Getting an Employer ID Number (EIN)

After legally forming a new business, the next thing you need to do is get an employer identification number (EIN).  Think of this as the SSN for your business – it will be used to open bank accounts, show up on tax forms, and generally be the way the government keeps track of it.

The good news is that getting a EIN only takes a few minutes and is completely free.

 

Let me repeat: getting an EIN is free.  Under absolutely no circumstances should you ever pay someone to help get you an EIN.  A few companies with questionable morals have convinced people that it’s a complicated process that you need their special expertise for.  They even have the top Google results for someone searching “get an EIN”, which leads many unsuspecting new business owners to think that they’re the only way to get one. (/rant)

 

The steps to get your number are below.  Most of them are pretty straightforward, and none justify paying someone $250.

1.       Go to the following IRS website:  How to Apply for an EIN | Internal Revenue Service (irs.gov)

2.       Click Apply Online, then Begin Application

3.       Pick the legal structure for the business you just formed (LLC, partnership, etc)

4.       Select how many members (owners) and the state you’re in

5.       It will ask you to confirm (if you’re an LLC they’ll let you know you’re going to be disregarded entity, but that you have an option to be taxed as an S-Corp if you choose to)

6.       Select why you’re applying for an EIN (will usually be because you’re starting a new business)

7.       Fill out Responsible Party (that’s you). Select “I am one of the owners”

8.       Fill out business address

9.       Legal name of business and its start date (this is the same as what you filled out with the State)

10.   The following questions:

  • Does your business own a highway motor vehicle with a taxable gross weight of 55,000 pounds or more?   (Probably not, but if you’re starting a construction company I suppose it’s possible)            
  • Does your business involve gambling/wagering?  (Unless you’re starting a casino, select No)           
  • Does your business need to file Form 720?  (This is for excise taxes- its unlikely this applies to you, but if you do things like import goods or special manufacturing then select Yes)
  • Does your business sell or manufacture alcohol, tobacco, or firearms? (self explanatory)
  • Do you have, or do you expect to have, any employees who will receive Forms W-2 in the next 12 months? (Select yes if you have plans to hire someone in your first year. If you’re a sole proprietor, a partnership or a single-member LLC you won’t be getting a W-2 so you can say No)

11.   Select the industry that most closely aligns with your business, then the category on the next screen.  If you don’t see one that matches exactly you can select Other and type it in.

12.   Choose to receive confirmation Online

 

That’s it!  Make sure you save the PDF of the letter showing your EIN (you’ll also eventually get a copy in the mail, but as you’ll need the EIN to do things now, why wait?)

Qualified Business Income Deduction

What is the Qualified Business Income (QBI) deduction?

The QBI deduction is one of the most important deductions for business owners to be aware of.  It was created as part of the 2017 Tax Cut and Jobs Act, and essentially provides a 20% deduction on all business income for most small business.

The deduction is calculated on net business income and taken in addition to either the standard or itemized deductions.  That means you can use this deduction regardless of if you itemize or not.  Note that because the deduction is based on your final net business income, it only reduces your income tax, not your self-employment taxes.

 

How do you qualify?

The QBI deduction is available to “pass-through entities,” which are basically the entities that don’t pay taxes at the entity level.  So sole-proprietors, partnerships, LLCs, and S-corps all qualify.  C-corps do not.

 

What are the limitations?

This is where it gets slightly more complicated.  Below are income limits for 2021:

Married Filing Jointly:   $326,600

Head of Household / Single:  $163,300

Married Filing Separately:  $163,300

 

If your taxable income (before the QBI deduction) is below the limits above for your filing status, you don’t have anything to worry about: you’ll simply take 20% of your business income as a deduction.  If you’re above the above limits, your ability to take the deduction is subject to limitations.  You can only take the lesser of:

1)      20% of QBI

2)      50% of W-2 compensation OR 25% of W-2 compensation plus 2.5% of unadjusted basis of qualified property (whichever is more favorable).

 

Since test #2 is a mouthful, here’s a brief explanation. W-2 compensation is the total compensation paid to employees (including any amount they deferred into a retirement plan), the ‘reasonable salary’ you paid yourself as an S-corp employee, and any amount reported to you on a K-1 as part of a partnership.

Unadjusted basis of qualified property is the basis of tangible property, such as equipment and machinery, before any depreciation. It only includes property that has not reached the end of the depreciable period or 10 years after it’s been placed in service, whichever is later. 

 

What is an SSTB?

A specified service trade or business (SSTB) is a business that replies on the “reputation or skill of its owner”.  The following are listed explicitly as SSTBs:

  • Accounting
  • Actuarial science
  • Athletics
  • Brokerage services
  • Consulting
  • Financial services
  • Health services, such as performed by doctors and nurses
  • Investing and investment management
  • Law, including lawyers
  • Performing arts
  • Trading

If you work as an SSTB, your ability to claim the QBI deduction is eliminated above the income thresholds mentioned above.

 

Wrapping up

If this sounds complicated, that’s because it is.  In fact, the QBI deduction passed a few years ago and the IRS is still trying to clear up questions on it.  (There’s been a running controversy about if rental income can qualify, for example.)  The good news is that you don’t really need to know the nuts and bolts of how it works in order to get the deduction.  Let us worry about that.

Home Office Deduction

One of the tax deductions that causes the most confusion (and worry) is the home office deduction.  Are you eligible for it?  

Who Can Claim It

To claim the home-office deduction, you must be self-employed. If you work for an employer and currently working from home, you’re not eligible.  It doesn’t matter if you rent or own your own home.

First – what IS (and is not) a home office

Before we dive into how to calculate the deduction, we should discuss exactly what a “home office” is. The tax code defines it as a place used “regularly and exclusively” for business.  That means a spare bedroom turned into an office qualifies, but the dining room table you sometimes sit at for work does not.  You can use part of a room as an office if it’s a definable space (ie, “the corner area with the desk and shelves” counts, but “40% of the living room” does not).  It can also be a separate structure on your property if you decide to turn a detached garage or shed into an office (and use it only for that purpose).

The tax code also requires that the home office be your “principal place of business.”  That doesn’t mean you’re only allowed to work at your home – having more than one work location won’t disqualify you.  It just means you either spend most of your time working at the home office or that the home office is the only place you do ‘administrative and management’ activities.  For example, if you own a landscaping company and spend most of your time working at customer’s properties but keep your records and bills at your home office, you will qualify for the deduction.  If that same business owner also maintained an office on Main Street where administrative duties were handled, they would NOT qualify for the home office deduction.

The IRS has helpfully created the following flowchart that recaps what we just discussed:

Source: IRS
Source: IRS

Now that you know if your home office qualifies, we can discuss how to calculate the deduction itself.

The “Simplified Method”

If the idea of allocating expenses or doing complex calculations makes you break out in a cold sweat, the IRS does offer a ‘simplified method’ for claiming the deduction.  To use this method, simply multiply the size of your home office square footage (up to a maximum of 300 sf) by $5.  That’s it. All your regular home expenses (like mortgage interest) can still be claimed as itemized deductions, and there’s no depreciation or anything like that to worry about.

Obviously, the main downside to this method is that you might be leaving money on the table.  If your home office expenses are high, you might be entitled to more than $5 per square foot.  In that case, use the regular method.

The “Regular Method”

To calculate the home office deduction using the ‘regular method’, you need to allocate home expenses you paid during the year to the portion of your home that was used as an office. (Similar to how you calculate your rental expenses if you’re renting out part of your home.)

Direct expenses are expenses that relate only to your home office.  For instance, painting the spare bedroom you use as your office.  These expenses are fully deductible.

Indirect expenses are expenses that affect your entire home.  These would include mortgage interest or utilities expenses.  These expenses are partially deductible.  To figure out the percentage you can deduct, divide the home office area by the total area of your home. If you have a 500 sf home office in a 2000 sf home, 25% of your mortgage interest can be labeled a home office expense.  Other common indirect expenses include real estate taxes, telephone and cable bills, and homeowner’s insurance.

The expenses you calculated above will go on Form 8829 (Expenses for Business Use of Your Home).  The total amount on that form will feed into your Schedule C as one of your business expenses (if you’re a sole proprietor or single-member LLC; if you’re a member of a partnership it’s slightly more complicated, but you still might be able to deduct the expenses).

Limits

Unlike some other deductions, there aren’t any dollar limits on the deduction itself and the amount of the deduction won’t phase out as your income rises.  However, the amount of the deduction can’t be more than your business income for the year. For example, if you make $10,000 in your business but have $15,000 of home office expenses, you can only use $10,000.  The remainder can be rolled forward and used next year.

If you have any questions on the above or are just wondering if your own home office qualifies, send me a message and I’d be happy to discuss.

Business Expenses

Which Expenses Are Deductible?

If you’re a small business owner, you’ve likely asked yourself at one point “can I deduct this on my taxes?”  Here’s a quick rundown on what you can – and can’t – claim as a business deduction.

The Rules

The IRS says you can only claim an expense as a business deduction if it’s both ordinary and necessary

An ordinary expense is something that most other businesses in your industry will have.  Paying for cheese and tomato sauce is ordinary if you own a pizzeria, but those same expenses would be incredibly unusual for a landscaping company.

A necessary expense is something that is “helpful and appropriate” for your business (note that despite the name, it doesn’t have to be absolutely ‘necessary’ for your business to function.) The costs associated with traveling to a conference may be “helpful and appropriate” expenses if they help you meet new clients to grow your business.

Common Deductions Almost Every Business Will Have

Regardless of industry, there are going to be some expenses that most business owners will have simply due to the costs associated with running a business.  These include:

Home Office – if you’re working out of your home, you can claim this special deduction (even if you rent)

Rent – the costs associated with leasing office space are deductible

Advertising / Marketing – the costs for running ads on Google or Facebook, printing flyers or brochures, or paying fees on Yelp or Thumbtack can all be deducted

Utilities – if you’re responsible for paying for the electric or heat at your office, you can deduct those

Legal / Professional Fees – if you met with a lawyer to get your business of the ground, you can deduct those costs.  If you hire someone to help with tax or bookkeeping (hint, hint) those are deductible as well.

Insurance – Professional Liability insurance is deductible, as are insurance premiums you pay on your rented office space

Salaries / Wages – if you hire employees or pay contractors, those costs are all deductible

Interest Expense – the interest (but not the principal) you pay on a bank loan is deductible

Office Supplies – the money you spend on paper, pens,  printer ink and other supplies all count

What is NOT Deductible

Now that we’ve covered a lot of things you can deduct, here is a list of things that can not be deducted:

Taxes – state and local taxes are deductible on your personal return (if you itemize), but they aren’t business expenses and shouldn’t be on your business tax return

Fines / Penalties – If you received penalties for paying your taxes late, a fine from the city government, or a parking ticket, you’re out of luck.

Commuting Expenses – costs associated with travel from your home to your regular work location are not deductible.  However, if you make a special work-related trip that’s farther than your usual commute, that may be deductible.

Entertainment Expenses – If you take a prospective to a baseball game, you cannot deduct the expenses. These actually were partially deductible for a while, but the 2017 tax law has eliminated this deduction. 

Country Club Dues – these are not deductible, even if you take clients out golfing. Sorry.

Clothes – your new outfit doesn’t count as a business expense, unless you can’t wear it for anything but work.  So a new suit is not deductible, but if you have to buy your own pilot’s uniform you can deduct those costs.

Your cellphone bill – if you have a phone you use exclusively for work, you can deduct the entire amount.  But if you only have one phone that you use for both personal and business then you do not have a “work phone,” and you are not entitled to deduct the full amount of the bill.  Estimate the percentage used for work and claim that as an expense instead.

When in doubt…

A very common saying you’ll come across when discussing business expenses is “pigs get fat, but hogs get slaughtered.”  You should absolutely take every deduction you’re entitled to.  If you stretch the boundaries too far, however, they’re going to break and the IRS will be asking you some uncomfortable questions. A good rule of thumb is to picture yourself explaining an expense to an IRS auditor or a judge – if you would have no problem telling them what the expense was for then you’re probably fine to deduct it. If you would be embarrassed to explain what the amount relates to, then you might want to leave it off of your tax forms.

S-Corp Conversions

Using an S-Corp to Lower Your Taxes

If you’re a small business owner, you’re well aware of the pain of self-employment taxes and how much they can take out of your pocket.  (And if you’re not yet aware, you’re in for a rude awakening next April.)  What if there was a way to make the same amount of money but pay less in taxes? That’s where an S-Corp comes in.

What is an S-Corp?

An S-Corp is a special type of corporation that has fewer than 100 shareholders.  For tax purposes, its treated much like a partnership (even if you only have one owner).  The net income from the S-Corp is reported at the business-level and any profits flow through to any shareholders to be taxed on their personal returns.

Ok, but how does this help me?

If your business is currently a sole-proprietor or partnership, your compensation is simply the net income from the business at the end of the year – and this entire amount is considered your salary.  But if your business was an S-Corp you could pay yourself a set salary.  Why is that important?  Your salary is what determines how much you pay in self-employment taxes (Social Security and Medicare).  You will owe 15.3% of your salary in these taxes (subject to contribution limits).

The salary you set for yourself will be treated as another business expense, just as your rent or utilities expenses are reported now. The net profit at the end of the year then is treated entirely as a dividend. This amount still flows to you like it did before, only now it is entirely free of self-employment taxes.

An Example

Jim owns his own business as a sole proprietor.  He makes $200,000 in revenue and has $100,000 in expenses.  At the end of the year, the net profit of $100,000 flows onto his personal tax return.  He owes approximately $15,000 in self-employment taxes. He will also pay income tax on $100,000 of income.

Bob owns his business as an S-Corp.  He also makes $200,000 in revenue and he also has $100,000 in expenses.  Bob pays himself a salary of $60,000.  At the end of the year, he owes approximately $9,000 in self-employment taxes (15% of $60,000). The other $40,000 flows to him as a dividend.   Like Jim, he will pay income tax on $100,000 of income (the $60,000 of income on his W-2 and the $40,000 of income on the dividend).

Jim and Bob have the same revenue and the same expenses.  But Bob saves over $6,000 in taxes.  That’s money he can reinvest in his business or just go on a nice vacation with.

 How do I set my salary?

For many business owners who decide to go the S-Corp route, this is the hardest part.  There are no black and white rules about what number to use.  The IRS requires you have a “reasonable” salary.  If you decide to give yourself a salary of $200 and keep the rest as a dividend, you’re likely facing an audit and/or a court appearance.

Some of the ways you come up with a “reasonable” number include what you would hire someone else for to do the same job.  You could also use your own past salary as a guide – for instance, many formerly salaried IT employees begin work as independent contractors doing the exact same work.  In that case it could reasonable to pay yourself what you used to make.

You could also hire any number of firms to provide a detailed report with recommendations on what you should set the number at.  This may give you peace of mind and lots of documentation to use if you’re ever challenged on it, but keep in mind the person responsible for your numbers being accurate will always be you.

 What are the downsides?

Since nothing in life is free, there have to be downsides to this pathway to saving money on taxes.  The two largest are paperwork and fees. 

As a salaried employee, you’re going to have to file quarterly payroll reports with the government.  You’re also going to have to file forms relating to unemployment insurance.  You’re going to file W-2 forms and a W-3 form.   While you’re welcome to fill out those forms by hand, realistically this means you’re going to have to use a payroll provider if you don’t already have one. These range in price depending on the provider, your number of payroll runs, and your number of employees, but generally cost between $30 and $50 per month. (If you don’t already have a payroll provider, I can do it for you.)

At the end of the year, you’re going to have to file a corporate tax return (1120-S) by March 15.  Corporate tax returns tend to be more complex (and expensive) than personal returns, and usually require the assistance of a tax professional.  In addition to the corporate return, you’ll obviously still have to file your personal tax return as well.

To decide if the S-corp election makes sense for you, you’ll need to do a cost-benefit calculation.  If you can save $5,000 or $10,000 on taxes, paying someone to do the filings and spending a little more on tax preparation fees is a no-brainer.  But if you’re currently making $30,000 in profits and the conversion would only save you $500 in taxes (which would be eaten up by payroll and tax prep fees), it might not make sense for you at this time.

How do I get started?

If you’ve read all of the above and think an S-Corp is the way to go, we should chat.

You’ll need to file Form 2553 by March 15 of the year you want the conversion to take effect.  (They have historically been lenient about ‘late’ filings if you decide to try to do it after that point, but it’s always easiest to follow the letter of the law.)

After filing that you can begin setting up the quarterly payroll filings.  You’ll also want to calculate your estimated tax amounts to ensure proper withholding.

I would obviously be happy to help with any of the steps above, or just talk through your various options. Drop me a line to set up a meeting.

Dividend Taxation

How are dividends taxed?

Dividends are treated in one of two ways.  Ordinary dividends are treated just like any other income, such as salary your job.  In that case, they’re taxed at whatever your ordinary tax rate is.  They could also be treated as qualified, which allows them to be treated at lower tax rates (currently 0%, 15% or 20%, depending on your income level).

What are qualified dividends?

The government has three rules to determine whether a dividend you received can be considered qualified, and thus eligible for the lower tax rate.

  1. It must be from a US company, or a qualifying foreign company.  If you buy a stock that is trading on the NYSE or Nasdaq you don’t need to worry about this rule too often.
  2. It must not be specifically excluded by the IRS.  These are mostly Real Estate Investment Trusts (REITs) and money-market account dividends. If you buy a regular common or preferred stock you’ll satisfy this rule.
  3. It must satisfy the holding period requirements.

Rule #3 is what affects most taxpayers, so let’s discuss that in more detail

What are the holding period requirements? 

To qualify for the lower tax rates, you must hold the investment for more than 60 days during the 121-day period that starts 60 days before the ex-dividend date.  Basically, just picture a 60-day window on both sides of the ex-dividend date: you need to hold a security for at least 60 days during that period to qualify. (Note: for preferred stock investments, the periods are 90 and 181 days, respectively).  This rule is intended to prevent investors from just scooping of shares of companies the day before the ex-dividend date and then selling them off again when they receive the cash.  The tax code incentivizes long-term investing, and the holding period requirement ensures that to receive the beneficial rates you need to actually hold on to the security for a slightly more substantial amount of time.

What do I need to do?

The good news is that if you’re buying and selling your investments through a reputable broker, they’re going to track the holding periods and make sure your investment qualifies for you.  So you don’t need to keep detailed notes or mark on your calendar when you purchased each security. But even though they’re doing the heavy lifting, it’s still important you know the rules, so you don’t accidentally un-qualify yourself. For example, don’t sell a security after 58 days when holding it slightly longer will grant you a better tax rate. You’ll also want to consider the rule when computing your ROI for different securities: if you’re comparing a REIT and common stock and they both have the same stated dividend, you may have a better after-tax return with the latter.

Renting Out Part of Your Home

What are the tax issues when I rent out part of my home?

When most people think about ‘rental properties’, they picture buying a small house or condo and collecting rent from a tenant.  The tax issues with doing that are relatively straightforward: you just keep track of how much they paid you, and how much you spent on expenses related to the property, and the net amount is what you pay taxes on.

But what if you’re not renting out a different property?  What if you’re just renting part of the house you already live in?  How do you determine which expenses you can deduct?

First – find out if you even need to pay taxes

Before we talk about potential tax issues, there’s an important exception you should be aware of.  If you rent your own home for 14 days or less, you don’t need to pay a single penny in taxes.  It doesn’t matter how much they paid you or who the tenant was.  So if you turn your apartment into an Airbnb for a couple of weekends and make a killing, you don’t need to tell the IRS. 

If you have a longer-term tenant

Assuming the above exception doesn’t apply to you and you rent your property for more than 14 days, you’ll report your rental income on your tax return on Schedule E.  The income you receive from the tenant will be reported as revenue. Just like you would with a separate rental property, you can deduct rental expenses related to the maintenance and upkeep of the property.  It’s just a little more complicated.

There are two different types of rental expenses that you should be aware of.  Direct expenses are expenses you can assign specifically to the rental portion of your home.  So, if you’re renting out the basement of your house, and the toilet in the basement bathroom needs to be replaced, that would be a direct expense.  The entire amount would be reported as an expense on Schedule E.

Indirect expenses are a little more work to figure out.  Essentially, they’re expenses that aren’t specifically related to the rental portion of the property, but contain amounts that are rental-related. For example, if you have a mortgage, a portion of the interest paid can be assigned to the rental property. How do you split the bill?  The IRS says you can use “any reasonable method”.  In practice, this typically means either dividing by square footage or dividing by total number of rooms.  If your entire house is 2,000 square feet, and you’re renting out 500 square feet of space, you can deduct 25% of your mortgage interest for rental purposes.  You can also use this allocation to divide costs on things like real estate taxes, utilities paid for the whole house (assuming the rental portion doesn’t have its own meters), a new roof for the entire property, or landscaping costs.

One word of caution: if you’re deducting things for the rental you would otherwise deduct yourself, you can’t double-count anything. If you paid $20,000 in mortgage interest and half of it was related to the rental, you would use $10,000 on Schedule E (rental income) and $10,000 on Schedule A (itemized deductions). 

What if I move out?

If you find yourself in a situation where you wind up moving out of your primary residence during the year and turning it into a rental, you’re still entitled to all of the rental expense deductions as if it were a totally different property.  The only difference is that in the year you converted it into a rental property, you would divide the number of days it was rented at fair market value out of the entire year.  For example, if you moved out and tenants moved in on October 2, the property would have been rented for 90 days at the end of the year.  You can deduct 90/365, or 24.6%, of your mortgage interest for the year as a rental expense.  The following year, if it were rented the entire year, you would simply deduct the entire amount.

1031 Exchanges

What is a 1031 Exchange?

A 1031 Exchange, also called a ‘Like Kind’ or ‘Starker Exchange’, involves the owner of one investment property exchanging it for a different investment property.  Because this is treated as an exchange, and not a sale, there are no taxes due on the transaction.

Why would you do a 1031 Exchange?

As mentioned above, no taxes are due after completing an exchange.  If you own a piece of property that has appreciated in value, successfully completing an exchange will allow you to defer the capital gains due indefinitely.  Say you bought a house ten years ago for $250,000 to generate rental income.  The house is now worth $400,000.  If you were to simply sell the house, you would owe capital gains taxes on the $150,000 appreciation – or about $22,000 in taxes.  If, instead, you did a 1031 exchange, you could trade in the same house and use the money to buy an apartment building.  Because this isn’t treated as a sale, you don’t owe any capital gains taxes.

What are the requirements?

In order to qualify for the Section 1031 treatment, you have to meet a number of requirements.  You can’t just buy and sell properties and then claim it was a 1031 exchange after the fact.  These are:

1.       You must identify the replacement property within 45 days of selling your old property

2.       You must purchase the new property within 180 days of selling the old property

3.       The new property must be at least as expensive as the old property

4.       The same ‘person’ must own both the old and the new property

5.       You must not receive the proceeds from the sale of the old property

Let’s run through each of these in a little more detail:

45-day Identification Period: Within 45 days of selling your old property, you must create a list of possible new properties you plan to replace it with.  If you wind up purchasing a property NOT on this list, your exchange will be disqualified.  There is no limit to the number of properties you can identify, but most experts agree you should have a minimum of three.

180-day Purchase Period: Within 180 days of selling your old property, you must close the sale on the new property.  Combined with the 45-day identification period, these two rules mean that when considering a 1031 exchange you must have a few properties in mind and then actually buy one of them.

Basis Requirement: Your new property must be at least as expensive as the old property.  Since you’re transferring your basis from the old property to the new one, all of it must be ‘used up’.  If you sell a $100,000 rental home, you can’t purchase an $80,000 apartment and call it an exchange.  Note that you don’t have to match the prices – the new property just has to be at least as expensive.  You can sell that $100,000 house and buy a replacement property for $500,000 if you want to. This rule is intended to prevent you from exchanging an expensive property for a cheaper one, deferring the taxes, and keeping the cash on the difference.

Ownership: The same ‘person’ must own both the old property and the new property.  But in this case, ‘person’ is defined in the legal sense.  A partnership can successfully do an exchange, as long as the legal partnership is the same for both the old and new properties.  But you cannot sell an old property as an individual and buy a new one as part of a partnership. The easiest way to follow this rule is to ensure that the tax return reporting the rental income is the same for both the old and new properties.

Receipt of funds: In the time period between selling the old property and purchasing the new property, the fund from the sale must be handled by a Qualified Intermediary.  A Qualified Intermediary is essentially just a middle-man who holds the money and prevents you from spending it on anything other than its intended use (similar to an escrow account). You must never actually touch the money; if you do, the exchange will be disqualified. Many banks or law firms can provide you with a Qualified Intermediary for a small fee.

Reporting requirements

After you’ve successfully completed the 1031 exchange, there is one final step to be aware of.  You’ll need to tell the IRS what you did.  This is done on Form 8824 and basically just tells them you transferred the basis of one property into another property and that you don’t owe any capital gains taxes on the transaction.  Note that both sides of the transaction (selling the old property and buying the new one) must be reported on the same tax return, so you may need to file for an extension if you sell the old property near the end of the year and the new one won’t be purchased before April 15.

Who should I call for help?

There are a few people you’ll want to talk to before completing a 1031 exchange.  For one, as mentioned above, you’ll need a Qualified Intermediary.  If your intermediary knows what they’re doing they’ll walk you through most of the steps and help you make sure you follow the rules.  You’ll also want to speak to your tax/financial advisor to make sure deferring the taxes and purchasing a new property fits in with your long-term goals and objectives.  You’ll also need a tax specialist to help you report the exchange on your tax return (I would not recommend you fill out Form 8824 by yourself).

Self Employment Taxes

What are self-employment taxes?

Self-employment taxes are simply the amounts you pay towards Medicare and Social Security.  If you previously worked for an employer, you never had to think about them since they were deducted from your paycheck before you ever got your hands on the money. 

Every employee pays 6.2% of their pay towards Social Security and 1.45% of their pay towards Medicare.  Those amounts are then matched by their employer – so in total, you pay just over 15% of your total pay towards these entitlement programs.

However, if you work for yourself, you’re both the employee AND the employer.  Which means you’re on the hook for the entire amount. 

 

How do I calculate these taxes?

The total amount of self-employment tax is calculated based on your net business income (ie, your revenue less expenses).  If you have other income on your tax return, such as a rental property or investment income, those amounts would not be impacted by this tax.

To calculate your self-employment taxes, you first start with 92.35% of your net income.  (That amount isn’t random – it’s basically allowing you to deduct the employer portion of the taxes: 100% – 6.2% – 1.45% = 92.35%).  This amount is then used to calculate the tax: multiply it by 15.3%* to get your total self-employment tax. It goes on Schedule 2 Line 4.

* Note: you only have to contribute to Social Security up to the ‘maximum contribution limit’, but all of your earnings are subject to Medicare taxes.  If you made more than the limit ($137,700 in 2020), multiply your income by 2.9% (the Medicare portion) and add the maximum Social Security contribution ($17,074 in 2020) to find your total self-employment tax amount. 

But wait – you’re not done yet.  Half of that amount can be used as a deduction.  Multiply the total amount you just calculated by 50% and use it on Schedule 1 Line 14.

Is there a way to lower my self-employment taxes?

There isn’t a way to directly lower these taxes, as the amount owed is simply a percentage of your business income.  But since the amount is based on your net business income, lowering that amount will consequently lower the self-employment taxes as well.  So finding other business deductions will have the double benefit of lowering both your income AND self-employment taxes.

There is one exception: if your business is currently a single-member LLC being taxed as a sole proprietor you may elect to be taxed as an S-Corp instead.  Only the ‘salary’ portion of your income is subject to self-employment taxes.

How do I pay self-employment taxes?

When you complete your tax filing at the end of the year, you’ll include Schedule SE in your return.  This form shows what you owe and will flow into other parts of your return – the total amount will be on Line 15 of your 1040, which will roll up to the ‘Total Tax’ amount.  These self-employment taxes will also be reflected in your quarterly estimated payments, so paying those throughout the year will help reduce interest and penalties later.

If you have any questions about anything in this article, please send us a message.

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Legal Entities

Which type of legal entity is right for my business?

One of the most common questions I get from people who are thinking about starting their new business is how they should set up their business.  So let’s walk through some of the various options and which one might be right for you.

 Sole Proprietor

This is technically one of your options, but it’s more accurate to say it’s what happens if you don’t decide to do something else.  That’s because the IRS treats you as a sole proprietor if you make any business income and haven’t told them to treat you otherwise.

Legal Issues

The biggest downside to being a sole proprietor is that because your business is not a separate legal entity, you are personally liable for everything the business does.  If an unhappy customer or vendor sues you for a million dollars, you might lose your life savings.

You do not need to file any paperwork to be a sole proprietor, but you might still need a business license to operate a business.  Check with your local town government to find out.  If you’re operating a professional service you also might need a state license.

Taxes

Since this is not a separate legal entity, for tax purposes all income you make from your business will be on your personal tax return (Form 1040 – Schedule C).  You will list all your revenue and expenses on Schedule C and the net profit is what you’ll pay taxes on.  Remember that you’ll pay both income tax AND self-employment taxes on your profits.

Partnership

If you decide to go into business with someone else, you can form a partnership to split the startup costs and share in the profits.  You can have as many partners as you want and can agree to structure it however works best for you.

Legal Issues

When you form a partnership, the most important document is what’s called a “Partnership Agreement”.  This basically spells out exactly how you’re going to allocate the costs and eventual profits of the business, as well as who gets to make final decisions or how voting rights will be determined.  Sometimes these can be very simple: you and your friend each put up $5,000 and agree to split everything 50/50. 

These agreements can also be more complex: you and your friend decide to open a restaurant, but since you have all the experience, the friend puts up all of the startup costs and you agree to manage the day-to-day business.  At the end of the year, you still agree to split profits equally. You can also agree to split up costs unequally: investor A puts up $20,000 and investors B and C each put up $2,000.  It’s up to you how you want to structure any deal – just make sure to put it in writing.

One of the downsides of a partnership is legal liability.  As a partner, you’ll be responsible for the debts and obligations of the partnership as if you personally signed for them yourself. If your partner takes out a giant loan, the partnership as a whole is responsible for paying it back (even you).

(Note: since we’re discussing setting up a business, we’re speaking here about ‘General Partnerships’ where each partner has a hand in running the business. There is a separate investment structure known as a “Limited Partnership” that limits your exposure to this risk, but you can’t actually make any decisions as a limited partner. You’re essentially just an investor.)

Taxes

A partnership is what is regarded as a “pass-through entity,” which means that its profits are not actually taxed – the amounts are simply passed through and taxes are paid on your personal return.

As a separate legal entity, a partnership will file its own tax return (Form 1065).  This return will show the total revenue and expenses for the partnership as a whole.  When this is completed, each individual partner will receive a form (Form K-1) showing what their share of the profits was.  This info is used to populate your individual tax return, and you’ll pay taxes on those amounts at your personal tax rates. 

 Limited Liability Company (LLC)

LLC’s have become incredibly popular in the United States, and for good reason.  They generally combine the favorable tax treatments from the above options while eliminating the legal liability issues.

Legal Issues

An LLC is a separate legal entity.  It can open its own bank accounts and have its own contracts with customers and vendors.  It can even own real estate. This also means that someone could hypothetically sue your LLC for a million dollars and bankrupt the business – but just the business.  Your personal savings (other than what you invested in the business) are safe.  This limited liability is one of the main appeals of setting up an LLC.

One drawback of creating a separate legal entity is that it doesn’t come free.  LLCs are created by filing paperwork with the state.  The forms are generally fairly simple, but the fees can vary (currently $50 in some states, all the way up to $500 in Massachusetts – which would be where my own LLC is incorporated).  You’ll also need to file Annual Reports and pay the fees annually thereafter.

Taxes

Depending on if the LLC has one owner or multiple owners, for tax purposes it is simply treated as a sole proprietor or partnership.  If you’re the only owner (known as a “Single Member LLC”, or SMLLC), all of the income and expenses from the business will be reported on your personal tax return on Schedule C.  If there are multiple owners, your LLC will file a Form 1065 as if it was a partnership, and each owner will receive a K-1 to use to fill out their own return.

 S-Corp

An S-Corporation is a type of corporation that follows specific rules regarding how many members you have and who those members are.

Legal Issues

Similar to an LLC and Partnership, an S-Corp is a separate legal entity.  It is created by filing paperwork with the state and paying the required fees.  As a corporation, its owners are shareholders and the company can assign shares however it chooses.  However, by law, it cannot have more than 100 shareholders and there can only be one class of stock (ie, no “A-shares” and “B-shares” to give certain people more power).  All of the shareholders must be individuals, not other corporations or partnerships – you can’t have an S-corp own another S-corp.

Taxes

An S-corp files a corporate tax return (Form 1120S).  The amounts on this return are then passed on to each shareholder through a K-1, similar to a partnership.  You’ll receive a K-1 even if you’re the only shareholder of the business.

C-Corp

A C-corporation, more widely known just as a corporation, is the business structure you’re probably most familiar with – basically every large company is set up this way.

Legal Issues

A corporation is a legal entity that is owned by shareholders.  Unlike an S-corp, a C-corp can have as many different shareholders as it wants, can have as many classes of stock as it wants, and can be owned by non-individuals.

Taxes

Unlike the other entities we’ve discussed, a C-corp is NOT a pass-through entity. Profits taxed at the entity level before shareholders even touch them.  Currently, 21% of net profits are taxed at the corporate level, and the remaining profits then continue to sit in the business bank accounts.

If the corporation decides to return that money to the shareholders as a dividend, that money is also taxed on the shareholder’s personal tax return.  This is what’s known as “double-taxation” and is the reason that financially speaking it doesn’t make sense for most small business owners to set up their company as a C-corporation.

Summary

So which entity is right for you?  As a general rule, setting up an LLC winds up being the best choice for most new small business owners, due to its limited legal liability and tax treatment.  But the right choice for you could be different, so reach out to a qualified tax advisor or attorney if you need help.