Getting killed by the IRS taxes

The IRS is a lot like summer mosquitoes. You wish they were not there, yet they are, and nothing you can do about it. They will bother you, but they will not keep you from going outside.

One big difference is that, unlike mosquitoes, the IRS bites can be fatal. For your business, that is. But –

It will never happen to me!

I know. You’re responsible and honest. The problem is – it’s not about responsibility or honesty. It’s about timing and emergencies.

Imagine you’re a single professional on a $70k salary. Are you willing to write a $3,000 check every December for one year worth of gas? I doubt so. Yet, when you’re charging $60 once a week at the pump – it is the same $3,000 per year, it just does not feel that overwhelming.

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Now, how about writing a $15,000 check to the IRS every April? No way, right? Interestingly, you will have paid the IRS more than $15,000 each year from that $70k salary of yours! But you do not mind, since all this insane amount of taxes gets quietly deducted from your paychecks. So quietly that nobody seems to even notice. You do not miss the money that you never touched.

Once you start working for yourself, everything is different. There are no paychecks. Nobody takes money out for taxes. One year later, after you made the same $70,000 as you used to earn in salary, the IRS comes knocking on your door. They want their $15,000. In fact, since you’re now self-employed, they will want $20,000 rather than $15,000. It’s a long story, but self-employed do pay more taxes.

So, here you are, with a $20,000 IRS bill and no cash in the bank. Are you in trouble yet? Not yet. You call the IRS begging for help, and they graciously let you pay it off (with large penalties and interest, of course) over 6 years. $300 a month you can afford, it’s no biggie.

Before you know, the next year is over. You still have unpaid $17,000 balance from last year’s taxes, and now you have new $20,000 for this year. Do simple math: you’re now $37,000 in the hole. Should I tell you what will happen on the 3rd year of your business? I think you get the picture. And it ain’t pretty.

This is why there is only one way to stay in business: set aside money for the IRS every single month. Or, better, every single week. Yes, it will hurt, but it will not kill you. Waiting until the bump grows into a mountain is a slow but certain financial suicide.

How much should I set aside?

This is a great question. I wish I had a great answer. Unfortunately, there is no simple formula to figure out how much taxes will be due on your next $10,000 deal. It could be anywhere from the manageable $1,500 all the way to the ridiculous $4,000. In other words, between 15% and 40%. It depends on a lot of factors, and most of them are not in your control.

To add insult to injury: if your state have a state income tax, remember to add this to the IRS taxes.

Look again at my $70,000 example earlier. I said that it will cost you about $20,000 in taxes. Which is roughly 1/3 of the income. In other words, whatever you make in your business, should be split into one third and two thirds. You keep two thirds, and the remaining third belongs to Uncle Sam.

Set aside one-third of your business profits for taxes. Ideally, from each deal or every month.

How do I pay the IRS on a regular schedule?

Strangely, this is not as easy as it should be. The IRS wants you to make so-called estimated tax payments quarterly. By the way, if you think that “quarterly” means once every 3 month, you are wrong. Everywhere else, but not with the IRS. The IRS concept of quarterly is adhering to a weird schedule:

  • April 15
  • June 15
  • September 15
  • January 15

Don’t ask me why, I don’t know either. But the psychotic schedule is the small problem here. The big problem is that it still involves huge payments. In my $70,000 example, you would need to write $5,000 checks four times a year, including one in January, right after Christmas and right before the huge property tax bill. Ouch.

Writing $1,700 check every month would be much easier, kind of like another large mortgage. Unfortunately, there is not a simple system to do such payments, no IRS forms, and no automated system. I can suggest four different ways to arrange monthly payments to the IRS:

  1. This is the simplest but impractical method, because it requires a lot of discipline. You will simply set aside the monthly (or weekly) tax money in a saving account, and from that account draw money for the quarterly IRS payments. Of course, the trick is to avoid tapping into this money for emergencies like broken AC or having to make up to your wife after forgetting your anniversary.
  2. Enroll in the Federal online payment system called EFTPS. The setup and the system itself are fairly easy, however there is no automatic payment option. You will have to sign in every month and initiate each monthly payment. The good part is that you retain control over these payments. The bad part is that you retain control, because you will be forgetting and/or be tempted to skip payments. And then you’re back to square one.
  3. Set up an automatic monthly payment to the IRS via your bank’s online payment system. This makes things automatic and reliable – which is good. What is not so good is that you will be sending the IRS “random” checks, and once in a while you may have to deal with a check not received or not correctly credited to you. Very important gotcha: on each check sent to the IRS, you must include your Social Security number. If your bank system does not allow you to enter “memo” on the checks – then it will not work for you. Also, your checks must be written to “The United States Treasury”, as opposed to “IRS.”
  4. If your business is organized as an S-corporation, you need to set up a formal payroll system, issuing yourself regular paychecks, just like when working for another company. From these paychecks, you will need to do tax withholdings, and then deposit this money monthly with the IRS via the EFTPS system. If you have other employees, then you just add yourself to the payroll system already in place. Warning: contrary to the common misconception, you cannot have payroll checks to the owners from LLCs and partnerships, only from corporations.

Whatever you do, don’t do what most people choose: ignore the elephant in the room and regret it later.

Let Uncle Sam have your tax money voluntarily. Don’t wait until it becomes a fight, because you are not going to win that fight. If you don’t believe it, read my article about IRS collection powers. You will lose the fight and, more importantly, lose your business.

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