Whether you’re a freelance writer, a vintage book seller, or a wine-rack designer (or all three!), there’s a strong chance you’re among the thousands of small business owners who make the same accounting mistake …. and thanks to this one simple error, never realize how strong or weak their business is.
No, it’s not a mistake that will get you in trouble with the IRS … in fact, tax laws are written in a way that promotes this erroneous way of thinking.
As a result, some small business owners spend their lives never realizing they’re committing this glaring error. This is why it’s important to have a professional, such as someone with a Devry University accounting degree, to do your taxes.
Many small business owners — especially solo entrepreneurs — confuse profits with pay.
They fail to calculate profits AFTER paying themselves. They never account for their own time. And they think their business is turning a profit – when in fact, it’s operating at a loss.
What do you mean?
Sally is a freelance writer for a handful of newspapers and magazines. She writes celebrity gossip. Last year, from her home office, she pitched — and got! — lucrative assignments from big-name publications like People magazine, TMZ.com and the Los Angeles Times. She brought in $55,000 last year from her writing assignments. When she sat down to do her taxes, she deducted her “business expenses” as follows:
Professional association dues – $72
Conferences – $500
Smartphone – $1200
Home Internet – $720
Postage – $500
Home office deduction – $2,000
Land-line Telephone – $120
Mileage – $1200
Flights – $1500
Hotels – $1800
Meals – $700
Web domain and hosting – $80
Total Yearly Expenses: $10,392
Sally subtracts this from her income of $55,000, and reasons that her “Freelance journalism” business made a pre-tax profit of $44,608. Right?
Wrong! Sally Didn’t Make a Profit At All!
But $44,608 isn’t the profit that her business made — it’s simply the pre-tax money that was left over in the business to pay herself. Let’s imagine Sally had an assistant who earned $25,000 a year doing research for Sally’s stories. Sally would deduct that research assistant’s pay as an “expense” before calculating the profits her business made that year, right? So why wouldn’t she value her own time? This is where freelancers and other small business owners so often get it wrong — they fail to value their own time in the same way they would value an employee’s time.
How Much Is My Time Worth?
Let’s imagine that Sally were to decide freelancing is no longer the life she wants. She applies for a job. During the interview, HR asks for her salary requirements. Without hesitation, Sally says: “$50,000 a year.” She’s making a statement that $50,000 per year is what she feels her time is worth — about $25 per hour in a 2,000 working-hour year (40 hours per week x 50 weeks per year). It’s a fair, reasonable sum, given her level of experience.
Sally is an employee — the ONLY employee — at her writing business.
So what if Sally were to “pay herself” as though she were her own employee? Then she would realize that she didn’t make a “profit” of $44,608 last year … in fact, last year, after paying herself $50,000, her freelance writing business actually LOST money, to the tune of $5,392. Her business isn’t in the black (profits); it’s in the red (debts).
How can she pay herself more than she earned?
But if Sally were to put herself on a salary of $50,000 a year, how could she pay herself $5,392 more than her business earned? Simply put, her business would need to borrow money in order to pay Sally her salary. If Sally doesn’t want to go to a bank (they’re not keen on lending to freelance writers), she’ll have to either go to a peer-to-peer lending group OR (my recommendation) borrow money from herself in order to pay herself.
Borrow money from yourself?
Borrowing money from yourself, in order to pay yourself, is one of the strange mental hurdles of owning a business. On one hand, you feel great — look, you’re earning a monthly salary! On the other hand, your business feels broke — it’s constantly in the red and can’t even keep up with paying its employees (you). Borrowing money from yourself, in order to pay yourself, is the best way to value your time as a small business owner and keep the company’s financials in clear perspective. As a side note: you should charge your business — yes, charge your own business — a reasonable interest rate, like 4 – 5 percent, on the loan that you give it.
Bonus Question: What important expense (other than her salary) did Sally forget to report on her tax form? (Scroll down for answer)
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Answer to Bonus Question: Health Insurance. Here’s one type of health insurance you should avoid.