Multiple Streams of Income - Part 2 Tax Advantages

Now that you have an understanding of the importance of having more than one income stream (see Part 1), let’s talk about how you can do this in a way that makes sense for you.

This is where the fun starts. If you are going to create another stream of income, why not pick something where you can be your own boss? How amazing would it be to not answer to anyone but yourself? How would it feel to make your own hours, take a vacation whenever your heart desires, and keep the lion’s share of your earnings (as opposed to getting paid what someone else decides you are worth)? You can work your own business on a part-time basis, building it in a way that complements your job and family responsibilities. One day you may decide to replace your current full-time work situation with another opportunity—one that allows you more control over your own destiny.

These are all phenomenal reasons to open a home-based business, but I am about to cover the biggest reason—a reason that can begin to put money in your pocket immediately. I am referring to the many tax breaks that are available for home-based businesses.

Tax-Saving Strategies

Most people are employees: individuals that work for someone else for a living. I myself was an employee for the first eleven-and-a-half years of my accounting career. While there’s nothing wrong with being an employee, many of the tax laws in the Internal Revenue Code were written to save taxpayers money, but employees are unable to take advantage of them. Implementation of many of these provisions requires that an individual own a business; these laws are simply geared towards business owners, not employees.

Fully understanding some of the tax-saving strategies I am about to explain requires a working knowledge of taxes. While reading that sentence might cause you to shudder, take a deep breath and relax—I promise this is going to be fun and easy. No one expects you to memorize the tax code; just follow along with me and get a general understanding of the methodology the government uses in order to decide how much of your hard-earned money you get to keep. Once you understand some basic concepts, you can start to use them to your advantage. Trust me—you are going to absolutely love this next section!

Whenever individuals discuss their income tax returns, they typically discuss how much money they will either receive as a refund or will be required to pay the federal and/or state government. Very rarely, however, will you hear them speak about the amount of money they pay into the system for Social Security and Medicare (also known as federal payroll taxes). That’s because employees automatically have 6.2 percent of their pay withheld for Social Security (sometimes shown on a paycheck as F.I.C.A.) until they reach the Social Security wage base limit in a given year ($127,200 in 2017). Once an employee reaches the maximum amount of taxable earnings, no more Social Security taxes are withheld.

In addition these same employees have 1.45 percent of their pay withheld for Medicare. This tax has no limit. The highest paid athlete, for example, pays Medicare tax on his entire salary, just as someone working for much less does. Since these figures are straight percentages and automatically withheld, most people do not think about them even though they are significant. These taxes amount to more than state income taxes for almost all taxpayers.

In addition employers must match the Social Security and Medicare taxes paid by the employees. The result is that the federal government receives 15.3 percent of all wages up to $127,200 (6.2 percent of Social Security and 1.45 percent of Medicare from both employee and employer) and 2.9 percent of all wages above $127,200 (1.45 percent Medicare from both employee and employer).

Tax Implications for the Self-Employed

Now that you have a basic understanding of how Social Security and Medicare taxes are imposed on employees, let’s look at how these taxes impact self-employed individuals.

You might already be aware that you must pay both federal and state income taxes on the net income earned when you are self-employed. If you are a sole proprietor—if you own an unincorporated business by yourself—net income is the profit that remains after all expenses are deducted from gross income. But what you might not realize is how federal payroll taxes affect a sole proprietorship.

Employees are taxed at fixed percentages for both Social Security and Medicare taxes, and employers must match the amounts paid by their employees. When someone is self-employed, there is no paycheck and no withholding for these taxes. Does that mean self-employed individuals are exempt from these taxes?

Unfortunately the answer is no. The government imposes what it calls self-employment tax. Self-employment tax is levied on the net profit earned in a self-employed business. Without getting too technical, just be aware that the self-employed individual is responsible for both the employer and employee shares of these taxes. The rate is approximately 14.1 percent, and the sole proprietor receives a deduction for half of the tax—very similar to the way an employer is able to deduct not only gross wages paid but also their portion of these federal payroll taxes.

I promise that the hard part of your taxation education is now over. This is where it starts to get good. An employee always pays a fixed amount for both Social Security and Medicare taxes. If the employee has deductions, those will never reduce his or her federal payroll taxes. This is not the case, however, with a self-employed individual. A deduction in a sole proprietorship reduces not only federal and state income taxes but federal payroll taxes as well. I’ll explain this in more detail in the examples that follow.

Deductions for the Self-Employed

Many deductions are available to the self-employed that are either not available to employees (or available but not quite as beneficial as they are to the self-employed). Let’s explore some of the most common.

·      You can hire your children (as long as they are under eighteen) and they will not be subject to federal payroll taxes.(This one tip alone can save you thousands of dollars per year.)

·      You can write off your business mileage to the tune of 53.5 cents per mile in 2017.

·      You can deduct part of your rent, telephone and utility bills.

·      You can deduct a portion of your travel expenses, meals, and entertainment.

·      You can deduct the cost of computers, Internet expenses, and office furniture.

·      You can deduct certain medical expenses in a manner that yields a higher deduction than if you were an employee .

I want to make it clear that I am referring to legitimate home-based businesses. I am in no way condoning any type of a tax scam. Please keep in mind that I’ve just scratched the surface of the deductions available for home-based businesses. I am providing you with an overview of the deductions and tax saving strategies available, not an in-depth look at them. I want you to begin to understand that there are many deductions available to the self-employed.

A Tale of Two Families

In order to clarify some of the tax advantages I’ve mentioned, let’s look at the following two examples. Each family is made up of a husband, a wife, and two children (under the age of eighteen). In each situation the husband and wife both earn $75,000 per year, for a combined income of $150,000. In the first example the wife is an employee, while in the second the wife earned her $75,000 in a sole proprietorship. Both families live in New Jersey (my home state), they have no other income in addition to their wages, and they had the following itemized deductions in 2014. Please note I used the mileage rate of 56 cents per mile which was the 2014 rate:

Real estate taxes: $ 8,000

Mortgage interest: $10,000

Donations: $1,000

 Scenario #1

Dual Wage Earners

The Adjusted Gross Income (AGI) for our dual wage earners is $150,000. When we subtract the itemized deductions listed previously and the exemptions allowed for a four-member household, the result is a federal income tax of $19,313. In addition, the New Jersey state tax is $4,794, the Social Security tax is $9,300, and the Medicare tax is $2,176. This results in a total tax bite of $35,583.

Wage Earner plus Entrepreneurial Mom

This family shows an AGI of $144,701. The reason this is less than the $150,000 AGI of the dual wage earners is that the entrepreneurial mom is subject to self-employment tax and receives a deduction for 50 percent of it ($5,299). When we subtract the same itemized deductions and exemptions as we did for the dual wage earner family, the result is $17,988 federal tax, $10,597 self-employed tax, $4,794 state tax, $4,650 Social Security tax, and $1,088 Medicare tax. This results in a total tax bite of $39,117.

At this point you might be thinking that my entire dialog outlining the tax benefits of owning your own business seems like a lot of hot air. But let’s see what happens when I change a few facts.

Let’s assume that the wife in both instances has driven 10,000 job-related miles. The employee wife claims 5,000 commuting miles and 5,000 miles related to various business activities—none of which are reimbursed by her employer. The self-employed wife claims 10,000 miles, all of which were related to various business activities. Each wife has $2,000 in valid entertainment expenses. Once again the employee wife has not been reimbursed for these expenses. (If she were reimbursed, then there would be no deduction.) Lastly, let’s assume that each family wishes to establish a $2,000 savings account for each of their children.

Scenario #2

Dual Wage Earners

Each family begins with gross earnings of $150,000 with the same itemized deductions and exemptions. But let’s look at the ramifications of the additional expenses listed. The wage-earning wife is an employee, and therefore the mileage and entertainment expenses must be deducted as “unreimbursed employee expenses.” These expenses are deducted on Schedule A as itemized deductions, but only to the extent that they exceed 2 percent of the Adjusted Gross Income. And as an employee, the commuting miles to and from work are not deductible at all, and meals and entertainment expenses are only 50 percent deductible. (I know I am throwing a lot of numbers at you, but I promise this will all make sense very shortly.)

The result is that the dual wage earner family still has an AGI of $150,000 and the same itemized deductions and exemptions from Scenario 1. For the 10,000 miles the wife drove for business (half of which were commuting miles), she received a deduction of $2,800. For the $2,000 she spent entertaining clients, she was able to claim a $1,000 deduction (meals and entertainment are 50% deductible by law). The total of these deductions is $3,800, which exceeds 2 percent of the AGI resulting in an itemized deduction of $800. The resulting tax liabilities are $19,113 federal tax, $4,794 state tax, $9,300 Social Security tax, and $2,176 Medicare tax. The total tax bite is still $35,383.

Wage Earner plus Entrepreneurial Mom

The entrepreneurial wife has no commuting miles since she has a home-based business; her office address is her home address. In addition since she files as a sole proprietorship she is able to deduct her mileage and $1,000 of entertainment on her Form Schedule C. She employed both of her children to clean the office, file papers, and perform data input functions in her business, for which she paid them $6,000 each. Since they are minors working in their mom’s sole proprietorship, they are not subject to Social Security or Medicare taxes. Additionally, since they earned less than $6,200, they are not subject to any federal income tax, and they are also below the New Jersey state filing threshold of $10,000.

As a result of these deductions, the entrepreneurial mom’s income is reduced to the $56,400. The end result is that federal income tax is reduced to $13,669, self-employment tax is reduced to $7,969, and New Jersey tax is reduced to $3,711. Only the Social Security tax ($4,650) and the Medicare tax ($1,088) of the husband remain unchanged. This family’s total tax bite is now $31,087.

The entrepreneurial mom deducted additional expenses of $18,600 ($12,000 payroll, $5,600 mileage, and $1,000 entertainment), resulting in a tax savings of $8,030. That $8,030 is the difference in tax between Scenario #1 ($39,117) and Scenario #2 ($31,087). This is a 43 percent savings! By comparison our dual wage earners saved $200 on $3,800 worth of deductions, slightly over 5 percent.

In Scenario #2 the taxes paid by the entrepreneurial family were $4,296 lower than the amount incurred by the dual wage earning family. Note that when our entrepreneurial mom incurred additional expenses, it reduced not only her federal income tax, but also her New Jersey and self-employment tax. This was not the case with our dual wage earners. Although, to be fair in certain states additional itemized deductions would have resulted in a slightly reduced state income tax.

Let me reassure you—I did not go crazy here. I did not list deductions for home office, self-employed health insurance premiums, furniture, computers, cell phones, etc. I merely selected a few simple strategies to illustrate tax savings ideas. There are many other strategic deductions available for the entrepreneur.

Both families also wished to establish a $2,000 savings account for each child. The entrepreneurial family allowed the government to pay their contribution—they simply used their tax savings. There is a requirement that the wages paid to minor children must be used for their benefit. Some of the ways the wages can be used are for school activity fees, clothing, or any other expenses parents spend on their children during the course of the year.

This is exciting news, but it gets even better. Since each child earned wages, the money also could be used to contribute to a Roth IRA. And, although a Roth IRA does not allow for a tax deduction when contributed (we don’t need one here because neither child has an income tax), the money accumulates in the Roth IRA tax-free and there is zero income tax upon withdrawal. Ladies and gentlemen, that is what we call a Grand Slam!

What Will You Do?

In today’s economy, having multiple streams of income is more of a necessity than a luxury reserved only for the rich and famous. Between unemployment and company downsizing, nobody’s job is safe. It’s become too risky to rely on only one source of income. I hope that, after reading this , you now see the value of home-based businesses—not only for the diversification of income aspects but also the tax savings opportunities.

Many home-based businesses can be started with very little capital, making them available to almost anyone. When it comes time to doing your taxes, a tax accountant who is knowledgeable about home-based businesses and the deductions available is a wise investment. While online programs have certainly made things easier for individuals wanting to file their own taxes, a professional can identify strategies and deductions you might not be aware of.