Archive for Self-employment Tax

How to Know if the S Corporation is Your Best Choice in Entity Structure

You have a lot of details to consider when it comes to choosing the entity structure for your business. You can run it as a sole proprietorship, a single-member LLC, an S corporation, or a C corporation. How do you know which is the best choice? One of the biggest considerations is how your choice in entity structure affects your tax bill, and that’s exactly what this article looks at—specifically focusing on the pros and cons of the S corporation.

What an S Corporation Is

An S corporation is basically a federal tax election status. Your company can be formed as either an LLC or a corporation and still make the S corporation election.[1] That means your business name could end with (and legally be) “LLC”, but for tax purposes, you file as an S corporation. This tax status allows your company’s tax credits, deductions, and income to pass through to you as shareholder. For the right kind of business, this could grant liability protection with the benefits of personal taxation.

Knowing the Rules

In order to qualify for S corporation status, you only need to meet a few rules that are fairly easy for singly-owned businesses (or even husband-wife ownership teams):[2]

  • You must be a domestic corporation (LLC’s are included in this designation).
  • You must have no more than 100 shareholders.
  • Each individual shareholder must be either a US citizen, resident alien, or estate. Certain types of trusts and tax-exempt entities may also be shareholders.
  • Your business must carry one class of stock only.

So, the real question is: does an S corporation election make sense for your business?

Pros and Cons

No matter which entity structure you choose, you’ll come across both advantages and disadvantages. There is no one choice that works for every business and consistently generates the most tax advantages. You will need to do your research and make the best determination for you and your company. That being said, weighing the tax savings is an important part of the decision-making process.

Here are the positive tax implications for electing S corporation status:

  • You Pay Less in Payroll Taxes—Operating as an S corporation makes the owner both a shareholder and an employee. This means you 1) receive distributions for your investment in the business, and 2) receive a salary for the work you do. The salary is paid to you by your corporation (because it acts as a separate entity from you as an individual), and thus is subject to payroll taxes. However, because you also receive income as an investor, you have the opportunity to pay yourself a lower wage (reducing your payroll taxes) and still make good money on the dividends. Of course, you should research what a reasonable wage would be—the IRS can ding you for paying yourself too little in salary.
  • You Can Split Taxable Income—This can be a tax advantage if you want to provide money to someone, such as a parent. You basically have two options. You can give the money directly to your mom or dad as a gift, but this comes out of your after-tax dollars because you’ve already earned the money and must pay income tax on it. Alternately, you can give the parent a share in your company’s stock, so that the gift money comes in the form of dividends. The second option is probably the better one if your parent is in a lower tax bracket than you are because you’ll be able to provide the same amount of cash with less going to taxes.

For example, your parent is in the 10 percent tax bracket and you’re taxed at 35 percent. You have to make $15,385 at your tax rate in order to give an after-tax gift of $10,000. But, if you give stock that earns $11,111, your parent still gets $10,000 after their 10 percent taxes. Of course, the second method also means your parent is now part owner in the company, so you’ll have to weigh the consequences. Note that this strategy is not a good choice for splitting income with your children because they will be subject to the kiddie tax for investment income over $1,900 if they are younger than 19 or in college and younger than 24.[3]

  • You Avoid Double TaxationIn general C corporation dividends are taxed at 15 percent. In addition, a C corporation is in the 15 percent income tax bracket for the first $50,000 it earns; however, the income tax percentage jumps up to 35 percent if your business is a personal service corporation, and you still have to pay taxes on dividends on top of that. If your corporation’s income exceeds $50,000, it has moved into the 25 percent income tax bracket. You can see that the numbers keep creeping up, since the amount you’ll earn (and pay taxes on) in dividends depends upon what’s left after income taxes. With an S corporation, you are likely to avoid this frustrating situation.

With these advantages, you may already be considering taking the S corporation election, but remember that no entity is a perfect choice all around.

Here are some reasons you may decide not to go with an S corporation for tax purposes:

  • You’ll Have Corporate Paperwork (and Extra Fees)—If your business currently operates as a sole proprietorship, you’re in the easy situation of paying your taxes on Schedule C of Form 1040. However, if you switch to an S corporation, you will take on all the corporate tax paperwork that comes along with it. Remember, your corporation will be a separate entity from you as an individual, so you will have paperwork for each. Pretty much any time money goes anywhere between you and your corporation, you’ll have more required paperwork to fill out. Because you probably have neither the time nor the expertise to handle all of these tax, accounting, and legal documents, you’ll likely need to pay for a tax preparer (and/or accountant) and lawyer. When you operate as a sole proprietor or single-member LLC, in contrast, you and your business share assets, and money can flow more easily between the business and yourself (but you should still keep the finances separate!).
  • Your Assets are Not Yours—As mentioned above, a sole proprietorship or single-member LLC has one set of assets, and they belong to the business owner. But, when you create an S corporation and designate business assets, you no longer own those items—the corporation does. This means you’ll be watched much more closely regarding how assets are used, and taking company assets for personal use can trigger a taxable event. Of course, even sole proprietors must watch out for Section 179 recapture rules.
  • You May Have to Pay Extra State Taxes—Some states require S corporations to pay state income taxes or franchise taxes. And, here’s the bigger kick in the teeth, it’s not offset by any additional personal tax deductions for you.
  • Your Heirs May Have Higher Taxes—Upon your death, a sole proprietorship or single-member LLC’s assets are valued individually at fair market value, which usually means lower taxes for your heirs.[4] For a corporation, on the other hand, the company’s stock is marked up to fair market value, and this could be much different from the value of the individual assets.
  • You Get No Break on Medical CostsIf you’re a more than 2 percent owner in your corporation, you won’t be getting much in tax benefits for your health insurance, and neither will your spouse. You see, attribution rules dictate that your spouse has the same ownership interest as you. So, if you’re a 100 percent owner, your spouse also has 100 percent interest in the company. This also means you cannot provide your employee-spouse with a Section 105 medical reimbursement plan, unlike the owner of a sole proprietorship or LLC. The Section 105 benefits are not counted as W-2 income.
  • You Have to Pay Payroll Taxes for Your Employed Children—A proprietorship and single-member LLC both get the benefit of no payroll taxes for wages earned by their own underage children. They also don’t pay Medicare, FICA, or employment taxes for the owner’s kids. Unfortunately for S corporation owners, both the corporation and the child will be subject to payroll taxes.
  • You May Lose Out on 401(k) ContributionsBecause your S corporation income is divided between salary and distributions, you’ll have less money available to contribute to your retirement plan. Contributions are based on your salary, and you’ll probably have kept this amount low in order to save on self-employment taxes.

If none of these disadvantages deters you, then an S corporation may be a good fit for your company. The main reason to opt for an entity structure other than sole proprietorship is to attain liability protection. So, ask yourself how much liability protection you need for the type of business you’re in, and then hire a tax professional to help you figure out which entity structure generates the biggest tax savings for you. You’ll more than make back the money spent on professional advice in the years of tax-savings from choosing the appropriate entity structure.

  1. IRC Section 1361(a)(1)
  2. IRC Section 1361(b); Reg. Section 301.7701-3(c)(1)(v)(C)
  3. IRC Section 1(g)(2); Rev. Proc. 2011-52
  4. IRC Section 1014(a)

Are You a “Dealer” or “Investor” for Tax Purposes?

Tax law is forever classifying people and making structures that either create benefits or disadvantages on your tax return. Part of getting the most from your return is about understanding the definitions of the IRS. Two that seem very similar, but have distinctly different consequences on your taxes, are real estate dealer and real estate investor.

What’s the Downside of Each?

We’ll start by discussing the disadvantages. That’s right—there is no golden choice when trying to figure out if you classify as a dealer or an investor. In either case, there will be some disadvantages.

As a real estate dealer:

  • Your profits are taxed at both the ordinary income rates (up to 35 percent) AND the self-employment rates (up to 14.13 percent).[1]
  • You may not depreciate property that you are holding with the intention of selling.
  • You may not use the tax-favored installment method to report dispositions of your property.
  • And, you may not use the Section 1031 exchange to defer taxes on properties you hold as a dealer.

As a real estate investor:

  • You are subject to the net capital losses limit of $3,000 (applied after gains are offset against losses).
  • You must treat selling expenses as a reduction in sales proceeds, which means those expenses produce benefits at the capital-gains tax rates only.

Admittedly, the dealer gets the lesser deal when it comes to disadvantages. The investor does get to depreciate property, is allowed to sell using the tax-favored installment method, and may choose to use a Section 1031 exchange, thereby deferring taxes on a disposition.

What about the Up Side?

Every coin has a heads and a tails. And, it’s the same with tax designations. Both dealers and investors gain some advantages from their respective positions.

Advantages for real estate dealers include:

  • You are treated as a business and may treat most expenses as ordinary business deductions (advertising, commissions, legal fees, real estate sales, etc.).
  • Your property sale losses are not limited capital loss cap of $3,000 that limits investor properties.
  • Your losses are deducted as ordinary losses.
  • You get to deduct the entire loss (either immediately or using the net operating loss rules to deduct it over time—these rules allow you to carry back your losses up to five years and forward up to twenty years).

Advantages for real estate investors include:

  • Your sales profits are taxed at 15 percent or less, a tax-favored capital gains rate.
  • You are not subject to the self-employment tax.

Practical Application

So, what does all this mean for you and your business? Let’s run through some example numbers. For the example, we’ll say you have a $90,000 profit from a property sale. Based on the tax rates mentioned above, your taxes as a dealer could be as high as $36,370.[2] Your taxes as an investor might be as high as $13, 500.

You can clearly see that having your properties qualify as investment sales generates a considerable tax savings—potentially $22,870!

However, depending upon your business structure and activities, it may not be possible to define all of your property sales as investment sales. No problem. The IRS has no qualms with an individual taxpayer acting as part dealer and part investor. You read that right; you can balance the pros and cons of each situation. It’s simply a matter of taking each property on a case-by-case basis.[3]

Not so fast. You may think the IRS is giving you some kind of free gift by allowing this pick and choose method, but it’s not quite as unstructured as all that. You will be required to make a clear distinction in your record books. You didn’t think the IRS was going to let you off without documentation, did you? And, this means you must decide before-hand which route you’re going with each property sale. You cannot simply go back over your sales at tax time and assign designations. You will have to establish what your intent was with the sale—dealer sale or investment sale.

Tips on Documentation

Good documentation of your purpose and activities helps you to establish your case with the IRS. You should determine, and make note of, your intent for the property throughout the process:

  • When you purchase the property;
  • During your ownership; and
  • At the time you sell it.

If you keep records throughout the process (not just at the time of sale) it gives your case credibility. It’s important to keep in mind, however, that if your return is challenged in court, they will likely examine the sale when they rule on whether you acted as a real estate dealer or real estate investor on a particular property.[4] None of this means that your purpose may not change between the time you buy a property and sell it, but at least you will be prepared to understand and plan for such a scenario.

The All Important Point-of-Sale

Important: The point-of-sale is the most critical part of the process in determining your investor or dealer status. It’s often the deciding factor in IRS decisions. Although a single piece of real estate can have features of both dealer and investor property, it can only be treated as one or the other. Take a look at the characteristics of each from a tax standpoint.

  • Real Estate Dealer—First off, dealer property is held with the intention of being to customers in the ordinary fashion of business or trade.[5] If you buy and sell many properties throughout the year, you are likely a dealer regarding those properties.[6] Unfortunately, the IRS has not established any set number for determining dealer status, so it’s all about making your case. In fact, number is only one factor, and in previous rulings:
  1. A company earned dealer status with only one sale because it had already agreed on sale to a third party prior to purchasing the property itself;[7]
  2. A taxpayer, Mr. Goldberg, did not earn dealer status even with 90 home sales in a year.[8] In his case, the homes were built for rentals and used as such prior to the time of sale.

However, in the majority of cases, more sales equal dealer properties. In addition to the influence of the number of properties sold, real estate that you subdivide also has an increased chance of achieving dealer status,[9] except under Section 1237.[10] Removing a lien can also make a property more salable under the ordinary processes of business[11] (recall that dealer property is sold in the ordinary course of business).

Several other traits indicate a dealer business transaction over investment actions. They include active marketing and sales activities,[12] property held for a short period of time (indicating the intention to turn over the property for profit),[13] generally making your living as a dealer,[14] regularly buying and selling real estate for your own account,[15] and buying property with the proceeds from another property.[16]

  • Real Estate Investor—In contrast to dealer property, investor property is held with the intention of producing rental income[17] or appreciating in value. This means that investor properties are typically held for longer periods of time[18] and are not often sold, unlike the quick turnover of a dealer property.[19] Other situations in which a court may rule your property is an investor property include acquiring the real estate by inheritance,[20] dissolution of a trust,[21] or a mortgage foreclosure.[22] It’s even possible for you to make improvements to such property prior to selling it and still retain investor status.[23] [24] Just don’t put the proceeds into more real estate or subdivide the property[25] if you want to maintain that status.

If you don’t make clear in your documentation which type of property sale you are making, the IRS will make the decision based on their interpretation, and that is not the best situation for you! So, look at those characteristics above again. Since you’re going to know at the outset what your purpose is with each property, you can make sure to include as many of the appropriate features as possible well before the sale.

  1. The usual self-employment tax rate times the Schedule SE adjustment.
  2. Assuming the real estate profits were your only income.
  3. Tollis v Commr., T.C. Memo 1993-63.
  4. Sanders v U.S., 740 F2d 886.
  5. IRC Section 1221(a)(1).
  6. Sanders v U.S., 740 F2d 886; Suburban Realty Co. v U.S., 615 F2d 171.
  7. S & H, Inc., v Commr., 78 T.C. 234.
  8. S & H, Inc., v Commr., 78 T.C. 234.
  9. Revenue Ruling 57-565
  10. IRC Section 1237.
  11. Miller v Commr., T.C. Memo 1962-198.
  12. Hancock v Commr., T.C. Memo 1999-336.
  13. Stanley, Inc. v Schuster, aff’d per curiam 421 F2d 1360, 70-1 USTC paragraph 9276 (6th Cir.), cert den 400 US 822 (1970); 295 F. Supp. 812 (S.D. Ohio 1969).
  14. Suburban Realty Co. v U.S., 615 F2d 171.
  15. Armstrong v Commr., 41 T.C.M. 524, T.C. Memo 1980-548.
  16. Mathews v Commr., 315 F2d 101.
  17. Planned Communities, Inc., v Commr., 41 T.C.M. 552.
  18. Nash v Commr., 60 T.C. 503, acq. 1974-2 CB 3.
  19. Rymer v Commr., T.C. Memo 1986-534.
  20. Estate of Mundy v Commr., 36 T.C. 703.
  21. U.S. v Rosbrook, 318 F2d 316, 63-2 USTC paragraph 9500 (9th Cir. 1963).
  22. Cebrian v U.S., 181 F Supp 412, 420 (Ct Cl 1960).
  23. Yunker v Commr., 256 F2d 130, 1 AFTR2d 1559 (6th Cir. 1958).
  24. Metz v Commr., 14 T.C.M. 1166.
  25. U.S. v Winthrop, 417 F2d 905, 69-2 USTC paragraph 9686 (5th Cir. 1969).

How Commissioned Employees Have Vanquished the AMT and You Can, Too

When it comes time to prepare your taxes, you may have an unpleasant surprise waiting in the alternative minimum tax (AMT). Despite its intention of ensuring that top earners pay their fair share of taxes, the AMT really can be a kick in the pants for employees, who cannot deduct their business expenses. Particularly in the case of commissioned employees, this creates a huge difference in the amount of taxes they pay.

What You Need to Know about the AMT

The AMT was created during the 1986 tax reform, and it basically taxes income that is deductible under the regular tax, such as employee business expenses. Here are just a few of the types of employees who pay their own work expenses:

  • Mortgage brokers and bankers,
  • Insurance sales professionals,
  • Traveling sales professionals,
  • Real estate sales professionals, and
  • Emergency room physicians.

Why are commissioned employees particularly burdened by this tax? It’s because they often have a slew of business-related expenses that they pay out of pocket. Then, here comes the AMT to tell them they are not allowed to deduct any of those expenses. However, independent contractors performing the exact same duties as those commissioned employees can deduct many of their expenses.

What Employees Can Do about It

If your income level boxes you into the AMT, you don’t have to give up and lose thousands of dollars to additional taxes. And yes, it is potentially thousands. Take, for instance, the case of Dan Butts, an Allstate insurance agent. In one year, he paid about $10,000 more in federal income taxes than agents at State Farm.

What did Butts do wrong? Nothing—the difference lay in how he was designated by his employer. Butts was considered a W-2 employee, but the State Farm agents were independent contractors with 1099’s. Look at that scenario again. Butts did the same job, at the same pay, and with the same deductions as the agents at another company, but because of his designation, he paid $10,000 more in taxes.

That is a ridiculous situation for an employee to be in simply because the AMT does not permit deductions for business expenses! Fortunately, if you’re in a commissioned position, like Butts, you can do something about this unfair situation. He simply amended his tax return to put his W-2 employee commission earnings on the Schedule C form that self-employed individuals (including contractors) use. He deducted his expenses and saved that $10,000.

Of course, the IRS noticed that he used the wrong form, and he ended up going to court over the issue. . . and winning! Of note in this case is that the court granted Butts independent contractor status even though he had been employed as an employee with Allstate for years and enjoyed employee benefits[1]. The ruling went his way because he carried a “risk of loss”, just like the agents who were independent contractors.

However, you should keep in mind that using the Schedule C to avoid the AMT may work differently in various fields. For instance, a mortgage loan officer named Dan Cibotti worked for Liberty Trust Mortgage, Inc. as a commission-only W-2 employee. More and more commissioned employees are filing on Schedule C, and Cibotti was one of them. In his case, the court ruled that he was considered an independent contractor, despite having a W-2 that reported his income as an employee, because[2]:

  • He set his own hours and chose his own work location and method of finding clients;
  • His employer did not provide him an office;
  • He claimed a home-office deduction;
  • He was paid 100% on commission;
  • He had the possibility of gain or loss on his business activities; and
  • He received no employee benefits, such as a retirement plan or health insurance.

As you can see, the two situations were quite different, but each involved a commissioned employee who fought for his right to file as an independent contractor and won.

Going Forward

Now that other cases have set the precedent, it is becoming easier for insurance agents and other commissioned employees to avoid the AMT. In fact, the IRS, in chief counsel notice N(35)000-141(a), ordered its lawyers not to challenge individuals who claimed independent contractor status under the Butts precedent, but the IRS can be a stubborn entity. The notice that allowed independent contractor status also instructed the lawyers to:

  • Calculate self-employment tax on the agent’s net income and allow a credit just for the employee share of FICA and Medicare (i.e., employer payments are not included);
  • Calculate taxes on employee benefits, like employer-paid medical insurance and Section 125 contributions;
  • Calculate taxes on 401(k) contributions and make the taxpayer aware that they may not fall back on the Lozon decision, which concluded that such contributions were not taxable until withdrawn[3].

This notice has since expired, but if you plan to pursue independent contractor status, it would be wise to compare AMT savings with the potential tax disbursement outlined in the above IRS strategy.

Other Cases

Several other cases for independent contractor status have gone to court with varying results. Wesley Wickum, a district manager for Combined Insurance Co. of America, amended three years of tax returns and reclaimed $27,000. His salary included commission from his sales, bonuses, and override commissions based on the salespeople he recruited and supervised. In a funny twist, his company had previously considered the salespeople and managers to be independent contractors, but had changed the status out of fear of IRS penalties for wrongly classifying employees as contractors!

You can see the repercussions on business. The AMT hurts a company’s best salespeople—those who make the most commissions. When such a worker is classified as employee instead of contractor, the AMT comes into play, and may cause the best salespeople to leave the company.

A sales agent named Paul Hathaway also amended three years of tax returns after learning of the Butts case[4]. He was a commissioned employee, and although his company provided a W-2 each year and gave him benefits, he paid his own expenses for food, samples, travel, telephone, stationary, and business cards.

William Johnson and Barbara Lewis, on the other hand, lost each of their cases for independent contractor status. Johnson was a full-time hospital equipment salesperson who worked on commission, but the court ruled that he was an employee because his employer 1) restricted him from hiring employees and 2) required that he file daily call reports[5]. Lewis sold hair care products to salons and also made commissions. The court ruled her an employee by status because 1) her employer required her to file daily sales activity reports, 2) her employer supplied her with leads, which she was expected to follow up on, and 3) she had a negligible “risk of loss”[6].

AMT Tax Savings

If you’re going to claim independent contractor status for your commissioned income, take these cases as examples what kind of evidence you need. Remember, your savings could be thousands of dollars. Need an example? Let’s say you’re a mortgage loan officer, like Wickum in the case above. If you made $200,000 and spent $125,000 in business expenses, you have a net income of $75,000.

With regular taxes, those business expenses are reduced by 2 percent, leaving a regular taxable income of $79,000 (.02 x $200,000 = $4,000; $125,000 – $4,000 = $121,000; $200,000 – $121,000 = $79,000). But, for AMT purposes, this employee gets no deductions on those expenses. That means the taxable income is the full $200,000. That’s a huge difference!

So, if the employee files taxes on Schedule A, the amount owed is $45,000. On Schedule C (as an independent contractor), it would only be $15,000. You can see why commissioned employees argue for their contractor status.

If your work situation involves unreimbursed business expenses and a status as employee, you have options to establish your status as an independent contractor for tax purposes. Since the IRS has established a position on this issue, you can start by discussing your status with the local IRS district director. If necessary, you can escalate the situation by requesting a private letter ruling from the IRS. This route does cost money, but it will likely be less costly than going to court. Litigation like the Butts case has not happened in years, so you have a good chance of a ruling in your favor if your circumstances and evidence are sufficient. The AMT seems to be here to stay for the present, so don’t let thousands of dollars slip away from you every year.

  1. Butts v. Commissioner, TC Memo 1993 478, affd. per curiam 49 F.3d 713 (11th Cir. 1995).
  2. Dean Cibotti v Commr., TC Summary Opinion 2012-21.
  3. Lozon v. Commr., TC Memo 1997-250.
  4. Paul E. Hathaway v. Commr., TC Memo 1996-389.
  5. William O. Johnson v. Commr., TC Memo 1993-530.
  6. Donald J. Lewis, Jr., v. Commr., TC Memo 1993-635.