# S Corporation – Computing the Tax Savings

When deciding if you should elect Sub-chapter S corporation status for your company, you need to run the numbers first!

Electing to be taxed as a Subchapter S Corporation instead of as a Sole Proprietor could mean big tax savings for you as a small business owner. Notice I said could–because it’s not always the case. It’s really important to run the numbers – all the numbers – and do a comparison so you can make an informed decision.

This post is going to be a little technical. I apologize for that up front. I’m going to try to keep it in plain English though, because even if you can’t run the numbers yourself, you need to see what I’m talking about so you can discuss this with your accountant.

Here’s an example where I think choosing to be a Sub S Corporation is the right choice for a business owner: Jack Sparrow is a single, self employed pirate with net self-employment income of \$100,000. (Yes, Johnny Depp was on TV last night.)  Jack has no other income to report on his tax return.

I ran the numbers for 2014 and it shows the total tax on the 1040 return to be \$30,680. (\$16,550 for the income tax and \$14,130 for the self employment tax.)

That’s a lot of taxes!

But what if Jack were to set up a Sub Chapter S Corporation? He’d have to set himself up to receive payroll–(that’s part of the deal with an S Corporation, you have to pay yourself a salary) but the rest of his income would be taxed at his regular tax rate (they call that ordinary income) instead of at the self employment rate.

So for my example, I set Jack up with a payroll of \$40,000, his S Corp income is \$56,340 (not \$60,000 because he’s paying some payroll taxes that are deducted.) So when I run the taxes for that, I’m showing that his total tax on his 1040 is \$17,400.

Right here you’re probably going, “\$13,280 in tax savings per year? Awesome! Sign me up now!”

But it’s not that simple. Because remember, part of being an S Corporation means that you must set up a salary for yourself and pay the payroll taxes. If you don’t include the cost of those payroll taxes in your calculations, you’re not giving yourself a true comparison of the total tax cost.

For Jack’s example, we set up a payroll for \$40,000. From his \$40,000, Jack will have \$3,060 withheld as his employee share of FICA-that’s the Social Security and Medicare tax that gets withheld from everyone’s wages.  Also, remember when I said his S Corp income was \$56,340 instead of \$60,000? That’s because as an employer, Jack also had to pay an additional \$3,060 for the employer’s share of FICA, and I added another \$600 for state and federal unemployment taxes. The unemployment tax will vary by state but \$600 is a reasonable estimate.

When you add those payroll tax costs to the 1040 tax cost, Jack’s total S Corp taxes are now \$24,1120. That’s still a big tax savings of \$6,650! In this case, of course I would recommend that Jack go for the S Corp.

Just for fun, what if Jack were offered a pirate job as a wage earning position? All W2 income with no self-employment at \$100,000 per year? Just running the numbers straight like that,  his 1040 taxes would be \$18,341 and his FICA withholding would be \$7,650 so his total tax cost would be \$25,991 which turns out to be \$1871 more than his S Corp taxes.

Now in real life, there would be other considerations – like health insurance and other fringe benefits that might make Jack want to jump at that wage position.  But I left all of that out for this comparison.

The chart at the bottom of the post shows the numbers for Jack’s case side by side so you can see how I got to my numbers, in case you want to replicate them for yourself.

So, how do you determine if YOU should have an S Corporation instead of a sole proprietorship? You look at these numbers and it’s pretty persuasive. If you could save \$6,000 or more a year, who wouldn’t do that? But taxes have a lot of moving parts these days. Maybe you have investment income, maybe you have wages from another job. Maybe you have deductions that are allowed on a Schedule C that aren’t allowed for an S Corp. Healthcare costs can also make a difference and so can your retirement savings goals.

If you don’t run the numbers fully through a tax program, including the payroll tax costs, you could actually lose money going with an S Corp. I ran a scenario the other day – this is a real person’s actual numbers: her tax savings by converting to an S Corp–before adding in any payroll taxes, was only \$1,338. She’d spend that much in accounting fees for the payroll and additional tax return. Adding in the FICA and employer payroll taxes we send her to the loss column. I never would have known that had I not sat down and ran the numbers based on her whole situation.

While that taxpayer’s situation was unique, your situation is also unique to you. Before electing to be an S Corporation, make sure you have all the facts and run all the numbers.  You’ll be glad you did.

Here’s that chart I promised you:

Comparison of wage, vs. self-employment, vs. Sub S Corporation taxes

# Getting a 1099MISC When You’re Not Self-Employed

If you receive a 1099MISC document in the mail, and there’s a dollar amount listed in box 7 for Non-employee compensation, the IRS treats that as self-employment income and you’re supposed to pay self-employment tax on that income.  If you own your own business, that’s perfectly normal.  By the way, I’ve got lots of blog posts and tax tips for self-employed folks on this web-site so be sure to check those out.  I’ve got a list at the bottom.

But what if you’re not self employed?  Really not self-employed.  You’re stuck with a document that basically requires you to pay extra tax, what do you do?

First, only dollar amounts in box 7—count as non-employee compensation.  If you received dollar amounts in box 1 for rents or box 3 “other income” you don’t have to worry about the extra self-employment tax.  The rent goes on your Schedule E for rental income and the other goes on line 21 of your 1040.

But let’s get back to that non-employee compensation again.  What did you do to earn that money?  Is it in your field of work?  If the answer is yes, then it’s going to count as self-employment income even if you don’t think of yourself as being self-employed.

I’m going to use my friend Rick as an example.  He works for another tax company and he’s very good at what he does.  Every year, Rick gets laid off on April 15th.   My company stays open all year round and sometimes I’m super busy in September and October.  I could probably use some extra help around then.  If I hired Rick to help me with some tax returns, I’d give him a 1099MISC for the money I paid him and he’d have to report that as self employment income.   Even though Rick normally works for another company, he’s still in the business of preparing taxes.  The money I pay him for tax prep would definitely be considered self-employment income.

But let’s say I hire Rick to paint my office instead.  Rick’s not a painter, he doesn’t do that as a business, he’s just helping me out because I need my office painted and I’m helping him out because he needs the money.  We’re friends.  Painting is not his line of work.  So technically, he’s not self-employed and he shouldn’t have to pay self-employment tax on that income.  It’s a one shot deal never to happen again.  How do you account for that?

Well, it used to be that if you received a 1099MISC for non-employee compensation for under \$1000 and you put that amount on line 21 of your 1040—the IRS would let that slide and not audit for self employment tax.   But starting with 2013 tax returns, the IRS has announced that they will send notices to anyone with 1099MISC income (with non-employee compensation) on line 21 instead of putting it on a Schedule C—where it will be taxed with self-employment tax.

There’s no box to check or form to fill out with your 1040 to say, “Hey, I’m not self-employed!  I shouldn’t have to pay self-employment tax!”  So what do you do?

You’ve basically got two options:

One:  Claim the income as business income and write off any and all expenses associated with the job.  This is going to be the best choice for people who have expenses with a job like mileage or supplies.

Or, two:  File your 1040, pay the self employment tax, and then file an amended return 1040X taking the income out of self employment and putting it on line 21 with the explanation that you are not self-employed and the income should not have been subject to self employment tax.

Why do this as an amendment instead of doing it that way the first time?  Because the IRS has already announced that they are sending letters out to anyone who puts 1099MISC for non-employee compensation income on line 21.  And they charge fines and penalties for underreporting your tax.

By filing and paying the self-employment tax first, then amending, you’re giving the IRS the opportunity to examine the situation and make a determination.  You may win, you may lose.  But if you win—the case is closed and they won’t come back at you.  If you lose—it doesn’t matter.  You already paid the tax and they can’t fault you.  No harm, no foul.

Most people who receive a 1099MISC for non-employee compensation are going to be considered self-employed by IRS standards.  You may as well file the schedule C with your tax return and pay the self-employment tax.   If you think you might be an exception give us a call, we can help you sort out your options.

# Why Am I Being Audited By the IRS?

Photo by redjar at Flickr.com

The first question I’m always asked when someone receives an audit notice is, “Why me?  What’s wrong with my tax return?”

If you received an audit notice, that’s a perfectly legitimate question, and you have the right to ask.  It’s a very important question too.  The answer you get from the IRS can help you to limit the scope of the audit—that‘s really important.  If you know what the audit is about, you know where to focus your energies.

Often times, an IRS agent may respond with, “Oh, I don’t know why your return was pulled, it’s just a random audit.”  However, sometimes they don’t seem so “random”.  Actual random audits (and yes, they do occur) involve reviewing every single line item on the tax return.  They’re used to help determine how future audits are handled.    Most audits, are not random, and if you’re being audited you have the right to know why.

So what does trigger an audit?  The most common type of audit is called a correspondence audit.  Usually what happens there is that the IRS received a notice saying you received income from a source and it doesn’t match anything on your tax return.  They call it “document matching.”  (Hey, it’s the IRS; creative names are not their forte.)

Document matching audits are usually pretty simple.  For example, the IRS gets a W2 from a job you had for 2 weeks in January but you completely forgot about it at tax time.  You never got the W2 so you didn’t include it on your return.  That’s a fairly typical correspondence audit.  In a case like that you just sign the form and pay the tax.  That’s a simple “oopsies.”   You’re not a criminal, you just made a mistake.

Sometimes, document matching is kind of screwed up.  For example:  I just handled one where the document matching showed three interest statements for “First National Bank”;  one for \$21, one for \$16, and the third for \$54.  The tax return showed interest for “First National Bank” as \$91 (\$21 + \$16 + \$54 = \$91).  We just handled that with a phone call.  Document matching is done by computer.  Normally, a human would have caught the numbers added together and the audit letter would never have gone out, but the computer isn’t that sophisticated.

One of the best ways to prevent document matching audits is to make sure that you report everything on the correct line.   If you have a 1099 with an amount in box 7 and you don’t have a Schedule C with your tax return—that will generate a correspondence audit.  Another common correspondence audit involves capital gains.  If you’ve bought or sold stocks or had stock options through your job—there should be a Schedule D with your tax return.

If you’re dealing with something new in your taxes, even if you’re very good at preparing your own, I recommend at least having a second look done before you file.

In-person audits are more often based on statistical data.  The IRS uses something called a “DIF” score.   To put it in simple terms, a DIF score basically highlights when things on your tax return are out of the “normal” range.  Basically, a computer algorithm kicks out something like:   “Joe Schmoe’s charitable contributions are out of line with his income.  So Joe will be audited for his charity donations.

So how do you know what’s normal?  That’s the magic question isn’t it?  The IRS does not release its DIF score formulas.  Even if they did—if you have a legitimate deduction, you shouldn’t let DIF scores (or the threat of DIF scores) keep you from claiming what’s legitimately yours.

I once worked on an audit for a fellow whose return was being looked at for the mileage he claimed.  In truth, his actual mileage was much higher than what he reported, but his co-workers had convinced him that he shouldn’t claim all his mileage because he’d get audited.   Claiming the lower mileage didn’t protect him from an audit—and—it cost him money for all those years that he didn’t claim what was rightfully his.

Your best defense against an audit is always going to be doing your taxes right in the first place and having the documentation to back up your claims.

If you’re a W2 wage earner, the most likely audit area will be your charitable contributions and employee business expenses, because most everything else can be determined through document matching.

Small business owners (Schedule C) are much more likely to be audited—mostly because there’s so much more to audit.   In every Schedule C audit I’ve ever worked on, the IRS has requested the mileage log.  Every audit—mileage log.  Every single one.

In addition to the mileage log, they’ll often want to examine the expenses or the revenues, sometimes both.  If you own your own business, I can’t stress enough the importance of keeping good records.

If you’re being audited, the IRS agent should be able to tell you why.  If you honestly don’t know why you’ve been selected, and you’re not getting clear answers from the IRS, hire someone to represent you.  A professional can usually find the audit trigger (or triggers) within a matter of minutes.

# Some Hidden Truths About the Standard Mileage Rate

Photo by Yul B Karel at Flickr.com

Hello again.  Mike here.  Today I am going to discuss some issues regarding automobiles.  Don’t worry—I won’t get too crazy with the details as one could write an entire novel on this subject.  It will be rather minor things that can have a big impact on your tax return.  Also keep in mind that this is geared towards self employed taxpayers who use their auto for business and report income and expenses on Schedule C and not necessarily employees who use their vehicle for business and report it on a Form 2106.

Let’s get started with some numbers.  The 2012 Standard mileage rate is 55.5 cents per mile.  It is expected to be 56.5 cents per mile in 2013.    A taxpayer can either deduct actual costs incurred by the taxpayer’s automobile, or use the standard mileage rate method to calculate the amount deductible by business use.

Most people use the standard mileage rate for whatever reason – it produces more of a tax benefit or he or she has not been keeping track of actual expenses.  What makes up this seemingly arbitrary 55.5 cents(2012) or 56.5 cents (2013) per mile anyway?  The IRS says that depreciation, lease payments, maintenance and repairs, gasoline, oil, insurance, and vehicle registration fees all make up this cents per mile figure.

Where most people jump off the diving board too early is figuring the costs NOT included in the standard mileage rate.  These are costs IN ADDITION to deducting the standard mileage rate and it is applied using the business percentage of the vehicle.  Parking fees and tolls are applied 100%.

These costs include:

Interest Expense
Personal Property Taxes
Parking Fees
Parking Tolls

Let’s do a quick example to demonstrate your tax savings.   A single, self employed individual (we’ll call her Mary) makes \$50,000 doing a catering business.  Her cost of goods sold is \$25,000 making gross income \$25,000.  She records 20,000 business miles out of 25,000 miles for the year.  The overall balance due for this taxpayer is \$2,061.  Keep it simple here; don’t worry about dependents, adjustments to income, credits, etc.

She just records her mileage and nothing else because that is what she has been doing for years.
However, after talking to her astute accountant, she later points out that she paid \$100 parking fees, a few tolls at \$50, \$300 in interest on the car, and paid considerate personal property taxes of \$308.

The parking fees and tolls get added dollar for dollar to the standard mileage rate calculation.  The interest and the personal property taxes are added by the business percentage or 80% (20,000 business miles/25,000 total miles).  This “extra” \$636 (\$100 parking fees + \$50 tolls + (80% * \$300 interest) + (80% * 308 personal property tax)) is added IN ADDITION to the business mileage calculation.
After adding to additional information to the automobile, her balance due becomes \$1,922.

Her tax savings are \$139 (\$2,061 – \$1,922).

Happy Savings!

-Michael

P.S. Attached is a 2012 auto expense worksheet that will help you organize your automobile expenses and help you decide whether to do the standard mileage rate or actual expenses method.
2012 Auto Expense Worksheet

# How Do I Write of a Bad Debt?

Photo by JamesCohen on Flickr.com

I recently received an email from a client about a bad debt.  It’s the second time I’ve gotten that same question in one week, so it seemed like a good idea for a blog post.

Here’s the question:  “I’ve had trouble collecting on a \$500 invoice and I’m not sure it’s worth any more time and effort dealing with it.  Is there a way to write it off and get some kind of tax advantage?”

Now most of my clients, including the person asking the question, are on what’s called a “cash basis accounting” system. If you’re on a cash basis accounting system, it means that you don’t record income unless you actually receive it.  Same with expenses, you don’t count an expense that you’re going to pay, only ones that you’ve already paid.  In a case like this–you don’t have to make a special line item adjustment for a bad debt–it’s just not counted in your income in the first place.   So for this particular client, she doesn’t have to do anything (except fume over the dude who didn’t pay him for his work.)

But some businesses are on what’s called an “accrual” accounting basis–that’s where you count income as soon as it’s billed, not when it’s actually paid.  Usually, businesses that have inventories, like stores for example, use an accrual basis method of accounting.  With an accrual method of accounting, you’d report income as you billed it.  Using the example from above, if the business owner billed the \$500, he would have already counted it as income, even though it didn’t actually reach his pocket yet.  For a business like that, you’d write the bad debt off as an expense.   There’s actually a line right on the corporation forms for “bad debt expense”.  While there’s no special line on the Schedule C for bad debts, you would just make your own line item for “bad debts” in part V–other expenses.

And that’s all there is to writing off a bad debt for a business.  Now if you’re dealing with a personal bad debt–like a loan to a relative that’s never going to get paid, that’s a whole other story.  I’ll write about those in my next post.

# Tax Tips for Daycare Providers

Photo by Angela Vincent on flickr.com

First things first, let’s tackle the big “problem” many daycare providers have – licensing. The IRS demands that you report all of your daycare income, but if you’re not licensed, you don’t qualify to claim any of the deductions. Now the whole licensing thing varies by state. Here in Missouri, you do not have to have a daycare license if you care for four or fewer children who are not related to you. If you’re exempt from licensing requirements for your state, then you’re qualified to claim all of the federal tax deductions relating to your daycare business. Different states have different rules. Just across the river in Illinois, the licensing requirements are much stricter. Be sure to look up the rules for your state before you claim daycare deductions.

Your daycare income will go on a form called Schedule C which will be part of your regular 1040 tax return. You are required to pay self-employment tax on your daycare income; that will be 13.3% for 2011, generally it’s 15.3%. Self employment tax is in addition to your regular income tax, so you can see why claiming your expense deductions can come in kind of handy.
The first, and probably the biggest, daycare deduction is for the business use of your home. That’s going to go on a Form 8829 and it’s going to be linked to your Schedule C. You won’t be able to deduct all of your rent, utilities, and expenses, but you’ll be able to deduct a portion of them as a percentage of how much of the home the kids have access to and how long you’re open. Kids put a lot of wear and tear on your home so definitely take advantage of this deduction.

Another big expense for many daycares is food. You can deduct as a business expense 100% of the cost of the actual food the kids you care for eat. If you’re doing your taxes yourself when you’re looking at the actual Schedule C form, there’s a section for “meals and entertainment” –you don’t want to use that line. That only gets counted as a 50% expense – that’s for sales people taking clients out to lunch and stuff like that. You’re going to want to put the food for kids on a separate line in the “other” expenses category. Call it “food for kids”. (Okay, that seems pretty “duh” but I didn’t have a better way to say it.)

If you get reimbursements under the Child and Adult Food Care Program of the Department of Agriculture, that’s not taxable unless you get more money than you actually pay out for food for the kids. Usually, you’ll get a 1099 showing you received a payment. If that’s the case, you must report it as income on your Schedule C, but then you’ll deduct the cost of food in the expense category. (If you get a 1099 and don’t show it as income, you’ll get a nasty IRS letter—that’s why you want to show it on the Schedule C even though it’s not supposed to be taxable.)
If you’re deducting food, keep separate receipts for your daycare food from your family food. (Right, I know, that’s not easy.) But remember, you can’t take a deduction for the food you feed to your own family. Now let’s get real: you just shop and buy groceries for your daycare kids and your family in one fell swoop don’t you? (Okay, that’s what I’d do, and I’m one of those anal retentive accountant types!)

Here’s how you solve that problem. The IRS has official “snack and meal rates”. Granted, they haven’t been updated since June of 2010 but I’ll work with what the IRS gives me. The rates are as follows:

• Breakfast: \$1.19
• Lunch: \$2.21
• Dinner: \$2.21
• Snack: \$0.66

Alaska and Hawaii have different rates:

• Alaska: \$1.89, \$3.59, \$3.59, \$1.07
• Hawaii: \$1.38, \$2.59, \$2.59, \$0.77

So let’s say you take care of Oliver 5 days a week. His parents take care of breakfast and dinner, but you do provide lunch and a snack every day. Oliver stayed home two weeks over Christmas and one week over Easter, other than that you’ve had him all the other days. You take \$2.21 for lunch and add \$0.66 for lunch and that makes \$2.87. That’s what you spend on Oliver’s food on a daily basis. You multiply that by 5 days a week and get \$14.35. You multiply that by 49 weeks (there’s 52 weeks in a year and you didn’t have him for 3 weeks) and you get \$703 spent on Oliver’s food that you can deduct from your income.

Granted, you probably spend more than that on your daycare kids, but at least this gives you something to work with, especially if you haven’t been keeping good records.

Don’t forget the other deductible things either: money you spend on toys and games, and extra costs of laundry and cleaning supplies. If you take the kids on field trips, be sure to keep track of your mileage and the cost of admission to events. And remember that if you’re reading magazines to help you with taking care of the kids, those can be a business expense too: things like Family Fun Magazine that give you tips on things to do with kids, that’s work reading.

Taking care of other people’s children is hard work. You deserve every penny you earn. My job is to help you keep it.