He crafts his business proposals while sprawled on a mountaintop. She counsels her clients from the breezy comfort of her lakeside deck. They make scads of money and deduct everything, such as cars and computers, that wage slaves can’t.
They belong to the new glamor profession–the self-employed. Working for oneself has become the pet fantasy of millions of workers dismayed by glass ceilings, corporate layoffs and paper-thin annual raises.
But here’s the catch: Going solo can wreck you. Not because your business could fail–though it might. What most corporate evacuees cruising the aisles of office-supply stores don’t realize is that some of the biggest pitfalls involve their personal finances. You lose a bundle when you kiss your W-2 goodbye.
All those benefits you never think twice about as an employee are worth 40 percent of your salary, according to a study by Hewitt Associates, a benefits consultant in Lincolnshire, Ill. But you’d have to earn more than 140 percent of your former salary to buy them on your own because you won’t get the good deal that your company did.
“You get creamed. You are absolutely penalized for working for yourself,” says Shane Maxwell, a New York City free-lance editor and writer. Here are the booby traps and what you can do about them:
– The tax penalty. The first thing the Internal Revenue Service gives you when you open your business is a slap in the face. Specifically: 15.3 percent in Social Security and Medicare taxes. As an employee you pay only half that because your employer shoulders the other half. On your own, you owe it all.
The IRS does cut you a little slack. You only have to levy that 15.3 percent against 92.35 percent of your earnings, and you can take half of the tax amount as an adjustment on your personal return. But the bottom line is that an employee earning $50,000 a year would pay $3,825 in Social Security and Medicare taxes, while a sole proprietor with the same income would pay $6,076.
Business deductions are supposed to slash that bill. But writing off the biggest expense–your mortgage–is a mixed blessing. The rules on home-office deductions have tightened. And taking one “really increases your chance of being audited,” says Janice Johnson, a director at Coopers & Lybrand.
Other deductions are the first line of defense. “Self-employed people often overpay their taxes because they’re not aware of all the deductions,” says Gene Fairbrother, lead consultant for SOHO America, a Minneapolis association serving small-business owners.
First, move personal expenses into your business. If you have $50,000 of profit, your tax rate is 43.3 percent (15.3 percent in Social Security taxes plus 28 percent in income taxes). That means you can save 43.3 cents on every dollar of expenses you can legitimately shift to your company.
One key example is medical costs, described below. Other deductions–from advertising to office improvements–you may not know about are in the IRS’ free “Tax Guide for Small Businesses.” Call 800-829-3676 to order.
Also examine your company’s legal status. Sole proprietorships are a simple way to do business, but a C corporation or an S corporation can sometimes save you taxes. There’s no quick answer. Consult an accountant with your tax returns or financial statements in hand.
– Health insurance sinkhole. Small-business owners go ballistic trying to get individual coverage. Choices are limited and the waiting period before pre-existing conditions are covered typically stretches to 12 months.
The second battle is finding insurance at a decent price. Rebecca Hoffman, co-owner of a New York City information-research company, switched health plans four times over the last four years because each plan boosted its premiums by 40 percent after the first 12 months. “It’s been one of our highest-expense items,” she says.
There’s a little-known way for sole proprietors to take 100 percent of their medical costs as a business expense–not just premiums but also co-payments, dental bills, eye exams and prescription drugs. Here’s the key: You must legally and formally employ your spouse. Under Section 105 of the IRS code you can then create a medical-reimbursement plan that covers such employee expenses. AgriPlan/BizPlan, in Madison, Wis., will act as a third-party administrator of such plans for $175 per year. Call 800-298-2923.
The next best alternative is a group that offers coverage to its members. Compare plans offered by the Independent Business Alliance (IBA, 800-450-2422), the National Association for the Self-Employed (NASE, 800-232-6273) and trade groups. If you’re saddled with a pre-existing medical condition, ask your state’s department of insurance if insurers are required to cover you or if it has a high-risk pool you can join.
– Not-so-incidentals. Most people overlook these miscellaneous items, such as paid vacations, retirement plans, disability, liability and life insurance. But guess what: They constitute nearly half of an employee’s benefit package. Losing the matching dollars many companies fork over for a 401(k) plan will cost you 3 to 6 percent of your former salary. Losing paid vacations doesn’t begin to reflect the extra expenses associated with self-employment.
“You have to pay for all kinds of things you didn’t have to before. But nobody pays you when you’re billing or making copies,” says Janey Gubow, owner of JAG Entertainment, a New York City producer of special events.
Free yourself for moneymaking by dumping administrative tasks on a bookkeeper or software program. Home-based workers will have to dig to find disability insurance. Call IBA or NASE. Depending upon your profession, you may also need liability insurance. Homeowners’ policies usually won’t cover you for accidents involving your business.
