W9/1099 Employee looking for help on how to set up an LLC for tax benefits

[monothemonkey]

I've been a W2 employee in the past.  After reading Rich Dad Poor Dad, I'm realizing that there are many advantages to having an entity in which you earn your money.  I am currently working a lucrative commission job selling Solar Power.  They don't deduct anything out of my paycheck, and have recommended I set up an LLC so that I can deduct expenses such as my phone, phone bill, vehicle, car insurance, and anything else that I use directly for work.  My employer will eventually have a presentation for us with a CPA, but until then, I'd like to learn the In's and Outs of setting up an entity.  Are all the deductions above possible?  What other deductions can I plan on making?  Until I get the LLC set up, I'm planning to hold 30% of my income aside just for taxes.  After that 30% is removed, I'll be aggressively saving 50% of my check for retirement, and living off the remaining amount.

Can I make a purchase now, before my LLC is set up, and deduct it after my LLC is set up?  I use my cellphone for work, and I have an old and slow phone that doesn't have enough storage.  Before I go and purchase a new one, I want to ensure that purchasing it too early wouldn't ruin my chances of getting to deduct the purchase as a business expense.  I will also be looking at a "new" vehicle as my current vehicle has over 200k miles and some engine issues. 

Assuming I make $100k this year, I will hold about $30k aside for taxes.  Does this mean that I can potentially deduct up to $30k in expenses?  If I'm doing this estimation wrong, please help me understand what I am doing wrong in this theoretical example.   Obviously I will not spend money just to spend money and get deductions.  I just want to understand how this works.

[Maccountant]

Hi Monothemonkey,

The company you work for, since you mentioned that you were a W-2 employee in the past. I assume you will be receiving a 1099 this year? If so, you may not actually need a LLC since your employer is your only client (legal liability is low, albeit I am not an attorney and this should not constitute legal advise). You can still deduct all your business expenses on the schedule C.

In your case the real advantage to forming an LLC is to file sub-chapter S Corp elections to have the business taxed as an S- Corporation. This is exactly what MMM had his accountant do for him to save on payroll tax. The process for creating a LLC varies by state but typically is not too involved.

The problem with becoming an independent contractor is that you need to pay income tax and both half's of payroll (self employment) tax (an additional 15.3%). So if you are in the 25% marginal tax bracket and have to pay an additional 15% in payroll tax your looking at 40% marginal tax rate - ouch

I don't want to get too convoluted but suffice to say if you file sub-chapter S elections for your LLC and file as a S-Corp you can reduce some of the payroll tax bite by taking shareholder distributions (not subject to payroll tax). Although you do need to pay yourself a "reasonable" salary from the corporation. So there is the added cost of a corporate tax return and running payroll, but can save thousands in payroll taxes.

My best advise is to talk to a competent CPA that can educate you on all the ins and outs of this strategy. If you don't mind working with a CPA remotely send me a direct message and we can talk.

[bacchi]

Yep, you're already a business owner and can deduct expenses.

The new 2018 tax changes are interesting, though. A pass-through LLC can shelter 20% of its income, which could change the S-corp equation.

[Maccountant]

An S-Corp would also get the 20% QBI deduction, just the payroll run through the S-Corp would effect the QBI for the S-Corp. It has been proposed that they determine a "reasonable salary" for Schedule C income but the powers that be are unsure of how to implement such a statute. So potentially the QBI would be greater for a Schedule C rather than an S-Corp, but will the benefit ultimately exceed the amount you are saving on payroll tax, by using an S-Corp? I doubt it.

This is where it really is a numbers game, you have to factor in all the other expenses in play and see how profitable the business intents to be going forward. Sit down an do some tax planning with a professional that can help you understand the process and figure out what course of action will save you the most money.

[monothemonkey]

I'm still a little confused.  Does incorporating as an entity like an LLC give me the additional 20% QBI, or could I take these same deductions without incorporating?  I don't need any liability protection, but I am trying to reduce the self employment tax.  Without an entity, can I deduct all business expenses on a Schedule C?

And how do expenses work if they are used for work, but also used personally.  Example would be all of the deductions I'm looking at: new phone, phone bill, vehicle, car insurance, etc

[bacchi]

I'm still a little confused.  Does incorporating as an entity like an LLC give me the additional 20% QBI, or could I take these same deductions without incorporating?  I don't need any liability protection, but I am trying to reduce the self employment tax.  Without an entity, can I deduct all business expenses on a Schedule C?

And how do expenses work if they are used for work, but also used personally.  Example would be all of the deductions I'm looking at: new phone, phone bill, vehicle, car insurance, etc

Even without an entity, you can deduct all business expenses on a Schedule C. That's assuming you're self employed and will receive a 1099 next January, which it sounds like you are and will.

For the most part, you can deduct % of use for bills and electronics. For the car, it's easiest to deduct using the mileage deduction.

You definitely need an LLC to get the 20% QBI deduction. Unless you designate it otherwise, the LLC is a simple pass-through entity.

[terran]

You definitely need an LLC to get the 20% QBI deduction. Unless you designate it otherwise, the LLC is a simple pass-through entity.

I don't think that's true. From everything I've seen sole proprietors will be eligible for the QBI deduction.

[bacchi]

You definitely need an LLC to get the 20% QBI deduction. Unless you designate it otherwise, the LLC is a simple pass-through entity.

I don't think that's true. From everything I've seen sole proprietors will be eligible for the QBI deduction.

Yeah, I think you're right.

So, OP, you get most of the benefits just because you're self employed and use a Schedule C. It may be worth it to create an S-Corp next year.

Oh, look into a solo 401k as well.

[CareCPA]

My general philosophy is to create the LLC, and let it remain a disregarded entity. This way, when you bill, everything is in the LLC name with the LLC EIN.
The benefit is whenever you decide to become an S Corp, if you make a late election (say you decide to elect in September* and make it retroactive to the beginning of the year), all the income is already in the LLC, so you get the tax benefits of the S Corp election for the full year. If you have have to scramble to create an entity and elect S Corp, you can't retroactively attribute income earned by you personally to the new S Corp.

*S Corp elections must be filed within 2.5 months of the start of the year you want it to be applicable, or 2.5 months of entity formation. However, the IRS has historically been very lenient on late elections. There is always the risk they will become less lenient.

[Wile E. Coyote]

An S-Corp would also get the 20% QBI deduction, just the payroll run through the S-Corp would effect the QBI for the S-Corp. It has been proposed that they determine a "reasonable salary" for Schedule C income but the powers that be are unsure of how to implement such a statute. So potentially the QBI would be greater for a Schedule C rather than an S-Corp, but will the benefit ultimately exceed the amount you are saving on payroll tax, by using an S-Corp? I doubt it.

This is where it really is a numbers game, you have to factor in all the other expenses in play and see how profitable the business intents to be going forward. Sit down an do some tax planning with a professional that can help you understand the process and figure out what course of action will save you the most money.

Agreed, it really is a numbers game.  There are situations where you are better off as a sole proprietor with a higher QBI deduction and situations where you are better off as an S corporation with SE tax savings.  There are many variables that come into play, including how much income you have, what is a "reasonable salary" (if you are an S corporation), what your non business taxable income is, whether you are in a specified service business, etc.  OP should find someone that can run some modeling for them based on their facts.

As for the comment about proposals to determine "reasonable compensation" for Schedule C income, there were never any IRS proposals on that point.  There were some commentators that mistakenly believed that is where the IRS might go, but the proposed regulations indicate that the reasonable compensation rule was intended to apply only to S corporations.

[cchrissyy]

all that stuff you want to deduct as business expenses - you can already do that. you don't need an llc. that's classic 1099-income sole proprietor or independant contractor sort of stuff.

and no if you hypothetically had 100k income and 30k taxes, the deductions aren't limited to 30k. whatever your actual expenses are is fine. if somehow (I doubt it, but, somehow!) your expenses were 50k, or 100k, you could claim every bit of that against your income before calculating tax owed, if any.

[goodday,eh]

there is nothing a sole proprietor business can deduct that an S corporation can't deduct, and vice versa.  An S corporation really only saves you on the self employment taxes.  It won't save you money on income taxes (though you can put a little more in your solo 401k if you do that).

The only reason you create an LLC or corporation if you're not worried about legal liability is to save on self employment taxes.   And to do that you have to create an LLC or corporation and then make the S corporation election. 

And this can save you a lot on self-employment taxes depending on how aggressive you want to be on your "reasonable salary."  Because you get to control how much you pay in self-employment taxes.   If you make a $100k as a sole prop, you'd pay $15k in self employment taxes.  Pay yourself a "reasonable salary" of $50k, and you'll only pay $7,500.  You're saving $7,500.  If you're more aggressive on that salary, then you can save more.

[Wile E. Coyote]

there is nothing a sole proprietor business can deduct that an S corporation can't deduct, and vice versa.  An S corporation really only saves you on the self employment taxes.  It won't save you money on income taxes (though you can put a little more in your solo 401k if you do that).

The only reason you create an LLC or corporation if you're not worried about legal liability is to save on self employment taxes.   And to do that you have to create an LLC or corporation and then make the S corporation election. 

And this can save you a lot on self-employment taxes depending on how aggressive you want to be on your "reasonable salary."  Because you get to control how much you pay in self-employment taxes.   If you make a $100k as a sole prop, you'd pay $15k in self employment taxes.  Pay yourself a "reasonable salary" of $50k, and you'll only pay $7,500.  You're saving $7,500.  If you're more aggressive on that salary, then you can save more.

. You do have to take into account the reduced QBI deduction due to the “reasonable salary.”

[goodday,eh]

good point. 

I do think that you still win out with the S corporation and reasonable salary, but it certainly makes the calculation more complicated.  And you have to be more aggressive on your salary.

If you make $100k, you'd pay $15k in SE Taxes as a Sole Prop

If you run it through an S Corp and pay a reasonable salary of $40k, you'll pay $6,120.  But, you reduce Your QBI by $40k.  That's a loss of a $8,000 deduction.  So, even if you were in the 37% tax bracket, that would cost you another $2,960 in taxes.  So, the S corp in this case would save you $6,040 ($15k - $6K - $2960).

If you run it through an S Corp and pay a reasonable salary of $60k, you'll pay $9,180.  But, you reduce Your QBI by $60k.  That's a loss of a $12,000 deduction.  So, even if you were in the 37% tax bracket, that would cost you another $4,440 in taxes.  So, the S corp in this case would only save you $1,560($15k - $9K - $4,440). 

May not be worth the hassle at that point.

[SeattleCPA]

You definitely need an LLC to get the 20% QBI deduction. Unless you designate it otherwise, the LLC is a simple pass-through entity.

I don't think that's true. From everything I've seen sole proprietors will be eligible for the QBI deduction.

Yeah, I think you're right.

So, OP, you get most of the benefits just because you're self employed and use a Schedule C. It may be worth it to create an S-Corp next year.

Oh, look into a solo 401k as well.

Just to clarify this, you don't need an LLC to get a Section 199A deduction. A sole proprietorship or an LLC taxed as a sole proprietorship may lead to the deduction.

I've kept this blog post about the 20% deduction up to date:

https://evergreensmallbusiness.com/pass-thru-income-deduction-dozen-things-every-business-owner-must-know/

Also MADFIentist published a guest post I did about this that's FI-centric:

https://www.madfientist.com/section-199a/

[SeattleCPA]

good point. 

If you run it through an S Corp and pay a reasonable salary of $40k, you'll pay $6,120.  But, you reduce Your QBI by $40k.  That's a loss of a $8,000 deduction.  So, even if you were in the 37% tax bracket, that would cost you another $2,960 in taxes.  So, the S corp in this case would save you $6,040 ($15k - $6K - $2960).

If you run it through an S Corp and pay a reasonable salary of $60k, you'll pay $9,180.  But, you reduce Your QBI by $60k.  That's a loss of a $12,000 deduction.  So, even if you were in the 37% tax bracket, that would cost you another $4,440 in taxes.  So, the S corp in this case would only save you $1,560($15k - $9K - $4,440). 

May not be worth the hassle at that point.

The accounting doesn't really work this way. It's more complicated. You can't for example deduct more than 20% of your taxable income (adjusted for any capital gains). This means you don't lose any Section 199A deduction for wages that get sheltered by deductions: pensions, SE health insurance, itemized deductions, etc.

E.g., if someone pays $60K in wages via an S corporation but has (to keep things simple) a $24K pension fund deduction, a $12K self-employed health insurance deduction and a $24K standard deduction, it may be that the W-2 wages don't reduce the Section 199A deduction.

Another separate issue is, someone paying more than a 24% marginal tax rate needs W-2 wages in order to get a Section 199A deduction. This gets complicated pretty fast, but here's a gritty blog post that explains why in some cases you need to bump your wages in order to maximize the Section 199A deduction:

https://evergreensmallbusiness.com/s-corporation-shareholder-salaries-sec-199a-deduction/

[CareCPA]

@SeattleCPA this may be a dumb question, but I haven't dug in as deeply as you have.
The section 199a deduction is limited by W-2 wages paid from the S Corp, but which box on the W-2? If you're a sole employee S Corp, your box 1 and box 3 wages could be very different.

[SeattleCPA]

@SeattleCPA this may be a dumb question, but I haven't dug in as deeply as you have.
The section 199a deduction is limited by W-2 wages paid from the S Corp, but which box on the W-2? If you're a sole employee S Corp, your box 1 and box 3 wages could be very different.

So great question... and it depends... sort of.

If we're talking about the potential Section 199A deduction and not the wage-based limitations: W-2 wages paid by a S corp reduce the S corporation's qualified business income. Also, all the other deductions that accompany those wages (employer payroll taxes, maybe the SE health insurance appearing in box 1 of a correctly prepared shareholder-employee W-2, employer pension match, etc) also reduce qualified business income.

Note to everybody else reading this: qualified business income is what you use to calculate the 20% Section 199A deduction...

If we're talking about the wage-based phase-out calculations: Once someone earns taxable income over the threshold, the total W-2 wages paid by the business also factor into the Section 199A deduction calculation. The proposed revenue procedure (link below) that came out with the proposed regulations describes the three ways you can "come up with" the right wages number. You can read through the proposed rev proc for details, but they let you look at W-2 box 1 or box 5, let you adjust W-2 box 1 amount for elective deferrals, etc.

https://www.irs.gov/pub/irs-drop/n-18-64.pdf

General comment: CPAs who want to do a decent job with the Section 199A probably want to get client W-2s in coming year. People often screw this up. And the errors could easily result in the wrong Section 199A deduction amount.