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Taxes...incorporating...
Disrupter
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Hey all, so I am someone with a full time job who also does freelance work on the side. I have a bunch of friends who are freelancers full time.
One of them has decided to incorporate his business. He was explaining how he is taxed to me and it doesn't sound right. I don't know enough about it, but I am afraid he is taking some money without paying taxes on it. So if anyone could educate me that would be helpful.
His plan is as follows:
Basically the corporation gets paid. Lets say it makes 50k in a year.
He then pays himself a w2 for 20k. He pays that like one normally does.
Then he takes the other 30k and uses profit sharing to distribute it to the share holders (which is just him). In this case he doesnt pay federal taxes on this chunk.
This seems fishy to me. Ive tried doing research and Ive read that you DO pay income tax if you are paid profit sharing as an employee. But I havent found anything saying what you pay as a shareholder. But it seems crazy to me that you wouldn't need to report it as income. Anyone know anything about this?
If I ever wanted to do this myself i would consult an accountant. But for now I am just curious whether or not my buddy has misunderstood his.
One of them has decided to incorporate his business. He was explaining how he is taxed to me and it doesn't sound right. I don't know enough about it, but I am afraid he is taking some money without paying taxes on it. So if anyone could educate me that would be helpful.
His plan is as follows:
Basically the corporation gets paid. Lets say it makes 50k in a year.
He then pays himself a w2 for 20k. He pays that like one normally does.
Then he takes the other 30k and uses profit sharing to distribute it to the share holders (which is just him). In this case he doesnt pay federal taxes on this chunk.
This seems fishy to me. Ive tried doing research and Ive read that you DO pay income tax if you are paid profit sharing as an employee. But I havent found anything saying what you pay as a shareholder. But it seems crazy to me that you wouldn't need to report it as income. Anyone know anything about this?
If I ever wanted to do this myself i would consult an accountant. But for now I am just curious whether or not my buddy has misunderstood his.
Disrupter on
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Downside? It's basically double taxation.
Upside? No liability if the company gets sued.
This is pretty relevant.
http://slashdot.org/index2.pl?fhfilter=irs+payroll
Also, if his company makes 50k in net revenue, the corp pays taxes on that. then he'll pay taxes on his income on top of that. incorporating is not going to save him any money on that front, unless he's planning on breaking the law.
Is there a lot of liability in his profession? as in, could someone sue him for lots of dough? incorporating will protect his personal assets in that case. i don't really see another reason to do it, especially if it's a one man operation. unless he's getting a grant or something to do so. but again, i'm no expert.
It seems that "profit sharing" pay would probably get taxed automatically at the top bracket, something like 30%. Then he might get more back. Why doesn't he just claim it all like normal?
but they're listening to every word I say
If he's trying to get back more money... tell him to stop trying.
Great if you're wealthy and you don't care, not so great if your business goes under and you're unemployed and need to see a doctor.
all in all, i don't think your friend has thought this through.
He should tread carefully, tax evasion bad, and interest on back taxes is usurious.
The problem is, I met the guy once and I dont trust him one bit. This accountant is the same guy who had my former boss switch us all from w2 employees to 1040s without any compensation for the fact we were now having to pay the extra social security and medicare. Which I took at the time then promptly found new work. Though researching it later, its illegal to do so.
So this accountant had my former boss switch us illegally to 1040s and is now advising my buddy on how he will pay his corporate taxes.
I just spent about 40 minutes on AIM trying to talk to him and try to figure out what hes trying to do. To be honest im not sure he knows 100% i think hes just buying what the accountant is selling. But im pretty sure the accountant walks away scott free if he gets audited.
Since he doesn't know the details its hard for me to. The jist of it is he is under the impression he can pay himself a lot less in the W2 as an employee and then share the profits to the stock holders and avoid paying a lot in taxes.
In fact his exact quote is
"If I made $50k:
* As a freelancer, I'd be paying $9,385 total in taxes.
* As an S-Corp with $20k salary & $30k profit sharing, I'd pay about $4,060 in taxes.
"
The worst part is, having met with his accountant he is posting this information in a freelancer community, advising others to incorporate to get similar results.
What kind of Corporation is it? Is it an LLC with an S-Election? Is it just a S-Corp? Is it a C-Corp?
I mean, if he's an S-corp, then yeah he's right, he will save on payroll taxes, but he also has to deal with like, franchise taxes to the state.
http://www.irs.gov/businesses/small/article/0,,id=98263,00.html
Looking at that table it seems like the idea is that he will be double taxed on the income he pays himself in salary but he will avoid paying employment tax on the money he does not pay as salary.
It still doesnt seem like it would be worth it, but I suppose I could be mistaken. But if your paying full income tax on 50k and then again on 20k, it doesnt seem like youd save anything by not paying employment tax on 30k.
there are some books on this at amazon, maybe they are at a local library
http://www.amazon.com/Inc-Yourself-10th-Judith-McQuown/dp/156414741X
http://www.amazon.com/INC-Grow-Rich-Protect-Forever/dp/B0015HEMW4
This so hard.
That's a good idea. Though a question is, does the deductions for business affect the corp different than personal filing? IE, do you have to prove you used it 100% for business like you do with filing it on your taxes? Or do you just have to prove you bought it for company use and that you use it occasionally? Same for computers and such. Also does the company have to run a profit for 3 out of 5 years like filing on your own taxes, or can they just run a slight negative profit?
If he were either a freelancer or LLC he would be paying self employment payroll taxes of 15.3% on all earnings on top of the normal federal income tax.
As an S-Corp (but not C-Corp) he is paying himself a 20k salary which is a tax deductible expense for the business. Payroll taxes are only paid on that 20k, rather than the total earnings. Everything left over is distributed to himself as dividends as the sole shareholder of the corporation. He's still paying his personal federal income tax on everything, but he's avoiding that 15.3% payroll tax on everything else.
Many accountants recommend this for freelancers and sole member companies as it can reduce their tax liability greatly in a legal way.
That'd be my guess.
But to speak more directly on the situation, this would most likely be considered tax evasion.
http://www.irs.gov/businesses/small/article/0,,id=203100,00.html has more information, but basically if his work is worth 50 grand a year and he is not being paid that, he is not being paid a reasonable salary. The IRS would then over rule the FORM of this transaction (distributions to shareholders) and instead apply the SUBSTANCE of the transaction (compensation) which would have the employee owing all applicable taxes on the earned income.
Concerning the reasonable salary, since he is the only person working at the s-corp and he is doing all the work and his work is earning 50k? You can't really make the case that his work is only worth 20. Maybe you could cut it down by a margin and say that his work is worth, for example, 42 and the remaining 8 is all overhead to be kept by the company? But then if you were to immediately make a distribution for the 8k, you're essentially just paying yourself 50.
It makes sense. I suppose the only shadey issue is the one of what reasonable pay is. So to save a lot he would have to risk being audited based on unreasonable pay.
I guess that solves this thread. As he already knows about the reasonable pay thing and has concluded whatever his payment is, is enough. Everything else seems to be on the up.
They don't take tax fraud lightly. Which is what he's doing if he's using the S Corp as a tax shelter by underpaying his salary.
Well just to clear up one point, there is no double taxation with S-Corps, only C-Corps. S-corps are flow through taxation entities just like partnerships and LLCs. The only time double taxation comes into effect is when a C-Corp pays its corporate income taxes, then the shareholders get taxed on their dividends to create double taxation.
In this case it's not double taxation, just avoiding paying payroll taxes which for other pass through entities such as partnerships and LLC's full payroll taxes have to be paid on everything.
Yes. I've read that the most common reason for audit for single entity S-corp is "reasonable compensation" and "hobby loss rule."
Also, wouldn't he (as an employer) have to pay the employer matching payroll taxes on the salary he pays to himself?
The S-Corp pays taxes on its profits, but the payroll he pays to himself is not considered profit, so there isn't a tax on that, he only pays normal income tax on that. Hence no double taxation? Is that the gist of it?
As for him being prepared for the IRS. Its hard for me to talk to him, he got really defensive asking me why I was "arguing with him" when I was asking him how it worked because "it sounded fishy".
The problem is, his accountant is really the one doing this, he is just listening to the advice he paid for. The assumption on his part is the accountant wouldn't advise something that isnt kosher. Its hard for me to refute a paid professional's advise.
He has recieved warning on the forum he posted his situation on saying that he had to be careful about "reasonable pay". His response was "yes, for everyone it would be different, this is just what my accountant said works for me."
Not exactly. Regular C- Corporations have to pay a corporate income tax on their profits, those profits are then either kept in the company or distributed to the shareholders through dividends which are taxed again at the personal level. S-Corps profits are not subject to a corporate level income tax. The profits are 'passed through' to the individual shareholders where it is taxed at the personal level only.
Would he like to get sued and have people come after his personal assets?
I have dropped it. Its more for my own knowledge at this point. Really I have no intention of being all "hey I spoke to folks on a gaming forum and OH BOY! You are in trouble!"
I also never had, nor never plan to have, any intention of arguing with him. He seemed to take it as an argument at first due to the nature of AIM. I was really just trying to understand what he was doing. Im still trying to figure it out.
The help/advice in this case is less "help me convince my friend hes a tax fraud" and more "help me understand what he is doing for my own knowledge."
But at the same time, had the advice come back that my buddy's accountant is completely wrong and I should point him to website A where it will explain things. I may have risked him getting pissed off to give one last shot to prevent trouble. As it is, it seems what he is doing is legit, but it gets shadey with what a reasonable salary is.
Why would I want to do that to a buddy?
I...I dont know. Is one better then the other? I know in an LLC your assets arent vulnerable. Are they in an S-corp? I know hes not filing as an LLC because it is more expensive to do so.
But he gets to avoid paying SS and medicare on these profits? Thats pretty crazy. Yeah sounds like a dubious move to say the least. Reasonable salary is such a odd way of putting it. Tax codes leave so much ground for moving into gray areas its silly to me.
But even that 26K AFTER taxes is a lot more then 20K before taxes.
Its the reasonable salary part that he is being shady on, and I think he already knows that and is willing to take the risk. Not much I can do there even if I wanted to.
In any case, you would want to report the accountant because he is clearly helping clients to defraud the government, something which is dishonest, illegal, and costs the rest of us both lost tax revenue and money spent on enforcement by the IRS.
This isn't some grey area; it's a widely-recognized illegal tax shelter.
The first thing any honest accountant does in this situation is explain that underpaying salary as an S Corp is fraud, is likely to be picked up, and has severe penalties.