8% Income Tax Rate vs. 40% Optional Standard Deduction (OSD) vs. Itemized Deduction

You can now save money by paying taxes. But it still depends on whether you choose 8% Income Tax Rate, 40% Optional Standard Deduction (OSD), or Itemized Deduction.

If you are just starting in business and you still don’t know much about tax, handling your taxes and records is confusing and very difficult.

One particular type of tax that you must pay is income tax. Simply put, when you earn, you have to pay taxes.

Filing and paying your taxes on time and accurately is a must if you want to avoid penalties imposed by the BIR. But at the same time, you need to be smart to save money especially in this time of the pandemic.

This is the main reason why I made this guide – so you know what you should use in your income tax computation.

I’ll be discussing the differences, advantages, disadvantages of the 8% income tax rate, 40% optional standard deduction, and the itemized deduction.

And at the end, I’ll give my final thoughts and help you choose what to use.

Understanding the Income Tax Rates

If you are a beginner, income tax rates in the Philippines are difficult to understand. This is true even though the BIR releases various revenue regulations to help you with your income tax computation.

Since TRAIN law took effect, there are now two types of income tax rates in the Philippines. One is the Graduated Income Tax Rate and the other is the 8% Income Tax Rate. If you are a corporate taxpayer, unfortunately, you’re not allowed to use the 8% income tax rate and left to stick with the graduated income tax rate.

Graduated Income Tax Rate

At the graduated income tax rate, the computation of the income tax you must pay is based on your net income. Net income refers to your income after all the allowable deductions have been made. Under this tax rate, you’ll use either itemized deduction or the optional standard deduction.

Allowable deductions are those expenses you incurred related to your business. Not all expenses are allowable. For example, you can’t deduct personal expenses as they’re not related to your business.

According to the BIR itself, here are examples of allowable deductions.

1. Expenses
2. Interest
3. Taxes
4. Losses-
5. Bad Debts
6. Depreciation
7. Depletion of Oil and Gas Wells and Mines
8. Charitable Contributions and Other Contributions- Research and Development
9. Pension Trusts

Example

For example, if you sell ten cars for ₱100,000 each, you have ₱1,000,000 gross sales. The cost of goods sold for each car is ₱65,000. To sell these cars, you hire a salesman and spend a total of ₱50,000 for his salary.

The cost of goods sold is the amount that costs you when purchasing the cars to be sold (puhunan). And the salary is your operating expense. These two fall under category number 1 in the example of allowable deductions.

Itemized Deductions

If you use itemized deduction, you’ll report each expense you incurred related to your business. So if you have 20 types of expenses, you’ll need all of these to compute your net income. These will be your allowable deductions.

As an absolute rule, you need to support these expenses with valid source documents. Valid source documents refer to the BIR-registered official receipts or invoices that were issued to you when paying your expenses. If you don’t have the valid source documents of these expenses, you can’t claim these as allowable deductions.

Now, using the example above, your income tax will be computed as follows.

Please refer to the income tax table below for the computation of income tax.

Advantages

• Higher tax savings if you have a lot of expenses to claim as allowable deduction.
• Recommended for startup with no income.

Disadvantages

• You need to keep valid source documents.
• Additional responsibility as you need to withhold certain portions from income payment (eg. salaries, rent, other income payments).
• May be difficult to understand for first -timers.
• Prone to BIR audit because of itemization of expenses.

Option Standard Deduction

Under optional standard deduction (OSD), you don’t need to list all the expenses you incurred related to the business at these will be disregarded when computing for the net income. Your allowable deduction is going to be 40% of your gross sales or gross receipts. The 40% is a fixed percentage imposed by the BIR. This is going to be the same for all taxpayers using the optional standard deduction.

Under the optional standard deduction method, your net income is computed as follows.

Using the same example, you can compute your income tax as follows.

Using both methods, you can see a huge depression in the income tax you pay. Not let’s talk about the 8% income tax rate below.

Advantages

• Easy to compute your income taxes.
• Recommended for taxpayers with small amount of expenses (eg. service concern, professionals, freelancers, content-creator) – if they want to use graduated tax table.
• Don’t require valid source documents for allowable deduction because it is fixed at 40%.

Disadvantages

• Not recommended for taxpayers with large amount of expenses.
• Not recommended for startup business.
• Not recommended for taxpayers earning ₱250,000 and below (choose what 8% income tax rate instead).

8% Income Tax Rate

The process of computation of income tax under 8% Income Tax Rate is easy. You no longer need the allowable deduction. You also don’t need an income tax table because your income tax is an 8% flat rate based on gross sales or gross receipts and other non-operating income after deducting the first ₱250,000 exemption.

Using the same example above, you can compute your income tax as follows.

Advantages

• Easy to compute income taxes.
• Recommended for taxpayers earning less than ₱250,000 a year.
• Don’t require valid source documents as you don’t need to use allowable dedcutions in computing income taxes.
• You don’t need to file and pay percentage taxes.

Disadvantages

• Not recommended for higher income earners
• Not applicable to corporations
• Not applicable to VAT-registered taxpayers

Income Taxes Comparisons

We can see that the itemized deduction has the lowest income tax. If you stop reading at this point, you would say the itemized deduction is the best way of computing your income tax so you will go for it. No, this is not the sole basis of determining the best method to choose. There are certain factors you want to consider. Furthermore, other tax consequences must also be put in mind.

Choosing the Best Income Tax Rate

When choosing the best income tax rate to use, these factors might help you choose among the methods above.

Size of the Business

Not all registered taxpayers are the same in terms of business scale and sizes. There are businesses with hundreds of branches, medium-sized enterprises, small business owners, freelancers, professionals (licensed and no license), online shops, gamers, content creators, and corporations. And choosing the best income to save money makes a taxpayer smarter and wiser.

Estimated Amount of Income for th Year

Another factor to consider is the estimated amount of income to earn for the year. If you don’t already know, taxation in the Philippines is progressive. As your income grows, so does your income tax. One way to lessen the tax is to choose the appropriate method of computation of income tax based on the amount of income.

Valid Source Documents

Invoices and receipts are essential when claiming allowable deductions. In this way, it can lessen your net taxable income that results in less income tax. A valid source document is a VAT-registered document.

You can determine if the document issued to you when paying expense is valid if it has a printer’s BIR-accreditation number and related stuff at the bottom. An example of a valid source document is shown below.

If you pay for your expenses and the seller had issued you non-BIR-registered receipts or invoices, you cannot claim the expenses as allowable deductions. This means your income tax will be higher.

Presented below is an example of non-BIR-registered receipts.

Volume of Transactions

If you have a lot of transactions every day, you need to keep your valid source documents. This is a must if you want to claim them as allowable deductions under itemized deduction. And it is hard to do it when you don’t have a bookkeeper handle these things for you.

Other Tax Consequence

One of the most important factors when selecting your income tax rate is the tax consequence of the income tax rate itself. What I’m trying to point is that if you select one of the methods, what will be the other tax types be imposed on you by the BIR.

Percentage Tax

If you choose to be taxed at an 8% income tax rate, you’re not required to pay quarterly percentage tax.

Withholding Tax

If you select itemized deduction, you claim business expenses supported with valid documents as allowable deductions. However, you must consider some tax types indicated in your Certificate of Registration.

For example, to claim a Rent Expense, you need to withhold a certain amount from the rent payment to the lessor. Another example is that if you have employees, you need to withhold a certain amount from their compensation.

Financially speaking, you don’t pay additional taxes because these will come from the income of the payees (lessor and employees). But this withholding process is a legal responsibility imposed by the BIR to you as a withholding agent. And mind you, the withholding process is a tedious one! Failure to do so will result in paying a bunch of penalties.

Recommendations

Disclaimer: Don’t take my personal recommendations as professional advice. Hire someone to handle your taxes if necessary. These suggestions and recommendations are based on my work and business experience.

1. If you a freelancer, online shop, content-creator,small-business owners, startup business, professionals who render services and you estimated that your annual earnings or revenues will be less than ₱250,000, choose the 8% Income Tax Rate. You won’t be paying percentage tax in that case.
2. If you are a large taxpayer that loves to keep records, receipts and invoices of it’s expenses up to the last centavo, choose the Itemized Deduction. Make sure to comply with additional tax compliance though like withholding taxes.
3. If you’re not tax-conscious and you don’t mind paying a lot of money and want to avoid BIR audit, choose either optional standard deduction or 8% income tax rate. Trust me, more than half of taxpayers using optional standard deduction and 8% income tax rate will most-likely avoid BIR surprise audits.

Recommended Reading: Install eBIRForms And Setup Your Company in 3 Easy Steps

References

Bureau of Internal Revenue. (n.d.-a). Income Tax. Retrieved January 12, 2022, from https://www.bir.gov.ph/index.php/tax-information/income-tax.html