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No matter what type of business owner you are—from freelancer to franchise owner—understanding these financial planning basics for entrepreneurs can help you overcome the various obstacles you’ll face along your path to financial freedom.
Financial Planning Basics for Entrepreneurs Part One: Cash Flow Planning
For many entrepreneurs, cash flow planning is a challenge. This is especially true in your startup years, when revenue is unpredictable, and expenses are inevitable. In fact, 29% of failed startups point to cash flow problems as a central issue, according to data from the U.S. Bureau of Labor Statistics.
Moreover, lower paychecks also tend to come with the territory when you work for yourself. Based on recent PayScale data, 83% of small business owners take an annual salary of less than $100,000, and 30% reportedly take no salary at all.
The combination of these factors explains why financial planning basics for entrepreneurs can actually feel complex. The good news is you can still make smart financial decisions for your business, yourself and your family—even during times of uncertainty. In this article, we’re sharing a few key cash flow planning strategies business owners can implement to take control of your finances and reach new levels of success.
Cash Flow Planning Strategy #1: Create a Business Budget
A recent study by Clutch found that nearly two-thirds of small businesses (61%) did not create an official, formally documented budget for 2018. Notably, most businesses that reported not having a formal budget were smaller in size (1 to 10 employees). This is concerning, since having a budget can actually help you grow and scale your business faster.
The most successful business owners know exactly how much cash is coming into the business and how much is going out. When there are no guidelines around spending, a business can quickly run out of money.
A business budget not only informs spending, but it also reveals potential cash flow issues, which you can then fix before they become major problems. In other words, a budget guides your business towards profitability and away from potential bankruptcy. Whether you’re currently cash-flow-positive or not, creating a business budget is essential for successful cash flow planning.
Cash Flow Planning Strategy #2: Pay Yourself First
While budgeting is indeed necessary for the success of your business, it’s not always the answer when it comes to managing your personal finances. That doesn’t mean budgeting can’t work for you. It just means that very few people can successfully stick to a budget over the long term.
An alternative cash flow planning solution is to “pay yourself first.” In other words, since you’ve already created a business budget, you can make your personal income a line item under business expenses. That way you can ensure your personal financial obligations are met and balance your business budget at the same time.
To pay yourself first, calculate your personal financial liabilities, taxes, savings goals, and other necessary expenses for the year. This is the amount you’ll allocate to personal income in your business budget.
If you find yourself with a budget surplus at the end of the year—either in your business or personal finances—you can decide how to use that money most effectively. The goal of cash flow planning is simply to ensure cash flow remains positive—not to dictate every spending decision.
Cash Flow Planning Strategy #3: Planning for Unpredictable Income
One of the most common challenges entrepreneurs face when it comes to cash flow planning is unpredictable income. Sometimes your business doesn’t have the free cash flow to pay yourself as expected. However, to be able to consistently meet your personal financial obligations, you’ll need to project a reasonable income estimate for the year.
If your business is profitable and cash flow is relatively consistent, you can use your income from prior years to determine a reasonable range for what you expect to make each month. Then, compare this range to your projected expenses and savings targets. If the low end of the range covers your obligations, use this number for budgeting and cash flow planning.
On the other hand, some entrepreneurs are better served by coming up with an average monthly income. You can budget off of this number, and in months where your income is above average, save the extra cash to cover expenses in lower income months.
Again, the goal is to end the year cash positive, so it’s best to be conservative with your estimates to the extent possible. You can reinvest any cash that’s leftover at the end of the year back into your business or put it towards a personal financial goal.
Financial Planning Basics for Entrepreneurs Part Two: Tax Planning
When you’re a business owner, tax planning isn’t just about preparing for tax season in April. Instead, it’s an ongoing process that you need to stay on top of throughout the year. One of the key financial planning basics for entrepreneurs is understanding the way self-employed individuals are taxed in the United States, and how you can plan accordingly.
Tax Planning Tip #1: Be Aware of the Self-Employment Tax
If you’re newly self-employed, it helps to have an understanding of how your taxes are calculated. In addition to paying taxes on your income, you’re also responsible for paying a self-employment tax. Self-employment tax consists of Social Security and Medicare taxes, also referred to as FICA.
When you work for someone else, you usually split FICA tax with your employer. However, you have to pay all of it when you’re self-employed. On the bright side, you can deduct half.
Tax Planning Tip #2: Separate Your Business and Personal Finances
One of the advantages of self-employment is you get to deduct certain business-related expenses from your top-line income. In other words, you can reduce your taxable income by finding deductions and exemptions that apply to you as a business owner.
Deducting too many expenses or the wrong type of expenses can trigger an audit. Therefore, it’s critical to separate your business finances from your personal finances. In addition, you’ll want to keep meticulous records of the expenses you deduct.
An easy first step is to open a separate business account for your company. That way, you’ll have an accurate record of all the money coming into and going out of your business. You can also use this account to park cash designated for paying quarterly and end-of-year taxes.
Additionally, you may want to apply for a business credit card or designate one of your personal credit cards for business expenses only. When it comes time to prepare your tax return, you can simply use the statements as a record of your business spending.
Tax Planning Tip #3: Set Aside Cash from Each Paycheck
The United States is a pay-as-you-go income tax system, which means Uncle Sam expects you to pay taxes as you earn money. As a self-employed individual, you’re required to withhold cash from your own paycheck to make quarterly estimated tax payments to the IRS. This can be challenging, especially when your income is unpredictable.
The IRS provides an estimated tax worksheet, which can help you figure out how much to set aside and pay each quarter. Alternatively, a simple rule of thumb is to set aside 30% of your income each pay period. Regardless of the method you use, be careful not to get behind on your estimated payments or underpay. Not only will this make your April tax bill more of a burden, but you might also be assessed a penalty by the IRS.
Keep in mind, this is a very high-level overview of estimated tax payments. Part three of this blog series will be dedicated to calculating and paying estimated taxes to avoid major pitfalls.
Tax Planning Tip #4: When In Doubt, Seek Help
Tax planning can be complex when you’re self-employed, and mistakes can be expensive. In addition to enlisting the help of a CPA to prepare your taxes, you may want to consider working with a financial planner to help you manage your personal finances throughout the year.
Financial Planning Basics for Entrepreneurs Part Three: Paying Estimated Taxes
Calculating and paying estimated taxes can be one of the most challenging financial planning basics for entrepreneurs. However, with the right systems in place, you’ll start to feel more confident in no time. In part three, we’re sharing everything you need to know about paying your estimated taxes.
Paying Estimated Taxes Step #1: Calculate Your Estimated Income Tax
If you don’t expect your income to change drastically from the previous year, you can use your latest tax return as a baseline. First, you’ll want to find your Adjusted Gross Income (AGI). The IRS defines AGI as gross income minus adjustments to income.
Next, subtract the current tax year’s standard deduction from AGI. Alternatively, if you itemize, subtract your itemized deductions. The result is your estimated taxable income. You can use an online tax calculator to find your federal tax bracket and get a rough estimate of what you’ll owe in income tax.
Paying Estimated Taxes Step #2: Account for Self-Employment Tax
In our last article, we touched on how self-employment tax is one of the unique tax planning considerations for entrepreneurs. In 2021, the self-employment tax rate is 15.3% of net earnings. This is the sum of the 12.4% Social Security tax and 2.9% Medicare tax on net earnings. Although you’re responsible for paying this entire tax yourself as a self-employed individual, you can deduct half of it as a business expense.
Notably, the federal government only taxes the self-employed on 92.35% of your income. Therefore, to calculate self-employment tax, first multiply your estimated net income from Step #1 by 92.35%. Then, apply the current self-employment tax rate of 15.3%. This will give you an idea of what you’ll owe on top of your estimated income taxes.
Please note! Social Security tax is only paid on the first $142,800 in 2021. This amount is adjusted regularly by the IRS. In addition, Medicare tax jumps to 3.8% if your wages exceed $200,000 (for single taxpayers) or $250,000 for joint taxpayers.
Paying Estimated Taxes Step #3: Estimate Your Tax Payments
Now that you have estimates for income tax and self-employment tax, you can combine the two to get your total estimated tax liability for the year. Divide this number by four to find your quarterly estimated tax payments.
If your income is relatively stable throughout the year, you can pay the same amount each quarter. Otherwise, you may want to go through this exercise each quarter to determine how much to pay. However, do your best to avoid underpaying or missing due dates. The IRS may assess a penalty depending on how late you pay and the amount of your underpayment.
To avoid penalty, here are two best practices you can follow:
- Pay at least 90% of the current year’s tax liability or 100% of last year’s tax liability, whichever is smaller.
- For high earners—AGI above $150,000 (or $75,000 if married filing separately)—pay 110% of last year’s tax liability.
In addition, the IRS may waive the penalty in certain situations. Lastly, if you have other income sources—for example, your spouse is a W2 employee—you can reduce or cover your estimated payments by withholding additional tax from W2 income.
Paying Estimated Taxes Step #4: Pay Your Estimated Taxes
Estimated taxes are typically due every year by the following deadlines:
Q1: April 15
Q2: June 15
Q3: September 15
Q4: January 15 (following year)
In most cases, the easiest way to pay your quarterly taxes is electronically through IRS Direct Pay. Through this system, you can make direct payments to the IRS using a bank account, debit card, or credit card.
On the other hand, businesses and self-employed individuals with large tax payments may be better served using the Electronic Federal Tax Payment System (EFTPS). However, keep in mind that this program requires you to enroll ahead of time.
Finally, if your state or city has an income tax, you likely have to pay estimated state taxes here, too. Since this guide only covers how to pay your federal estimated tax payments, you’ll want to check on the requirements for your state and local municipality.
Good Planning is the Key to Success
Once you’ve mastered these financial planning basics for entrepreneurs, you can focus on your long-term financial goals. Oak Capital Advisors specializes in the unique financial planning needs of entrepreneurs and business owners. If you’d like to see if we’re a good fit, we encourage you to get started by requesting a free retirement assessment.
The information included in this blog article is for educational purposes only and should not be construed as advice. Please consult with a tax expert if you have questions about your personal tax situation.