OUR ULTIMATE TAX GUIDE FOR CREATIVE SMALL BUSINESS OWNERS
Most of this blog post comes from the book Unf*ck Your Biz.
Consider this blog your crash course on taxes for creative and online-based business owners. Much of it follows the frameworks from our tax for beginners course, The Tax Toolbox and the chapter on tax from my book, Unf*ck Your Biz.
TYPES OF TAXES
Taxes generally fall into one of two categories: income taxes and consumption taxes. Governments collect income taxes on our income. The tax amount is tied to how much we earn and make. Consumption taxes are tied to what we buy. There are many subcategories of tax, but most fall into one of those primary categories. Income tax is made up of three specific subtaxes: federal income tax, self-employment tax, and state income tax.
When I refer to income taxes generally, I’m referring to federal income tax, self-employment tax, and state income tax collectively. That’s one broad category separate and apart from sales taxes. Whenever you read/listen/ask about taxes, be clear and ask yourself “are we talking about income or sales tax here?”
Income Taxes
Here’s what we really need to know about income taxes.
We file our income tax returns each spring. They’re typically due by April 15th.
We gotta do bookkeeping to file our taxes.
The IRS (and many states) require that we pre-pay our tax balance on a quarterly basis.
We discuss each of these more below with links to other, more specific, posts. Meanwhile, Let’s talk about how our taxes are actually calculated because it’s something I think we all need to know.
First, we have to find our taxable income. In my book, we work through this formula to learn how to do that:
NET BIZ INCOME + ALL OTHER INCOME = TOTAL INCOME
TOTAL INCOME – ADJUSTMENTS = ADJUSTED GROSS INCOME (AGI)
AGI – STANDARD DEDUCTION = TAXABLE INCOME
Here, I just want you to know and understand that your tax isn’t calculated on your full income. You get to reduce your income by some tax benefits. The result is your taxable income. From there, we apply the tax brackets.
Here’s some example brackets (note the dollar amounts change each year).
Assume you make $85,526. Check the single bracket to find that.
The income spills over into the 24% tax bracket by $1 right? Many taxpayers believe that last $1 is really screwing them over, and they’d give it back if they could. These taxpayers believe that one extra dollar makes all their income subject to a 24% tax. Thus, the extra dollar actually makes them lose more money than the extra dollar gave them.
But that’s not how this works. Imagine each tax bracket as a bucket. Visually picture a row of buckets side-by-side. Rather than send you a paycheck, imagine your boss, clients, or whoever is paying you, walks up to these buckets and drops in cash. New client. Yay! Here’s my bank address. Drive on over and fill up my money buckets. Sounds strange, but stay with me.
Your new client drives over. She pays you $9,877, which happens to be $1 more than the lowest tax bracket. She puts $9,876 cash in bucket #1, and drops the last dollar in bucket #2.
A couple days later, your second client comes along and drops more money into bucket #2. You have all your clients do the same until bucket two fills. You now have $40,125 in cash. Clients start tossing money in bucket #3. And on and on we go. You get the picture.
Come tax season, each bucket is taxed at its own rate. Uncle Sam shows up at a designated bucket/money-gathering location and asks for his taxes.
He says, “Give me:
10% of the $9,876 in Bucket #1, which is $987,
12% of the $30,249 in Bucket #2, which is $3,630,
22% of the $45,400 in Bucket #3, which is $9,989, and
24% of the $77,775 in Bucket #4, which is $18,665.”
Pretty cool right? Different dollars are subject to different tax rates. We can average the amount we pay to find our effect tax rate.
For example, assume you have total income of $100,000 and taxable income of $80,000. You are in the 22% tax bracket. But let’s say, for easy math, that your federal income tax is $14,000. That’s an effective tax rate of 17.5%.
You owe, self-employment tax of $5,000 and state income tax of $1,000, so that’s $20,000 total income tax.
$20,000 is 25% of $80,000. We’d say your total effective tax rate is 25%. I’d then have you set aside 25% of all business income for taxes (not including sales tax). The math is pain, but see how easy it would be once you figure that out?
That’s the gist of how the IRS determines how much in tax you owe.
Sales Taxes
“Am I subject to sales tax?” That’s the magic question. Sales tax is quite complex and varies by state. Our goal here is for you to know where to look and how to discover what your obligations are.
The golden rule of sales tax is to never, ever spend money collected for sales taxes. That’s tax fraud. We don’t want to commit tax fraud. Tax fraud is a no-no.
Ideally, I could give you a simple rule for when to collect sales tax. Unfortunately, it’s not that easy. There is no federal sales tax, which means there are no rules that apply to everyone. Instead, we must look at general principles across the states and ask ourselves, “Do we owe sales tax in this state, and do we need to collect it?” The short answer is we need to worry about sales tax in a state when we have nexus with that state, but what the hell does that mean?
When is there Nexus
In law, we have a fun concept called nexus. Nexus can most easily be defined as a connection between two things. Under sales tax laws, there must be a nexus between your business and a state for you to be subject to sales tax in that state.
PHYSICAL PRESENCE NEXUS
Physical presence is the most obvious form of nexus. If you live, work, and do all the things in the state of Illinois, you have a nexus with Illinois. In most states, you would also have a nexus if you have an office or employees in the state or where you have a “regular presence” in the state.
ECONOMIC NEXUS
In 2018 with the South Dakota v. Wayfair case, the nexus rules expanded. Under the new rules, a business may have an economic nexus with a state, and be subject to sales tax, if they surpass certain sales thresholds. For most states, that threshold is $100,000 in sales or 200 total transactions in the state within a given year. In our program, Unf*ck Your Biz, we have a state-by-state guide with the nexus thresholds for each state. You’ll want to do your own research. Give it a Google if needed.
If you can confidently say you meet neither of these thresholds, you can disregard economic nexus and focus solely on physical presence. If you are above those thresholds, you will want to further research the rules in that state.
On What Do We Owe Tax?
Your first question is Do I have a nexus? Yes or no? If no, we no longer care about that state’s remaining rules. If yes, we gotta ask, “Okay, on what types of sales does this state collect sales tax?”
We can broadly sort each type of sale into one of three categories: tangible personal property, digital goods, and services.
In short, tangible personal property is any type of physical good other than real estate. Digital goods are items like ebooks and photographs. And we all probably get what a service is.
Do your due diligence to find the rules in any state in which you have nexus.
If you are subject to sales tax…
You need to collect the tax, file sales tax returns, and pay the tax.
Filing Frequency
Some states require annual filings, some monthly, and some quarterly. Check your state’s rules. Some are based on volume. In California, we have all three frequencies, but the vast majority of creative entrepreneurs file quarterly.
Sales Tax Returns
Sales tax returns are generally much shorter and simpler than income tax returns. I have talked to business owners who say it takes about 30 minutes per quarter with good processes. If you already have an accountant, ask if they offer sales tax return services.
We’ve got more posts
Want to learn more about sales tax? We got posts on that coming soon.
WANT UPDATES ON TAX DEADLINES?
Not everyone can have a lawyer and tax pro in their back pocket. Although we make that pretty doable with our monthly service.
We offer peace of mind in our monthly Newsletter where we send monthly legal updates, tax deadlines, and helpful guides and checklists when helpful.
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YOUR GENERAL REQUIREMENTS
Whew, ok bestie. You should now have a good understanding of income taxes versus sales tax. Let’s talk about your general requirements. Like, what do you actually HAVE to do?
Bookkeeping - you have to know how much money you made and spend to really do anything
Annual federal and state income tax returns - these are the things we do that are due in April each year
Sales tax returns and payments - we discussed those above. Remember they’re different from income tax stuff.
Quarterly tax payments - in addition to filing our income tax returns annually, we’re generally also supposed to make our income tax payments on a quarterly basis.
I break down the bookkeeping basics here.
But to learn more about the quarterly taxes, give this blog post a read.
Bookkeeping 101
We do bookkeeping for two reasons.
First, properly accounting for income and expenses in the correct accounts helps us file our taxes more easily. If we match our accounts to the categories on the tax forms, it's as easy as taking the total for that account and reporting it to the same category on the tax return. Also, if you get audited, you have to prove, or “substantiate,” your deductions. Bookkeeping is one way to do that. More on this substantiation BS later.
Second, our bookkeeping gives us key financial insights. Without solid data points, you may as well consult a Magic Eight Ball when making decisions. Our profit and loss statement (P&L for short) is where we gather this financial information.
The Profit & Loss
A profit and loss statement (P&L) is created by and for your company. It’s typically not submitted anywhere. The P&L shows a snapshot of income, expenses, and profit. Let’s take a look.
At the top we have total business income, which we call revenue.
Next, we have cost of goods. Cost of goods is a business expense that is part of the end product. My friend Lauren runs a successful Etsy shop for which she creates wreaths for various holidays. All the craft stuff she buys to go into the wreaths are costs of goods. However, the scissors she needs are not a cost of goods. They don’t become part of the end product. The scissors are a supply.
Perhaps a simpler example would be a bakery. Picture a cupcake. All the ingredients that go into the cupcake are costs of goods. If I’m eating it, it was a cost of goods to the baker.
The majority of service providers will not have costs of goods but for small exceptions. On my website, I sell a physical copy of this book. The book costs roughly $12 to print. That is my cost of goods. The book sales are a small portion of my revenue pie (less than 2% of my total revenue), but I still must track my cost of goods.
Gross profit is revenue minus cost of goods sold. Gross profit is an essential number to stay on top of if you’re in a primarily product based business. However, if you have $0 in cost of goods, your gross profit is the same as your revenue.
Next on the P&L come the expenses. Expenses are most of the things we can deduct other than the cost of goods. There are a few expenses we don’t include on the P&L because they are part-personal/part-business expenses. I call these hybrid expenses. Generally, these include your cell phone, internet, other utilities, rent, and home expenses if you have a home office, and use of your car. We should pay for these from our personal bank account and account for them separately from what I call our fully deductible business expenses.
Gross profit minus these fully deductible expenses equals our profit, also called net income. We could stop there, but I add a couple extra lines. Take a look.
In an S Corp, owners put themselves on payroll and get a check just like they would if they were an employee of any other company. Those checks, the owner’s salary, are a business deduction. The owner gets a W-2 to report the income, and the business deducts the payments as an expense. Don’t you worry: I explain this in detail later. For now, try to focus on why this irritates me from a consistency perspective.
I might talk to three business owners who each have revenue of $100,000 and expenses of $30,000, aside from the owner’s salary. Business owners B and C each take a $50,000 salary through payroll.
Business owner A says their profit is $70,000, which is the revenue minus the expenses.
Business owner B says their profit is $70,000, which is the revenue minus the expenses even though they took a $50,000 salary.
Business owner C says their profit is $20,000, which is the revenue minus the expenses and salary.
Can you see how all three have essentially the same profitability with $100K revenue and $30K expenses? Business owners B and C are actually identical, but they’re calling profit two different things.
My extra lines are the P&L are designed to give us uniform language and fix this issue. We don’t include the owner’s salary with the rest of our expenses. And note that when I say “salary,” I always mean salary run through payroll subject to tax withholdings. If you are simply transferring money from one bank to another on your own, that’s not salary. I’ll call that type of payment owner payments or distributions.
The “owner’s profit” is the profit before deducting salary. We then have the owner’s salary expense. Owner’s profit minus owner’s salary is business profit. If you don’t run payroll, your owner profit and business profit would be the same because salary would be $0.
Here’s the breakdown using my method:
Using the example above, we could say that business owners A, B, and C each have owner’s profit of $70,000. Business owner A also has business profit of $70,000 because he doesn’t take a salary. Business owners B and C each have business profit of $30,000. We need to know these different profit numbers for tax purposes, but we can see by the owner’s profit that each business is essentially in the same financial position.
Here’s a simple example of why knowing these numbers are useful. If you apply for a car loan, the lender needs to know your income. If you don’t get a W-2, you show your profit from a tax return. That’s all they need. But, you should know your take-home pay as well as your monthly expenses. Your owner profit gives you a better indicator of what you can actually afford.
This distinction should make even more sense later when we discuss how owner profit and business profit is taxed in different business structures. If you are not on payroll, I’ll also share how you can treat your owner’s payments like owner’s salary to structure your P&L similarly to someone who is on payroll.
Chart of Accounts
Think of each section on the P&L like an accordion. If you could click on it, there would be a dropdown of categories. Maybe you click on those categories and it accordions into subcategories. We call each category an account. Your chart of accounts is your list of accounts.
Earlier, I shared the two primary reasons we do bookkeeping: tax compliance and financial analysis. You want to organize your income and expenses into accounts, or categories, in a manner that assists these two functions.
Think about Monica’s towel categories from Friends:
Guest
Fancy guest
Personal
Fancy personal
Decorative bathroom
Parents or very special guests
Cleaning
Kitchen
Decorative kitchen
Specifically for hair
Specifically for male “guests”
If Monica only had one guest towel, why not just move that to “cleaning” and only have “fancy guest” guest towels? One towel does not a category make.
Here’s perhaps a more practical example. In my own chart of accounts, I track three different “team” related categories. I can view them together and separately, which is very useful information.
And yes, that’s a real life screenshot of my bookkeeping. And you can actually access my books in real time if you want to get a real-life view.
Bookkeeping Requirements
The IRS website tells us, “You may choose any recordkeeping system suited to your business that clearly shows your income and expenses. . . . This summary is ordinarily made in your business books. . . . Your books must show your gross income, as well as your deductions and credits. For most small businesses, the business checking account is the main source for entries in the business books."
The most common way small business owners meet these rules is by using a program like Quickbooks, using a simple spreadsheet, or hiring a bookkeeper.
Which System is right for You?
You can use any recording keeping system, as long as it provides a summary of your business transactions.
You don’t need a fancy program, nor do you have to spend money. You could use a notebook and paper if you want. (I’m not recommending that to anyone.) Instead, the simplest option would be to use a spreadsheet. This is your minimum viable strategy. One caveat to this is that certain business entities require more specifics. Partnership agreements and operating agreements usually specify details on bookkeeping, and you must meet certain requirements should you ever wish to issue stock in your business.
A spreadsheet works great if you have fewer than maybe fifty-ish transactions to classify per month. This would look like maybe ten client payments and forty expense charges. This should only take about ten to fifteen minutes per month to track. This system works well when you only have a few clients and are without a lot of expenses.
You can find great programs for less than $30 per month. So why not always go with a software? I have seen several business owners sign up for the programs, sync their bank account, and let it roll with no oversight. Transactions get misclassified, and by the following tax year, the whole account is a mess. It costs as much to have a professional untangle the mess as it would have been to have them do all the books from the start. This is why I suggest either committing to learning the program of your choice and checking in on it each week, or using a more manual system, like the spreadsheet.
Those are your two DIY options: spreadsheets and bookkeeping softwares. You can also hire this shit out. There are lots of reasons to hire out bookkeeping. You can find many books about staying in your zone of genius and hiring out the remaining tasks in your business. You can also find books that put a large emphasis on cash flow, budgeting, and reducing expenses. We want to balance these two considerations.
Show Me the Receipts
Must you have receipts for every deduction? That’s the key question. The answer: kind of. It depends. Maybe.
Helpful, yeah? Really, the more documentation you have, the better. You want to save everything and keep it organized.
If you’re not there yet, don’t sweat it too much. There is some flexibility. The IRS is strict with a few specific small business deductions, including travel costs, meals, and vehicle mileage. The IRS requires that we document these expenses at the time they occur. That means logging the miles or saving the receipts.
For meals, keep your receipts and note on the back the date and the purpose of the meeting. Recently I had my brand photos taken and the photographer and I had lunch after. On the back of the receipt, I wrote: “2/5/23, Lunch with brand photographer to discuss shot list.”
If you’re ever audited, you must do your best to substantiate your deductions. This means providing some sort of logical explanation for the deductions. Sometimes bank statements may suffice. For other deductions, like those noted above, they won’t.
We have a tendency to overcomplicate things when we may not need to. Ultimately, you want to find a system that works for you. Here are some tips to get started:
Keep your receipts, particularly for travel and meals. Get one of those nice file folders to organize them in or keep an envelope in your bag. If you don’t want to deal with the paper, store your receipts electronically. Most bookkeeping programs allow you to save photos. There are also some phone apps specifically created for maintaining receipts.
Save your electronic invoices. Anytime you buy something online and get an email confirmation of purchase, save that email in a tax or receipts folder. At the close of the year, export them and upload them to a Google Drive folder.
Use MileIQ or a similar program to easily log your miles. Quickbooks has a mileage tracker, which is fabulous if you’re already using the program.
Setup Your Books
Telling you how to do bookkeeping is a challenge. It’s much easier to show you. In our signature program, Unf*ck Your Biz, we teach bookkeeping setup through Quickbooks and with a spreadsheet. However, if you’re not ready to join us in the program, I highly recommend starting with the Bookkeeping Blueprint.
WANT UPDATES ON TAX DEADLINES?
Not everyone can have a lawyer and tax pro in their back pocket. Although we make that pretty doable with our monthly service.
We offer peace of mind in our monthly Newsletter where we send monthly legal updates, tax deadlines, and helpful guides and checklists when helpful.
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How to Estimate Your Quarterly Taxes
Once we become self-employed, we have to take care of our own taxes. Through helping small business owners, I have found there’s a bit of a disconnect once entrepreneurs go out on their own. When taxes are automatically taken out, we may not really have an appreciation for how much tax we owe, and how the whole system works.
How taxes are calculated
Here’s a short breakdown:
First, we have to consider federal income taxes. Here’s the simplest way I can explain how we calculate federal income tax. I’ll leave some info out to streamline it.
figure your net business income (income minus deductible expenses)
Add any other income (income from another job, spouses jobs, stock sales, rental income etc.)
Subtract the federally allowed standard deduction
Then, use the above tax brackets to calculate your tax.
State income tax is pretty much calculated the same. The difference is that the tax rates across the board tend to be much lower. Usually, most of the brackets are under 10%. Some states have no income tax.
Collectively, we call the tax on Medicare and Social Security “self-employment tax,” and I call it SE tax for short. The tax is a flat 15.3% up to around $128,000 and 2.9% thereafter.
Alrighty, Let's Look at an Example
Penny the Photographer made $80,000. She paid second shooters $10,000 and had other deductible expenses of $25,000. Penny also made $3,000 on sales of stock. Check out the below graphic for the example calculation of the three types of tax. Please note that I likely used older brackets for this math.
A Few Notes
So the first thing I want to call your attention to is the federal tax owed. The tax amount is $4,130 on $36,000. If you look at the above bracket, you'll see that this taxpayer falls into the higher end of the 12% tax bracket, but when we calculate the tax, it's actually 11.5% of the taxable income after you apply the bracket properly. Us tax pros call this the "effective tax rate." If we assumed our tax payer had taxable income of $39,000, she would fall in the 22% bracket but still have an effective tax rate of around 12%.
The second item I want to note is the amount of state income tax. California is one of the highest tax states, and you'll notice that the tax owed is about 1/4 of the federal tax. This is why I tell clients to set aside a specific amount of money and then pay 80% to federal and 20% to the state.
Lastly, I want to point out the amount of self-employment tax. It's calculated on net business income, and it's a flat rate of 15.3%. This is important for two reasons. First, you don't get the standard deduction to reduce taxable income. Second, the tax rate is not graduated on a bracket. The first dollar is taxed at 15.3% just like the last. I point this out because I'll often file returns for clients who have business profit of around $10,000. After they take the standard deduction, they're taxable income is $0, so they owe no income tax, but self-employment tax is $1,500.
Calculating Your Quarterly Tax
Ok, so now that you know how taxes are calculated, explaining how we're supposed to pay quarterly taxes will be easy(ish).
What the taxing authorities want us to do is estimate our tax for the year, divide it by 4, and then pay that amount in equal installments. Using the table example above, Penny owed $4,130 in federal income tax and $6,885 in self-employment. Both of those taxes go to the IRS, so we can lump them together for a total of $10,988. If we divide that in four, we get $2,747, so Penny should pay that amount each quarter. The same, typically, works for the state.
Finding Your "Savings Percentage"
It's easy peasy (kind of). First, you figure out what percentage of all your business income you need to set aside. Then, you actually set it aside. Take that pool of money, and pay it towards your quarterly taxes on each due date.
Here's how I recommend doing it. Find your total tax for the prior year and then divide that by your GROSS income to find your "savings percentage." Let's look back at Penny. If we add up her three tax amounts the total is $12,045. Her gross income was $83,000 which was her business income before expenses plus her other income (the stock sales). This comes out to a total of 14.5%.
In short, she owed 14.5% tax on her total income. If Penny hopes to make more this year, she can extrapolate and save more.
Therefore, if we assume that Penny's income and expenses will be relatively similar this year, she needs to set aside 14.5% of all of her business income to cover her taxes.
Curious to get a rough guideline of how to actually save the taxes? Checkout the Roadmap download above.
For more info on how to save and pay the tax, check out this blog.
But, Do You HAVE to Pay Quarterly Taxes?
None of us HAVE to pay quarterly taxes, but there is a good chance you may be penalized for not paying them. Here's the actual rule:
If you expect to owe at least $1,000 in tax for the taxable year; and you expect your withholding and refundable credits to be less than the smaller of either 90% of the tax to be shown on your return; or 100% of the tax shown on your prior return (when the prior return covered the whole year).
Take a look at the following example to demonstrate this framework.
Greg, in his second year of business, makes $25,000 from his part-time garage business. He also gets a salary for his full-time job. He owes tax of $10,000 on his total income. Greg has $7,000 withheld from his paycheck for his full-time job. In his first year of business, he owed $8,000. Apply the first part of the rule. Does Greg owe at least $1,000 in tax? Yes. He owes $10,000. Now apply the second rule, which has two parts. Part I: find out what 90% of your tax due would be? Here, Greg’s tax due is $10,000. 90% of that would be $9,000. Part II: find what the total tax due for the prior year was. Here, Greg’s tax due in the prior year was $8,000. The lessor of those two parts is $8,000. Now, we ask whether the amount withheld was less than $8,000. Greg had $7,000 withheld, which is less than $8,000. He must make quarterly tax payments.
If Greg had $8,000 withheld, he would not be required to pay quarterly tax, but it would still be advisable for him to set aside the appropriate percentage of his income to eventually pay the tax.
Let's Talk Penalties
The IRS penalty for late payment is 0.5% per month the payment is late. If you owe $4,000 per quarter and don't make any quarterly payments, the penalty total comes out to around $600 on $16,000 of tax. In other words the penalty is equal to about 3.75% of the tax owed.
I always advise that you definitely want to make quarterly payment, but don't get into credit card debt doing it. Penalties are never ideal but they tend to be quite a bit lower then most other forms of interest, so don't stress out if you're feeling behind.
My Top Tip
Even if you won't be penalized, it's always a good idea to pay your quarterlies. My advice is always this: "You need to save for your tax bill if you if you don't have to pay it in installments on a quarterly basis. If you have to save it, you might as well pay it."
Also, no one wants to file taxes and get a $12,000 tax bill.
The How To…
If you want to know how and where to go to pay the tax, I’ve made the simplest resource for you. It’s $10, and it’s called the Quarterly Quickie.
Get the Quarterly Quickie
I WROTE A WHOLE-ASS BOOK, AND
I never thought people would be jazzed about reading a book on law in tax, but the reviews are in! And most read something like "I read this whole book, and I didn't hate it, and now I know stuff.
But for real, it walks you through my full "Unf*ck Your Biz Framework" - something I created for my first course, which was $2,000 and saw over 70 graduates - and is like the A to Z guide to get you started.
UNF*CK YOUR BIZ, THE BOOK -
UNF*CK YOUR BIZ, THE BOOK -
“I never thought I would say I enjoyed reading a book on taxes, but I definitely did. Braden’s wit and spunk made this, often times, traumatic topic of taxes, actually really fun and enjoyable. He put into perspective the proper ways of filing your taxes, as well as covering if you should become an LLC, S Corp or sole proprietor, for small business owners. It was jam packed with knowledge and key tips that I have already put into effect in my own business! I’m so thankful that Braden has decided to share his knowledge and help us small business owners. Highly, highly recommend reading this book and getting your legal stuff figured out!”
- Kelsey, Owner of Kelsey Rae Designs
