We operate on the assumption that if one person asks a question, there are probably others wondering who haven’t taken the time to ask. A question on calculating taxes was asked a few months ago via email. We realized recently that we should address it here.
I’m looking for clarification on the “taxes” category of overhead. If I understand correctly, my state taxes (we have a flat Commercial Activity Tax) and local taxes (Net Profits) should be included here. We don’t have any overhead-included employees nor do we buy anything pre-tax where we would pay sales tax later. We are structured as an LLC, so we don’t pay any taxes at the Federal level directly for the business.
So do we consider taxes on the owner’s salary in our calculations for overhead, or our own self-employment taxes (we both do on the job work and figure in an hourly wage, though we do not withhold payroll taxes for ourselves or classify ourselves as employees…), or do we not really worry about this since this is actually paid at the personal level? That is the only part I am not really clear on when trying to come up with an accurate overhead number. I feel like taxes on income are a significant amount in general, and I’m just not really sure how to account for it accurately. Or even if I should! I don’t want to inflate our costs improperly, but I don’t feel like I have a good system for making sure we set aside enough money throughout the year to pay our estimated taxes.
They’re correct that any taxes that are paid by the business need to be included in overhead when calculating your markup. An exception would be sales tax. If you collect sales tax from your clients and pay it to the state, that should be added to your final sales price and itemized as sales tax in your contract.
Draw a line between your business finances and your personal finances. The business pays its taxes. You pay your personal taxes from your salary. Your salary is included in your overhead as a pre-tax amount.
Let’s say you need $80,000 per year to pay your personal bills and set aside funds for savings and giving. Current tax brackets would put you in the 25 percent tax bracket (married filing jointly). Find the reciprocal by subtracting your tax bracket from 1; in this case, your reciprocal is .75. Divide $80,000 by .75, and you’ll get $106,667. Include $106,667 in your overhead expenses when you calculate your markup. With a salary of $106,667, you can pay 25 percent in taxes and still have $80,000 to live on.
This assumes, of course, that your projected sales volume can support that salary. The owner’s salary should be about eight percent of total sales, so If your salary needs are $80,000, you’ll need a sales volume of about $1 million. If you earn half of your salary by working on jobs, you’ll need a sales volume of about $500,000. If you can’t sell and build that in a year, adjust your salary accordingly because if you take more money out of your business than your sales can justify, your business won’t be around for long.
At the other end of the spectrum, if your business is able to make a profit on top of your eight percent salary (as you should if you’re pricing your jobs right), the profit your business makes will probably, depending on your legal structure, be considered personal taxable income, even if you choose to keep the profit in the business. If that’s what your business is facing, be grateful and start setting aside funds.
There are two ways to pay personal taxes. If your business has employees and you include yourself as an employee, you’ll be withholding taxes through the business. If you aren’t an official employee, or if the withholding isn’t enough to cover your projected tax liability, you need to make quarterly estimated tax payments on your own. Estimated tax payments might be needed because if you don’t pay enough income taxes throughout the year and end up with a large personal tax bill in April, you can also get hit with a penalty for not paying enough throughout the year.
To make these quarterly payments, set aside an appropriate percentage from every paycheck or draw from the business. Put it where it can’t be touched so you have the funds to make the payments. (This is done on the personal side.) Keep funds in reserve until you know what happens in April; if you’ve set aside too much money, consider it your tax refund.
Look at it this way: if you were employees of another business, your employer would be withholding and paying an adequate amount to cover your income tax. You wouldn’t have a choice; it happens whether you ask for it or not. Since you aren’t employees, you have to choose to set aside and pay those funds just like your employer would. Self-discipline instead of forced discipline.
In the past few weeks, we’ve dealt with an unusually high number of business owners who are in debt to the IRS. Some of them were surprised by the debt; they didn’t realize how high their tax bill would be when it was received. Others just let themselves get behind.
Taxes are the price you pay for being profitable. It’s a good thing when your business is in the black and you need to pay taxes on it. It’s not good when you’re taken by surprise.
The knowledge and experience Michael Stone gained in his 60+ years in construction has helped thousands of contractors improve their businesses and their lives. He is the author of the books Markup & Profit Revisited, Profitable Sales, and Estimating Construction Profitably, and is available for one-on-one consultations as needed.
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