Tax guidance is provided by Charles Renwick, CPA. Everyone’s situation is different and the general guidance provided herein should only be used as a starting point for assessing your individual and business tax situation.
You Are a Small Business Owner – Take Taxes Seriously
Do you own a small business? Are you a real estate professional or other professional that receives a 1099? If so, you are a small business owner and you operate as a small business. As a result, you have the responsibility of paying your own taxes. If you do not plan or develop a tax strategy, you will likely face significant tax liabilities. The good news is that with a little planning and a strategy, you can legally reduce your tax bill, significantly.
Note, if you have not already formed an LLC and opened a business bank account, you should do that first. The mechanics of forming an LLC are not the subject of this article, however most of the tax strategies discussed in this article are only available if you already have an LLC in place.
Small Business Taxes
Generally, small business face two primary tax filing and payment obligations:
- Income Tax – Federal (and State if applicable)
- Payroll Tax – Federal
While all individuals with income over $650 are subject to federal income tax filing requirements, income taxes are likely actually not the primary tax that will impact your total tax bill. This is because the federal government provides various deductions and credits to reduce income tax liability for lower income taxpayers. Additionally, the income tax brackets are progressive, which means income over various thresholds is taxed at a higher rate than income below the thresholds. One common misconception is that earning a higher income will subject all of your income to a higher tax bracket. This is not true. Only the income above the bracket threshold is subject to the higher tax rate. The income below the threshold is still taxed at the lower rate.
To be clear, due to the standard deductions, child credits, and progressive tax bracket structure, it is not uncommon for there to be little or no income tax for self employed individuals that are married and have multiple children and with income less than $60,000. That said, as income increases into the $100,000 range, deductions and credits can phase out and income tax liabilities can increase significantly.
To most people’s surprise, payroll taxes are the primary tax paid by both self employed individuals and non-self employed individuals. Payroll taxes consist of the “Social Security Tax” and the “Medicare Tax”. Together, these taxes total 15.3% of all employment earnings below $137,700 (adjusted annually for inflation). While 15.3% might not seem like a lot, the government does not provide child credits or standard deductions against this tax. Thus, when compared to the income tax, it is easy to see why this tax is much greater for individuals making less than $137,700. For example, for a married individual with three kids making $80,000, there will likely be no federal income tax due, however there will be payroll taxes due of $12,240 ($80,000 *15.3%).
How to Minimize Taxes
Clearly, you need to have a strategy to reduce both your income tax and your self employment tax and in most cases for small businesses, it is more important to focus on reducing your self employment tax. Fortunately, there are two primary ways to legally reduce both of these taxes:
- Maximize Your Business Deductions
- Use the S-Corporation Tax Structure
Maximize Your Deductions
Maximizing your deductions is the most effective way to reduce both your income tax and payroll tax liability. In many cases, if you receive 1099 income of less than $35,000, there are likely available deductions that will reduce your income to a sufficiently low level so that no tax is due.
- Car Mileage and/or Car Depreciation
- Home Office
- Business Meal
- Medical expenses
Deductions – Blocking and Tackling
While there are some very specific rules that apply to some deductions, the most important thing you can do to ensure you maximize your deductions is to keep as much documentation as possible.
- Keep track of all your spending (use an accounting system like Xero or Quickbooks)
- Keep all your receipts (digitize them)
- Track the miles on your car (take picture of odometer every year)
- Business/Family travel (documented the business component)
The importance of proper documentation cannot be overstated if you get audited by the IRS. While the chance of an audit is remote, having clean books and records is of primary importance. If you do not have receipts and documentation, the IRS will disallow your deductions and you will have to pay tax and penalties on those deductions.
Deductions – Conflicting Goals and Limits
While keeping robust documentation and being aggressive with your business deductions is usually the best approach, there are times when you might not want to be aggressive with your tax deductions. Specifically, if you need to report enough income to qualify for home/business loans. While you will pay no taxes if there are sufficient deductions to fully offset income, you will likely not meet the income requirements to qualify for home mortgage, if needed. Additionally, there are limits to what you can reasonably deduct. The more money you make, the more likely you will not be able to find allowable deductions to reduce or eliminate your tax liability. Thus, a second strategy must also be employed.
S-Corporation Tax Structure
As noted previously, 100% of your net income (revenue less deductions) will be subject to the “self employment tax” if you do not adopt a tax planning strategy. This 15.3% can be very significant, even at low income levels. For example, 15.3% of $30,000 is $4,590! Is there anything that can be done to reduce this liability? Yes, establish an S-Corporation tax structure!
What are IRS Tax Structures?
The IRS code defines different types of tax entities/structures that are subject to taxation and/or reporting:
- Individuals (sole proprietors)
- C-Corporations (double taxation)
- Partnerships (pass-through)
- S-Corporations (hybrid)
- Estates and Trusts (other)
While the history and development of these various structures is beyond the scope of this article, at a high level, C-Corporations are called C-Corporations because the rules governing the taxation of these entities are published in Subchapter C of the IRS code. Similarly, S-Corporations are governed by the rules in Subchapter S of the IRS code.
From a tax and liability perspective, there are two ends of the spectrum. C-Corporations provide liability protection to owners but are subject to double taxation (tax at the corporate level and also at the owner level), however corporate stock owners are not subject to self employment tax. Sole proprietors have no liability protection, do not have double income taxation, but are subject to self employment taxes.
Fortunately, the IRS also established a “middle ground”, The S-Corporation. This entity is not subject to double income taxation, the owners have liability protection, and the owners are not subject to self employment tax.
Why would anyone not choose to be an S-Corporation?
If all one needs to do to avoid paying self employment taxes is become an S-Corporation, why wouldn’t everyone become an S-Corporation? The simple answer is because S-Corporations require additional paperwork and have associated accounting compliance costs. Specifically, S-Corporations require an additional tax return and are subject to all of the rules of Subchapter S (rules that are not applied to individuals). Maintaining compliance with these rules and requirements generally requires the assistance of a CPA. However, considering that even at low income levels, the amount of tax savings available is significant, most savvy small business owners become an S-Corporation for tax purposes.
What About LLCs?
As you can see, LLCs are not on the list of entities/structures defined by the IRS code. LLCs are relatively new hybrid structures and the IRS has established a rule that allows LLCs to elect their tax status. If you make no election and you are a single member LLC (one owner), you will be taxed as an individual with all of your income subject to both income tax and self employment tax. If you make no election and you are a multi-member LLC, you will be taxed as a partnership. The IRS allows you to either stay in these default categories or to elect taxation as if you were a C-corporation or as an S-Corporation. Thus, an LLC simply needs to make an election to be taxed as an S-Corporation. This is called “Making the S-Election”!
To be clear, forming an LLC for your business and making the S-Election is generally the most advantageous tax and liability structure for most small businesses (including real estate agents)!
Cost of Compliance
As noted previously, the primary cost associated with implementing a tax structure is the cost of compliance, specifically, the cost associated with engaging a CPA. However, when considering this cost, it is important to consider not only the total cost but also the marginal cost. In most cases, both the total cost and the marginal cost are significantly lower than the tax savings. In other words, tax compliance is not actually a cost but a profit center.
Marginal Cost Analysis
When evaluating the cost/benefit of a new tax approach, you should not only consider the total cost but you should focus on the marginal cost. The marginal cost is the additional cost associated with additional compliance. This is important because without adopting any tax structure or planning, you will still face compliance costs. Specifically, you still need to prepare your taxes. Generally, a self employed individual without a tax structure will either use online software, use a national chain (H&R Block) or hire a local CPA. Thus, you already have this compliance cost. The typical cost of this type of service annually is $450-$600. Since you will incur regardless of your approach, this cost is not a marginal cost. The annual cost associated with implementing a S-Corporation tax structure is $700-$1,500. This is a marginal cost. It is more than you will pay if you do not implement a tax structure.
While the total cost of compliance with an S-Corporation structure is the sum of both of these costs, the marginal cost is only $700-$1,500. In other words, it is worth implementing an S-Corporation tax structure if it will result in savings of $700-$1500. As noted earlier, self employment taxes on $30,000 = $4,590 so this type of tax savings is generally achievable. Additionally, most CPAs also provide deduction maximization strategies as part of their compliance fee, thus you get to truly minimize your tax liabilities. As you can see, the savings typically significantly outweighs the costs, especially the marginal costs.
Summary and Next Steps
Taxes can quickly become your largest cost and if you do not plan properly you can quickly owe the IRS a considerable amount of money. However, with a bit of planning and with the help of a qualified CPA, you do not have to pay more than you legally owe and you can save (keep) a considerable amount of money. Just follow these simple steps:
- Establish an LLC
- Keep good records and use and accounting system
- Contact a CPA and make the S-Election
While there are time constraints on when an S-Election can be filed (the standard time frame is within 75 days of the formation of your LLC or within 75 days of the beginning of the year), a good CPA can petition for a late filing exception and the IRS may accept this up until March 15 of the following year, if you already have a CPA. For example, you have until March 15, 2021 to try to get an S-Election accepted by the IRS so that you can take advantage of the S-Corporation tax structure for 2020.
About the Author
Charles Renwick, CPA is a Chartered Financial Analyst (CFA), Certified Public Accountant (CPA), licensed in both Louisiana and Georgia. As Managing Director of CMR Associates, Charles provides a broad range of business services for private clients and individuals. Charles focuses on state and federal tax strategies, tax structure compliance, business system development/implementation, and investment analysis. Email Contact: firstname.lastname@example.org