If I had a nickel for every time I have been asked this question, I would be sitting on an island under a palm tree with a little umbrella in my drink. After over 22 years of doing bookkeeping and tax preparation, this is still the number one question I get asked.
The answer is in two parts:
- What am I being taxed on?
- Where did the actual money go?
So what you ARE you being taxed on? Simply stated, it is the net profit of the business. The net profit is derived from the profit and loss statement of your business
The Profit and Loss Statement
| Income | $135,000.00 |
| Cost of Goods Sold | $60,000.00 |
| Gross Profit | $75,000.00 |
| Operating Expenses | $35,000.00 |
| Net Profit | $40,000.00 |
Income = The money you charged for you goods or services.
In this example it is $135,000.00
Cost of Goods Sold: What money it cost you to make the
goods/services you sold. ( $ 60,000.00)
The calculation is: Income – Cost of Goods Sold = GROSS PROFIT ($ 75,000.00)
Operating Expenses ($ 35,000.00)
These are the expenses directly related to the business.
The last calculation is: Gross Profit – Operating Expenses = NET PROFIT
| Income | $135,000.00 |
| Cost of Goods Sold | $60,000.00 |
| Gross Profit | $75,000.00 |
| Operating Expenses | $35,000.00 |
| Net Profit | $40,000.00 |
Here is where it gets tricky. Your idea of net profit and the IRS idea of net profit are most likely two different things. The Cost of Goods Sold and operating expenses must be actual and allowable.
Actual and Allowable Expenses
The problem that I most often see is what people see as Cost of Goods Sold, and especially Business Operating Expenses are not in line with actual allowable deductions.
For example, let’s say I’m in the manufacturing business and I make paper airplanes. I go to the store and purchase paper that I will put into the machine that folds it into the airplane that I sell. This is an actual Cost of Goods Sold. It is purchased to directly make the saleable product.
Now on the other hand, I have a home office and three awesome dogs. As much as my dogs may provide me with comfort and a sense of security, I cannot write off the dog food I just gave them as a business operating expense just because I label it “Security System”.
So it is important to have the actual Income, Cost of Goods Sold and Operating Expenses be both actual and allowable expenses. Whatever is left over is the net profit, and that is what is being taxed.
So Where DID the Money Go?
But at the end of the year the profit and loss statement says you have a net income of $40,000.00 but your check books says you have $ 550.00. So where did the money go?
Well, I can only assume that you did live somewhere and eat something during the course of the year. This money that you lived on is considered an owners draw. And contrary to popular belief, that is not a write off.
This is where the self employed persons make the biggest mistake I see. Most self employed persons do not understand, nor live by, what I call the Net Paycheck Principal. You must keep aside a portion of your income to pay taxes.
The Net Paycheck Principal
At some point in every self employed persons life, they have worked for someone else. Remember back when you worked for that guy you could not stand because everything was money, money, money. You punched a time clock and at the end of the week you got paid. But remember how you got paid:
Hours 40 @ 15.00/hr = $600.00 The is your gross paycheck. But did you get $600.00? No you got paid 472.21. Why, because all of your taxes were withheld and paid to the government for you by the employer. The pay after the taxes were taken out is your net paycheck.
As self employed persons we forget that when a check comes in for a completed job, part of that check belongs to the government. (I know that is painful, but it is the truth.) That part is our income tax and social security and medicare tax. It is our responsibility to pay Estimated Taxes into the government on a quarterly basis to estimate what we will owe and pay it into the government throughout the year.
Gross vs. Net Paycheck
So in our example our paper airplane manufacturer has tax to pay on $ 40,000.00, but has only $ 550.00 in the checking account. The problem, he cannot pay his estimated taxes. Why, because he lived on a gross paycheck rather than a net paycheck.
To be self employed and be successful, you must factor in the taxes to be paid as part of the overall cost of doing business…in other words, you must set aside a percentage of your net income and pay the taxes.
Disclaimer: The contents of this article are not meant to be tax advice, legal advice or personal therapy
-Lisa