Filing income taxes can be a daunting task for individual business owners and self-employed professionals, but it’s a necessary one. With the right approach, you can optimize your tax payments and save money.

When it comes to choosing income tax rate, you have two primary options in the Philippines: The Graduated Income Tax Rate or the 8% Income Tax Rate. Also note that under the Graduated Income Tax Rate, you further have the option to elect your type of deduction – the Itemized Deduction or the Optional Standard Deduction (OSD).

Let’s explore the options and see which one might be the better fit for you.

A. Graduated Income Tax Rate – Itemized Deduction

When you choose Itemized Deduction, your allowable expenses are based on actual business-related expenses supported by valid receipts.

Pro:

1. • Tax Savings: Unlike the OSD and 8%, when your expenses exceed your income, you won’t owe any income tax. In addition, you can benefit from this type of deduction if your business incurs higher amount of expenses, allowing you to arrive at a lower income tax base

Cons:

1. • Time-Consuming: Maintaining Itemized Deduction requires meticulous record-keeping. You must record all your business expenses in your accounting books, known as Books of Accounts. However, this is not to say that the other income tax options do not require the maintenance of your books
   • Organizational Skills: Keeping receipts for your business expenses for up to ten years from transaction date necessitates excellent organizational skills
   • Knowledge Requirements: You must possess basic knowledge of allowable deductible expenses in the Philippines
   • Cost: If you choose to outsource your accounting and bookkeeping, expect a higher retainer fee compared to OSD
   • Audit Requirement: When your gross annual sales, earnings, receipts, or output exceed Three Million Pesos (₱3,000,000), you’re obligated to hire an independent Certified Public Accountant (CPA) to audit your Books of Accounts, Income Tax Returns, and accounting records
   • Business Tax: You are still required to pay your business taxes (VAT or percentage tax, as applicable)

 B. Graduated Income Tax Rate – OSD

With OSD, your allowable expenses are calculated as forty percent (40%) of your gross sales/receipts. Here’s a closer look at its pros and cons:

Pros:

1. • Time-Saving: OSD streamlines your tax filing process because you don’t need to itemize your expenses
   • Receipts Not Required: Unlike Itemized Deduction, OSD doesn’t require you to substantiate receipts of your expenses for income tax purposes. However, it’s wise to keep records of your actual business expenses in case of a tax audit by the Bureau of Internal Revenue (BIR)
   • Cost-Effective: The retainer fee for your accountant and bookkeeper is typically lower compared to Itemized Deduction
   • No Audit Requirement: Individual taxpayers are not obligated to hire an independent CPA to audit their accounting records, even when gross annual sales, earnings, receipts, or output exceed Three Million Pesos (P3,000,000)
   • Positive Income Statement: Choosing OSD ensures your income tax return/statement consistently shows a profit, which can be advantageous when applying for loans

Cons:

1. • Inflated Profit: OSD can give the appearance of profitability even when your business isn’t truly profitable, leading to higher income tax liability
   • Business Tax: You are still required to pay your business taxes (VAT or percentage tax, as applicable)

C. 8% Income Tax Rate

In 2018, the BIR introduced a new tax scheme under the Tax Reform Acceleration and Inclusion Act (TRAIN law), known as the 8% special tax rate on gross sales. This flat tax rate is calculated based on your total gross sales and other non-operating income exceeding ₱250,000. The advantages and disadvantages under this option are almost similar to OSD. Let’s look at them.

Pros:

1. • Time-Saving: Similar to OSD, the 8% option streamlines your tax filing process because you don’t need to itemize your expenses. In addition, this option is already in lieu of the percentage tax currently pegged at 3%, so if this is not your registered tax type in your Certificate of Registration (COR), you don’t need to file the same
   • Special Deduction: You are entitled for ₱250,000 deduction per year from gross income. Note, however, that this is only available for those individuals whose income comes purely from business/practice of profession; otherwise, no reduction/ deduction is allowed.
   • Receipts Not Required: Like OSD, this doesn’t require you to substantiate receipts of your expenses for income tax purposes. However, as mentioned earlier, it’s wise to keep records of your actual business expenses in case of an examination.
   • Cost-Effective: The retainer fee for your accountant and bookkeeper is typically lower compared to Itemized Deduction
   • No Audit Requirement: Individual taxpayers are not obligated to hire an independent CPA to audit their accounting records as well
   • Positive Income Statement: Choosing 8% ensures your income tax return/statement consistently shows a profit, which can be advantageous when applying for loans
   • Small chance to be a candidate for audit – there might be a smaller chance to get selected for a BIR examination unlike when you avail the Graduated Income Tax Rate wherein you need to support every expense claimed through proper documentation

Cons:

1. • Inflated Profit: 8% can also give the appearance of profitability even when your business isn’t truly profitable, leading to higher income tax liability
   • Fixed Tax Rate: Your income tax rate will not change even if your income will increase or decrease

Who Can Opt for the 8% Income Tax Rate?

Individuals who earn purely from business or professional income, as well as mixed-income earners, can take advantage of the 8% income tax rate if their gross sales and non-operating income do not exceed the ₱3 Million VAT threshold for the taxable year. However, the following taxpayers are not qualified to avail this option:

1. Purely compensation income earners
2. VAT-registered taxpayers, regardless of the amount of gross sales/receipts and other non-operating income
3. Non-VAT taxpayers whose gross sales/receipts and other non-operating income exceeded the ₱3 Million VAT threshold
4. Taxpayers who are subject to Other Percentage Taxes under Title V of the Tax Code, as amended, except those under Section 116 of the same title
5. Partners of a General Professional Partnership (GPP) since their distributive share from the GPP is already net of costs and expenses
6. Individuals enjoying income tax exemption such as those registered under the Barangay Micro Business Enterprises (BMBEs)

How to Avail of the 8% Income Tax Rate

To benefit from the 8% income tax rate, you must indicate your intention to use this option before filing your income tax return for the 1st Quarter of the taxable year, or on the initial quarter return of the taxable year after the commencement of a new business/practice of profession. Failure to do so will automatically place you under the graduated income tax rates. Moreover, such election shall be irrevocable, and no amendment of option shall be made for the said taxable year.

Choosing the Right Option for You

Now that you have a grasp of these options, you can make an informed decision that aligns with your business’s financial situation and long-term goals. The best option depends on various factors, including the level of your income, expenses, nature of business, and long-term goals. Remember that consulting with tax and audit professionals in the Philippines can provide valuable guidance tailored to your specific circumstances. Ultimately, the right tax deduction method can help you legally minimize your tax liability and optimize your financial outcomes.

Nonetheless, don’t let the complexities of tax compliance overwhelm you! If you’re a self-employed individual or a small business owner in the Philippines, we are your ally in understanding the nuances of the income tax options. Benefit from our wealth of expertise to guarantee precise filing, capitalize on tax savings, and enjoy peace of mind. Reach out to our tax compliance services today and streamline your tax processes with us.

Disclaimer: Please be reminded that the information provided in this blog post is intended for general guidance and informational purposes only. It should not be construed as legal advice. Every individual and business situation is unique, and various factors can influence your specific tax circumstances. Therefore, it’s essential to consult with a qualified tax professional or legal expert to receive tailored advice that considers your specific needs and circumstances. Always exercise due diligence and seek professional guidance to make informed decisions regarding your tax obligations.