1. Become a business.
You may already have started a business, but it’s also possible even as an employee. You can go to your employer and ask to become an independent contractor. The company you establish will employ you. Your employer will then establish a contract with your new company. Some employers may be hesitant, but it reduces their tax liability. The IRS is fine with this as long as you are an employee of a business. That business can either be someone else’s business or your business. That way employment taxes are paid.
2. Set up an entity.
Examples of entities include the Limited Liability Company (LLC) and the Corporation. This entity will pay you a salary. If you fail to establish an entity, you’re likely giving away 90% of your tax benefits. Discuss this with your tax advisor and your attorney to figure out which entity works best for you.
3. Elect how to tax that entity.
You must declare how your entity will be taxed. You must fill out an IRS form declaring your election. Take time to discuss with your tax advisor and make sure they fill out the form and file that form on your behalf. You want to choose between an S corporation or a C corporation. If you don’t choose then you will be taxed as a sole proprietor, which will eliminate half of your tax benefits. Even though you may have chosen to set up your entity an LLC, this does not exist in the tax law. You must elect to be taxed as an S corporation or a C corporation. Broadly speaking, if you plan to take all your money out of the business and not plan to leave it in to grow your business, you should be an S corporation. This works well because there’s only one level of tax and it’s at the shareholder level (owner level). Only you are taxed, not the company. If you plan to leave your money in your company, you likely should be a C corporation. A C corporation sees a flat 21% corporate tax rate. Don’t forget in a C corporation, the corporation is taxed and is taxed again at the shareholder level when money is distributed. If you plan to grow your company and not remove all the money out of your company, then it’s best to have your company be a C corporation. Once again, always consult with your tax advisor since your situation is unique. This discussion applies to starting online businesses and service businesses but not to investment real estate.
4. Pay yourself a reasonable salary.
Since you are in business now, you need a bookkeeper. Your bookkeeper can help you complete the withholding of your salary and file the payroll tax reports. You could choose to use a payroll company to handle your payroll as well. Make sure you discuss this with your tax advisor. Consider a reasonable salary of what you would pay someone else to do your job. Typically, you won’t need to take a salary of more than half of the money you’re bringing in. For an S Corporation, the salary is subject to social security taxes, but the distributions are not. Generally, if you take a 50% salary and the remainder is distributions, you should be ok. In this case, it means that half of the money that you take out of the company is salary and the rest of the money you’re going to take out as a distribution on a quarterly basis. If you find you need your money more often than that, set up a loan between yourself and the company and borrow the money as you need it. On a quarterly basis, have your bookkeeper make a journal entry to record it as a distribution. If your company is a C corporation, all the money you take out will need to be in salary—otherwise you’re going to pay tax twice.
5. Start taking business deductions.
Besides the great benefit of cutting your social security tax in half, consider the benefits of taking business deductions. To make an expense deductible, you must make it meet 4 criteria. First, the expense must have a business purpose and be related to your business. Second, it must be ordinary, which means it’s typical in your business. Third, it must be necessary, meaning the purpose of the expenditure is to make you a profit. Lastly, you are going to document the expense. Documentation is critical. If the expense is not documented, then it’s not deductible. Remember, if you’re an employee, you don’t get the deductions even if they are business related. As long as you meet the four criteria, your home office, your car, your meals, etc. are deductible.
Once you have established your business and followed these steps, you are going to start making more money. You start to realize the increased opportunities for making money. Your income will grow when you grow your business and spend money on business expenses that are intended to make you more money. As your income grows, your taxes decrease. With extra money, you are able to create a wealth strategy and invest in other activities the government incentivizes, allowing you even more tax benefits. When you learn to do these things, you will make way more money and pay way less taxes.
To learn how the team at TFW Advisors® can help you with your wealth and tax strategy, book a call with us today!