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Should I incorporate? For Self-employed individuals, 1099-misc employees, independent contractors, Sales agents, etc.

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If you’ve been self-employed or are starting as a self-employed individual, you’ve probably have come across the dreaded SELF-EMPLOYED TAX. Getting paid in full is not as fun as you thought once it comes to tax time. So what is the Self-employed Tax, it basically both the employee and employer portion of Social Security and Medicare taxes. On the cuff, it would seem that you get paid less than if you were an employee, however, you are your own boss and you simply have to price your services accordingly or achieve your sales goals accordingly.

Even after you strategize your goals, you reduce your profits with expenses, and you put yourself on a consistent budget to eliminate surprises. The IRS does give you a way to minimize your SE tax and this is to incorporate. Now there are different types of entities your could elect, LLC, LLP, C-Corp, partnership, S-Corp, but for the purposes of minimizing the SE tax we will discuss the most common Pass-through entity, the S-Corp.

The Internal Revenue Service may take a close look at your taxes if you choose this route, as you could end up lowering your overall tax liability while generating the same net income.

S-Corp distributions

If you decide to incorporate as an S-corporation, you can categorize some of your income as salary and some as a distribution. You’ll still be liable for social security and medicare taxes on the salary portion of your income as well as the Employer portion, however, the benefit on is that you’ll just pay ordinary income tax on the distribution portion. Depending on how you divide your income, you could save a considerable amount of self-employment taxes just by converting to an S-corporation.

IRS view of S-Corporations

The IRS tends to take a closer look at S-corporation returns since the potential for misuse is so large. For example, if you make $200,000 in one year but only designate $30,000 of that as salary income, you might trigger an IRS inquiry, since you are avoiding so much self-employment tax. The guiding principle is that you must designate a “reasonable” amount of your income as wages, rather than a distribution. What constitutes “reasonable” can often be a gray area, but if you push the envelope too far, you put yourself at risk for an IRS audit and potentially penalties and interest on any back taxes assessed by the IRS.

S-Corporations have additional costs

While an S-corporation may save you in self-employment taxes, it may cost you more than it saves. As with larger corporations, an S-corporation has both start-up and ongoing legal and accounting costs. In some states, S-corporations must also pay additional fees and taxes. For example, in California, an S-corporation must pay tax of 1.5 percent on its income with a minimum annual amount of $800. This tax is not required for sole proprietors.

Expenses, Assets & Depreciation

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Most business owners are familiar with the Profit & Loss Report, to most money you make is income and money that goes out is an expense. But that’s not always the case, an expense is something that gets used up rather quickly and therefore the benefit is used up quickly.  Some examples are office supplies, you purchase during the year and they get used up during the year. But there are other purchases that tend to hold up business owners record keeping because even though money is being spent, it is not fully expensed the year they you use it. This can give you a incorrect analysis of your business and not match up when it comes to taxes.

Assets

Sometimes when you make a purchase it’s not an expense, it’s actually an asset.  An asset is something where the usefulness is used up over the course of several years. It provides a benefit over a longer period of time.  Examples include equipment, vehicles, or a computer.

As an example, when you purchase a vehicle and use it to deliver products, it’s providing a benefit to you over the course of much more than just one year.   That’s the difference between an asset and an expense.  Does the purchase benefit you over the course of a long period of time?  An asset will help you continue to earn revenue over the course of several years.

Matching Revenues and Expenses

In accounting rules, revenue and its associated expenses should be recorded in the same period.  This is called matching.  Let’s say you purchased a camera and recorded the entire purchase as an expense in the year you purchased it — 2015.  But the camera helps you earn money in 2015, 2016, 2017, 2018, 2019 . . . a long time.  So the expense and the revenue aren’t matched up together.   You’ve got revenue produced by the camera recorded over the course of several years, but the expense of the camera is only recorded in one year.  The revenue and expense are not matched.

Matching is a very important accounting principle, the revenue and associated expense need to be matched together.  This is where depreciation comes into play.  The way you get the revenue and expense to match up, is to depreciate that asset over the course of several years.

Depreciation

Lets say you bought a $5,000 computer, that expense needs to spread out over how long you think you will have that computer.  In other words, The expense needs to spread over the computer’s useful life – the period of time that it will be of benefit to you.  Often for small equipment that’s 3-5 years.  Let’s say you think the computer will last you 5 years, (i.e. it has a useful life of 5 years) you take $5,000/5 years=$1,000 of depreciation you should take each year on that computer.

In this way you are spreading out the expense to match the revenue you earn in future years.

Depreciation also serves to show that the asset you purchased is losing value every year.  Let’s say you are a florist who purchased a vehicle to deliver flowers.  It’s only used for business.  You purchased the vehicle for $20,000 and you think it will last you for 10 years, so that’s $2,000 of depreciation every year.  The car is helping you earn your revenue over the course of 10 years.   When you take that depreciation each year, you can see that that car is losing value every year.  After the first year of depreciation the asset is valued at $18,000, after the second year $16,000, and so on.

That makes sense in our heads.  A car loses value every year.  As the years go on, your asset is losing value.  Depreciation shows that declining value.

What if your not ready to file your taxes by April 18th?

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Are you worried about not filing your taxes on time?

The last day to file your tax return is Monday April 18th. No worries! You can always file an extension, also the state of California does an automatic file extension for you. The IRS actually gives you 6 more months. This is good news for people who have not yet file because they probably moved from a different state and have not yet received all their forms, or just haven’t had the time to get the tax form done. Even though the IRS gives you an extension and your procrastinating because you owe you should calculate how much you owe and send a payment to the IRS remember they may charge penalties and interest if you don’t pay on time.