Gyroscopic Investing

I've decided to start my business up again, and I could use a bit of tax efficiency advice. Here's the situation:

I'm married filing jointly, and my day job puts me in the 25% tax bracket, approaching the 28% bracket. I live in CA and am subject to their humongous income tax, currently in the 9.3% bracket. As a result, this year when I ran my business as a sole proprietorship, I was subject to a 44.9% tax on every dollar my business earned (25% federal income tax, 10.6% federal payroll tax, 9.3% CA income tax)

How can I structure this more efficiently? LLC? S-corp? What can I deduct to reduce my business's taxable income?

Would an LLC help at all for taxation purposes (vs asset proetction purposes)? LLCs and S-Corps are passthroughs and as such any income the passthrough entity earns will fall on your personal bottom line anyway, won't it? I take it you are already maxing out any 401K plans you have? Does your business have a pension plan set up for you (although this could actually be counterproductive under non-top heavy non-discrimantion rules if you have a lot of employees....what you'll save in taxes you'll more than lose in pension contributions to your employees)? Just how much will your business increase you income...to the 33% bracket, the 36% bracket, or 39.6% bracket?

Moda and MT would be the ones to ask to really get into specifics on this.

EDIT: an LLC might helpif your side business can be reasonably expected to bring in less than 50K per year; an LLC (that you took a C-Corp election for) domiciled in a tax friendly state like Nevada that soaked up most of a California LLC's income through transfer pricing arrangements might work; a C-Corp has entity status (files as a separate taxpayer and doesn't pass through income on your personal return) and any C-Corp income is IIRC taxed at 15% only on the first 50K of income. Of course, you then have to move the cash OUT of the coporation and thus face either double taxation (as a dividend) or taxation at your personal rate (if you later choose to pay yourself a salary from the corporation); however, if you know at some point in the future that your income will be lower and you'll be in a lower tax bracket then this could work (there may be issues with "excess retained earnings" for a C-Corp but you'd have to ask the abovementioned two board memebrs about that).

My personal advice would be to get out of California ASAP; as soon as I saw the line that said "I live in CA" I was like...yep, there's your problem right there. 

There are certain rules surrounding the income derived from S-Corps not being subject to self-employment taxes (as opposed to LLC's), but you'll probably want to consult an accountant about that because I'm a bit rusty and I know you have to pay yourself some reasonable "salary"... or at least I thought so.

If you're in a position to save the money, you are allowed to contribute up to $50,000 (about), or 25% of your business income, whichever is lesser, to a SEP plan, but that won't wipe out your SE taxes.

If you work out of your home, try to deduct every last flea-bitten square foot you can as a business expense... the problem is, the IRS says you have to use an area of the home "regularly and exclusively" for the business.  To be honest, if I were doing it, I'd stretch the meaning of those terms to kingdom-come... I won't sugar-coat it.  45% is just asinine for your position in life.

If you're taking 150 sq. ft. out of a 1,500 s.f  home as business, you'll be able to deduct 10% of everything you spend on that home, and this may be another stretch, but I do a bit of a "cost segregation" on the home.  Any trim, flooring, appliances, land improvements, furniture, etc, might qualify for Sec. 179 or Bonus depreciation.  Other things too.

Barter. (facepalm)... you're still supposed to report this as income.  But where there's no paper trail, there's no likilihood of jail.

If you drive a car deduct your miles.

Try to combine family trips with business trips.

I don't know man.  You're in a pickle.  SE tax is a b!tch that keeps on taking.  Cali doesn't make it any better. 

None of this is official advice... just my take.

Thanks for the response, D1984. A few answers and clarifications:

I'm already maxing the 401k provided by my day job.

This past year, the business's gross income was 40k; net was 17k. I'm not anticipating netting 50k anytime soon, although I wouldn't complain!

I'm the only employee of this business and it's not super likely I'll hire any employees, at least not until it makes me a lot more. 

I'm moving out of CA at some point in the future; as soon as the business makes enough to support my family on a monthly basis after the tax bite. At that point, my tax bracket will be much lower because I'll lack the high-income day job that's currently putting me in a high bracket. I'll be in the 15% bracket at the highest, maybe even the 10% bracket. Depends on how much I contribute to my SEP-IRA at that time, I guess. I'll be trying to contribute enough that I avoid entering the 25% bracket.

PS,

I've run a business as an S-Corp in California for a dozen or so years.  I ran the business as a sole proprietorship for the first few years and had to bite the SE tax bullet.  I'm not sure it is worth the cost of setting up an LLC or S-Corp until it "feels" worth the hassle.  If you business has potential for liability issues then it is probably worth making that change sooner rather than later.

There are a limited number of ways to minimize taxes, and Moda has pointed out a few.  The home office deduction is an audit red flag, so I'm not sure it is worth it unless you really dot i's and cross t's.  SEP limits are higher, as I recall (we run a 401(k) since we have employees).  As an S-Corp/LLC you do need to pay yourself some salary exposed to SE taxes, although you should consult a tax guy to see what reasonable limits are.

You can do some of the same things as a business that individuals itemizing do:  pool expenses to maximize deductions in a given year, etc.  And you can be as aggressive as you (and your tax guy) are comfortable with in claiming business expenses.

But if you have legitimate business income, count your blessings and pay the tax.  It is better (at least slightly) than running at a loss!

Thanks, moda and WAH.

I've never actually taken anything but the standard deduction so I'm kind of a n00b at deducting the kitchen sink, and I was hoping for some pointers.

I work out of my apartment, so can I deduct my rent? I have a whole room; don't know the dimensions but it's probably about 30% of the total square footage. Would that mean I can deduct 30% of my rent?

I have to drive for the business, so I'll deduct the miles. What's the conversion of miles to dollars? Should I just estimate what percentage of the driving is business-related? There's no real way to calculate the exact mileage. Can I deduct the car itself? Gas costs?

Can I deduct the equipment I purchased for business use? What about my inventory? Shipping costs? Web hosting and eStore costs?

What's your business? That might help figure out some strategies that are outside of the box.

Also, when the Payroll Tax break goes away and you're paying another 5% tax next year, at that point, when half your marginal business income is gone to taxes, are you getting to the point of throwing your hands up in the air, saying screw it, and not even bother? Unless it's something you really enjoy and love to do.

TripleB wrote: What's your business? That might help figure out some strategies that are outside of the box.

Selling 3D printing hardware and 3D printed parts.

http://techpaladin.com/

TripleB wrote: Also, when the Payroll Tax break goes away and you're paying another 5% tax next year, at that point, when half your marginal business income is gone to taxes, are you getting to the point of throwing your hands up in the air, saying screw it, and not even bother? Unless it's something you really enjoy and love to do.

I already did. 

But now I'm reconsidering, because fuck that, I'm not going to let the feds prevent me from learning more about electronics and business, and creating value for others in the process. Furthermore, once I can get the business earning enough after taxes to sustain my family, I'm quitting my full-time job and then the taxes are going way, way down. I'll probably be eligible for all the credits that poor people get.

Right now, without any special deduction skills that I'm hoping people can share, I'm projecting that this year's my post-tax business income will be around 9k which is close, but we'll need about 12-14k/yr, and ideally more so I can still keep saving and investing a reasonable amount.

You need to use a regular C corp or an offshore IBC/LLC to get to lower income tax brackets.  A C corp will have a 15% tax rate on the first 50K then it goes up from there.  An offshore IBC/LLC would be as low as zero depending on the location but I'm not sure how that would work when registered as a "foreign corp" doing business in CA.  You could get creative and be only a "consultant" to the IBC/LLC and keep the business profits offshore and just pay taxes at your normal rates on what you're paid as the consultant.

The other thing is you could maximize a Roth 401K Solo or SEP to a significant degree that would lower your adjusted gross income, by 50K-55.5K max.  That sounds like the best way to go to me because there are moderate expenses for legal entities (as well as trust issues), especially offshore ones.

The C-Corp is fine - right up to the point where you start to make real money!

On the home office deduction, theoretically you pro-rate the square footage of the space you use for the business, plus a proportionate share of utilities, insurance, etc.  The problem is, if you hang a non-business coat or store non-business stuff in the room you use as an office, the IRS could disallow the deduction.  I haven't looked at the stats in a while, but but the home office deduction is disproportionately audited.  So be careful!

The mileage rate is 56.5 cents per mile for 2013.  I'd keep a log in the car and record business miles that way.

Business-related equipment, books, journals, supplies, web hosting, etc. are all legitimate business expenses.  Think about what you do that is related to the business that costs money.  It is probably deductible.

Things I did in hindsight that really helped my business:

1) Get a good tax guy/gal.  One that really understands small business.  They can explore avenues of tax minimization specifically targeted at your business.

2) Maximize deductible contributions to tax-deferred accounts (SIMPLE, SEP, solo 401(k), etc.).

3) Convert to a Corporation/LLC as soon as it feels right to you (i.e., the business is generating regular income).

With a sole proprietorship you really need to be careful about showing a profit - you want to show a profit!  The IRS can disallow expenses if they consider your "business" to be a "hobby".  Not good.

I know that self-employment tax is a bitter pill to swallow, but remember you are paying that as a corporation/LLC as well since it all comes out of the same pot.

Pointedstick wrote: Thanks, moda and WAH.

I've never actually taken anything but the standard deduction so I'm kind of a n00b at deducting the kitchen sink, and I was hoping for some pointers.

I work out of my apartment, so can I deduct my rent? I have a whole room; don't know the dimensions but it's probably about 30% of the total square footage. Would that mean I can deduct 30% of my rent?

I have to drive for the business, so I'll deduct the miles. What's the conversion of miles to dollars? Should I just estimate what percentage of the driving is business-related? There's no real way to calculate the exact mileage. Can I deduct the car itself? Gas costs?

Can I deduct the equipment I purchased for business use? What about my inventory? Shipping costs? Web hosting and eStore costs?

You can deduct all those things. There is a formula for calculating the home office deduction. A good tax program will guide you through it. Since you are renting I don't need to remind you of one reason you might not want to take the home office deduction. If you own your own home then you'll have to pay capital gains on the portion you declared as a home office when you sell your house (I found that out the hard way).

Since I was a consultant I never had to worry about inventory. That looked pretty complicated to me. Good luck.

I WAS able to always deduct 100 percent of the office equipment I bought without having to depreciate it over the years which also sounded like an accounting nightmare. There are rules and formulas for that too. Again, get a good tax program for business and it'll help you with all that stuff (and you can deduct that expense too).

MangoMan wrote:WAH, could you clarify what you meant by this?

Probably not

It has been a good while since I considered the options, but one advantage of a C-Corp was being able to shelter some profits within the corporation tax-free (a few tens of thousands as I recall).

As you indicated, C Corporations pay a reduced tax rate on the first dollar of profit and that scales up from there.  Those earnings are then taxed if passed to individual shareholders as dividends.  Even if there are no dividends, and you draw everything out as salary, you pay maximum social security/medicare on those dollars (as you pointed out), which you do not do as an S-Corp (pass through earnings are not subject to FICA and Medicare).

Assuming the business is successful, at some point the C might start generating profits that end up in double-tax land.

Since S-Corps are a pass-through entity, corporate losses can reduce personal income taxes.  Not so for a C.  Not a great "advantage" but it can be helpful at times.

So you can essentially run a small C Corp like an S Corp, paying out everything in salary and expenses, but that results in higher taxes, ceteris paribus, for the C Corp.

Again, I'm not a tax attorney (although there is at least one lurking on this forum), so individual due diligence is in order.

Pointedstick wrote: I'm moving out of CA at some point in the future; as soon as the business makes enough to support my family on a monthly basis after the tax bite.

I'm also considering moving to a different state, but my reasons are for retirement, not running a business.  My main criterion is the cost of living where ever I end up choosing to go.  These costs include the total of state taxes on income, property, and sales.

Taxes by State
http://www.retirementliving.com/taxes-by-state

Even though my primary motive for a possible move is retirement, I'm also planning on having earned income from freelancing (which I think of as "getting paid for having fun" by having a "profitable hobby").

The self-employed worker
http://www.youtube.com/watch?v=WDAGUt8QqO8

Unfortunately, contracting on a direct basis as a sole proprietor is fraught with tax perils.  The IRS sometimes reclassifies independent contractors as employees.  As a result, I may have to incorporate to avoid these tax traps (since incorporating is a safe harbor for these tax rules).

IRS 20 Factor Test – Independent Contractor or Employee?
http://comptroller.illinoisstate.edu/do ... actors.pdf

LifeStyleFreedom wrote:I'm also considering moving to a different state, but my reasons are for retirement, not running a business.  My main criterion is the cost of living where ever I end up choosing to go.  These costs include the total of state taxes on income, property, and sales.

For all the California bashing I do (I consider it to be a hobby), CA does not tax Social Security income.  But it does tax just about everything else, has very high sales tax, etc.

Pugchief,

Right on the "YMMV".

Assuming your S-Corp is generating income, the FICA/Medicare hurdle (whatever that tax happens to be in 2013) is a big advantage for S-Corps, although the "Replacement Tax" sounds like a pain and may negate that advantage in IL.