Tax is a complicated subject. Taxes for the Reseller more so. One of the driving factors behind my interest in Reselling at this time is the complications that are thrown up by the ‘Hobby’ and how it stretches Tax Law to the limits very quickly. I’m going to try to tackle a few important topics here, though I’m sure there are more to explore in future posts.
- Pass through entities = YOU owe the tax, not the company.
- Money Out is not the taxable event = you can owe taxes even if you don’t ‘pay’ yourself.
- Inventory isn’t the answer to lowering taxes
- Estimated Taxes are just like Payroll deducted taxes (not the FICA part..)
Let’s start with the idea of remitting taxes. Most people start out with their employer remitting the tax for them in the form of payroll deductions. City, State, and Federal taxes can be due depending on your location. The amount you pay each month as a regular employee is dictated by what you tell your employer to withhold using form W4 when you are onboarding. When people have a life event, like getting married, or having a child, they often should look at submitting an updated W4 since they may have more dependants to claim, and therefore less taxes owed at year end.
If you don’t have your employer remit taxes for you via payroll, then you need to manually remit via the Estimated Tax system. This allows you to wire in cash to the relative agency (Federal, State, City). They want it on a (roughly) Quarterly basis in order to have access to your money sooner. If you get to the end of the year and you owe taxes due to underpayment, they may impose a penalty because you didn’t get the funds to them in the appropriate quarter. Additionally, if you have your employer remit the correct amount with regard to your salary, but you have a side gig, you’ll have to top it up via estimated taxes, or asking them to withhold more.
Safe Harbor rules appear frequently in the Tax Code. This is a great CYA for taxpayers. You can avoid penalty for underpayment if you follow these rules:
Adjusted Gross Income (AGI) under $150,000 will be protected by Safe Harbor if you pay:
- 90% of current tax year bill
- 100% of last years tax bill
Adjusted Gross Income (AGI) over $150,000 will be protected by Safe Harbor if you pay:
- 90% of current tax year bill
- 110% of last years tax bill
More on Safe Harbor can be found in Publication 17 here
The important part of this for the reseller is that if they aren’t sure on how much tax to pay, they can opt for the second line in each of the above, either 100% of last years taxes, or 110% if a higher earner. This removes the confusion and mystery of year end income, and how lucrative Q4 might be.
For those who quit their job mid year, it might be important to look at how much year to date (YTD) taxes were remitted by their former employer, deduct that from last year, and then use the difference as a roadmap for current year estimated tax payments, keeping them within the Safe Harbor, here’s an example:
Last year, Tony paid $12,000 in taxes. He quit in March to go all in on Amazon, YTD the employer withheld $3K. If Tony wants to be within Safe Harbor rules he needs to remit at least $12,000 over this year, so has a shortfall of $9,000. He can split this amount up over the estimated tax deadlines and meet safe harbor.
Note – Safe Harbor protects you against underpayment penalty, but you’ll still be liable for the additional tax, if any, and also note, that if you file an extension on your taxes, you still need to actually pay them even if you haven’t filed them….
Key Concept: YOU owe the money in a pass through company
If you own a LLC, or an S Corp, you are part of a Pass through entity. This means that the tax liability is at a personal level. Your company doesn’t owe or pay taxes, you do.
That sounds weird, but take it a step further. There is no concept of the ‘company’ keeping all the profit. It’s a pass through entity. This means that if your company earns $100K in income and you don’t do anything to reduce that income, you owe the taxes on that.
Inventory isn’t the answer
People often say things like:
I took nothing out of the company, I just buy more inventory and keep on selling.
Generally speaking, this will not protect you from taxes owed. Let’s look at Cost of Goods Sold (COGS) to learn more:
COGS = Beginning Inventory + Purchases – Ending Inventory
Let’s say you started with nothing, year 1. You buy $10,000 of Inventory and have $5,000 remaining. Your sales are $10,000.
- COGS = 0+$10,000-$5,000 therefore, COGS = $5,000
- Sales $10,000 – $5,000 = $5,000
That $5,000 is subject to tax, unless you can somehow deduct it, or defer it, away.
If you were facing that $5,000 liability, and thought to buy another $5,000 of Inventory, the COGS equation becomes:
- COGS = 0+$15,000-$10,000 therefore COGS = $5,000
- Sales = $10,000 – $5,000 = $5,000
The same result, though you have less cash with which to implement deferral or deduction strategies.
For the person who took nothing out of the company, but suddenly hit $1m in sales, they are going to have to calculate taxes owed based not on how much they paid themselves, but on Sales – COGS. Inventory on hand will not save them, in fact, it might be a real problem when a tax bill comes and all they have left are Playstations. Money OUT isn’t the taxable event, paying yourself isn’t the event, Sales are.
Safe Harbor is a very important rule to protect you from underpayment, and important for those who have less (or no) employer deductions for the current year. However, taxes are due in pass through companies regardless on whether you took money ‘out’ or paid yourself. A C Corp is treated differently, in that the taxes are due not on the owner, but on the Corp. They are due again when the money is taken ‘out’. But either way, taxes are due, so make sure that you keep enough out of Inventory to pay them, or to stop buying inventory and find other ways to deduct or defer taxes, such as Section 179 plans, deductible expenses, retirement plans, or other things.
There’s a lot more to this, such as accounting methods (Cash, Accrual, Hybrid) and other considerations, but for the average (or above average) reseller, be prepared to know what to do to your 2016 income to reduce your tax bill, buying more stuff won’t save you come tax time.