Uncle Sam will get his

Editor’s note: The City Wire has invited David Potts, an accountant with more than 25 years of experience, to provide a series of detailed commentaries on the accounting side of starting and maintaining a business.

guest commentary by David Potts

When people start a business for the first time, especially young people, they are shocked to learn that even though they didn’t make much money, their taxes on their net income can be huge.

Let’s look at an illustration. To avoid being too clinical I will show you how the tax is calculated without offering much in the way of gory details.

Mike is single and newly self-employed. In 2008 his business had a net profit of $50,000. How much will he owe in taxes? Mike will have to pay federal and Arkansas income taxes and federal self-employment tax.

Mike’s federal taxable income after deducting one-half of his self-employment tax [$3,825], his standard deduction [$5,450], and his exemption [$3,500] is $37,225. His income is taxed in layers. For an unmarried taxpayer the first $8,025 is taxed at 10%, the next $24,525 is tax at 15%, and the final $4,675 is taxed at 25%. Mike’s federal income tax is $5,650.

Mike’s self-employment tax is $7,650. It is calculated by multiplying his net income from self-employment by the self-employment tax rate of 15.3% [$50,000 X 15.3%].

Arkansas seems a bit kinder to Mike. Arkansas’ income tax is also taxed in layers but the highest tax rate is 7% on taxable income over $31,700. Mike’s Arkansas taxable income is $48,000 after subtracting his $2,000 standard deduction. His Arkansas income tax is $2,492 (after subtracting his $23 personal tax credit from the $2,515 tax shown in the Arkansas tax tables).

So Mike will pay a combined federal income tax, federal self-employment tax, and Arkansas income tax of $15,792, 31.6% of his $50,000 net income.

Keep in mind that both the federal and Arkansas income tax rates are progressive, i.e. the more you make the higher the tax rate. Overall, Mike is paying 31.6% of his net income in taxes, but let’s examine the last layer, the last $4,625. This layer is taxed at 25% Federal income tax, 15.3% self-employment tax, and 7% Arkansas income tax. Incrementally, Mike is paying 47.3% tax on the last $4,625 he earned. Ouch!

The biggest surprise for Mike was the self-employment tax. The self employment tax is the Social Security tax and Medicare tax you pay when you are self-employed. When Mike was an employee working for somebody else, the employer withheld 7.65% from his earnings for Social Security and Medicare tax. But his self-employment tax is double what was withheld from his earnings by his employer. His self-employment tax is 15.3% of his earnings. Why did it double? When Mike was employed, his employer had to match the 7.65% Social Security and Medicare taxes withheld from his wages and send it to the US Treasury on Mike’s behalf, for a total of 15.3%. Now Mike must pay the full amount himself.

Lessons to be learned: business deductions are valuable to a self-employed person in terms of the reduction in taxes paid. Think of it as Uncle Sam pitching in and helping you buy something for your business. For example, if Mike had spent another $1,000 on advertising for his business, his taxes would have been reduced by $473 so his advertising would have only cost him out of pocket $527.

The disclaimer: The above illustration is general in nature and the results would be different for people without the same facts and circumstances. There are ways to minimize the impact of taxes on your business. Generally it starts with good planning. Start by hiring an experienced CPA who works with small businesses on a regular basis.

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David Potts is a certified public accountant also accredited in business valuation. Owner of Potts & Company, Certified Public Accountants for more than 25 years, his practice focuses on small and medium size businesses and their owners in the areas of taxation, accounting and bookkeeping, and advisory services. He is a Fort Smith native and a graduate of the University of Arkansas at Fayetteville. You can follow his blog at ThePottsReport.com.