• Peridot Consulting Inc.

101: Transitioning from Employee to Self-Employed

Updated: Nov 30, 2018

A common question I get from a budding new self-employed client, is “I’ve heard I got to start paying taxes now that I am self-employed” or a rendering of that.


Your first paycheck gut punch

Many taxpayers are introduced to taxes at their first paycheck as a teenager. When they know they worked 10 hours at $10/hr. and are getting $85.50 on their paycheck. The question is always, why is it not $100 – then they look at the paystub and see these foreign concepts of ‘Social Security” and “Medicare” and Federal and even State withholding. Talk about a gut punch at a young age.


People have always known about taxes, but that very first paycheck is disheartening but it is a realization, that, ‘Nothing is certain but for death and taxes.’ Being a ‘W2’ employee makes taxes relatively easy. The employer is doing everything for us. Taking the taxes out, sending them off to the relevant agencies, and we get to keep the rest. Our tax returns, for the most part, are easy as well. Just a W2, less our withholdings, and we even probably got a refund. This is a typical experience for many taxpayers starting their taxpaying life.


Don’t let taxes keep you from becoming “Self Employed”

Going from this to ‘Self Employed’ can get extremely intimidating when the responsibility shifts, from being a complacent ‘law abiding’ taxpayer – via your w2 – to suddenly becoming a responsible self-employed individual. I can understand how the system we are in may stifle this entrepreneurship. From not only fear and fright of losing a ‘steady paycheck’ but you suddenly and may possibly be losing your benefits and are now the one and only person in charge of paying your taxes. It can be a common question: “What do I do, and how do I do it?” – and as much as I want to simply answer this question, the problem with my chosen profession, is that the answer, almost always, is ‘It depends.’


Once you’ve gone from that safe and secure W2 and decided to throw fear and doubt out the window and address this entrepreneurial urge head on, first congratulations, the hardest part is over, second – breathe, because it’s not so hard to make things easier on yourself from the beginning.


First – get a separate checking account.

If you’re starting a new business the first thing you need to do is get a bank account that is solely for your business. All business income goes into this account, and all business expenses go out of this account. If you need money for personal use, just transfer it, or write yourself a check, to your personal account. Start off keeping ‘business’ – business, and ‘personal’ – personal. By doing this, when it comes down to the basics, at least the bank statement is doing the accounting for you. Doing this from the beginning will make your ‘Business’ Life so much easier. It is like learning how to type in high school. It made those college papers so much easier than if you were still on the two fingered punch method. (if you decide to move into a bookkeeping software, like QuickBooks, your already there, because this software just connects to the bank account, and viola, your accounting 101)


Second – Taxes.

Congratulations, adulting is hard. If you are no longer that w2 employee, it is now your responsibility. Your taxes will be paid when you file your tax return. If you pay estimated taxes, they are a concurrent payment of tax you pay each quarter of the year, and the tax return serves as a reconciliation of these payments. If you underpay, you’ll owe more, if you overpay, you’ll get a refund. If you don’t pay any estimates, you owe if you have income, or won’t get a refund if you don’t have income.


Estimated taxes are based off the LESSOR of current year tax or prior year tax. That word salad is the taxing authority’s way of saying, look if you make more money this year than you did last year, at the least pay in what you owed total last year, and the difference you can owe at tax filing. If you make less money then you did last year, we won’t make you pay in all that tax since you did not make as much, just pay what you’ll owe this year.

With this information, it is the rule of thumb that if you know that you’re at least making what you made in the prior year, take your total tax you paid last year, divide it by four, and send that in every quarter. If you make more, the tax return will show an amount due when you file.


And to address the question of the nuanced middle? Your year last year is not comparable to this year, because, this year is all new. Estimated taxes fulfill two issues. One is paying the taxes you owe and avoiding underpayment penalties, and two is cash flow. If you don’t ‘have’ to pay estimates, because last year you had no tax, but you also do not want to have one big check due come April 15th, then make the burden easier, and pay estimates. If you don’t know what to send in, it stresses the importance of being able to estimate your net income every quarter. You want to be able to see all your income, all your expenses, and take a percentage of this net income and send it in. If all else fails, if you follow the first step, the bank statement will make that easier on you. It is important to note, that if you underpay your taxes, compared to last year, the underpayment interest rate for the IRS in 2018 is 5%. (not considering State)


More on Estimate Taxes from the IRS here.


Third – LLC vs. S Corp vs. C Corp

After all of the above musings, it is, and should always be a consideration: ‘Should I be an LLC, or Scorp, or Ccorp…. And what the heck are those, and how do I do that?’ Well…. I wish the answer was easy and a thorough conversation with a trusted advisor is highly recommended, because, brace for it, - it depends. Every entity selection possibility has its own, unique, benefits and costs. They each have something that make them great, and they each have something that makes them not so great. I will do my best to quickly summarize SOME of these below. Before I do, I have to say this as clearly as I can, I am not an attorney, have never been an attorney, and you should consult an attorney if you deem there is relevant legal considerations you need to make. I am going to stick to my corner, which is tax. That being said….


LLC- Limited Liability Company

From a tax perspective, if you are the only owner of your business and choose to be an LLC – There is no difference between this and doing nothing at all and being a ‘Sole Proprietor’. Single member LLC’s the IRS considers a disregarded entity. This is basically saying, it all ends up in the same place, we might as well skip the middle man. – Then why do an LLC?


Well, as per my disclaimer above, there can be a plethora of legal reasons, but the main one is that it can create a legal barrier between your business life and your personal life. An LLC is an independent legal entity. An LLC from a tax and bookkeeping perspective has a low barrier to entry. Nothing changes. Many people starting fresh will do and LLC for the legal reasons, and the ease of entry for the tax reasons. But the tax benefits stop at ‘its easy’ because there is no tax planning at all with an LLC. Do keep in mind a multiple member LLC (more than one owner) does change the affects a little, but that is for another blog. – As well as you can be an LLC and then ‘choose’ to be taxed as another entity, like and Scorp.


S-Corporations

Sort of the next step up from an LLC, an S corporation goes from ‘nothing much has changed’ with the LLC, to suddenly a lot has changed.


An S corporation does a few things.


1. It introduces its own tax return (Form 1120S) which is an information return. This tax return shows all the income from the business, and all the expenses. The ‘Left Over’ either a profit or a loss, will be taxed on the respective owner’s personal tax return via a conduit called a ‘K-1’. A K-1, is just a sheet of paper showing the owners share of income from this entity, and how that share should be reported on their tax return. And that is where the tax burden is realized. Depending on the nature of the business, but once you get into a Scorp you probably will have to start paying yourself a W2. Yes, you are suddenly both an employer and employee, and it is very important to keep a good, independent, set of books and records away form your personal life.


2. What is the benefit of a Scorp? The bottom line is a tax we like to call “Self-Employment Tax”. Self-Employment Tax is the social security and Medicare taxes. They together make up a staggering 15.3% of tax. (12.4% Social Security, and 2.9% Medicare). How then, does and Scorp help with this? Well, you only pay Self Employment Tax on earned income. In an LLC, if the income is earned all of the net income will be taxed on Self Employment taxes (up to their limitations) – regardless of how much you actually ‘take out’ of the business, or ‘pay yourself’. In a Scorp, only the amount you pay yourself in the W2 is subject to this tax. The ‘left over’ net income that comes to you via the K-1 is not subject to Self-Employment tax. A Scorp does not ‘punish’ the owner for leaving money in the company, so this is a savings of 15.3% on tax – a no brainer, right? Well, as always, it depends. Scorps do have to be a December year end, they have limitations on who can own a Scorp, how many shareholders, benefits to owners, the nature of the income, etc.


C-Corporations

Whenever I consult with clients on entity selection, I always make a point to carve out space for the C -corporation. I have found that a lot of professional advisors skip right over the C- corporation (maybe for good purposes) and don’t even bother explaining it to the client as a possibility. We’ve all probably heard the common complaint about C- Corps – double taxation. What is double taxation? Well… let’s get back to that.


1. C Corporations have their own tax return, on form 1120. Depending on the nature of the business, the Ccorp may have a fiscal year end (not December, you get to pick the year end), and the ‘left over’ income get’s taxed to the Corporation, not to the owner. C Corporations do not have a K-1. They are their own, independent, taxpaying entity. And that tax rate is a flat 21%. Owners of a C corp, if earning money in the C corp, are employees of this corporation, just like everyone else, and get a W2. They can get benefits, just like every other employee, (that you cannot in a Scorp).


2. Ok, lets address this double taxation. If you are an owner of a C corp. and pay yourself a salary, you are getting taxed (via your w2) on your personal return for this salary. Then you left money in the corporation, and it paid 21% tax on this net income. Later in the next year, the corporation has a lot of excess cash and you want it as the owner. For the most part, the only way to get that money is two ways: Via your Salary (w2) or a Dividend. If that extra cash came from the prior year (that you just paid tax on) and want to take it out in your W2 – it just got taxed twice. (last year, and now again this year on your W2). If you decide, I don’t want to pay Self Employment Tax on that, so I am just going to take a Dividend. Dividends, on your personal return, are taxable but not to Self-Employment tax. Great, but no so fast, Dividends are not a deduction to the corporation…. (what?) – so what that means is if you take a $20k dividend, that corporation will not deduct that $20k (and if not deducted, it does not reduce the income by that $20k, so it is paying tax on that $20k at 21%). Then you, receiving that dividend, will most likely pay tax on that dividend (again) on your personal return. And that is, double taxation. (no brainer here too, right?)


Not so fast, there are a plethora of situations where the benefits of a C corporation fit right in line with the taxpayer’s situation, as with any of this, it all depends.


More on business structures here.


In summation, make it easy on yourself to begin with, research the entities, and talk to an advisor. If you are married, have kids, have investments, a retirement plan, rental houses, future plans, etc. all these and many more do play a MAJOR role on what entity to choose and why. Every entity has a benefit, and a cost, and at the end of the day you weigh these cost/benefits with your very unique situation, choose a course, and take advantage of the advantages, and minimize the costs.



-John Michael Kledis EA, CFE, CVA is Principal and founder of Peridot Consulting, Inc.


Disclaimer: This is a brief synopsis and individual situations may vary. The above has left out many details for summation purposes. Do not take any advice from this column and please consult with relevant parties before making any decisions regarding the subject matter within. Any U.S. federal tax advice contained in this blog is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter that is contained in this blog. This blog does not give you the secret to life (that I’m aware of) and probably won’t make you happier, especially since you just took 10 minutes reading about taxes. You should have a newfound empathy for the author, as it is his life’s work, and truly realizes the ramifications of that, and is not as cool as he thought he’d be in when he was in middle school.

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Peridot Consulting, Inc.

60 N. Market Street

Asheville, NC 28801

(828) 242-6971

633 Merrimon Ave., Suite B

Asheville NC 28804

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