Why the Self-Employed Are STILL Smarter Than You

January 7, 2011
Self-employed, Self-determination, Incorporate, Save Taxes, Make Money

Self-employed, kind of. Also he blinked when we asked permission to use the photo

This is an updated version of a post that ran on LenPenzo.com 11 months ago. We’re thinking of doing something similar every Friday, the argument being that a) of our 3 weekly posts, you probably pay the least attention to the Friday one and b) everyone else recycles content once in a while, so why not us? As it stands you’re still getting over 2000 words of freshness weekly. More importantly, we actually edit our stuff. Those 2000+ words are polished to a keen sheen before you get to read them. Otherwise, we’d be like that one chick who cranks out 20 blog posts a week and opens them with insight like “Thanksgiving is a great time to reconnect with family.”

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Who pays a greater share of his income in taxes – Warren Buffett, or his driver? (Actually, Buffett’s so eccentric he probably drives himself. In a 1970 LTD with 8 million miles on it.) Still, posing the question implies its answer. Details below.

Politicians may tout the virtues of our “progressive” tax system, but it doesn’t really favor the poor over the rich.

Nor does it favor the rich over the poor, not when 40% of federal tax receipts come from 1% of the population. Fairly or otherwise, the tax system favors the diligent over the unprepared. (As most things in life, so maybe the system is fair.) Specifically, the system favors independent businesspeople over salaried workers.

This topic requires a book-length explanation (such as the groundbreaking and heretical Control Your Cash), but to summarize, starting your own business lets you enjoy tax advantages wage slaves only dream of. Take two people in the same field, making like incomes, living in the same city (which means their costs of living should be similar), only one owns his own business and the other works for someone else. It’s eminently possible that the latter person’s tax bill is 9 times the former’s.

Declare your independence today, if your career lets you make a horizontal shift to entrepreneurship. If you’re an anesthesiologist, you can’t rent out an office and put up a sign that reads “Mepivacaine Administered Here—Happy Hour 4–7.”  But if you’re an accountant, real estate agent, home inspector, software engineer, attorney* or in any kind of creative profession, you can take advantage of complex tax laws.

This isn’t the kind of entrepreneurship that requires you to open a physical storefront and spend years building a customer base. These are changes you can make now that will immediately impact your bottom line.

I tried to go as long as I could without using the first-person pronoun, but my story illustrates the point. 5 years ago I was working for a decently-sized advertising agency as a senior copywriter, making somewhat more than the nation’s per capita income. One day I ran the numbers and realized I could make more money going out on my own.

I collected most of my new clients, other ad agencies, via word-of-mouth. But most importantly, I took on the very agency I’d left as a client. And charged them about 30% more than they paid me as an employee. There are two components to that: 1) they were underpaying me to begin with, but had to cough up once I exercised my leverage and threatened to walk and B) the daily rate they paid me after the switch was just for the services I rendered – nothing else. It included no employee benefits, no capital expenditures for a workstation, no space reserved for me at the office Christmas party (thank God), no food/clothing/transportation allowance, no 6.2% Federal Insurance Contributions Act tax, no unemployment insurance premium. The responsibility for all that now fell on me.

Which is wonderful. It meant that instead of my former employer enjoying all the possible tax deductions from my labor, I got to take advantage of them. My taxes got a little more complicated – I now had to keep more detailed records, and file quarterly instead of annually – but the benefits grossly outweighed the costs.

It’s easy to get started, but also easy to make mistakes. You don’t want to be a single proprietor. You want to found an S Corporation, a legal entity that protects you from creditors who are forbidden from coming after certain classifications of income. An S Corporation lets you separate your money between salary and capital gains, the latter of which is taxed at a lower rate.

Find a company that specializes in entity formation. It’ll cost maybe $400-500 for them to register you with the relevant state’s Secretary of State office. You don’t have to register in your home state, either. If you live in California or New York, you don’t want to—those states’ laws don’t protect you enough from creditors. Register in Delaware or Nevada or, failing that, your home state.

Once you incorporate it starts forcing you to think like a businessman. Your income will now be tabulated on IRS 1099 forms, rather than those infamous W-2s. As a practical matter, once you incorporate you’ll pay (correction: your company will pay) you a salary. What’s a reasonable amount to cover your annual living expenses— maybe $24,000? Then that’s what Employee #1, you, will receive and pay taxes on. After deductions, your effective tax rate on the salary will be close to 0.

But what about the rest of your company’s income? Legally speaking, the rest of the revenue your S Corporation takes in is not salary, but shareholder dividends. Which are taxed at a lower rate than salaries are. And you can now deduct all sorts of business expenses before calculating the net shareholder dividends you’ll pay taxes on. Go to IRS.gov and check out Form 2106. Your employer fills one of these out every time you go on a business trip, or eat a meal on company time, or buy anything related to your job. Your employer, not you, then enjoys the tax deduction.

(As for Warren Buffett’s driver, he probably makes around $80,000 a year, which would put him in the 25% bracket. Almost all of Warren Buffett’s income is in capital gains, and the highest long-term capital gains rate in the U.S. is 5 percentage points lower than the assistant’s marginal tax rate.)

*Leeches, all of you. Thanks for making the tax code so damn complicated in the first place. If not you, then your ilk.

**This post was featured in Tax Carnival #79: Filing season begins**

Filed Under: Capitalism, Economics, Education, Entrepreneurship, Finance, Net Worth Tagged With: , , ,

Or Go Read Man Vs. Debt Instead

September 9, 2010

You're going to need one of these

Why can’t you be like other sites?

It’s the one complaint about Control Your Cash that we receive most often: where are the first-person stories about your struggles with income and debt?

1) There are several thousand other blogs that already memorized that riff and can play it by heart. We wouldn’t be bringing anything original to the party. Besides, this isn’t a place for self-indulgence. We don’t give a damn about the details of your finances*, and don’t expect you to care about ours. Or anyone else’s but your own.

We used to think that other people’s Facebook photos were the Ultima Thule of human boredom. But they’re captivating compared to hearing a personal finance blogger yammer about how he’ll now pay off his student loans 3 nanoseconds faster thanks to this handy new money-saving method he discovered for making your own duct tape. Also, the Sunday paper is full of coupons for your next grocery shopping trip.

2) No struggles to speak of.

Oh, does that sound condescending? Then would you feel inadequate if Danica Patrick told you she has no trouble negotiating traffic at 160 mph? How about if the chick from Evanescence said she could easily hit notes in the whistle register?

We’ve spent our adulthoods doing the prudent, common sense thing and seeing where it leads. So far, it’s working. At least more so than buying pet clothing and paying for tax refund anticipation loans might have.

You want commiseration? Start drinking or become a sex addict. Meetings in the church basement, Tuesdays at noon. No crosstalk, please.

Good. Now that we’ve got the children out of the room, join us for something worthwhile. Two things we try to do here:

-explain financial concepts that people presumably want to know about, or should, but don’t.
-show how not being financially idiotic can pay tangible rewards. And occasionally, show instances where you might think you’re doing the smart thing but aren’t.

If this sounds dictatorial, it isn’t. No more than your 3rd grade teacher was when she explained how multiplication works. Look, there’s no secret to gaining wealth. The mantra, again:

Buy assets, sell liabilities. Do this often enough, measure the results, and if you do nothing else you’ll get rich in spite of yourself.

Financial self-sufficiency is nowhere near as simple as “spend less than you earn”, but it’s not as complex as you think, either. That wedding you’ve been fantasizing about since you were a little girl? Unless it involves only you, the groom, a justice of the peace and a visit to IHOP afterwards, it’s a liability. Sell (i.e. don’t buy) it. The matching funds your employer offers for your 401(k), which will give you more tax-free income when you retire in exchange for a few seconds of incremental effort today? That’s an asset. Buy it.

Almost everything in your financial life fits into one category or the other – if not individually, then cumulatively. The bachelor’s degree in women’s studies is a liability. The interest-bearing student loan to pay for it is a meta-liability, and an obscene waste of money. The used DSLR camera that you can pick up from a highly rated eBay seller and is indistinguishable from a new one that’s twice as expensive? That might not be an asset by our definition, but the difference in their prices is. Buy the camera, assuming you’ll use it.

If you want patently obvious advice and feel-good pabulum, Google “personal finance blog” and you’ll find it. If you want to be challenged and inspired, stay here. Read the archives. And let us teach you how as much as you’re willing to digest about how money works (and how it doesn’t.)

*Dang. That should have been the subtitle for the book.

**This post is featured in the Carnival of Wealth #5**

Filed Under: Bad Examples, Consumer Debt, Education, Making Smart Choices, Personal Finance Tagged With: , , , ,

Meet your new role model, Part III of III

September 2, 2010

Believed to be negotiating with Brandon. 12 rounds, food money

This is the last installment in our series on Brandon, the $32,000-a-year tycoon who’s the new favorite to be Control Your Cash 2010 Man of the Year. Read the previous couple of posts to find out how he pays his car loans off early, lives in a decent home with positive cash flow, and spends strategically to get the most out of life (which, last we checked, still requires money.) Today, Brandon explains just how he receives that money and what he does with it.

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In sum, I take advantage of cost-savings overlaps, and try to kill a few birds with one stone.  I’ve discovered that I don’t need to buy to be happy. I have never taken advantage of charity, welfare, food stamps, etc. despite being qualified a few times. I never needed them, even when I was 21 and lived out of my car for 6 months.  I was raised middle class (slightly lower to start, then solid middle, slightly upper middle the last bit.) My mother and stepfather were frugal. I never wanted, but they didn’t overspend.  My mom used to talk about how she used to go out with friends and sip a Diet Coke the entire night, and that would be her only expense.* My parents are solidly upper-middle class now, perhaps upper here in the Midwest. Their financial help comes mainly in the form of hand-me-downs, but more recently a new bedroom set and couch when I bought my house (I didn’t need them, but it was nice), and the recent minor vacation stuff.

My mortgage rate is 5¾%. I bought at the worst possible moment in the last 2 years. It goes down to ~4.32% with the credit, although it’s a bit higher due to the delay in receiving the credit. I pencil it in as 4.4%.

I have a Sears credit card, for the credit limit and the very rare Craftsman lifetime warranty tool coupons and sales. I also have a Citi Driver’s Edge card, which Citi no longer offers, but it refunds 3% on gas, groceries and drugs, 1% on everything else, and 1¢/mile on my car).

I’d like to add 2 more cards, for what that’ll do to my FICO score and to avoid having all my eggs in one basket.  One of the likely candidates is a Pentagon Federal Credit Union Promise card, which carries no fees and is useful for foreign travel. I’m also looking for a 2% cash back card. Charles Schwab offered one, then rescinded the offer in April. Fidelity offers one, but I don’t like the way they set it up. Then there’s PerkStreet, which requires me to keep $5000 in my current account. I don’t care for the American Express Blue Cash** structure, so I’m waiting for something else: maybe a rewards card if I do more traveling, e.g. a Starwood American Express.

As for my investments, I’m a fan of Harry Browne and the Permanent Portfolio.

STOP.

Harry Browne (1933-2006) was an investment analyst and the Libertarian candidate for president in 1996 and 2000 (in other words, our kind of guy.) His brainchild, the Permanent Portfolio, involves putting equal amounts of your money in:

I.  an index fund
II. the longest T-bonds you can find, or AAA corporate bonds
III. gold
IV. cash (or its equivalent, short-term T-bills)

Ignore for 3 months. Then, if any class over- or underperformed by 10%, redistribute to maintain the balance.

CONTINUE.

I’m with Vanguard, but they charge a lot to buy bonds and non-Vanguard exchange-traded funds, so I’m looking at Wells Fargo. I have $4k in my Indiana Public Employees Retirement Fund account and $14k in my Roth IRA.  That’s allocated as:

I.  70% Standard & Poor’s 500 index fund
15% small cap value fund
15% emerging markets fund

II. 70% special stable income fund in state plan
30% Vanguard Extended Duration Treasury Exchange-Traded fund.

(Ed. Note: That latter item tracks the value of the Barclays Capital U.S. Treasury STRIPS 20-30 Year Equal Par Bond index. That fund invests >80% of its assets in U.S. Treasury securities held in the index. The fund weighs the maturity of each dollar, and tries to keep pace with the index, which usually means maturities of 20-30 years.

U.S. Treasury STRIPS [Separate Trading of Registered Interest and Principal Securities] are notes, bonds and inflation-protected securities whose interest and principal portions have been separated [“stripped”.] STRIPS work like bonds, selling at a discount and then maturing at face value. They’re formed by investment banks and brokerage firms, rather than sold by the Treasury.)

III. 80% iShares commodity exchange gold trust, which lets you trade gold throughout the day and not have to take physical possession of it.
20% physical.

My cash reserve is the IV leg.  I think we’ll see deflation for the next few years, maybe longer.***

Finally, between my roommate and work, I collect enough cans to pay the utilities. With regard to taxes, I haven’t looked into how to minimize my return, but considering I collect the rent and foreclosure income without having taxes taken out, I have a virtual head start on doing so.

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*The Control Your Cash authors always do this, despite not having to. Enriching taverns ≠ Controlling Your Cash.

**Even though Blue Cash only refunds you annually, Control Your Cash: Making Money Make Sense recommends it. At press time, Blue Cash gave you ½% cash back on the first $6500 you spent, 1½% beyond that.

But that was then. Today, that 1½% is 1¼%. Blue Cash does give 5% back on groceries and gasoline, which might only sway you if you categorize your spending to mesh with your card rewards. But groceries and gasoline are reasonably constant expenses for most of us.

Still, this brings up a worthwhile tangent. Would we still recommend Blue Cash?
Discover gives 1% back, in $50 increments. You’d have to spend $19,500 before Blue Cash gives you more cash back than Discover does. That could take well over a year, which is how long it takes Blue Cash to cut you a check anyway.

If that doesn’t give you a satisfactory answer, the next criterion should be convenience. (Notice we’re not even looking at interest rates. They don’t matter.) More American merchants accept Discover than American Express, but around the world, a Discover card is largely useless.

Ready for a little disclosure? Your blogger has an American Express Hilton Honors card, because a) there’s no annual fee and b) he stays in Hampton Inns a few times a month anyway. Which means I’m getting rewarded without changing my behavior to accommodate the card. (Lots of people do it the other way around.) In other words, if American Express offered a Celibacy Card or an US Weekly Subscriber’s Card, I wouldn’t be interested.

***Not sure if he’s right. Deflation is easy for the Fed to negate – just put more money in circulation. Inflation is harder to negate. And, of course, it’s open-ended. Practically speaking, deflation is limited to a few percentage points. Inflation can visit the exosphere.

Filed Under: Investments, Making Smart Choices, Net Worth, Role Model Tagged With: , , ,
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