Written by Norman Mangina
If you’ve been thinking about starting your own business, now might be a good time to start one. With the Tax Cuts and Jobs Act passed in December 2017, Congress made owning a business more appealing. The tax law change with the biggest impact for small business owners is the new qualified business income (QBI) deduction.
The QBI deduction gives many business owners a tax deduction of up to 20% of their business income. This means that a business owner with a profit of $100,000 now pays income tax on only $80,000 rather than $100,000. At a marginal tax rate of 22%, that’s a tax savings of $4,400. (There are numerous limitations that reduce the full amount of the deduction. Please talk to your tax advisor for specifics.)
Because of this new incentive, more people are considering starting a business. If you are one of these people, there are a few things you need to know before getting started.
There are other benefits to starting a business beyond the new QBI deduction.
As a business owner, you can deduct expenses that would normally be personal, non-deductible expenses if these expenses are business-related. Some examples of these are costs for cell phone service, internet service, travel, automobile, and insurance. As an individual, you generally cannot deduct these expenses on your tax return. However, if you are incurring these expenses in your business, then they are generally deductible saving you federal and state income taxes.
Another benefit to owning a business is the ability to design a retirement plan that works for you. Rather than being stuck with an IRA which has a maximum annual contribution of $5,500 ($6,500 for those over age 50) or an employer’s 401(k) plan with a maximum annual contribution of $18,500 ($24,500 for those over age 50), you can design a retirement plan that allows you to contribute up to $55,000 a year in tax-deferred contributions ($61,000 for those over age 50). This offers you a great way to save on taxes now and save much more in a tax-efficient way for your financial independence.
Of course, you also need to consider the costs of starting an running a business. There are legal costs to form your business and establish it as a separate legal entity (if you decide to create one). You’ll also have business taxes, licenses, and/or fees depending on the state and type of business you will be operating.
Beyond that, you’ll need to consider the cost of maintaining records and additional tax return preparation costs. As a business owner, you will be responsible for the employer portion of payroll taxes (Social Security and Medicare) that you do not pay as an employee.
It’s important to consider all of these costs as you evaluate starting your own business and what kind of income you need to generate.
If you’ve decided to move forward with starting your own business, one of the first things you need to do as a new business owner is choose a business entity. The most common choices are a sole proprietorship, partnership (for more than one owner), an LLC, and a corporation. Each one has different benefits and limitations. They also have different tax consequences, so it’s important to discuss these forms of ownership with a CPA or attorney before choosing one.
Generally, a sole proprietorship is the easiest form of business to establish but offers the least protection for you personally. A corporation or LLC offers better protection but requires more legal documents and ongoing recordkeeping.
Once you begin spending money in the business or earning income, it’s important that you begin tracking your business income and expenses through financial software like Quickbooks or Xero. This is such an important part of managing a business that so many new business owners put off or never do. These are the books and records of the business finances which make tax return filing much easier.
More importantly, these financial records give you valuable information about your business with which you can make decisions. How much are you making from different products or services you are offering? Should you be focusing on some more than others because they are more profitable? What are your expenses that you need to cover each month? Successful business owners learn from their past results and make the necessary changes to grow and improve their business.
Finally, don’t forget to create a plan for success. What are the fixed costs of the business and costs to provide the product or service? What amount of sales should be targeted to support the expenses of the business, your own compensation, and profits? This is typically summarized in the form of a budget. What is your income and spending plan, and how will you achieve that? Score.org has a great template to help you plan the startup cost and ongoing financial projections for your business.
As you evaluate the decision to start a business, don’t forget to seek guidance from your tax, legal, and financial advisors who can help you make the best decision for you.