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**