• Zack Gutches

How Starting Your Own Business Can Increase Your Overall Spending Power




Starting your own business comes with a myriad of decisions -- both involved, complex ones as well as tedious ones. Rather than dive into the various types of business entities (and the pros and cons thereof), I'll look at why it's even advantageous to have a business in the first place.


So you've got some sort of income-generating operation. Crafting. Music. Freelance writing. Magician. Landlord. You get the idea.


The first important thing for you to figure out, is whether your income-generating operation is a hobby or a business. Here's a concise, jargon-friendly source to help you make a reasonable conclusion.


Why does it matter if your business is a hobby or a business? Primarily because with a hobby, your expenses are most likely not going to be tax-deductible. Hobby expenses go on Schedule A of your tax return, and are only deductible if you itemize deductions. As I've written about previously, itemizing deductions (having more deductions than the standard deduction given to every taxpayer) is a difficult fate to achieve unless you are a high-roller. Therefore, with a hobby, you have to claim your income on your tax return, but you don't get to deduct your expenses! It's the worst of both worlds from a tax perspective, and thereby the worst outcome for your financial journey.


With a business, you can deduct your expenses against your income. In fact, if your expenses exceed your income, you can actually put "negative income" on your tax return, thereby offsetting some of your other income (like from your W-2 job, or 1099 contractor job, or sold investments). Let's look at an example:


You are a personal trainer part-time in addition to your full-time job as a Digital Marketing Associate. You generate $10,000 a year in income from personal training, and you incurred $12,000 in expenses during 2019.


Personal Training as a Hobby (cannot offset income with expenses):

Income from Digital Marketing (W2 income): $70,000

Income from Personal Training (part-time): $10,000

Total Income to be Taxed on: $80,000

Effective Tax Rate 25%

Total Taxes Paid $20,000



Personal Training as a Business (can offset income with expenses):

Income from Digital Marketing (W2 income): $70,000

Income from Personal Training (part-time): -$2,000 ($10,000 minus $12,000)

Total Income to be Taxed on: $68,000

Effective Tax Rate 25%

Total Taxes Paid $17,000


The result: You saved $3,000 in taxes because you were able to use the $12,000 of expenses you incurred to offset your taxable income.


Now stepping away from the business vs hobby discussion, let's look at owning a business full-time vs working for someone else full-time. There is "Power in the order" (keep reading, it will make sense shortly).


The order by which you get to spend money is favored in owning your own business. Why? Because when you own your own business, you get to spend before you pay taxes (using pre-tax money to buy stuff). When you work for someone else, you have to spend dollars that you already paid taxes on (using post-tax money to buy stuff). Let's just look at another example:


Alexandria is a business-owner, specializing in digital marketing consulting. Eugene, on the other hand, works for a multi-billion dollar marketing agency as a W2 employee. Both Alexandria and Eugene generate $60,000 a year. Now let's look at the difference in their spending power.


Alexandria:

$60,000 revenue

$60,000 expenses

$0 taxable income

25% effective tax rate

$0 Taxes Paid


Eugene:

$60,000 revenue

25% effective tax rate

$15,000 taxes paid

$45,000 Amount remaining for expenses


Notice how when using a business and able to use pre-tax dollars, Alexandria can spend $60,000 while Eugene can only spend $45,000. Again, it's because Alexandria can spend up to the amount she makes in revenue BEFORE paying taxes, whereas working for someone else requires you to pay taxes and THEN you can spend whatever is leftover after taxes are paid.


Although an extreme example, the point will always hold true no matter the dollar amount. This is the power of owning your own business (in whatever capacity it is).


The same concept applies to HSA's (Health Savings Accounts). I've written in depth about them here. Although HSA's are even more tax-advantaged, the same principle applies -- you can spend money that has not yet been taxed, thereby increasing your purchasing power. You could also extend this principle to FSA's (accounts that can pay for commuting/transit, parking, and child care related expenses if your work doesn't cover those already).


If you are thinking of starting a business, taxes are only a small portion of all things needed to be considered. So if you are thinking of starting a business, and would like assistance with entity structure, accounting methods, taxation planning, asset protection policies, etc., I would invite you to book a free discovery/consultation call to see if our services could help you strategically get the ball rolling and/or things to consider further when starting a business.


Until next time!

-Zack

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