Welcome to the official blog of Brittany Lanphier, managing partner of Lanphier Accounting LLP based in Denver, Colorado!
Any tax guidance in this blog is intended for informational purposes only and is not guidance on which Lanphier Accounting LLP intends for you to rely. All tax issues specific to your business or family are largely facts-and-circumstances based and you should consult your tax advisor (or Brittany directly) to discuss how this might relate to you.
Welcome back to the blog! For me, the last few weeks have been full of catching up on all the little administrative tasks that were deferred during March and early April…cleaning up the office, finalizing files, etc. It has been a great, productive time, and I finally feel like I have my head on straight again (even though I still have a long list of tasks to do!).
Dennis and I also managed to slip away for a 5-day vacation to Washington, D.C. for some sightseeing and relaxation. Being the history and political nerds that we are, we thoroughly enjoyed going through the museums and seeing all of the monuments. It is such a fun city and we didn’t even come close to seeing everything that we wanted to see. I highly recommend it to anyone looking to do a vacation on a budget. Almost all of the museums and tours are free, and we found a hotel on Expedia for a great price. We also discovered our favorite DC restaurant – Founding Farmers – just a few blocks from the White House. We had dinner there our first night and had to go back on our last night!
This week, we are excited to announce we have moved into our new full-time office space on 17th Street in Downtown Denver. It is a fantastic building in a fantastic location, and we can’t wait for all of our clients to come visit us. We will be sharing office space with Dennis’ new law firm, Hampton Lanphier LLP. Dennis and his partner, Audie Hampton, specialize in estate planning, will and trust administration, tax planning, and nonprofit organizations. Just like Lanphier Accounting LLP, there are committed to offering first-class services at affordable rates for small businesses and families throughout the Denver area, so please visit them online (www.HamptonLanphier.com) to learn more!
Now that we have arrived in May, many clients ask me what we do for the rest of the year once tax season is over. In fact, preparing tax returns is only a fraction of what we do in our practice! Some of our year-round tasks include managing the books and payroll for our business clients, compiling and reviewing client financial statements, representing clients during IRS disputes, and providing consulting services for clients looking to improve their businesses. Of course, there are always tax returns to prepare for clients who have extended their returns past the April 15th deadline.
FYI: To celebrate the end of tax season, From now until June 30th, we are offering a FREE business check-up to new and existing clients, including a detailed analysis of your industry and how your business measures up financially to your competitors. This is a $250 value free! Call our offices today to schedule an appointment and strengthen your business in 2010.
For this week’s tax segment, I want to pick back up with our discussion of self-employment taxes from several months back (catch up here). Since we have discussed the basics of self-employment tax and just how much of a drag they are for business owners, I want to tell you about a legitimate strategy for reducing your self-employment taxes by electing to be treated as an “S-Corporation”.
An S-Corporation is a “fictional tax entity”. By this, I mean that all business types (partnerships, corporations, LLCs, etc.) are created by state law. For instance, Lanphier Accounting LLP is a “limited liability partnership” created in the state of Colorado. Each entity type has tax and non-tax advantages and disadvantages depending on your business. An S-Corporation, however, is an entity type that only exists on a tax return. Any “eligible entity”can elect to be taxed as an S-Corporation, including regular corporations, LLCs, and partnerships. The reason I call it a “fictional tax entity” is that you cannot go to the Colorado Secretary of State and tell them you want to create an S-Corporation. Rather, you would create another entity (for instance, an LLC) and file an election with the IRS to have it taxed as an S-Corporation.
S-Corporations (short for “Small Business Corporation”) are taxed much like LLCs and partnerships. All of the earnings and losses “flow through” directly to the owner(s), meaning they are taxed in the year incurred by the business. There is one important difference — the earnings of an S-Corporation that flow through to its shareholders are not subject to self-employment tax.
You will remember from my previous post that self-employment taxes are a 15.3% tax in addition to federal income tax on any self-employed business earnings. It is the equivalent to paying both the employer and the employee portions of Social Security and Medicare tax (FICA). Many a small business owner has had a rude awakening come tax time as a result of this tax. With a little planning, however, you could save literally thousands of dollars on this tax simply by electing S-Corporation status.
Is there a catch? Of course there is! The IRS knows about this “loophole” and the opportunity for taxpayers to get out of paying self-employment taxes. Therefore, if you have an S-Corporation in which you are an active participant in the business, you are required to pay yourself wages just like an employee, and all of the relevant employment taxes with them. So on everything you pay yourself as wages, you are still paying all 15.3% of FICA just like you would have as a sole proprietor, LLC, or partnership. However, any net earnings you have in excess of those wages will NOT be subject to employment taxes.
So, if your mind works at all like mine, you are thinking, “Great, I will just pay myself $1 per day, and call that my salary! This rest will be employment tax free!” Not quite. The IRS requires shareholders to pay themselves a “reasonable salary” based on the work they perform for the business. Reasonable can be defined several ways, but the easiest definition is that it is an equivalent salary to what you would accept to do the same work for someone else. So if you wouldn’t work for someone else for $1 per day, the IRS says you can’t work for yourself for that little either.
Let’s look at an example to see how you could save taxes by using this strategy…
Example 1 – LLC Owner
Bob owns and manages his own software programming company. His business generates net income of $100,000 in 2010. Bob will report this $100,000 with his personal income tax return on Schedule C. All $100,000 will be subject to self-employment taxes:
Net Income $100,000
SE Tax (15.3%) ($15,300)
Income After SE Tax $84,700
Example 2 – LLC elects to be treated as an S Corporation
Bob decides he can’t stomach paying over $15K in Self-Employment taxes. He decides to elect to treat his LLC as an S-Corporation. Before setting up his company, Bob worked for another company doing the exact same work and was paid $65,000 a year. Therefore, he determines that this is a “reasonable salary”. He pays employment taxes on his $65,000 salary.
Business Income $100,000
Emp. Taxes (15.3%) ($9,945)
S-Corporation Income $25,055 Flows through to shareholder as “dividend”, not subject to self-employment taxes
Total Income Realized by Shareholder After Employment Taxes:
Total Income $90,055
Tax Savings $5,355 ($90,055 – $84,700)
Now, these are simplified calculations for illustration sake, but you can see that there are very real tax savings available using this strategy. Also, these examples do not take federal income taxes into account which would be the same either way.
Is this Strategy Right for Me?
Obviously, this is a really nice strategy for many small business owners. However, there are some factors to consider in determining if it is right for you.
1) Administrative Burden
Using this strategy definitely requires you to be proactive in planning and stay on top of your taxes at least quarterly. If you don’t, you could be facing penalties for failing to file quarterly employment tax reports. If you already keep great records, this might not be an issue for you, but if you are one of those business owners that hands your CPA a shoebox full of receipts every March, it might be more trouble than it is worth for you.
2) Increased Need for CPA
If you employ this strategy, you will want to keep your CPA in the loop and likely have them prepare your quarterly reports to make sure everything is in line. You don’t want to “fly by the seat of your pants” using this strategy. Also, an S Corporation requires a totally separate tax return from your personal return. So in addition to your Form 1040, you will have to file Form 1120-S (which is due by March 15th, not April 15th). So you will be paying your CPA a little bit more for tax return preparation than you were as an LLC or sole proprietorship.
For this reason, I really only recommend this strategy to my clients that are already making a good profit in their businesses and paying pretty heavily on the self-employment tax side. For those who aren’t, it might just not be worth the hassle of messing with an S-Corporation. The tax savings may be outweighed by the additional cost of my services required to maintain it. If, however, like Bob in our example, there is an opportunity to save several thousand in taxes, it might be worth it to pay your CPA a couple hundred per quarter to get you there. I am pretty up front with clients about whether or not I think it will be worth their time, so feel free to ask or inquire of your own CPA.
This has definitely been a high-level overview of this strategy. There are other rules relevant to eligibility for S-Corporation status, how to elect status, and what you need to do after you elect that I have not gotten into here. Once again, this does fall under the “don’t try this at home” category of tax planning, and you will most definitely want to consult with your tax adviser about whether this is the right strategy for you. With that said, this is a great strategy that many small business owners use, and anytime I see a client paying through the nose on self-employment taxes, I bring up this strategy.
I hope this has been a helpful look at the world of basic tax planning. If you have any questions, please don’t hesitate to contact me (Brittany@LanphierCPA.com).
Best to everyone! Thanks for checking in!
Brittany Lanphier, CPA
Lanphier Accounting LLP
600 17th St., Suite 2800 South
Denver, CO 80202