Have you ever heard the saying, “Asking for forgiveness is easier than asking for permission?” Whoever said that must not have been talking about the IRS. In my experience helping hundreds of small businesses get up and running, I’ve found that prevention is the key to avoiding unwanted interaction with federal and state tax agencies.
One saying that does hold true with the IRS is, “the squeaky wheel gets the grease,” and in this case, you don’t want any of that grease! So, how do you avoid it?
Understand self-employment and payroll taxes
In the process of starting your business, you may have talked to other business owners about taxes. Beware—even savvy business people sometimes misunderstand the tax system. It’s important to make sure you get the whole truth about which taxes affect you. The two taxes that are regularly misunderstood and most often end up being an unpleasant surprise are the Self-Employment tax and Payroll tax. There is no quicker way to get into trouble with the IRS than by ignoring these two taxes.
I recently met with a new business owner who, based on her 2013 business activity, was on track to owe $18,000 to the IRS in Self-Employment taxes. Understandably, she felt shocked. She didn’t have that much money set aside for taxes, which set her up for some serious problems with the IRS. That $18,000 was going to grow because of penalties and interest. However, after some help understanding the Self-Employment tax, she was able to navigate herself through the issue and reduce her tax liability to $9,000, a much more manageable amount.
Both the Self-Employment and Payroll taxes (also known as FICA taxes) are the government’s way of collecting Social Security and Medicare taxes. If you are a sole proprietor or the owner of an LLC, they collect it from you through Self-Employment taxes. If you are a W2 employee—of your own corporation or someone else’s—they collect it from you through Payroll taxes.
If you’ve ever been a W2 employee, you are probably very aware of these taxes because you see them being withheld from your paycheck. As an employee, you actually only see half of the total amount, as your employer is obligated to pay the other half.
Payroll tax example
If you are a W2 employee and you work 100 hours at $10 per hour, your gross pay will be $1000. From that, your employer would withhold about $75 (7.5 percent of the gross) from your check, but then they would contribute $75 and pay $150 (15 percent of the gross income) to the IRS. So $75 of that is your money, and $75 of that is your employer’s money.
Self-employment tax example
The IRS’ tool for collecting FICA taxes from a sole proprietor or an owner of an LLC is the Self-Employment tax. If you are an owner of an LLC, or a sole proprietor, then there is no one there to “withhold” Social Security and Medicare taxes from your pay and send them into the IRS. So, the IRS requests that you pay 15 percent of your gross income all at once at the end of the year. This was the big surprise experienced by the previously mentioned client.
For example, if your business brought in $100,000 in gross revenue during the year, and paid $40,000 in operating expenses (supplies, cost of goods sold, rent, etc.), then you would have a $60,000 net profit, and you’ve got your Self-Employment tax of $9,000 at the end of the year. That can be a hard pill to swallow if you’re not prepared, especially if you’ve been a W2 employee all your life and gotten used to a tax refund on April 15th.
What is the most efficient tax option?
If it works for your specific circumstances, take a look at forming an LLC and making the election to be taxed as an S Corporation. This structure can be the most efficient method for saving money on Social Security and Medicare taxes, as in the case of the business owner mentioned above who was able to save $9,000 for the year.
The key piece to remember is that S Corporation owners only pay the Social Security and Medicare taxes on the W2 payroll wages they get paid from the company. They don’t have to pay the Self-Employment or Payroll taxes on the rest of the money they pull out as “distributions.” Who decides how much your salary (subject to FICA tax) is going to be? As the owner of the company, you do. Who decides how much in distributions (not subject to FICA tax) the owners are going to take? You do that as well.
The point is to strike a proper balance between the W2 wage and the owner distributions. This way you save the 15 percent FICA tax on everything that you pull out as a distribution, which under the LLC entity choice would likely not be possible. Keep in mind that this isn’t a way to shirk responsibility—the IRS expects you to pay yourself a reasonable wage via W2 payroll, and to pay the associated Payroll taxes with it. If you tip the scales in your own favor, this is the kind of thing that could spark investigation.
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As was implied above, different business entities (sole proprietors, LLCs, S Corps, and C Corps) come with very different tax implications. If you are in the process of starting a business, I’m sure you are wrestling with the decision of which entity to choose. I truly wish I could lay it all out for you here in this article, but CPAs and Attorneys aren’t fibbing when they tell you “it depends.” There are just too many different circumstances for there to be a silver bullet that applies to every situation.
Don’t forget, prevention is a much better approach than reparation when it comes to dealing with the IRS. By understanding your tax filing and payment obligations, particularly with regard to the Self-Employment and Payroll taxes, you will be well equipped to stay off of the IRS radar. There are significant burdens you take on when starting and running a small business—don’t let dealing with the IRS be one of them.