Unlikely Partners:

Taxpayers and Uncle Sam

By Robert Johnson, CPA/PFS

The bad news gets more press than the good. So it goes with taxes. The classic line for tax season is “Bob, how much do I owe?” Uncle Sam is your partner so he wants his share.

The good news: Uncle Sam helps his taxpayer-partners save money. Let’s go through a quick primer on how tax rates, income and deductions work, then I’ll show you Uncle Sam’s good side.

How is Income Taxed?

All income less deductions is taxed through graduated rates. No mystery here. The more income you make, the more tax you pay. For married, the rates for 2005 are, in part:

$0 - $14,600 – 10%
$14,600 - $59,400 – 15%
$59,400 - $119,950 – 25%

If you’re a sole proprietor you’ll pay self-employment tax at 15.3% on the first $90,000 of net earnings from self employment.

Top Tax Rate

In 2005, for a sole proprietor with up to $59,400 of taxable business income, the top tax rate is 15% income tax and 15.3% self-employment tax or a total of 30.3%. As the sole proprietor moves to the next bracket his top tax rate for income tax jumps to 25% and the self employment tax stays constant at 15.3% for a total of 40.3%. If you live in a high tax state like Maine, add 8.5% for a total of 48.8%. This assumes you are not itemizing your deductions and not in the alternative minimum tax (AMT).

For each additional dollar of taxable business income from $59,400 to $97,456 our sole proprietor pays Uncle Sam 40.3 cents. Not so good. For each additional dollar of deduction from $59,400 to $97,456 our sole proprietor saves 40.3 cents. Much better.

Every taxpayer should know their top (sometimes called "marginal") tax rate.

How your business tax rate helps you manage your

business

Here are some examples that will help with the cash flow you can expect from additional income or the net cost of a deduction. State tax in not considered.

1. Deadbeat got you down?
You’re chasing a deadbeat account that owes you $10,000. You’re furious, but can’t get anywhere. How much cash do you keep after taxes are paid? Your top Federal tax rate is 40%. If you collect, you pay Uncle Sam 40% or $4,000, and keep $6,000. Was it worth all the sleepless nights and aggravation...or would time have been better spent with the customer that pays… or revamping your credit policy so it’s deadbeat proof?

2. How much does that computer really cost?
Improving productivity costs money, but not as much as you think. Let’s say you’re upgrading your computer system. You have made your business a commitment in time and estimate a $5,000 investment in hardware and software. What is the real cost? Our sole proprietor above will spend $5,000. Uncle Sam’s share is $2,000 (40%) in reduced taxes and the taxpayer’s share is $3,000 (60%). The net cost of the computer is therefore $3,000 – a good investment to improve efficiency.

The Bottom Line

Think of a tax deduction as always placing the item on sale with the discount your tax rate. But be sensible, this is not an excuse to “shop ‘til you drop.” Whatever the item or service - buy it only if you need it.