I was just listening to a Build and Analyze podcast, with the, clearly, very smart Dan Benjamin and Marco Arment. It was really great, I encourage you to go check it out.
I wanted to echo what they were saying. If you can’t afford to pay your taxes, or to pay an accountant (or lawyer, or any other professional for that matter) then your business really isn’t profitable enough. You aren’t charging enough!
It IS more complicated than you think, but a good professional can make it easier for you. Mr. Benajamin was commenting on how he used to have an S-Corp, and had to run payroll to get his money out but that maybe he was doing it wrong. I told him he was, and promised to write a quick blog post about why.
What makes being self employed different than working for a wage?
A couple things. When you work for a wage (which means you work for someone else who gives you a W-2), your employer bears the cost of half your social security and Medicare tax (FICA). In case you don’t know, there are two (main) types of tax. Income tax and FICA tax (a.k.a. Self-Employment tax).
The other major difference is that when you work for a wage, there are very limited deductions you can take against the income. And under audit, you have to prove that each is legitimate.
If you are self employed, you control the income as if it is a business. This means a couple things. You bear the cost of all the income tax (which never changes) but you also bear the entire cost of the FICA tax.
The upside, is that you only pay tax on whatever part of the income you didn’t spend in the business. And under audit, it is typically assumed that all deductions are business related, unless proven otherwise.
What the heck is a business entity?
If you are self-employed, you can set up a business entity like a corporation (C-Corp), LLC, or S-Corp. This effectively creates a separate legal and taxable entity that you deposit income into and spend business expenses in.
Corporations are the oldest form of business entity. They pay their own taxes. This is great because it completely insulates you from the business acitivty. But it has a problem with double taxation. This means that the corporation pays its own taxes, but to get the money out to spend personally, you have to take a dividend or a wage, which means that money was taxed twice
LLCs are great because they are easy and cheap to set up. BUT if you don’t have multiple people, then your Single Member LLC is a disregarded entity for federal purposes, which means the activity will still go on your Schedule C (individual return). Schedule C’s are an audit risk, which is why I don’t like them.
It is easy to get money out of your LLC. You can take distributions out whenever you want, because it is a pass through. That is awesome. No double taxation like a standard corporation has.
The LLC income will still be subject Self-Employment tax. That’s an extra 15% (or so).
Enter the S-Corp. The S-Corp is a corporation (legally) that has elected to be taxed as a partnership. The S-Corp works the same way (some differences here, but for now keep it simple) as the LLC. You can take distributions whenever you want. But the S-Corp pass through income will NOT be subject to SE tax. Yeah!
However, for this to stand up, you have to take “reasonable compensation” from the S-Corp. This technically means a W-2 (which means running payroll). Boo. Don’t even get me started on what “reasonable compensation” means. A good CPA can help you figure that out.
Here is my “hack”: The point of taking out “compensation” is that the IRS wants you to pay SOME SE tax on your earning. But you don’t need to do a W-2 to do this. You can make an adjustment on your returns at tax time to pick this tax up. Example: You make $50k of profit. You took it all out directly without W-2s or anything, you just transferred it to your personal account.
On your corporate return, take a deduction for $10,000 for “owner’s compensation”. On your individual return, put $10,000 of “other income subject to SE tax” and fill out the Schedule SE.
Reasonable compensation paid, SE tax collected, it took 90 seconds.