How Much Tax Do You Want to Pay

How Much Tax Do You Want to Pay? 

Roger: Welcome back. In the last episode, we talked about all the various legal formats that you could put a business under and what the differences are and the things you need to take into consideration. So today we're gonna make the next step. We're gonna talk about the tax consequences of those legal decisions that you make. 

So let's get started .

Announcer:

You are listening to the Mastering Business Basics Podcast, where we discuss how to build a solid foundation under your small business to improve your chances of success. And now here is your host, Roger Pearson. 

Roger:

Most businesses in this country are sole proprietorships, and a lot of people don't realize when they get into one exactly what that is because we have an influence of people doing things like Uber or Instacart and various other things, and they don't realize what they're getting themselves into, other than that, they don't make much money doing it after they get done deducting all of their expenses. But that's for another episode. 

Today, I want to go through the different legal formats and give you some of the basics of the tax consequences and what you gotta look for in those and why one may be better than the other one in your particular situation and your journey through your business and the size of your business. 

Of course, the most common one in this country are sole proprietorships. And because they're easy to start, you don't have to register with the state or anything like that. But the other problem is they probably, as a percentage of net profit, have the highest taxes of any legal format. And one of the main reasons for that is that people don't realize that 15.3% of their net profit in a sole proprietorship goes just to pay Social security, Medicare taxes. 

I mean, those that are used to getting a W2, the employer pays half of it. But on a sole proprietorship, you are the employer and you are the employee. Therefore, you get to pay both halves. And then the minimum tax rate in the federal tax code is 10%. 

So that means a minimum of 25% of your net goes right up in smoke on taxes, on federal taxes, social security and Medicare. And that doesn't take into consideration states, 'cause a lot of states have taxes too. More states have taxes and don't. 

In some high tax stage you may be paying up to 45, 50% of your net profit just in state, federal, and employment taxes. And that's an incredible number. How are you supposed to make any money or make a living off a sole proprietorship when you do that? 

But there is a time when it may be more advantageous, as I was saying last week, that if you're just starting out and you're testing the concept for a business to see if you like to do it, see if it's a viable concept, then a sole proprietor is probably the best, because you just start the business. If it doesn't work, you just stop the business and report whatever earnings or losses that you had during the time you were trying it out. So it's very easy that way. And the majority of businesses actually in this country are sole proprietorships simply because it's so easy. 

It does not take any legal framework at all to do a sole proprietorship. But it's gonna have higher overhead costs when it comes to taxes. I mean, the other expenses of a sole proprietorship are the same as any other legal format. It's just the tax structure is so bad. And the same tax structure is true of general partnerships because the income of the general partner comes down on the K-1 to their personal return, just like a sole proprietorship and they have to pay their entire payroll taxes the same as the sole proprietorships. So, those two are gonna have the highest, tax consequences of all, and that's something that you really have to take into consideration. 

The other thing is, although a lot of people ask me, well, what about my office expenses that I have at home? And can I take a percentage of the home office because I heard I could do that? 

Actually a sole proprietor is the only format that you can actually do that. A home office expense, you can either take a percentage of actual expenses or you can take the di minimis amount, $5 a square foot up to 300 square feet you can deduct, which gives you, I think, maxes out $600 deduction, which is a nice deduction. 

But if you get into partnerships and, S corporations or C corporations, of course you can't do that. So that has to be taken into consideration. The other thing that you're gonna have to do is make estimated tax payments, because if you leave the balance due of what you're gonna owe until the end of the year when you do your taxes, you're probably gonna have to pay a penalty on top of the other taxes simply for not doing estimated tax payments. 

Therefore, you have to have a good bookkeeping system, because you have to know at least on a quarterly basis what your net profit is, so you can figure out how much tax to send in to the government, because you don't have that employer deducting it from your W2. You're the employer. So it's your responsibility to take that and send it in to the IRS. So when you do your taxes, you're not gonna be penalized for underpayment. That's another consideration that you have to take in. 

And then the other thing is, if you're in a position where, and most people in sole proprietorships usually run into this, they have to use their vehicles to do their business, unless you're in the computer business and you do everything virtually. But if you do anything out in the real world, you're gonna probably have mileage. There's two ways to keep track of mileage. 

One's called the standard deduction and the other one is called actual expenses. The thing about, sole proprietorships , you could choose either one that you want and generally nine out of 10 times, unless you have to repair an engine or something the standard mileage is very generous. 

And a lot of people don't understand what that involves, but the standard mileage deduction, which changes every year, it's about 70 cents a mile right now. But that encompasses your car payments, your car insurance, your car maintenance, your gas, everything in there except for tolls and parking is basically included in your standard mileage. 

The other way is to take a percentage. If you have, of course, if you have a vehicle that's used a hundred percent for business, then a hundred percent of the expenses you can deduct. But if you have a car like most people that's used for personal and for business, then you have to keep track of what percentage of it is used for business and what percentage of it's used for personal. 

And then you take a percentage of all the expenses for the year and you deduct that, which is why the standard mileage is so much easier. You still have to keep track of your mileage and a lot of people starting out do not realize this. 

I've seen a lot the IRS doing a lot of requesting mileage logs lately. . Where's the proof that you actually wrote these expenses as legitimate business? So you have to keep a mileage log. And the mile log contains the date, the business purpose, like your client's name or you're going to staples, whatever you're doing for business purposes. 

And the number of miles it drove to go from your office at home to the business purpose and back. And you have to do that on a daily basis. Now, there's a lot of apps out there now that you can actually press the start button and the stop button. It'll figure out the mileage for you, and you just have to enter the business purpose. 

And then it'll, produce a report at the end of the year that you can use for your taxes. And I would highly advise you start using something like that because the other way is to do it all by hand and that's a pain. It's really a pain and a lot of people just forget to do it, and then they've got a mess on their hands when it goes times to do taxes, you just gotta mess on your hands. So you need to know that also. 

One of the things about the standard and actual is that when you get into partnerships, the partnership can reimburse you for your mileage. But the partnership has to have actually a legal agreement in place in writing stating that they have that policy where they will reimburse you, for your work mileage. Of course you have to be a general partner. You cannot be a limited partner to claim that. 
 

The S corporation has to have the same type of agreement in place where they'll reimburse the employees. But your S corporation, you have to be a W2 employee of the corporation to take advantage of the reimbursement plan of the corporation just as if you work for somebody else. 

And if the S corporation owns the vehicle instead of you personally, you could only use actual expenses. You can't use standard mileage. So these are all the considerations you need to take into account when you make the decisions in how you want to run business. And these are things that most people starting out simply do not know at all. 

One of the other things that I always get into when I talk about all of this is basis. Now a lot of people don't understand what basis is. Basis is basically how much skin you have in the game. That's what I call it anyway. How much basis you have in your business is important because a lot of people are cheating on this. And the IRS is really, uh, coming down hard on people. 

A lot of people were having big losses in their partnerships and S corporations and they were just writing the whole thing off. But the problem is that the law state you cannot take a loss in excess of your basis. And so your basis is how much you've invested in your business and how much profit you've made in your business. 

So for instance, if you take $50,000 and you put it in your business or you buy $50,000 worth of shares in your business, that's your starting basis. If the company makes money, your share of profit increases your basis. If the company loses money, then it decreases your basis. And your basis can never go below zero. 

So if you put in 50,000 and you lose 60,000, you can only deduct 50,000. The other $10,000 sits there until such time as you make enough profit to cover it, and then you can take it. So you have to understand that. And a lot of people were just, uh, taking the entire amount as a loss and not keeping track of it. 

And the IRS says, we're tired of that nonsense. We know we're losing millions and millions and millions, if not billions of dollars from people doing this. So they're cracking down on it. So you have to keep track of your basis, and that's something that I would definitely go to a professional for because it's kind of a complex thing.

Now, when you get into partnerships, of course there's different kind of partnerships as I was talking about before. . But the partnership income, our general partners comes down on a K one, what's known as a K one instead of a W2. You get a K one. And partnerships cannot W2 themselves, they simply cannot W2 themselves. 

So you're not gonna have any withholding taken out of anywhere. You're responsible for paying all of it at the personal level. So it comes down on the K-1 and your share of the profit that comes down, well, you're gonna have to pay for it. 

Now, if you're a limited partner, then it comes down as investment income. Because all you've done is invested. You're not working any part of the business. You just put money in the business investment. Therefore, it's gonna come down and, and be treated as something like capital gains. So that's an entirely different matter that you have to take into consideration. 

The other thing I wanted to talk about that I think is probably one of the biggest missed opportunities of small businesses is the subject of depreciation. Depreciation is something that most people don't understand, except this is one of the things, one of those things that huge corporations use to reduce their tax liabilities. 

Let me explain it by giving you an example. For instance, if you buy a computer for your business. The IRS says, no, by default, you cannot deduct the whole thing in the year you buy it if it's over $2,500, alright? There's an exception if it's under 25 that you can use. You have to deduct it over a five year period. 

If you buy office furniture that's known as seven year depreciable items and well, depending on what you buy it, it goes anywhere from three years all the way up to 39 years for commercial real estate that you depreciate them over. So you have to know that also, and that's also part of the basis that goes into your business. 

But the thing about depreciation is that there are, for every tax rule , there seems to be an exception. And so for depreciation, there's also exceptions that you can choose to accelerate the depreciation and deduct the whole thing the first year, or you can spread it out over the multiple years as it normally would be. 

Now a good tax professional is gonna sit down with you and say, okay. Let's take a look at your books this year. What are your plans in the future years? Because if you need more deductions this year, then you then you can deduct the whole thing this year. Or say that you got contracts coming up in the next year or two. 

You know you're gonna be making a whole lot more money in the next year or two. Maybe you can use the deductions there better. So you push part of that depreciation through depreciation or section 1 79, you push that into the next year or the next few years, so you have more deductions going forward, because you'll need 'em more then than you 

need them now. And anytime you have your taxes done by a tax professional and you have depreciable items, this is one of the discussions that that tax preparer should be having with you. Unfortunately, a lot, don't. They just put it down, let, the software do its thing and they don't have a strategy session with their clients on how to use the depreciation and another thing called section 1 79 to either accelerate or push off expenses. And this is one thing they should, if they're a good tax professional. They should be having that discussion with you every single tax season. 

Then we get into C corporations. Well, C corporations are an entity all to themselves. They have nothing to do with your personal returns. A C corporation's a big corporation like IBM, uh, Microsoft, Amazon, all the biggies. And anything that's on the stock exchange is gonna be a C corporation. But that doesn't mean that you can't use that at the local level if you want, a small business can be a C corporation. 

I have a C corporation, and the C corporation pays its own taxes. It's not paid for the personal level. The C corporation pays you one of two ways, either as a W2 employee or sending you dividends for your share of the profits of the corporation. 

Does the corporation have to give all of its profits out? No. It can hold part of the profits back for future use. You have to be careful how you do that because there are rules and the IRS says you can only hold such a percentage back for future, and you have to be able to substantiate. It can get complicated on larger businesses, which is why they hire all these expensive accountants . So you have to be aware of that. 

But if you totally, totally, totally want to isolate yourself and all of your personal assets from any possibility of somebody coming in and grabbing them, well then C Corporations the most secure. On the other hand, it can be one of the most expensive from a tax standpoint. 

Now, currently it's not. It used to be before 2018. I think the corporate rate was about 39%. And when Trump came in the first time, uh, it got reduced down to 21% which is more reasonable. So if you're in the 22% tax bracket on your personal returns, a 21% bracket is gonna beat that. 

Or if you're at a 30% bracket on your personal return, it's gonna be cheaper for the corporation to pay. So that's a consideration you have to take, what all your other income coming into your household from all your other work and all your other investments. 

The problem here though is that if your corporation pays you dividends, any corporation or any stock that you buy. because The stock in your corporation is the same as buying stock in any other corporation. The rules work the same is that, you pay tax on the dividends that come to you. they get paid out to you just like if you got dividends from any other broker. 

But the C corporation also has to pay tax on those same dividends. So it's called double taxation. And so that's one drawback depending on how large a corporation is. Now, if it's small and the dividends are small, and most of it's paid out in W2 and everything else. You're probably gonna be okay, but you have to be aware that is there. 

If, I mean, if all of a sudden your company takes off and you're making a huge amount of profit and you wanna bring it down to dividends, then you're gonna be paying that amount of dividends twice. Which isn't fair, but that's the way the tax laws are written. 

Which brings us to an S corporation. And S corporation is a hybrid. S corporations are basically a combination of a partnership and a C corporation. In that you're actually a corporation because as we learned before, corporations are started at the state level and by default they all start as c corporations. 

Basically what you do is you file a form with the IRS saying, I wanna be taxed and as a S corporation instead of a C corporation. That's all it is. You can remove that election at any time, as we talked about before. But it also means essentially that I want to pay the taxes on my personal tax return instead of having to pay the taxes at the corporate level. 

So there's no double taxation. You're just bringing down everything on a K one again, and it's gonna break it down. You're gonna get a W2, so the taxes are taken out for Social Security, Medicare there, and that's all that's gonna be taxed on Social Security, Medicare, what you have on the W2. The rest of your income that comes down on the K one is considered investment income because you invested in this corporation, and that of course is capital gains. 

So what happens is that as your business grows, say you start as a sole proprietorship, you decide the thing is gonna make money. You start making 40, 50, $60,000 profit a year. Well, you can't stay as a sole proprietor, the taxes will eat you alive. So you change to an S corporation, but that doesn't mean you can't be a c corporation or LLC at the state level. 

A lot of people are sole proprietor LLCs at the state level, but the s election with the IRS means that a partnership can say, I wanna be taxed as S corporation. The sole proprietor can say, I wanna be taxed as an S corporation and get the benefits of less taxation, because you're not paying out on your Social security Medicare. That's a huge difference. If you're making 40, $50,000 a year, that's a huge difference. So you're still putting money away in the social security because of your W2. 

Now, some people, and this is another thing they're cracking down on, some people say, well, they don't pay themselves a W2 and they bring the whole thing down on the K one as investment income, and the IRS has a fit about that. 

If they find you doing it, because they'll come in and, and reassess it and hand you a bill for what you should have W2 yourself and what you should have paid in payroll taxes because they say, you're not gonna W2, you're gonna bring 40, $50,000 down on a K-1 as investment income? 

You're doing that to evade payroll taxes. That is against the law. So they have a fit about that, and you can get yourself in a lot of trouble. So this is things you need to consider also. So when you become a successful by all means do an election to become an S corporation with the federal government and save yourself a lot of taxes. 

And I've helped a lot of people do this, but you have to know the timing because there's an overhead to being a corporation. You have to file separate tax returns and you have to do payroll, and you have to do a lot of other things that you don't have to do as a partnership or a self proprietorship. 

And if you're willing to do that and be in compliance with all those regulations, then by all means that's what you should be doing. 'cause it can save you thousands of dollars a year. And after all, you're in business to make money, and the taxes that you pay is an expense of the business. Therefore, you should be very good at dealing with them. 

Should you do this by yourself? Well, as you get going, no. You need to hire a good tax professional. But here's the deal and the reason why I do these podcasts and write my books and everything else. People need to know the basics of these because you need to know how to hire a good tax professional, what they should be talking to you about, what considerations that they should be taking into consideration to help you save the most amount of taxes for your business and keep that money in your pocket. 'Cause you can do a better job of spending that money than the government does. They waste so much the way it is. 

So if you know the basics of sole proprietorships, partnerships and corporations and the advantage of using S Corporations, the advantage of using depreciation, how to keep track of your basis, those are the basic things you take into consideration. 

And knowing those things, you can have intelligent discussions with other people how to best serve you, because you have to consider that when you hire an accountant or when you hire a tax professional, you are hiring an employee. They should be working for you. You not working for them. 

Therefore, they need to be doing the best job, but unless you know how to interview them and what to question and how they should be working with you, you're putting yourself at a disadvantage. You're not doing a good thing for your business. So this is why I bring these things up so that you can learn these things, that you can know these things, that you can do a better job of running your business, and that you can give your business a better job of survival because it takes money to run a business. 

And so the more money you keep in your pocket to run your business, the better chance your business has of surviving in the long term. I mean, it, it's sad because over 70% of businesses fail within the first five years. And it's sad. A lot of it is because people don't know the basics of business and they lose too much money, and they finally figure out, I'm not making any money. I'm losing my money. I'm paying it out in this, I'm paying it out in that and paying it out in taxes. I have no money left, uh, to run the business. And they disappear. 

And that's a shame. And I want to help prevent that if I can. Now, if you live in a state that also has taxes, I mean, you have to take the state considerations into account and there's just no way I can sit here and go through all 38 states that have state taxes. 

Uh, that would be a very, very long podcast, and you probably get very, very bored. But I've gone through some of the things that you have to take in consideration on your federal tax forms and the things you need to know to hire the right person to take care of these. And once you hire the right person, they can do things on the federal, then they're gonna do things good on the state also. 

That wraps things up for this episode. If you'd like a detailed summary, of course, of all that we've done, I did write a book on it. You can find the links for that out on my website, seagulltechnologies.com. 

And then next week we're going to kind of put these things, these two things together and talk about how you should organize your business. The things that you need to keep track of, how you need to keep your paperwork, because organization is just as important as knowing legal formats and taxes. 

In between those two are the things that , you need to know. Well, let me put it this way. The more organized you are in keeping track of how you do your business, the people you employ are gonna be able to help you. i have so many times it's like pulling teeth, getting the information I need out of new business owners. 

They just, they don't know how to keep the books. They don't know how to keep things that depreciable items separate from non depreciable items. They don't know how to keep their basis. They don't know these things, and you have to know these things. So we're gonna talk about some of those basic items that you need to take into consideration also on the day-to-day operations of your business. So I hope you join me with that. In the meantime, have fun with your business. 

Announcer: You have been listening to the Mastering Business Basics Podcast with your host, Roger Pearson. For more information about all of the business education options that are available, we invite you to visit seagulltechnologies.com and continue your journey.