An S corporation could cut your self-employment tax

If your business is organized as a sole proprietorship or as a wholly owned limited liability company (LLC), you’re subject to both income tax and self-employment tax. There may be a way to cut your tax bill by conducting business as an S corporation.

Fundamentals of self-employment tax

The self-employment tax is imposed on 92.35% of self-employment income at a 12.4% rate for Social Security up to a certain maximum ($142,800 for 2021) and at a 2.9% rate for Medicare. No maximum tax limit applies to the Medicare tax. An additional 0.9% Medicare tax is imposed on income exceeding $250,000 for married couples ($125,000 for married persons filing separately) and $200,000 in all other cases.

What if you conduct your business as a partnership in which you’re a general partner? In that case, in addition to income tax, you’re subject to the self-employment tax on your distributive share of the partnership’s income. On the other hand, if you conduct your business as an S corporation, you’ll be subject to income tax, but not self-employment tax, on your share of the S corporation’s income.

An S corporation isn’t subject to tax at the corporate level. Instead, the corporation’s items of income, gain, loss and deduction are passed through to the shareholders. However, the income passed through to the shareholder isn’t treated as self-employment income. Thus, by using an S corporation, you may be able to avoid self-employment income tax.  

Keep your salary “reasonable”

Be aware that the IRS requires that the S corporation pay you reasonable compensation for your services to the business. The compensation is treated as wages subject to employment tax (split evenly between the corporation and the employee), which is equivalent to the self-employment tax. If the S corporation doesn’t pay you reasonable compensation for your services, the IRS may treat a portion of the S corporation’s distributions to you as wages and impose Social Security taxes on the amount it considers wages.

There’s no simple formula regarding what’s considered reasonable compensation. Presumably, reasonable compensation is the amount that unrelated employers would pay for comparable services under similar circumstances. There are many factors that should be taken into account in making this determination.

Converting from a C corporation 

There may be complications if you convert a C corporation to an S corporation. A “built-in gains tax” may apply when you dispose of appreciated assets held by the C corporation at the time of the conversion. However, there may be ways to minimize its impact.

Many factors to consider

Contact us if you’d like to discuss the factors involved in conducting your business as an S corporation, and how much the business should pay you as compensation.

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Still have questions after you file your tax return?

Even after your 2020 tax return has been successfully filed with the IRS, you may still have some questions about the return. Here are brief answers to three questions that we’re frequently asked at this time of year.

Are you wondering when you will receive your refund?

The IRS has an online tool that can tell you the status of your refund. Go to irs.gov and click on “Get Your Refund Status.” You’ll need your Social Security number, filing status and the exact refund amount.

Which tax records can you throw away now?

At a minimum, keep tax records related to your return for as long as the IRS can audit your return or assess additional taxes. In general, the statute of limitations is three years after you file your return. So you can generally get rid of most records related to tax returns for 2017 and earlier years. (If you filed an extension for your 2017 return, hold on to your records until at least three years from when you filed the extended return.)

However, the statute of limitations extends to six years for taxpayers who understate their gross income by more than 25%.

You should hang on to certain tax-related records longer. For example, keep the actual tax returns indefinitely, so you can prove to the IRS that you filed legitimate returns. (There’s no statute of limitations for an audit if you didn’t file a return or you filed a fraudulent one.)

When it comes to retirement accounts, keep records associated with them until you’ve depleted the account and reported the last withdrawal on your tax return, plus three (or six) years. And retain records related to real estate or investments for as long as you own the asset, plus at least three years after you sell it and report the sale on your tax return. (You can keep these records for six years if you want to be extra safe.)

If you overlooked claiming a tax break, can you still collect a refund for it?

In general, you can file an amended tax return and claim a refund within three years after the date you filed your original return or within two years of the date you paid the tax, whichever is later.

However, there are a few opportunities when you have longer to file an amended return. For example, the statute of limitations for bad debts is longer than the usual three-year time limit for most items on your tax return. In general, you can amend your tax return to claim a bad debt for seven years from the due date of the tax return for the year that the debt became worthless.

Year-round tax help

Contact us if you have questions about retaining tax records, receiving your refund or filing an amended return. We’re not just here at tax filing time. We’re available all year long.

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Working in the gig economy results in tax obligations

Before the COVID-19 pandemic hit, the number of people engaged in the “gig” or sharing economy had been growing, according to several reports. And reductions in working hours during the pandemic have caused even more people to turn to gig work to make up lost income. There are tax consequences for the people who perform these jobs, which include providing car rides, delivering food, walking dogs and providing other services.

Bottom line: If you receive income from freelancing or from one of the online platforms offering goods and services, it’s generally taxable. That’s true even if the income comes from a side job and even if you don’t receive an income statement reporting the amount of money you made.

Basics for gig workers

The IRS considers gig workers as those who are independent contractors and conduct their jobs through online platforms. Examples include Uber, Lyft, Airbnb and DoorDash.

Unlike traditional employees, independent contractors don’t receive benefits associated with employment or employer-sponsored health insurance. They also aren’t covered by the minimum wage or other protections of federal laws and they aren’t part of states’ unemployment insurance systems. In addition, they’re on their own when it comes to retirement savings and taxes.

Pay taxes throughout the year

If you’re part of the gig or sharing economy, here are some tax considerations.

  • You may need to make quarterly estimated tax payments because your income isn’t subject to withholding. These payments are generally due on April 15, June 15, September 15 and January 15 of the following year. (If a due date falls on a Saturday or Sunday, the due date becomes the next business day.)
  • You should receive a Form 1099-NEC, Nonemployee Compensation, a Form 1099-K or other income statement from the online platform.
  • Some or all of your business expenses may be deductible on your tax return, subject to the normal tax limitations and rules. For example, if you provide rides with your own car, you may be able to deduct depreciation for wear and tear and deterioration of the vehicle. Be aware that if you rent a room in your main home or vacation home, the rules for deducting expenses can be complex.

Keeping records

It’s important to keep good records tracking income and expenses in case you are audited by the IRS or state tax authorities. Contact us if you have questions about your tax obligations as a gig worker or the deductions you can claim. You don’t want to get an unwanted surprise when you file your tax return.

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Why it’s important to meet the tax return filing and payment deadlines

The May 17 deadline for filing your 2020 individual tax return is coming up soon. It’s important to file and pay your tax return on time to avoid penalties imposed by the IRS. Here are the basic rules.

Failure to pay

Separate penalties apply for failing to pay and failing to file. The failure-to-pay penalty is 1/2% for each month (or partial month) the payment is late. For example, if payment is due May 17 and is made June 22, the penalty is 1% (1/2% times 2 months or partial months). The maximum penalty is 25%.

The failure-to-pay penalty is based on the amount shown as due on the return (less credits for amounts paid through withholding or estimated payments), even if the actual tax bill turns out to be higher. On the other hand, if the actual tax bill turns out to be lower, the penalty is based on the lower amount.

For example, if your payment is two months late and your return shows that you owe $5,000, the penalty is 1%, which equals $50. If you’re audited and your tax bill increases by another $1,000, the failure-to-pay penalty isn’t increased because it’s based on the amount shown on the return as due.

Failure to file

The failure-to-file penalty runs at a more severe rate of 5% per month (or partial month) of lateness to a maximum of 25%. If you obtain an extension to file (until October 15), you’re not filing late unless you miss the extended due date. However, a filing extension doesn’t apply to your responsibility for payment.

If the 1/2% failure-to-pay penalty and the failure-to-file penalty both apply, the failure-to-file penalty drops to 4.5% per month (or part) so the total combined penalty is 5%. The maximum combined penalty for the first five months is 25%. After that, the failure-to-pay penalty can continue at 1/2% per month for 45 more months (an additional 22.5%). Thus, the combined penalties could reach 47.5% over time.

The failure-to-file penalty is also more severe because it’s based on the amount required to be shown on the return, and not just the amount shown as due. (Credit is given for amounts paid via withholding or estimated payments. So if no amount is owed, there’s no penalty for late filing.) For example, if a return is filed three months late showing $5,000 owed (after payment credits), the combined penalties would be 15%, which equals $750. If the actual tax liability is later determined to be an additional $1,000, the failure to file penalty (4.5% × 3 = 13.5%) would also apply for an additional $135 in penalties.

A minimum failure to file penalty will also apply if you file your return more than 60 days late. This minimum penalty is the lesser of $210 or the tax amount required to be shown on the return.

Reasonable cause

Both penalties may be excused by IRS if lateness is due to “reasonable cause.” Typical qualifying excuses include death or serious illness in the immediate family and postal irregularities.

As you can see, filing and paying late can get expensive. Furthermore, in particularly abusive situations involving a fraudulent failure to file, the late filing penalty can reach 15% per month, with a 75% maximum. Contact us if you have questions.

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Home sales: How to determine your “basis”

The housing market in many parts of the country is strong this spring. If you’re buying or selling a home, you should know how to determine your “basis.”

How it works

You can claim an itemized deduction on your tax return for real estate taxes and home mortgage interest. Most other home ownership costs can’t be deducted currently. However, these costs may increase your home’s “basis” (your cost for tax purposes). And a higher basis can save taxes when you sell.

The law allows an exclusion from income for all or part of the gain realized on the sale of your home. The general exclusion limit is $250,000 ($500,000 for married taxpayers). You may feel the exclusion amount makes keeping track of the basis relatively unimportant. Many homes today sell for less than $500,000. However, that reasoning doesn’t take into account what may happen in the future. If history is any indication, a home that’s owned for 20 or 30 years appreciates greatly. Thus, you want your basis to be as high as possible in order to avoid or reduce the tax that may result when you eventually sell.

Good recordkeeping

To prove the amount of your basis, keep accurate records of your purchase price, closing costs, and other expenses that increase your basis. Save receipts and other records for improvements and additions you make to the home. When you eventually sell, your basis will establish the amount of your gain. Keep the supporting documentation for at least three years after you file your return for the sale year.

Start with the purchase price

The main element in your home’s basis is the purchase price. This includes your down payment and any debt, such as a mortgage. It also includes certain settlement or closing costs. If you had your house built on land you own, your basis is the cost of the land plus certain costs to complete the house.

You add to the cost of your home expenses that you paid in connection with the purchase, including attorney’s fees, abstract fees, owner’s title insurance, recording fees and transfer taxes. The basis of your home is affected by expenses after a casualty to restore damaged property and depreciation if you used your home for business or rental purposes,

Over time, you may make additions and improvements to your home. Add the cost of these improvements to your basis. Improvements that add to your home’s basis include:

  • A room addition,
  • Finishing the basement,
  • A fence,
  • Storm windows or doors,
  • A new heating or central air conditioning system,
  • Flooring,
  • A new roof, and
  • Driveway paving.

Home expenses that don’t add much to the value or the property’s life are considered repairs, not improvements. Therefore, you can’t add them to the property’s basis. Repairs include painting, fixing gutters, repairing leaks and replacing broken windows. However, an entire job is considered an improvement if items that would otherwise be considered repairs are done as part of extensive remodeling.

The cost of appliances purchased for your home generally don’t add to your basis unless they are considered attached to the house. Thus, the cost of a built-in oven or range would increase basis. But an appliance that can be easily removed wouldn’t.

Plan for best results

Other rules and requirements may apply. We can help you plan for the best tax results involving your home’s basis.

© 2021