paid. That's "reasonable" for one federal program, so it's good enough for me, despite typically being lower than the job pays a citizen (a topic for a whole other post).
Using a payroll service, you get a regular W-2 at the end of the year, which also makes things like applying for mortgages much easier than other forms of self-employment (it's stupid that paying myself as an employee makes it easier to get a loan, but reality is what it is). They'll send the money to the feds and any state entity that needs it.
For the reimbursement, I usually only pay for my car mileage and health insurance (since Blue Cross insists it's paid by me as an individual and not by a business). Since those reimbursements go on the corporate books as expenses, this is the only money I pay myself that I don't set tax money aside, though for 2010, I'm changing that behavior.
For any other money I pay out, I take 40% of it and put it into a specific personal savings account that I call "Tax Savings". That is its ONLY purpose. Why 40% instead of the 28% that my tax bracket calls for? Partly because I also will have to pay MN state taxes. However, this also works really well as a buffer in case I miscalculated something somewhere along the way and as a pretty good forced retirement savings plan.
When I go to pay my taxes on April 15 (and working this way, you'll always owe), I get to write a check on funds that have been earning interest instead of sitting in Uncle Sam's accounts all year. Any extra can be considered my "refund" and I usually contribute it to my retirement accounts for the previous year. Because you can make those contributions up until April 15, this also lets me reduce the amount I owe.
So, while I hate doing all of the paperwork and am never thrilled to send Uncle Sam that check, it's never a panic to figure out how to pay it and along the way I am helping out my retirement savings. Overall, I think it's a pretty good approach. Since it has those secondary benefits, I'm going to start doing the 40% on the reimbursement money too.
Since that 40% comes out immediately when I receive the money, I never really miss it, making the savings automatic and it adds up to more than you might think.