“Is now the right time to start my business?” is a common question we analyze for clients. Favorable labor, rental, and lending rates make it appealing to start a business, but it is difficult to give up the security and fringe benefits of a job in this uncertain market.
Many people do not realize that nearly all the deductions available to self-employed individuals, such as advertising, mileage, phone charges, internet fees, computers, travel, entertainment, education, subscriptions, office supplies, contract labor, etc., are also available to employees if the expenses are not reimbursed by the employer.
The expenses are deducted in different places on the Form 1040 – from adjusted gross income (AGI) on Schedule C for self-employed individuals and from AGI on Schedule A (itemized deductions) for employees. This treatment favors self-employed individuals, especially considering that employee expenses are subject to a 2% of AGI floor, but it does not consider the self-employment tax (13.3% for 2012 under proposed legislation).
Consider this contrast: Self-employed Barbara and employee Ed both gross $120,000 and have $20,000 of business-related expenses. Both are in the 34% marginal tax rate bracket. Barbara will have net income of $100,000 on which she will owe approximately $13,300 of self-employment tax. Half of this self- employment tax is deductible for income tax, giving Barbara $93,450 of taxable income and $31,773 of income tax, for a total tax of $45,073.
Ed’s entire salary of $120,000 is subject to payroll tax of approximately $6,360. His $20,000 of expenses must be reduced by $2,400 (2% of $120,000), meaning his taxable income is $103,600 and his income tax is $35,224. His total tax is $41,584.
What are other considerations? Self-employed individuals can make larger deductible contributions to retirement plans and take deductions for health insurance premiums, but they must pay higher amounts for tax return preparation, are audited by the IRS at a rate of 5% compared to 1% for individuals, and should pay estimated taxes throughout the year. In contrast, employers often match employee retirement plan contributions and subsidize health insurance and other fringe benefits.
Although the decision whether to leave an employer to start your own business is based primarily on non-tax factors, it is important to consider the tax aspects as well.