"He's right, but for the wrong reason."

Some of you have heard me say that. Most of you, I suspect, have experienced the phenomenon: you came up with the correct answer, but got there through a series of steps involving bogus premises or faulty logic. Perhaps you realized it yourself as you reviewed the process. Perhaps someone else pointed it out to you. Perhaps they were diplomatic.

I often see this in my office during income tax season. Just today, I had a new client come in who was certain she would owe taxes because she had significant independent contractor income. She did indeed owe taxes, and more than she thought, but for an altogether different reason: her W-2 income.

Right Idea, Wrong Estimate

Her thought process was not an unreasonable one, and in many cases would be correct. Taxes are not withheld from independent contractor income in any but esoteric cases. Instead, self-employed individuals are supposed to make quarterly estimated tax payments to avoid having a big chunk of money due on April 15. There is also a stick to go with that carrot: the IRS assesses a penalty if you do not have enough paid in through any combination of withholding and quarterly estimated tax payments.

My client knew that she had 1099-type income, and that she had not made any estimated tax payments. She also knew that the apparent income tax bite is particularly harsh for this type of earnings, since it also includes both the employer and employee share of Social Security taxes under the name of self-employment tax. Logically enough, she assumed she was in trouble and came to me for help.

When we worked through the numbers, though, her deductible expenses were just a touch more than her independent contractor income. You only pay tax on the profit, so she owed no tax for this income. Her loss of about $400 actually offset other income, and saved about $70 in taxes.

But that was not enough to keep her from owing money.

The Simple Case

Her W-2s did her in. I know that is counterintuitive, since W-2s have tax withheld. But there is no certainty that enough tax will be withheld. Indeed, the more W-2s you have, the more likely it is that the withholding will be insufficient.

She had seven W-2s and her husband had two. I saw the trouble coming long before she did.

The mechanics of computing withholding are a bit icky, but the concept is pretty straightforward. Annualize the gross income from this pay period (e.g., times 12 if you are paid monthly). Calculate the tax using the standard deduction and however many exemptions the person is claiming. Divide the tax by the number of pay periods per year to get the amount to take out this time.

This works perfectly well if that is the only income in the household, and if you are paid at the exact same rate every pay period. Let me assure you that there are such people in the world. You, however, are probably not one of them.

The More Typical Case

The minute we have a second income source, the assumptions become faulty. Suppose we have a married couple, each of whom makes $40,000 per year. Each employer is dutifully calculating the tax on that person's income. Even if they use the lower standard deduction for single taxpayers instead of the married one, the withholding will be insufficient because of progressive tax rates. U.S. income taxes are currently 10 percent of the first $X of income, then 15 percent of the next $Y of income, 25 percent of the next $Z of income, and so on. (X, Y and Z vary depending on whether the taxpayer is single or married, and are inflation-adjusted each year.) Each $40,000 income tops out in the 15 percent rate bracket, but the combined $80,000 income will be well into the 25 percent rate. Result: taxes owed.

My client's case showed another common situation where withholding fails to cover the taxes: small payments from many employers. She had worked part-time for seven suburban park districts, each of whom paid her $1,000-$2,000 over a six-month period. Annualized, that's $2,000-$4,000, or enough to live in a box on lower Wacker Drive. Accordingly, only one of her employers withheld any federal tax.

The final score was income $11,000, tax withheld, $13. And she owed about $1,000.

You, Too, Could Have a Problem

Do not think it cannot happen to you just because you have a regular job supplemented with acting. A cluster of small residuals and couple of low-tier Equity contracts can put you in the same spot.

Other types of income may also have federal taxes withheld, such as unemployment compensation and retirement plan payouts. They can cause similar problems. The withholding rates on these other types of income are both low and below the likely tax rate.

To mitigate the problem, always have secondary employers withhold at the single rate (even if you are married), with zero exemptions, to take out the most possible tax. In my client's case, that would not have helped, since the income was so low. If you have a "civilian" job, you can arrange for additional arbitrary amounts of withholding; my client's husband's employer will do just that in 2005. And if all else fails, make estimated payments. The IRS doesn't care what combination of withholding and estimates are used, so long as it gets paid.

Free Checklist Still Available

If you would like a free copy of my checklist of potential deductions for those in the arts, just call, write or e-mail me and I'll be pleased to send one out.

Are there money or tax questions you would like to see discussed in this column? Let me know, at 2835 N. Sheffield, Suite 311, Chicago, IL 60657, or call 773/525-1778 (888/525-1778 toll-free outside the Chicago area) or e-mail greg@gregmermel.com.

Greg Mermel is a certified public accountant whose clients in the arts range from individual performers to major theatre companies and suppliers. He has also been known to produce theatre.

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