Making sense of taxes borne by the self-employed

MANILA, Philippines–Long before they landed a special mention in P-Noy’s State of the Nation Address (Sona) in 2011 as a sector registering average earnings ridiculously below the minimum wage, the self-employed have always been the apple of the Bureau of Internal Revenue (BIR)’s proverbial eye.

This sector includes persons who own businesses in the form of single proprietorships and practicing professionals.

With the BIR always hot on their trail, they are often the subject of tax mapping operations and tax compliance verification drives.

What has evolved, though, is the way the BIR has approached the crackdown, so to speak—from the prudent audits of long ago to the name-and-shame ploy of today.

I certainly don’t blame the BIR for identifying the self-employed as one of its priority areas for tax audits because tax compliance from this sector is rather difficult to monitor compared to employees, whose taxes are settled through the employer via the withholding tax mechanism, thereby minimizing the chances of tax leakage.

Monitoring tax compliance of the self-employed sector is challenging because the reporting of income and taxes is done on a self-assessment basis where taxpayers voluntarily assess or calculate their own tax liability. This effectively means that taxpayers have the ability to control what information, be it income or expenses, they want to put forward to the BIR—until they get subjected to a tax audit, which is when their troubles begin.

This is, however, not to say that all self-employed taxpayers are deliberately underdeclaring their income.

Maybe there are those who do and some others, perhaps, inadvertently.

The bottom line is that statistics show an apparent disproportion in the amount of tax collections from self-employed individuals vis-à-vis the number of registered taxpayers under this sector.

This is one of the reasons why the BIR is giving them special attention, whether deserved or not.

On this note, it will be in every self-employed person’s best interest to ensure that he files the required income tax returns and pays the correct taxes.

A self-employed individual is required to report his income and pay the corresponding tax on a quarterly basis for the first three quarters using BIR Form 1701Q.

Afterward, a final return must be filed using BIR Form 1701 to reflect his final and adjusted tax liability for the entire year.

However, the filing of the return is the easy part.

The main—and always the most complex—part lies in how to make sense of the figures that need to appear on the tax return, in particular, the expenses that may be deducted from the taxpayer’s income.

A self-employed taxpayer lies somewhere in between an individual and a corporate taxpayer, in the sense that he is entitled to the basic and personal exemptions of an individual taxpayer and, at the same time, the privilege of deducting expenses available to corporate taxpayers.

The key to determining whether an expense is tax deductible is assessing whether the expense is ordinary and necessary to the business, trade or profession of the taxpayer.

The phrase “ordinary and necessary” generally refers to the purpose for incurring an expense.

Thus, ordinary and necessary expenses are those that are common and accepted in the industry and are essential to running the business or practicing a profession.

For instance, travel expenses are typical to most businesses. However, the purpose of the travel must be related to the pursuit of the business to qualify as tax-deductible.

Otherwise, they won’t qualify as allowable deductions.

Also inherent in the phrase “ordinary and necessary” is the element of reasonableness, which is related to the amount of the expense. An expense is reasonable if it is not lavish, extravagant or excessive under the circumstances.

For instance, traveling in a chartered plane to attend a business conference is likely to be seen as excessive.

When examining business expenses of self-employed individuals, the BIR’s paramount concern is to establish whether personal expenses are being claimed as business expenses. Because the tendency for abuse is high and very common, the BIR is ever vigilant.

For example, gym equipment used at the place of residence of the taxpayer is personal in nature and, therefore, should not be deducted for tax purposes.

Apart from the expenses being ordinary and necessary, the following are additional requirements that must also be met for the expenses to be tax-deductible:

• The expenses are paid or incurred during the taxable year.

• The expenses are duly substantiated. Thus, it is important to save receipts for every expense that will be claimed as deduction.

• For expenses that are subject to withholding tax, it must be shown that the tax required to be withheld has been paid to the BIR.

Self-employed individuals are not only taxpayers, but also considered as withholding agents, tasked by the BIR to collect in advance taxes from certain income payments made.

As an example, a self-employed person is required to withhold and remit monthly income taxes from the salaries of his employees. The same is true for income payments to most suppliers.

These conditions are so critical that failure to meet any of these conditions may result in the disallowance of the expenses, and consequently, payment of additional taxes.

Alternatively, in lieu of claiming itemized deductions, a self-employed person may opt to just claim the Optional Standard Deduction (OSD).

The OSD represents 40 percent of gross sales/receipts/revenues/fees. When claiming the OSD, the taxpayer is no longer required to keep track of whether his expenses comply with the foregoing requirements.

Best of all, this precludes an extensive examination from the BIR on the taxpayer’s expenses.

Obviously, the OSD works best if actual business expenses are below 40 percent, but it may not be too sensible if they are significantly above that level. Otherwise, the taxpayer may end up paying more taxes than necessary unless, of course, the taxpayer believes that paying a bit more is worth the benefit of avoiding the administrative burden of keeping receipts and having to justify the deductions with the BIR.

As you can tell, these complex tax reporting requirements —not to mention the kind of “special attention” that the self-employed have been receiving —are enough to deter soon-to-be entrepreneurs from putting up their own businesses, and professionals from putting up their own practice.

For some others, particularly micro-enterprises such as sari-sari stores, carinderias, repair shops, vendors and hawkers, prefer to stay underground, as you might say, claiming that their business is too small and their earnings too meek, to justify compliance with the prescribed tax payment and filing obligations.

The government obviously loses revenue from this marginal sector.

The question is: Is it worth the BIR’s efforts and resources to pursue tax collections from this sector?

I’d say yes. What else would have prompted the BIR in compelling micro-entrepreneurs to pay their income taxes under Revenue Memorandum Circular (RMC) 7-2014?

Regrettably, most of these micro-entrepreneurs are not aware of the tax relief available to them.

Another likely theory is that the government fell short of promoting programs that grant these tax benefits. One such program is the Barangay Micro Business Enterprises (BMBE) Act. Quite interestingly, the act was  signed into law some 12 years ago but has not gained the popularity it deserves despite providing generous benefits and privileges—income tax exemption, being the most important—to micro-entrepreneurs. This program would have covered most of these micro-enterprises.

While most may have missed registering as BMBEs, it is not too late to avail of the benefits of the program because, whether you are still in the process of starting a business or have already established one, you may still qualify as a BMBE and be certified as such.

But the tax benefits can get better; micro-entrepreneurs can look forward to a further respite from taxes with the filing of Senate Bill No. 2227 by Sen. Bam Aquino.

The bill seeks to achieve equity in the tax treatment of Marginal Income Earners (MIEs) and the Minimum Wage Earners (MWEs) by extending the same exemption from income tax and VAT or percentage taxes currently enjoyed by MWEs to MIEs.

However, the bill sets an annual gross sales/receipts threshold of only P150,000 for an MIE.

Since the objective is to equalize the tax treatment of MIEs with the MWEs, and considering that MIEs are expected to also incur expenses in running their business, the income limit may need to be adjusted to a realistic level to theoretically bring the gross amount to the same level as the MWEs.

Then again, whatever amount it will end up to be, it is hoped that when the MIE Bill gets signed into law, that it will have a better chance of success than the other programs of the government with the same objective.

Before the passage of the MIE Law, however, micro-entrepreneurs may just have to content themselves with the benefits of the current BMBE Act.

As a final note, I offer a plea to the government—the BIR, in particular—for its tax compliance campaign to not only focus on naming and shaming potential tax evaders but more importantly, on educating taxpayers on their tax privileges.

Then and only then, will their campaign be truly laudable.

(The author is chair and senior partner of Isla Lipana & Co., a PwC member firm)