Setting aside money for taxes, part 1

One of the most common questions I’m asked by my clients is how much money to set aside for paying taxes.

Answering that question is a two-part task:

1. First, we need to know the base amount of cash flow from which we’re taking money to set aside. There are a few ways to figure this, which I’ll discuss below.
2. Second, we need to know the percentage of that base amount to set aside. I’ll discuss this in the next post.
   

So, let’s think about the amount of cash flow from which you’ll pull money to set aside for taxes.

For most small business owners, it’s easiest to answer this question with cash revenue. You have the cash in hand when a client or customer makes a payment. It’s easiest at this point to take some of that cash and set it aside.

The issue from a tax perspective is that we tax net profit, or the amount after we subtract all the deductible expenses.

Setting aside a portion of revenue is a bit tricky if we don’t take expenses into account. We need a way to translate revenue into taxable income.

A quick and easy way to do this, if you have good records, is to look at your net profit margin (NPM). NPM is the proportion of revenue that is left after paying deductible expenses.

Net Profit Margin = Net Profit ÷ Revenue

NPM can fluctuate over weeks or months, so use the average over a reasonable period, such as a quarter or year.

Then multiply your estimated or average NPM by your actual revenue over the period for which you want to set aside money for taxes. This should give you a reasonable estimate of your taxable income from your business.

I recommend doing this every two weeks or every month. (Remember, the longer you wait to set aside cash for taxes, the larger the number will get, and the more difficult it will be to set that cash aside. I prefer pulling smaller amounts more frequently, but do what works for you.)

Quick note When calculating NPM, do not take owner draws, distributions, or other personal expenses paid by the business into account. These are not deductible expenses. Including these amounts will throw off you estimates and leave you setting aside a lot less than you actually need.