What is the best business structure for you?

When you operate a business, it is very important how you decide to initially structure that business. While a sole proprietorship is the easiest business to start and operate, not only will you miss out on tax strategies to lower what you pay the government, but you could find yourself personally responsible for the debts of the company if the company takes a turn for the worse. To avoid this risk, you can structure your business as a limited liability company, a limited partnership, or a corporation. These structures protect you from the debts of the company, hence creditors can’t go after your personal assets. Once you choose a corporate structure, it is not easy to switch to another, so it is important that you weigh all your options before deciding. 

LIMITED PARTNERSHIPS.

If your business is structured as a limited partnership, then all the profits and losses of the company will flow through to the individual returns of the owners, meaning there is no income tax at the business level. In a limited partnership, only the owners who are actively involved in the management of the business are personally liable for the debts of the company. Owners who are only financially involved in the company are not personally liable.

C-CORPORATIONS. This is the most common type of corporation, as there is no limit to the number of shareholders and it is easy to transfer ownership. One benefit of the C-Corporation is the ability of the managing owner to distinguish between income earned as a salary, and income earned as profits of the corporation, allowing them to only pay payroll taxes on a portion of the income. The major downside to the C-corp is what is referred to as double taxation, where the profits of the company are taxed first at the corporate level, and then again at the personal level as they are passed through to the owners.

S-CORPORATIONS. The main benefits of operating as an S-corporation, are that income is passed through the corporation without being taxed, and you can differentiate between salary and profits of the corporation. The S-corp provides the same benefits as the C-corp, without being subject to the double taxation of the C-corp. Another benefit to the S-corp over the C-corp is when an S-corp is sold, the proceeds are treated as capital gains, which have more favorable tax treatment than ordinary income, which is how proceeds from the sale of a C-corp are treated. While there are requirements to qualify as an S-corp, such as no more than 100 owners, they can provide significant tax advantages over the C-corp.

Once you choose a corporate structure, it is not easy to switch to another

LIMITED LIABILITY COMPANIES.

Similar to an S-corp, an LLC provides the liability protection of a corporation, along with the pass-through nature of a partnership. An LLC, however, places no restrictions on the number of owners, the tradeoff being that all LLC members pay self-employment taxes on all income. LLC also provides advantages upon dissolution as assets distributed to owners are not taxable until sold by the recipient.

Unlocking the home-office deduction

Small-business owners should not miss the benefit of a home office deduction out of fear of a tax audit. Going to an office is no longer a requirement of conducting business in the age of the internet, cell phones, Skype and GoTo meetings. This means an increasing number of small-business owners are working from home, and eligible to claim a home office deduction. When Properly implemented, this deduction can make a significant difference in your tax liability.​

WHAT CONSTITUTES A HOME OFFICE?

In order to claim a deduction for a home office the IRS requires that a designated space be used exclusively and regularly for business. Exclusively used for business means it cannot ever be used for personal reasons during the tax year, this includes any type of storage for personal items. Although the office is to be used only for business, the tax code does not mandate that it be a separate room, it can be part of a room – walls are not a requirement. The office must also be used on a regular basis for business.

Going to an office is no longer a requirement of conducting business in the age of the internet, cell phones, Skype and GoTo meetings.

HOW TO DEDUCT EXPENSES FOR THE HOME OFFICE

There are two different methods you can use to claim a home office deduction, the actual expense method and the simplified method.

ACTUAL EXPENSE METHOD

The actual expense method allows you to deduct all direct expenses and a portion of any indirect expenses. Direct expenses are any expenses incurred specifically for the home office, such as painting the office or putting in new carpet. Indirect expenses include any expenses incurred for the home such as mortgage interest, property taxes and utilities. To claim these indirect expenses you need to determine the portion of the expenses that relate to the home office. This can be calculated by dividing the square footage of the office by the square footage of the house. You can also claim depreciation or a rent deduction for the part of the home used for business purposes. On the downside, when you sell the home any depreciation taken needs to be recaptured. This can be an unpleasant surprise come tax time. When using the actual expense method, detailed records and supporting documentation must be kept for all expenses.

SIMPLIFIED METHOD

If you prefer not to maintain records of these expenses, you can still take a home office deduction using the simplified method. The simplified method is calculated by simply multiplying the square footage of the office by $5 per square foot (up to 300 sq. ft.). The advantage to this method is the IRS does not require you to keep any records that are required by the actual expense method. The main drawback of the simplified method is that you will not be able to deduct your actual expenses if they exceed the allowance of the simplified method.

The best solution is to keep track of all of your expenses and then determine at the end of the year which method will provide the greater deduction.

MILEAGE

Regular commuting to and from work is not a deductible expense, however travel between your primary office located in your home to your second office is classified as business miles that are deductible. This does not mean that you can set up a “home office” to deduct your regular commuting miles. It means that if your home office is where you conduct the majority of your business, you can deduct any mileage to a secondary location. Setting up a home office can potentially create several thousands of dollars in deductible mileage each year.

TAKE AWAY

Even the smallest home office can unlock significant deductions if the expenses are properly accounted for using either the actual or simplified method. It is very important that the space be used exclusively for business purposes.

The new deduction for pass-through businesses

The Tax Cuts and Jobs Act signed into law by President Trump at the end of last year included numerous changes to both individual and corporate taxes. One of the most notable changes was a new 20% deduction for pass-through businesses. This new deduction was created to ensure that pass-through entities were not penalized relative to the tax cut provided to C Corporations.

A flat 20% deduction for any pass-through business sounds pretty simple, but things are rarely simple when it comes to the tax code. And that is why we are here, to handle the more technical aspects of this new deduction. For now, here is a brief overview of the deduction requirements.

WHO QUALIFIES FOR THIS DEDUCTION?

The simple answer to this question is that any “trade or business” that is not a traditional C Corporation qualifies for this 20% deduction. That includes self-employment income from a sole proprietorship or a single-member LLC. It also includes income from a partnership or a S Corporation, as well as income from a rental property. What it does not include is any wages you receive as an employee, even if those wages are paid by a partnership or S-Corporation that you own.

A flat 20% deduction for any pass-through business sounds pretty simple, but things are rarely simple when it comes to the tax code. And that is why we are here, to handle the more technical aspects of this new deduction. For now, here is a brief overview of the deduction requirements.

HOW IS THE DEDUCTION CALCULATED?

This is where things start to get a bit more complicated. The deduction is calculated as 20% of your net business income. This means you must first deduct all of your normal business expenses, including any salary you pay yourself, before determining the deduction. This also means that your business must show a profit in order to receive the deduction

INCOME LIMITATIONS ON THE DEDUCTION

Like most deductions and credits in the tax code, the deduction is subject to various restrictions based on income and field of work.

If your total taxable income for the year is less than $157,500, or $315,000 if married and filing a joint return (MFJ) then you will receive the full benefit of the deduction. Note that this income threshold is based on your total taxable income, not just the income of your business. It includes any other form of income you or your spouse receive. However, if your taxable income is greater than $157,500 ($315,000 if MFJ) your deduction may either be reduced or eliminated entirely.

If your business qualifies as a “specified service trade or business” then your deduction will begin to phase out above these thresholds and will be completely eliminated at taxable income of $207,500 ($415,000 if MFJ).

If your business does not fit the definition of a “specified service trade or business” then you will continue to receive the deduction although it may be limited based on the amount your business pays in wages, or the value of the business assets

SUMMARY

With the introduction of this new 20% deduction for pass-through businesses, business owners are likely to see a reduction in their tax bill for 2018. The extent of the benefit you receive will depend on your total taxable income as well as the type of business you operate. If you expect your taxable income to be above $157,500 (or $315,000 if MFJ) then call us to help you determine how the tax law changes will impact you.

Staying out of the “Danger Zone” for the new small business deduction

The Tax Cuts and Jobs Act introduced a 20% deduction for small business owners. You can read our overview of this deduction in our last quarterly article. The gist of this new deduction is it will allow small-business owners to deduct 20% of their business income from their taxable income on their personal return. While this new deduction provides some welcome relief for small-business owners, there are restrictions on the deduction that highlight how critical proper tax planning is in 2018

If your business qualifies as a “specified service trade or business” then your deduction will start to be phased out at taxable income of $157,500 ($315,000 if married filing a joint return) and entirely eliminated at taxable income of $207,500 ($415,000 if married filing a joint return). While this means any service business owner with taxable income above $415,000 will receive no benefit from the deduction, the toll is heaviest for any business owner who lands in the middle of the phaseout range

Example: John and Mary own a small consulting business and have taxable income of $315,000. Since they are right at the lower phaseout threshold they will receive the full deduction and their taxable income will be $252,000 ($315,000 x 80%). The tax they will pay on this income is $49,059. Now if their taxable income increases by $100,000 they will be completely phased out of the deduction and their taxable income will jump from $252,000 to $415,000, increasing their tax bill to $96,629. That is $47,500 in federal taxes alone on $100,000 of income.

With what is effectively a marginal tax rate of 48%, small-business owners with taxable income between $315,000 and $415,000 are paying a higher tax rate than any other taxpayer! To avoid this heavy tax burden, proper tax planning is critical to reduce your taxable income and stay out of this “danger zone” of high taxes.

Strategies to Reduce Your Taxable Income

  1. Contribute to a retirement plan. As a small-business owner, you have several options to save for retirement while simultaneously avoiding the heavy tax burden of this phaseout range. By setting up a SEP IRA you can contribute up to $55,000 per year (subject to earned income limitations). A SEP IRA is a simple way to defer significant income for retirement and works best when you are the sole employee. If you have other employees in your business, be aware that you will need to contribute an equal percentage of wages for each eligible employee.

  2. Make the most of your medical expenses

    • Take advantage of the deduction for self-employed health insurance premiums. Unless you or your spouse are eligible to receive subsidized health insurance through your employer, you can reduce your taxable income by paying your health insurance premiums through your business.

    • Set up a Health Savings Account. If you have a High-Deductible Health Plan then you can contribute up to $6,900 per year to save for future medical costs. Your contributions will lower your taxable income in the year they are made, and as long as your distributions are for qualified medical expenses they will be tax-free.

  3. Increase your charitable donations. If you find yourself in the middle of this phaseout range after an exceptionally successful business year, then you may already be considering increased charitable donations. With the large tax burden you could be facing in this phaseout range, the tax deduction from your donations will be more valuable than ever.

These are just a few of the options available to you to lower your taxable income and avoid this danger zone of high taxes. Even if you don’t expect your income to reach the phaseout level for the new deduction, you can still realize significant tax savings by taking advantage of these strategies to lower your taxable income.

Putting your self-employment income away for retirement

If you are self-employed or own a small business you have the potential to put up to $56,000 per year towards your retirement by setting up a solo 401(k) ($62,000 per year if you are over 50).  Of that $56,000 you can put $19,000 into a Roth 401(k) where all of your distributions will be tax-free at retirement.

The Tax Cuts and Jobs Act has created a unique opportunity to maximize your retirement cash-flow by utilizing our current low tax rates to save in an individual Roth 401(k) account where your funds will never be taxed again. 

Before we get into the gritty details of the solo 401(k), be aware that the rules governing these accounts are a bit complex. If you are interested in setting up a solo 401(k) please reach out to us and we will help you determine if you qualify for one and how much you can contribute on an annual basis.

Qualifications

To qualify for a solo 401(k) you need to operate either a sole-proprietorship or an incorporated business and have no full-time employees other than your spouse. A full-time employee refers to any employee over 21 years of age who works 1,000 hours or more annually. You can utilize the solo 401(k) if you have part-time employees or independent contractors.

One advantage of the solo 401(k) over a traditional 401(k) is that as the business owner you are considered both the employer and the employee. This allows you to make employer contributions to your account on top of your traditional deferrals or Roth contributions. The employer contributions cannot be made to a Roth account. They must be made to the traditional 401(k), so they will be tax-deferred when they are made and taxable when you withdraw them in retirement.

Contribution Limits

Employee Contribution Limits: As the employee of your business you can contribute up to $19,000 ($25,000 if you are over 50) or 100% of your “earned income,” whichever is less. If you are a sole-proprietorship or a single-member LLC your “earned income” is the net profit of your business after deducting your business expenses. If your business is a C-Corp or S-Corp your “earned income” would be the amount of your W2 wages

Employer Contribution Limits: As the employer you can also contribute an additional 25% of your adjusted earned income. If you are a sole-proprietorship or a single-member LLC the formula to calculate your allowed employer contributions is a bit more complicated but works out to roughly 18.5% of your net profits. If your business is a C-Corp or S-Corp your allowed employer contributions are 25% of your W2 wages.

Combined Annual Limits: For 2019 the combined limit on employee and employer contributions is $56,000 ($62,000 if you are over age 50). This means if you contribute the full $19,000 as an employee the most you can contribute as the employer for 2019 is $37,000 regardless of how much earned income you have.  

Summary

With the potential to put away up to $62,000 per year towards your retirement, the solo 401(k) is a powerful tool to help you prepare for your future. While 401(k) plans have historically been very costly to set up and maintain, increased popularity has significantly reduced the administration costs in recent years. If you are interested in setting up a solo 401(k) for your business, we would be happy to direct you on how to get started

How to handle vacation and business travel expenses

Taking a vacation can be expensive, so naturally the idea of deducting your vacation expenses on your tax return is an appealing idea. However, before you get carried away planning a lavish vacation with the hopes of writing off the entire cost, make sure to familiarize yourself with the requirements to qualify your expenses as business travel. To qualify for a tax deduction the trip needs to serve a legitimate business purpose. Handing out business cards on the beach does not count. There are 5 criteria your trip must meet to be a qualified business expense:

    1. Profit motive.  The trip must serve a legitimate profit motive. This means that you can reasonably expect the trip to create profit either now or at some point in the future.
    2. Stay overnight. You can only deduct meal and lodging expenses when you are away from home overnight.
    3. “Rational Businessperson” test. Your trip will only qualify as a business expense if the business motive is strong enough that a rational businessperson would make the trip if business was the only motive.
    4. Primary purpose test. You can only deduct your travel expenses when your trip is primarily for business. This is determined by calculating the number of business days vs personal days of the trip. This may sound like a deal breaker, but it is easier to meet this requirement than you think.
    5. Maintain good records. If you do not properly document the business purpose of your trip, your travel expenses, or your actual business activities on the trip you will risk losing your entire deduction.

Your trip expenses can be broken down into two general categories with different requirements to be deductible:

Transportation Expenses

Transportation costs include airfare, train tickets, or the cost of a rental car to get to your destination. These expenses are all-or-nothing, if the majority of your trip days are business days you can deduct all of your transportation costs. If the majority of your trip days are personal you cannot deduct any of these costs.

Life Expenses

Life expenses include your daily meals and lodging. Unlike transportation expenses you do not need to meet the majority of business days threshold to take life expenses. Instead you simply take the life expenses for each business day of the trip.

What Counts as a Business Day?

It may be easier than you think to qualify most of your trip as business days. Each day of the trip only needs to meet one of these criteria to qualify as a business day:

    • Work more than four hours. You have a workday when you spend more than half of normal work hours pursuing business. Since a normal workday is eight hours you only need to work for more than four.
    • Presence-required day.  If you are required to be at a destination on a specific day for a legitimate business purpose. For example, if you have a meeting with a client in another city on Tuesday, then Tuesday qualifies as a business day even if that is your only business activity for that day.
    • Travel day. Days you spend traveling to or from your business destination count as business days as long as you are traveling in a reasonably direct route.
    • Weekends and holidays. If a weekend or holiday falls in between two business days you can count those days as business days as long as it would not be practical to return home in between the two business days. If you live in California and have meetings in New York on Friday and Monday, it would not be practical to return to California for the weekend. Therefore, all four days count as business days.
    • Saved-money-on-travel days. If you arrive at a destination a day early or leave a day late in order to save on your travel expenses you can count the extra day as a business expense as it served a legitimate business purpose of reducing your travel costs.

Summary

The rules governing business travel allow for some freedom to deduct vacation time as business expenses, but do not provide a blank check to write off an entire vacation simply because you spent a few minutes discussing business. You need to find the right balance between work and relaxation, properly document your work activities, and maintain records of all your expenses.

Deducting the business use of your vehicle

Standard Mileage Rate vs Actual Expenses

There are two primary methods for deducting the cost of using a vehicle for business purposes: The standard mileage rate method and the actual costs method.

Standard Mileage

With the standard mileage rate you can deduct a specific dollar amount for each business mile you drive during the year (for 2019 the standard rate is 58 cents per mile). The standard mileage rate is used more often since it only requires you to keep track of the miles you drive throughout the year and does not require records of any other expenses. However, the standard mileage rate can only be used for a vehicle that is in your personal name. If your vehicle is titled to your business, you are required to use the actual expense method..

Actual Expense

With the actual expense method, you can deduct yours out of pocket costs for fuel, insurance, repairs, etc. You can also deduct the cost of the vehicle by depreciating it over its asset life (typically 5 years). The actual expense method requires much more thorough record-keeping. You need to keep track of each vehicle-related expense throughout the year, and if you use the vehicle for both personal and business use then you also need to keep track of the total business and total personal miles for the year

Choosing the Right Method

If your vehicle title is in the name of your business you are required to use the actual expense method. However, if the title is in your personal name you can choose which method to use in the first year. You can switch methods in the following years, but there are additional restrictions to do so. It is in your best interest to take the time in the first year to determine which method will be more beneficial.

 The standard mileage rate method is intended to simplify record-keeping requirements while still providing for an accurate deduction for the cost of using your vehicle in your business. To that end, in many cases, the standard mileage rate method should provide the same or greater tax benefits as the actual expense method. However, there are specific factors that can make the actual expense method more beneficial:

  • Price of Car: Since you can deduct the cost of a car over several years with the actual expense method, a more expensive car increases the probability that the actual expense method will be more beneficial

  • Fuel Efficiency: With the standard mileage rate you get the same deduction no matter how many miles you get per gallon, so a less efficient vehicle will eat away at a greater portion of your allowed deduction.

  • Highway vs City: If you are driving primarily in a large city you are likely putting much fewer miles on your vehicle while still spending the same amount of car payments, insurance, etc.

If any of these factors apply to your situation then you may receive a greater benefit through the actual expense method. It is also worth noting that under the actual expense method you will receive a greater tax benefit in the first few years while you are depreciating the cost of the vehicle. Once the vehicle is fully depreciated your deduction will drop significantly. Under the standard mileage method, your deduction will be relatively consistent subject only to small changes in the standard rate each year.

 

Summary

If 100% of the use of your vehicle is for your business and you have large vehicle costs either from buying a newer car or driving mostly in the city, putting your vehicle title into your business can simplify your record-keeping requirements without sacrificing the benefits of the standard mileage rate method. If you use your vehicle for both personal and business needs or you drive an older vehicle with a low market value, you may want to keep it in your personal name to preserve the option to use the standard mileage rate.

Avoid the headaches and penalties associated with 1099 reporting

When a small business hires an employee, there are a number of expenses that are incurred in addition to the hourly wage. This could include the employer-provided benefits, office space, along with the technology and other tools required to do the job. The employer will also have to make the required payments and contributions on behalf of employees, including:

  • The employer’s share of the employee’s Social Security and Medicare taxes, which totals 7.65% of the employee’s compensation

  • State unemployment compensation 

  • Workers’ compensation insurance

Depending upon the industry, the additional contributions could increase your payroll costs by 20% to 30% – or more. You can avoid these expenses by hiring an independent contractor to do the same work​.

The additional contributions could increase your payroll costs by 20% to 30% – or more.

However, there are certain requirements that must be followed in order to avoid the headaches and penalties associated with 1099 reporting.

WHAT AND WHEN DO I HAVE TO FILE?

Businesses are required to report all income to the IRS for its employees and any independent contractors. For employees, a W-2 is required to be filed. Independent contractors on the other hand, get a little more complex. To make matters worse, congress recently passed the Path Act, and moved up the filing deadline for W-2’s and certain 1099’s. The required date to provide W-2’s and 1099’s to employees and independent contractors is January 31. The deadline for submitting these forms to the government is also January 31.

 

THREE STRATEGIES TO AVOID 1099 HEADACHES

The easiest way to avoid the penalties, and filing headaches caused by issuing 1099’s to independent contractors is to structure your business activities to minimize the number you must issue, and prepare them in advance, if you do have to issue them.

STRATEGY #1:

Choose contractors that operate as corporations. Your business is not required to issue 1099’s for payments made to corporations, S corporations, or LLC’s that elect corporate status for tax purposes (unless the corporation collects attorney fees or payments for health and medical services).

STRATEGY #2:

Make payments to independent contractors with a credit card, or a third-party payment network like PayPal. Shift the burden of reporting this income to the credit card company or the third-party network. They are required to report the payments on Form 1099-K.

STRATEGY #3:

Require the independent contractor to provide you with a W-9 upfront before making any payments to them. Here are the benefits:

  • You will know if a 1099 filing is required, because their business type is disclosed on the W-9.

  • You will know whether an LLC is classified as a corporation for federal tax purposes, and excluded from 1099 reporting.

  • By getting the W-9 upfront, it eliminates the need to chase the contractor down for the required information if you need to file a 1099. Once the contractor is paid, your leverage for getting the information is gone.

If an independent contractor refuses to provide you with a taxpayer identification number (TIN), and you pay the contractor more than $600 during the calendar year, then you are required to withhold federal income tax on payments made to that contractor. If you do not withhold, your business owes the tax, and it is on you to prove the contractor paid the tax.​

Avoid taxes on reimbursed employee expenses

If your business has employees then you likely have to reimburse them for out-of-pocket expenses they incur periodically. Reminder: If your business is a S or a C Corporation then you are considered an employee of the corporation, and are subject to the same reimbursement policies as any other employee. When accounted for properly, employee expense reimbursements are deductible to you as the employer, and tax-free to the employee. However, when these reimbursements are not accounted for correctly the IRS can reclassify them as wages, making the full amount subject to both employer and employee payroll taxes as well as income taxes for the employee. To avoid paying taxes on the expense reimbursements you pay to your employees follow these guidelines.

There are four requirements that must be met in order to reimburse your employee’s expenses without creating taxable wages for them:

  1. Legitimate business expense. You can only reimburse your employees for expenses that serve a legitimate business purpose. Reimbursing your employees for meals from an out of town business trip is a legitimate business expense but reimbursing your employee for a night out with their spouse over the weekend would be considered taxable wages to them. To maintain the tax advantaged status of your employee expense reimbursements you should document the business purpose of each expense.

  2. Proof of expense. Before you can reimburse your employee’s expenses you must receive proof from them that the expenses were paid.  The substantiation requirements for reimbursed expenses are the same as your ordinary business expenses. Receipts for purchases and mileage logs are the best way to substantiate your business expenses.

  3. Refund excess reimbursements. If you reimburse your employee for an amount greater than the expenses they incurred the excess amount will become taxable wages to the employee if not returned within 120 days.

  4. Reimburse expenses in a timely fashion. Expenses must be reimbursed in a timely fashion to avoid being reclassified as wages. The IRS states that timeliness is determined by the facts and circumstances of each situation. However, to provide additional guidance the IRS lays out circumstances in which reimbursements will always be considered timely:

    • Reimbursements paid in advance within 30 days before the expense in incurred

    • Substantiation of expenses provided to the employer within 60 days of payment

    • Returns of excess payments within 120 days of receipt

Expense Reports

While a formalized expense report is not required by the IRS to reimburse employee expenses, it is the best way to ensure that you are meeting the four criteria outlined above. If you have employees or if you are the owner of an S or C corporation we would encourage you to have your employees or yourself fill out expenses reports on a regular basis to reimburse out-of-pocket expenses.

Are you protecting yourself from your corporate income?

Individuals with self-employment income should consider the potential benefits of structuring their business as a corporation. That is because a corporation can provide asset protection and potential tax benefits that are not available to the self-employed individual who files a Schedule C with their tax return.

While there are potential tax savings with a corporate structure in place, it is critical that the corporation be the entity that actually earned the income.

WHAT DOES THAT MEAN?

A fundamental principle of tax law is that income is taxed to the entity who earns it; and any attempts to divert the income away from its true earner are not recognized by the IRS.

If you have self-employment income, you should consider the potential tax benefits of a corporation

AND WHAT DOES THAT MEAN?

It means the corporation (not the business owner) must be the entity that contracts for the services that it will have you (the business owner) provide.

It means the corporation needs to be the entity that gets paid (not the business owner) for the services provided.

It means the corporation must have control over the income it receives. Once it receives the income, it can then direct it to the business owner via payroll or a shareholder distribution.

WHAT ARE THE MAIN TAKEAWAYS HERE?

1. Have your clients or customers write their check directly to the business. Do not accept checks written to you personally. A check made out to you and signed over to the business puts the business owner at risk of double taxation and penalties.

2. Have the corporation pay you a salary for the services you are providing to the corporation.

3. Make sure that all contracts and agreements with clients are between the client and the corporation, not between the client and the business owner.