A CPA Explores: “How Much Income Should I Allocate to Taxes as a Business Owner?”
My clients who are real estate agents and business owners (flippers, wholesalers, etc.) often ask me how much of their profits they should be allocating toward taxes. They are sometimes surprised when I tell them that they should be earmarking upwards of 35% of their profits for taxes. My response is generally met with a mix of shock, sadness, and anger—and rightfully so.
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Taxes are likely your single biggest expense, whether you are running a business or not. Don’t get caught with a tax bill you can’t afford come April 15th, or worse, get slapped with an underpayment of estimated tax.
Breaking Down the 35% Figure
It should be noted that I am talking about what you need to withhold from your Net Operating Income (NOI), not your gross revenue. When you hire a savvy CPA, you’ll learn about all of the business deductions you get to take, and your reported NOI will hopefully decrease. Once you find your NOI (for simplicity, also called taxable income), you will likely need to withhold around 35% for taxes alone.
Where does that number stem from? Most people find themselves squarely in the 25% Federal tax bracket. We then want to add the state’s tax rate, so we can assume roughly another 5%. Now we are at a 30% tax rate before we’ve factored in self-employment taxes.
Self-employment taxes will amount to 15.3% of your profits if you are a business owner, flipper, wholesaler, etc. You are required to pay the employee and the employer side of the tax. Luckily, you can deduct the employer side of the tax on your 1040, but it’s not dollar-for-dollar.
You usually must pay self-employment tax if you had net earnings from self-employment of $400 or more. Generally, the amount subject to self-employment tax is 92.35% of your net earnings from self-employment. You calculate net earnings by subtracting ordinary and necessary trade or business expenses from the gross income you derived from your trade or business. You can be liable for paying self-employment tax even if you currently receive Social Security benefits.
So 25% + 5% + 15.3% = 45.3%. But wait—you said 35%, not 45%! You are correct, the 45% number we just found is likely what you will want to withhold per additional dollar of profit earned in your business if your income already places you in the 25% bracket. So if you are already in the 25% bracket and you make another sale, likely 45% of that income will need to be withheld for taxes.
But that’s a bit more comprehensive than I aim to get into for this article. Just remember 35% of your profits should be withheld for taxes, and you will likely be okay. Let’s look at a few examples below.
The Real Estate Agent
Dave is a real estate agent, and as the market looks promising, he expects to have a great year. Dave is not married, does not own rental property, and only engages in his real estate business to earn a living. Dave itemizes deductions in the amount of $15,000.
Dave grosses $150,000 during the year. His business expenses (including depreciation and amortization) amount to $40,000, leaving him with an NOI of $110,000. Dave operates as a sole proprietor, so all of that income is subject to the self-employment tax. Additionally, Dave’s state tax rate is 5%.
Let’s take a look at Dave’s tax liability:
Since Dave’s effective tax rate is 33%, he needs to withhold 33% of his profits for tax purposes throughout the year. He also needs to remit quarterly estimated tax payments, but we’ll get to that in a minute.
Dave discovered BiggerPockets and learned a ton about flipping houses. Dave anticipates a great year, so he quits his job and focuses solely on flipping. Dave is not married, does not own rental property, and only engages in his flipping business to earn a living. Dave itemizes deductions in the amount of $15,000.
Dave grosses $180,000 during the year. His business expenses amount to $100,000, leaving him with an NOI of $80,000. Dave operates as a sole proprietor, so all of that income is subject to the self-employment tax. Additionally, Dave’s state tax rate is 5%.
Let’s take a look at Dave’s tax liability:
Since Dave’s effective tax rate is 30%, he needs to withhold 30% of his profits for tax purposes throughout the year. He also needs to remit quarterly estimated tax payments.
The Part-Time Flipper (Who’s Married)
Dave and his wife each work a 9-5, and they decide they want to flip houses on the side to generate extra income. Dave’s income less a 6% 401(k) contribution is $60,000. His wife’s income, assuming the same, is $75,000. Dave does not own rental property and itemizes deductions in the amount of $15,000.
Dave and his wife gross $60,000 during the year. His business expenses amount to $40,000, leaving him with an NOI of $20,000. Dave and his wife operate the business together through a single member LLC, so all of that income is subject to the self-employment tax. Additionally, Dave’s state tax rate is 5%.
Let’s take a look at Dave and his wife’s tax liability:
Now here’s the interesting thing. Dave and his wife already earn a living and are partaking in this business on the side. What we want to know is how much should be withheld for taxes per dollar earned from the flipping business. To do that, we will just zero out the business income and see what our tax liability is:
You can see that without the business, the total tax is $25,313, and with the business, the total tax is $33,715. The net difference here is $8,402—that’s a 42% tax on the $20,000 in earnings. So every additional dollar they earn in their flipping business is subject to a 42% tax. Imagine if they were only withholding at a 30% rate and did extremely well for the year. Would they have enough liquid capital to pay their large tax bill? These are the scenarios I discuss with my clients.
Since they both have W2 income, they likely do not need to pay estimated taxes in the current year. Your employer remits estimated taxes to the IRS per paycheck, so it’s generally not something you need to worry about unless you start earning extra income on the side or amend your W4.
Estimated Taxes (Per the IRS)
Estimated tax is the method used to pay tax on income that is not subject to withholding. This includes income from self-employment, interest, dividends, alimony, rent, gains from the sale of assets, prizes and awards.
Estimated tax is used to pay income tax and self-employment tax, as well as other taxes and amounts reported on your tax return. If you did not pay enough tax throughout the year, either through withholding or by making estimated tax payments, you may have to pay a penalty for underpayment of estimated tax. Generally, most taxpayers will avoid this penalty if they owe less than $1,000 in tax after subtracting their withholdings and credits, or if they paid at least 90% of the tax for the current year, or 100% (110% is AGI is over $150k) of the tax shown on the return for the prior year, whichever is smaller.
So if your last year’s tax liability was $20,000 and your AGI is less than $150k, you need to make sure your quarterly tax payments amount to $5,000 in order to avoid the underpayment of estimated tax penalty. These payments are made through your W2 job, but if not enough, you will need to remit the remainder.
The deadlines for estimated taxes are: 4/15, 6/15, 9/15, and 1/15.
How an S-Corp Changes Things
An S-Corporation allows you to draw a salary out of your business. In a nut shell, your salary is the only portion of your profits that will be subject to the self-employment tax, whereas the remainder will be considered a distribution.
As an example, a business profits by $100,000 and they are operating out of an S-Corp, so they take a salary of $50,000. Now, only the $50,000 is subject to the self-employment tax, which will amount to $7,065. Without the S-Corp, the entire profit is subject to self-employment tax, costing the business $14,130 in self-employment taxes alone.
So get with a CPA today to run through your own scenario. It’s better to be proactive and understand what’s coming on April 15th than be in for a nice (maybe that’s not the right word) surprise.
Business owners: Have any questions? What has been your experience as an entrepreneur?
Be sure to leave a comment!