Is Business Profit An Impossible Goal?

Every day people go into small businesses with the hope of making enough money to enjoy life, save for retirement, and gain financial security.  But one big barrier stops them from making enough money to achieve their goals – it’s called “payroll taxes.” otherwise known as Social Security and Medicare.

Joshua Kennon, who writes the Investing for Beginners GuideSite for About.com, says,

The single biggest threat for those who want to move from the lower or middle class to the “capitalist” class, as some academics have called it, is the payroll tax….[which] effectively serves as a barrier that makes it nearly impossible for the average American to accumulate wealth, especially if he or she is self-employed and forced to pay the entire 15.3% themselves.

A friend told me a story that illustrates this problem. She started her small catering business a couple of years ago and until this year she never had a profit.  This year, her CPA tells her, she will have a profit.  But she won’t see much of that money, because she will have to turn around and give it back in both income taxes and payroll taxes on the profits.  By “payroll taxes” I mean Social Security and Medicare, which business owners must pay at the rate of 15.3 percent on the profits of their businesses.  So if my friend has a $10,000 profit, she must pay income tax on that profit, plus $1530 in payroll tax.

You might say that’s good, because she is building up credits toward her retirement.  Sure, but if she had a capital gain of $10,000, she would not have had to pay the $1530 payroll tax on it.  (The short-term capital gains tax rate is the ordinary income tax rate; the long term capital gains tax rate is currently 15%.) If she had a profit of $10,000 on rental income, she would not have to pay payroll tax on it.  If she earned $10,000 as an employee, she only has to pay half (her employer must pay the other half.)

So how does a small business owner get ahead?  The only way to avoid payroll taxes is not to make a profit, or to shelter some of that profit in qualified benefit plans, like SEP IRA, 401k, or other plans. If your small business is going to make a profit this year for the first time, run, don’t walk, to a reputable financial planner and start talking to this person about what you can do to legitimately and legally get into a qualified plan.

Image: sxc.hu