The tax system favors independent businesspeople over salaried workers.
Who pays a greater share of their income in taxes — Warren Buffett, or his administrative assistant?
Obviously, posing the question implies its answer.
Politicians may tout the virtues of our “progressive” tax system, but it doesn’t really favor the poor over the rich.
Nor does it favor the rich over the poor, not when 40% of federal tax receipts come from 1% of the population. Fairly or otherwise, the tax system favors the diligent over the unprepared. Specifically, the system favors independent businesspeople over salaried workers.
This topic requires a book-length explanation, but to summarize, starting your own business lets you enjoy tax advantages wage slaves only dream of. Take two people in the same field, making like incomes, living in the same city — the only exception being that one owns his own business and the other works for someone else. It’s eminently possible that the latter person’s tax bill is nine times the former’s.
Declare your independence today, if your career lets you make a horizontal shift to entrepreneurship. If you’re an anesthesiologist, it’ll be hard to rent out an office and put up a sign that reads “Mepivacaine Administered Here — Happy Hour 4 – 7.” But if you’re an accountant, real estate agent, home inspector, engineer, attorney* or in any kind of creative profession, you can take advantage of complex tax laws.
I’m not talking about the kind of entrepreneurship that requires you to open a physical storefront and spend years building a customer base. I’m talking about changes you can make now that will immediately impact your bottom line.
I tried to go as long as I could without using the first-person pronoun, but my story illustrates the point. A decade ago I was working for a decently-sized advertising agency as a senior copywriter, making somewhat more than the nation’s per capita income. One day I ran the numbers and realized I could make more money going out on my own.
I collected most of my new clients, other ad agencies, via word-of-mouth. But most importantly, I took on the very agency I’d left as a client — and charged them about 30% more than they paid me as an employee. There are two components to that: 1) they were underpaying me to begin with, but had to cough up once I exercised my leverage and threatened to walk and B) the daily rate they paid me after the switch was just for the services I rendered nothing else. It included no employee benefits, no capital expenditures for a workstation, no space reserved for me at the office Christmas party, no food allowance, no 6.2% Federal Insurance Contributions Act tax, no unemployment insurance premium. The responsibility for all that now fell on me.
Which is wonderful. It meant that instead of my former employer enjoying all the possible tax deductions from my labor, I got to take advantage of them. My taxes got a little more complicated — I now had to keep more detailed records, and file quarterly instead of annually — but the benefits grossly outweighed the costs.
It’s easy to get started, but also easy to make mistakes. You don’t want to be a single proprietor. You want to found an S Corporation, a legal entity that protects you from creditors who are forbidden from coming after certain classifications of income. An S Corporation lets you separate your money between salary and capital gains, the latter of which is taxed at a lower rate.
Find a company that specializes in entity formation. It’ll cost maybe $500 for them to register you with the relevant state’s Secretary of State office. You don’t have to register in your home state, either. If you live in California or New York, you don’t want to — those states’ laws don’t protect you enough from creditors. Register in Delaware or Nevada or, failing that, your home state.
Once you incorporate it starts forcing you to think like a businessman. Income will now be tabulated on IRS 1099 forms, rather than those infamous W-2s. The former is where you want most of your income to come from. As a practical matter, once you incorporate you’ll pay (correction: your company will pay) you a salary. What’s a reasonable amount to cover your annual living expenses; maybe $24,000? Then that’s what Employee #1, you, will receive and pay taxes on. After deductions, your effective tax rate on the salary will be close to zero.
But what about the rest of your company’s income? Legally speaking, the rest of the revenue your S Corporation takes in is not salary, but shareholder dividends. Which are taxed at a lower rate than salaries are. And you can now deduct all sorts of business expenses before calculating the net shareholder dividends you’ll pay taxes on. Go to IRS.gov and check out Form 2106. Your employer fills one of these out every time you go on a business trip, or eat a meal on company time, or buy anything related to your job. And your employer then enjoys the tax deduction.
* It tears me inside to know that by writing this post, I’m giving you leeches an economic edge.
About the Author: Greg McFarlane is a writer who lives in Las Vegas and Lahaina testament to the power of entrepreneurship. He is the author of Control Your Cash: Making Money Make Sense, a financial primer for people in their 20s and 30s who know nothing about money. You can buy the book here and reach Greg at greg@ControlYourCash.com.