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TL;DR

Who is this for?

Small businesses and independent contractors earning between $50,000–$157,500 as a single filer (and 315k for married filers).

What's in here?

Why is this important?

If you an independent contractor earning $115k, you could save over $10k by understanding the rules.

Reading Time: 45 minutes

Use the menu to the right to jump to a specific section.

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#Setting Up An Entity

If a taxpayer is in the beginning stages of forming a business an important item to consider is which type of entity they want to be. Do they want the flexibility and limited liability of the LLC? Does it make more sense for them to be an S Corp (still with limited liability) and pay themselves W-2 wage and take advantage of recent tax law changes?

entity

Or, does a person set up a C Corporation due to the recent tax rate decrease? The table below outlines the potential tax saving benefits of an LLC.

Scenario: Income - $150K a year | Status - Single, Self Employed

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EarningsPays his/her self a fair W-2 wage throughout the year of $40K-$50K
The remaining profits from the company of $100K would be picked up on the K-1 received from the business and the earnings would not be subject to self-employment tax.
All $150K of earnings are subject to SE.
Approximate Taxes$27K$44K

In this scenario when compared to an LLC the S corporation set up offers significant tax savings of over $15k.

  • A quick note on the QBI deduction mentioned above. It is a new item that emerged for 2018 that offers the opportunity of a 20% deduction on qualified business income (income earned from sole proprietorships, S Corps, and LLCs). This is a complicated calculation which is shown below in its own dedicated section, but it is important to note that this item should be heavily considered when choosing an entity.
  • Also, for all the consultants out there – you must be under $157,500 for single filers and $315,000 for married filers for the year in order to get the 20% deduction. Once you’re above those amounts limitations kick in and consulting income is ineligible for the deduction.

There are many things to consider when opening up a business and what is right for one person may not necessarily be the best option for another. The right entity depends on facts and circumstances which are unique for each taxpayer.

General Practice Tips

Whether you’re an LLC, S Corp, C Corp, or an individual, taxes season will be easier if you keep in mind:

  • Hold onto your receipts, keep a journal and detail what exactly you did. It is a lot easier to take the time out now to do this than a year from now when memory of what exactly happened may not be as clear.
  • It would also be wise to separate business credit cards/ debit cards from personal so expenses won’t slip through the cracks.

#Travel

Travel expenses associated with business are potentially deductible if the expenses are “ordinary and necessary” and directly related to the trade or business. The exact type of expense that is deductible depends on facts and circumstances.

travel

Deductible Travel Expenses

  • Trips that are primarily for business rather than pleasure could be 100% deductible for business days.
  • Travel days (to and from) do count as business days IF these days are between days of planned business activities where it would be deemed impractical to travel back to the primary residence.
  • Transportation costs such as baggage fees, airfare, and Ubers to and from the location of business activity may be deductible.
  • Out of pocket expenses for business days are fully deductible (keep in mind these items are subject to the Meals & Entertainment rules discussed below).

It should also be mentioned that expenses incurred on behalf of a family member are generally not deductible. However, the expenses could be deductible if:

  1. The person is your employee,
  2. The person has a bona fide business purposes for the travel, AND
  3. The person would otherwise be allowed a deduction for their travel expenses.

Example

“Jerry drives to Chicago on business and takes his wife, Linda, with him. Linda isn’t Jerry's employee. Linda occasionally types notes, performs similar services, and accompanies Jerry to luncheons and dinners. The performance of these services doesn’t establish that her presence on the trip is necessary to the conduct of Jerry's business. Her expenses aren’t deductible.

Jerry pays $199 a day for a double room. A single room costs $149 a day. He can deduct the total cost of driving his car to and from Chicago, but only $149 a day for his hotel room. If both Jerry and Linda use public transportation, Jerry can deduct only his fare.”

Travel Takeaway

  • If you want to be able to deduct your spouse traveling with you, then he/she should be given an employee position with an actual purpose

#Home Office

For 2018 the laws regarding home offices have been changed. No longer can a person deduct home office expenses on their personal income tax return in itemized deductions. This would occur if you were an employee of a company and you had a home office setup as well. However, the option is still there for taxpayers who are self-employed (have a Schedule C).

home-office

A home office is the taxpayer’s principal place of business if the taxpayer uses it exclusively and regularly to administer or manage the trade or business and does not conduct substantial administrative or management activities at any other fixed location.

Generally the home office deduction is based on the percentage of your home devoted to business use. So, a taxpayer should determine the square footage of the space used exclusively for business as well as the entire square footage of the residence. From there a pro rata % would be used to determine deductibility on the Schedule C.

Example

Ryan owns a home which includes a home office. Ryan’s business is reported on his personal return on a Schedule C.

Table supports horizontal scrolling on small screen
Size of home 1,000 sq. ft.
Area used exclusively for business 100 sq. ft.
Deductible mortgage interest and real estate taxes on Schedule C10%

This gets reported for AGI purposes so ultimately the deduction is worth more reported on the Schedule C than in itemized deductions. This is especially true this year as state taxes and real estate taxes combined are capped at $10K for itemizing purposes.

Home Office Takeaway

  • Ensure that the space being deducted is used exclusively for business

#Auto Expense

If you use your car in business and the vehicle is used exclusively for that purpose, you may be able to deduct the entire cost of operations of the vehicle. That isn’t always the case as the vehicles are often used for personal purposes as well.

auto

Deductions are still available at this point, but taxpayer’s must track business miles vs. personal miles and once again keep accurate records. The burden of proof is on the taxpayer at the end of the day so it is wise to have too much substantiation compared to too little. Once business miles vs. personal miles is determined the taxpayer can take a prorate % and determine the expense to report on their Schedule C.

Auto Expense Takeaway

  • Keep all receipts
  • Be able to substantiate the miles used for business purposes
  • The per-mile rate for 2018 is 54.5 cents for business miles driven

#Saving for Retirement

Taxpayers have plenty of options out there to help them save for retirement. We are all living longer these days and the amount a person may receive from Social Security won’t nearly be enough to cover the ever increasing cost of living. It is never a bad idea to plan for financial independence in the future while gaining some tax advantages along the way!

retirement

Simplified Employee Pension (SEP):
For self-employed individuals

  • Established by filing a simple one page form (Form 5305-SEP) and then opening a SEP-IRA through a bank or other financial institution.
  • Set up the SEP plan for a year as late as the due date (including extensions) of your income tax return for that year.
  • A SEP plan allows a contribution as much as 25% of your net earnings from self-employment ($56,000 for 2019 and $55,000 for 2018).
  • Contributions are tax deductible.

IRA

Taxpayer has the option between Roth or Traditional, selecting the IRA depends on a taxpayer’s current tax situation as well as their future projected tax situation

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Roth IRATraditional IRA
  • A Roth IRA in invested in with after-tax dollars so when you retire and take money out you won’t pay any taxes
  • No deduction for your contribution
  • Contributions are tax deferred, so when you take your money out at retirement it will be tax free
  • Receive a tax deduction now for contributions (income limits do apply)
Max contribution2018 - $5,500 ($6,500 if you’re 50 or older)
2019 - $6,000 ($7,000 if you’re 50 or older)

401K

  • If employed through a business your employer may offer a 401(K) plan to its employees.
  • Depending on the employer they may even match your contributions into the 401(K);
  • If your employer offers this you should always follow up on this offer as it is basically free money.
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Roth 401KTraditional 401K
Pay tax nowPay tax later
Max contribution2018 - $5,500 ($6,500 if you’re 50 or older)
2019 - $6,000 ($7,000 if you’re 50 or older)

Retirement Takeaway

#Child Tax Credit

For taxpayer’s who have children there is relief coming for 2018. Big changes are coming to the child tax credit for 2018 as the credit has doubled from $1,000 to $2,000 for each qualifying child.

child
  • In addition to the increase in the credit, the credit is now partially refundable. Previously the credit was nonrefundable which meant the credit could get a tax bill down to $0, but it wouldn’t result in a refund.
  • Now for 2018 $1,400 is refundable for each qualifying child. Assuming you have a tax bill of $0 before factoring in the credits and you have two qualifying children, a refund of $2,800 would be due to the taxpayer!
  • As with all good things there are limitations, however the good news is that the credit which was historically available to low to middle income households is now available for many more households.
  • In 2017 and prior phase outs of the credit began at $110,000 for MFJ and $75,000 for single filers.
  • For 2018 phase outs begin at $400,000 for MFJ and $200,000 for single filers!

Child Tax Credit Takeaway

#Meals & Entertainment

The law was changed to make the deduction of M&E more stringent. See table below for changes to deductibility.

Changed with the new law

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TypeOld LawNew Law
Entertainment, amusement, recreation. (entertainment at clubs, theaters, golf clubs, sporting events)50% deductible if directly related to businessNon-deductible
Entertainment Facility50% deductible if directly related to businessNon-deductible
On site meals an employer provides to employees for the convenience of the employer (Lunch served at training or over time work meals)100% deductible50% deductible

Unchanged with the new law

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TypeOld LawNew Law
Business meals during travel50% deductible50% deductible
Food and beverages for business meetings of employees, stockholders, agents or directors50% deductible50% deductible
Expenses for rec, social, or similar activities incurred primarily for non-management employees (Holiday Party)100% deductible100% deductible
Expenses for food and beverages made available to the public (coffee in waiting room of car dealership)100% deductible100% deductible
Business Gifts$25 per person$25 per person

Example

  • You meet at a client at a local steakhouse, have dinner and substantially discuss business and afterwards attend a sporting event.
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Dinner50% deductible
Sporting Event0% deductible

Meals & Entertainment Takeaway

  • Instead of taking a client to a Jet game take them out to eat as you can at least get some type of deduction for going out to eat!

#W-2 VS C2C

​A common question that arises at times for contractors is “what is the equivalent of getting paid X by W-2 compared to C2C”. C2C is an alternative to paying a person, you pay an entity (ex. LLC or C Corp).

Employers may favor the C2C arrangement due to the fact that it lowers employment taxes they would have to pay. On the other end of it the receiving entity would not have payroll taxes deducted from the money they receive. There would be more money upfront.

travel

However, taxes will eventually have to be paid on the money earned for services. If an LLC, eventually the money will be subject to self-employment taxes where the taxpayer would have to pay the employer/employee portion (as if they had received a 1099-MISC for independent contracting). If the entity receiving the money is a corporation, the owners would have to pay themselves a W-2 wage anyway to get the money to themselves, or be subject to tax on the corporation level and then again on the issuance of the dividend. There is no simple yes/ no answer when it comes to the equivalents of pay.

If a taxpayer is granted the option to utilize the C2C option it is important to know that they will have more cash up front, however if they do not write down this income with expenses they will eventually have to pay more in taxes (paying their share of self-employment). With this comes great opportunity to do some quality tax planning, and fully utilize the allowances within the tax law. Using some of the examples mentioned earlier a taxpayer can set up a home office or travel for mostly business and sneak a day or so in for pleasure. While doing this they are able to fully utilize the excess cash now for more immediate needs. Also, a taxpayer can navigate the new 199A rules mentioned below, and get into that sweet spot income wise where they have less mechanical limitations on the 20% deduction!

Example

Below are multiple scenarios for a married taxpayer with no children. In the first set of examples $115k of W-2 wages will be presumed. From here we will calculate total cash benefit along with total taxes paid.

The Second example will highlight some of the advantages someone can come up with by using C2C. In this scenario the taxpayer will pay relatively the same amount in taxes while actually deriving more benefit for the cash. They will use pre-taxed money to pay business expenses that relate to their personal lives and even their own home! Also, keep in mind that this is assuming there are no other business expenses in the C2C. If there are more expense outside of the ones listed below then there will be even less taxes paid.

W-2 Scenario

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NYCIL
W-2 Income
Social Security & Medicare Tax
Federal Withholding
State withholding
City withholding
115,000
(8,798)
(12,812)
(6,500)
(4,150)
115,000
(8,798)
(12,812)
(5,378)
Fed Refund/ (amount due)
State Refund/ (amound due)
Total Cash Received
Total Taxes Paid
908
1,650
85,298
(29,702)
908
(94)
88,826
(26,174)

C2C Scenario

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NYCIL
C2C Revenue
Home Office Expense
Business and Trip Expenses
50% meals deductible
199A DEDUCTION
Taxable Income
115,000
(3,600)
(6,000)
(1,500)
(14,512)
58,047
115,000
3,600)
(6,000)
(1,500)
(14,512)
58,047
Fed Refund/ (amount due)
State Refund/ (amount due)
21,952
7,072
21,952
4,559
Total Cash + Benefit Received
Total Taxes Paid
97,076
(29,024)
99,589
(26,511)

Compare W-2 and C2C: Total Cash Received

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NYCIL
W-285,29888,826
C2C97,07699,589

Assumptions for C2C

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Home Office DeductionsHome office SQ footageTotal SQ footageOffice %Deductible
$2,000 Interest per month2,00020,00010%2,400
$1,000 real estate taxes per month2,00020,00010%1,200
Meals 50% M&E - $3,0001,500
Travel and Business expense of $6,0006,000

W-2 vs. C2C Takeaway

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Original Due DateExtension
Sole Proprietor (1040)April 15, 2019October 15, 2019
Partnerships (1065) March 15, 2019 September 16, 2019
S CorporationsMarch 15, 2019September 16, 2019
C Corporations (1120)April 15, 2019 October 15, 2019

#Estimated Payments

As income is earned throughout the year an individual as well as certain entities require that a taxpayer pay in estimates during the year to cover their tax liability as they earn. You may say to yourself “well I usually pay this in when I file my return”. This is indeed correct that you can operate this way, however keep in mind that

There are ways to combat this, one way is by keeping quality records. If a taxpayer didn’t make money the first 3 quarters of a year and everything was earned in the 4th quarter then they shouldn’t have to pay in estimates throughout the year on profit that was not realized. In this instance a taxpayer may use an “annualization method” which would lower any underpayment penalty for the first 3 quarters. The form to file for this can get convoluted so it is recommended to contact your tax professional if you run into a situation similar to the above.

  • If a person intends on making estimates during the year, they will generally have the following due dates to look forward to:
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1st quarterApril 1
2nd quarterJune 15
23rd quarterSeptember 15
4th quarter (entities)December 15
4th quarter (individuals)January 15

With the recent changes to itemized deductions which will be discussed later it is no longer advantageous to make individual estimate payments by year end as it was in the past.

Estimated Payments Takeaway

  • If income is looking like it’s going to be higher than expected consider reinvesting in the business by purchasing new tangible property and depreciating in full.

#Other 2018 Tax Law Changes to Consider

With the enactment of the Tax Cuts and Jobs Act of 2017 (TCJA) sweeping changes have come across the tax landscape. Some of these items may significantly impact taxes for 2018 and going forward.

Important items to consider:

Tax Rates:

​Below are the rate changes from 2017 compared to 2018. You will also notice that the standard deduction has just about doubled for both the filing status of Single and Married Filing Jointly (MFJ).

Single

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2018 Tax Rates2017 Tax Rates
Standard$12,000Standard$6,350
Deduction
10%
12%
22%
24%
32%
35%
37%

0 to $9,525
$9,525 to $38,700
$38,700 to $82,500
$82,500 to $157,500
$157,500 to $200,000
$200,000 to $500,000
Over $500,000
Deduction
10%
15%
25%
28%
33%
35%
39.6%

0 to $9,325
$9,325 to $37,950
$37,950 to $91,900
$91,900 to $191,650
$191,650 to $416,700
$416,700 to $418,400
Over $418,400

Married Filing Jointly

Table supports horizontal scrolling on small screen
2018 Tax Rates2017 Tax Rates
Standard$24,000Standard$12,700
Deduction
10%
12%
22%
24%
32%
35%
37%

0 to $19,050
$19,050 to $77,400
$77,400 to $165,000
$165,000 to $315,000
$315,000 to $400,000
$400,000 to $600,000
Over $600,000
Deduction
10%
15%
25%
28%
33%
35%
39.6%

0 to $18,650
$18,650 to $75,900
$75,900 to $153,100
$153,100 to $233,350
$233,350 to $416,700
$416,700 to $470,700
Over $470,700

The caveat to the standard deduction increase is that filers who once itemized may now fall into claiming the standard deduction and in the end claim less of a deduction than they are used to.

This is due to the change from TCJA to the deduction for state and local taxes as well as real estate taxes. In the past a taxpayer on their Schedule A could claim deductions for their real estate taxes paid during the year and for state and local income taxes (your state withholding on a W-2/ estimate payments into the state). Now for 2018 a taxpayer is capped at a deduction of $10,000 between the two!

An example of this could be that Taxpayer A in 2017 pays real estate taxes of $12,000 and has state and local taxes claimed of $30,000. Taxpayer A would have $42,000 worth of deductions before even factoring in mortgage interest, charity, and miscellaneous itemized deductions (bank fees). On a side note miscellaneous itemized deductions have also been eliminated. Now in 2018 Taxpayer A is capped at $10,000 deduction between state taxes and real estate taxes. Depending on the amount of other deductions, a taxpayer who may have claimed over $42,000 worth of deductions in 2017 would now be in a position where the standard deduction of $24,000 (assuming married) outweighs the benefits of itemizing. At this point Taxpayer A would no longer be getting any benefit for his real estate taxes paid (a deduction he/she may have historically relied upon).

The takeaway here is that everyone depending on their unique circumstances is effected either negatively/ positively by the change in the new law. Taxpayers who live in high earning/ high expense areas who pay a good chunk of change in real estate taxes IE. New York metropolitan area are obviously effected negatively by this aspect of the TCJA.

Depreciation

100% bonus depreciation on new and used assets. This is effective for assets acquired and placed into service after 9/27/17 and before 1/1/23.

Example

A Taxpayer operates a business and during the year purchases and puts into service a $50,000 piece of equipment. The taxpayer is entitled to a depreciation deduction of $50,000 on his/her 2018 tax return.

§199A

A new provision to the Internal Revenue Code (IRC) is Sec 199A. This section of the code allows owners of sole proprietorships, Partnerships, or S Corporations a deduction of 20% of qualified business income earned in a qualified trade or business, subject to certain limitations. This law was designed due to another part of the TCJA. The act changed the tax rate for C Corporations from a graduated rate range from 15% to 35% down to a flat tax rate of 21%. Due to this benefit given to C Corp shareholders a change had to be enacted in order to keep the effective tax rate advantage over C Corp shareholders.

As seen above Section 199A can be a very cumbersome and overwhelming calculation with limitations that have to take into account W-2 wages of the qualified trade or business and the unadjusted basis of qualified property. The calculation of the deduction becomes more and more complicated as certain taxable income thresholds of the taxpayer are realized.

The deduction is at its simplest form with no limitations when individuals have overall taxable income for the year below $157,500 for single filers and $315,000 for married filers. When filers are under these thresholds they are entitled to a §199A deduction regardless of W-2 wages, unadjusted basis of property, or service type. Once a person goes over the above mentioned thresholds the deduction becomes increasingly complex and limitations will apply.

Items to consider

  • Qualified Business Income (QBI) = the net amount of qualified items of income, gain, deduction, and loss relating to any qualified trade or business of the taxpayer. These items must be effectively connected with the conduct of a trade or business within the U.S. and included or allowed in determining taxable income for the year. It is important to note that income or deduction relating to investment income or deduction items reported on the schedule K-1 are specifically excluded.
    • Simply put, the QBI would typically be included in the ordinary/rental real estate section of a k-1 that a shareholder/ partner would receive. (for a recipient of a partnership K-1 lines 1,2, and 3)
    • Recipients of K-1s should be aware to look for footnoted information that will help calculate the QBI deduction
  • QBI is not allowed for every type of income earned from flow through activities. The IRC states that the QBI deduction is only allowed for trades or businesses that are not considered to be specified service trade or businesses
    • Specified trade or business is defined as: “ any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its owners or employees”
    • Note that in the regulations there is an exemption for engineering and architects.
  • This is just scratching the surface of all the complexities associated with this new law and is intended to be a bird’s eye view of everything the §199A deduction encompasses.

§199A Takeaway

  • If a taxpayer is unsure of whether they will fall below $157,500 for single filers and $315,000 for married filers they should try their best to project the current Profit and loss for the year.
  • If they are going to be above the income thresholds it may be time to realize some expenses / make purchases of must needed business assets (depreciation described earlier)
  • It is strongly recommended you consult your tax advisor on this subject

The combined complexities of the new laws along with the amendments to prior laws will have professionals busy for the next few months! Hopefully after reading this a taxpayer can start to think about their current situation for the current year and moving forward. Readers are encouraged to reach out to their tax professional and ask questions as proper planning for all these new laws are crucial in optimizing tax savings.