SE taxes BLOW!

[specialkayme]

I've worked at a law firm since 2011. First real professional job. Through 2015 I was a w2 employee. 2015's AGI ended up being about $85k. January 1 of 16 I was asked to come on as a junior partner. Moving from w2 to k1. Realizing I'd be responsible for SE taxes at 7.5%, I negotiated a base salary of $97k, which after above the line deductions should have gotten me to about the same place I was when I was a w2 employee. Plus the upside of potential (but not guaranteed) distributions.

2016 is the first time I'm itemizing deductions (home interest and RE tax deduction put me over the edge), and in 9/16 we had our first daughter. So I assumed the two would probably make a wash on the SE taxes, and I'd probably pay the same in taxes in 15 that I did in 16.

I ended up paying about 17.5% in taxes in 2015. Uncertain of how everything would shake out, I paid estimated taxes of about 19%. Ended up doing a first draft of taxes last night, and looks like I'm going to end up paying taxes at a 28% rate.

Just venting, but man that sucks. Better deductions than last year, plus a kid, and I'm still seeing a 60% tax increase. Seems like SE tax payers get screwed.

[Heroes821]

To help I think we need more number information.

Married Filing jointly would be my guess, but are you sole income?

Did you max retirement contributions? Do you have an IRAs, HSAs?

You mentioned AGI in 2015 and then base for 2016. What was your base in 2015? Did you have zero deductions in 2015?

[SeattleCPA]

I've worked at a law firm since 2011. First real professional job. Through 2015 I was a w2 employee. 2015's AGI ended up being about $85k. January 1 of 16 I was asked to come on as a junior partner. Moving from w2 to k1. Realizing I'd be responsible for SE taxes at 7.5%, I negotiated a base salary of $97k, which after above the line deductions should have gotten me to about the same place I was when I was a w2 employee. Plus the upside of potential (but not guaranteed) distributions.

2016 is the first time I'm itemizing deductions (home interest and RE tax deduction put me over the edge), and in 9/16 we had our first daughter. So I assumed the two would probably make a wash on the SE taxes, and I'd probably pay the same in taxes in 15 that I did in 16.

I ended up paying about 17.5% in taxes in 2015. Uncertain of how everything would shake out, I paid estimated taxes of about 19%. Ended up doing a first draft of taxes last night, and looks like I'm going to end up paying taxes at a 28% rate.

Just venting, but man that sucks. Better deductions than last year, plus a kid, and I'm still seeing a 60% tax increase. Seems like SE tax payers get screwed.

I wonder if you're doing the tax return correctly. There's lots of stuff on the K-1 from the partnership that should drive down your income.

Also, remember that your taxes are not really impacted by distributions (the money you get)... rather your taxes are impacted by your distributive shares of the partnership's income and deductions. E.g., your K-1 box 1 may show $100K and you may get a distribution of $90K. You pay taxes on the $100K. Not the $90K.

P.S. Be sure you're getting your self-employed health insurance deduction and pension deduction from the K-1.

[DavidAnnArbor]

It doesn't make a lot of sense to me because now that you have a daughter you get to deduct another dependent off your AGI to arrive at your taxable income.
Is your wife suddenly working bringing in a whole bunch of income? 
Are you sure you're comparing accurately when you say you are going from 17.5% to 28% in taxes ?

[specialkayme]

Married Filing jointly would be my guess, but are you sole income?

MFS unfortunately. In income based repayment on student loans. Long story, but if I file MFJ it almost doubles my payments. Even though my wife makes about a quarter of what I do per year. Last 5 years I'd pay more in taxes MFS, but less overall. May not match up with alot of people's choices on here, but it works for me.

Did you max retirement contributions? Do you have an IRAs, HSAs?

Didn't max retirement contributions, but heading in that direction. IRA and 401k. 2015 I contributed $5,500. 2016 was $7,750. 2017 I'm on track for $7,750 plus $3,400 in HSA. Modest improvements. That's not counting employer contributions, which while they don't match they do contribute about $3,300 per year to retirement (none to HSA).

You mentioned AGI in 2015 and then base for 2016. What was your base in 2015? Did you have zero deductions in 2015?

Base in 2015 was $85k. I received a few bonuses, which ended up matching my retirement contributions (by chance, not planning). No deductions in 2015 other than standard deductions.

[specialkayme]

I wonder if you're doing the tax return correctly. There's lots of stuff on the K-1 from the partnership that should drive down your income.

Maybe not, it was a first run at the return. But I think it was 98% there.

Also, remember that your taxes are not really impacted by distributions (the money you get)... rather your taxes are impacted by your distributive shares of the partnership's income and deductions. E.g., your K-1 box 1 may show $100K and you may get a distribution of $90K. You pay taxes on the $100K. Not the $90K.

Something I didn't realize until I got my K1 :P

P.S. Be sure you're getting your self-employed health insurance deduction and pension deduction from the K-1.

I tried credit karma's tax return system for the first time. I like free. But they didn't give me credit for the health insurance or employee retirement deductions. Rather than screw with the software system, I moved back to turbo tax, which did give me credit for it.

[Heroes821]

Just curious does the firm have an on site CPA you can just take to lunch and ask some basic questions to make sure you're filing correctly?

[CareCPA]

As was alluded to earlier, the schedule K-1 can contain a lot of information that employees are not used to seeing. Make sure you understand how each line impacts you if you do your own taxes.

[specialkayme]

It doesn't make a lot of sense to me because now that you have a daughter you get to deduct another dependent off your AGI to arrive at your taxable income.

My thoughts exactly.

Are you sure you're comparing accurately when you say you are going from 17.5% to 28% in taxes ?

AGI in 2015 of $85k. Taxes paid of $15,100. Rate of 17.76%
AGI in 2016 92,5k. Itemized deductions of about $11,5k. With deductions makes taxable income around $76k. "Taxes" (w/o SE) of $14,8. SE taxes of $14,5. All rough and round. Maybe a grand off here or there. But combined tax of $29,300. Rate (from AGI) of 31.67%.

When I mentioned 28%, I was actually doing it based on an agi of 103k, not 92,5k. I just remembered wrong.

[CareCPA]

AGI in 2015 of $85k. Taxes paid of $15,100. Rate of 17.76%
AGI in 2016 92,5k. Itemized deductions of about $11,5k. With deductions makes taxable income around $76k. "Taxes" (w/o SE) of $14,8. SE taxes of $14,5. All rough and round. Maybe a grand off here or there. But combined tax of $29,300. Rate (from AGI) of 31.67%.

When I mentioned 28%, I was actually doing it based on an agi of 103k, not 92,5k. I just remembered wrong.

Don't forget you deduct half your SE tax on page 1.
The other half you were paying anyway when you had your W-2 as SS and Medicare, but you probably didn't factor those amounts into your "tax rate" for 2015. I think you're comparing against just income tax in prior year, so it's not apples to apples.
Don't get me wrong, it still sucks to pay more taxes, but I don't think it's a straight comparison.

[Cpa Cat]

Did you add your half of Social Security and Medicare taxes into your previous 17.76% calculation? Because that's what you're doing by adding self employment taxes into your current year's calculation.

[DavidAnnArbor]

AGI in 2015 of $85k. Taxes paid of $15,100. Rate of 17.76%
AGI in 2016 92,5k. Itemized deductions of about $11,5k. With deductions makes taxable income around $76k. "Taxes" (w/o SE) of $14,8. SE taxes of $14,5. All rough and round. Maybe a grand off here or there. But combined tax of $29,300. Rate (from AGI) of 31.67%.

When I mentioned 28%, I was actually doing it based on an agi of 103k, not 92,5k. I just remembered wrong.

Don't forget you deduct half your SE tax on page 1.
The other half you were paying anyway when you had your W-2 as SS and Medicare, but you probably didn't factor those amounts into your "tax rate" for 2015. I think you're comparing against just income tax in prior year, so it's not apples to apples.
Don't get me wrong, it still sucks to pay more taxes, but I don't think it's a straight comparison.

Really good point !

[specialkayme]

Just curious does the firm have an on site CPA you can just take to lunch and ask some basic questions to make sure you're filing correctly?

Unfortunately no. Because the firm's accountants messed up and didn't get us our K1's until April 5th, I don't have the ability to approach a CPA before April 18th either.

[specialkayme]

Did you add your half of Social Security and Medicare taxes into your previous 17.76% calculation?

Fair enough. I wasn't.

If I add back in SS and Medicare to the 17.76%, it ends up being 25.2%.
So an increase from 25.2% to 31.67% (or 6.47%, which is less than the 7.5% increase I was expecting).

I guess I just wasn't counting the SS and Medicare taxes in when I was paying quarterly taxes.

I also assumed the child and itemized deductions would negate the 7.5% anticipated SE increase. But was woefully incorrect.

[Heroes821]

Well this might be a good situation to file an extension for your taxes.  If only to talk to a CPA.

[specialkayme]

I might. I've got another week and a half to keep messing with it. If I file an extension I'll have to pay the estimated taxes by the 18th anyway. Which means I'm going to have to work my taxes up until then regardless. So if I'm going through all the work of preparing the return, I might as well file it, and if the CPA thinks it makes sense to file a 1040x go with that.

But I have a week to think about it.

Downside is there aren't many CPAs I can go to. I mainly do bankruptcy work, as it relates to tax indebtedness (not preparations, returns or planning so much). So I get to see all the returns that every CPA in the area messed up. Sadly the list that I haven't seen large errors from is fairly small. Of that small list, I typically send current clients to them, so it might make things a little odd for me to go to them personally. Just more to think about.

[jwright]

SE tax is calculated on your SE income; your itemized deductions and exemptions don't offset SE tax, only regular tax.  You could have a $500,000 mortage interest deduction at your income and you'd still be hit with SE tax.

[SeattleCPA]

I tried credit karma's tax return system for the first time. I like free. But they didn't give me credit for the health insurance or employee retirement deductions. Rather than screw with the software system, I moved back to turbo tax, which did give me credit for it.

I am a giant proponent of DIY tax return preparation. Well, I am if you're using good software, which it sounds like isn't the case with Credit Karma... But who knows. (I'm not familiar with the product.. and maybe you're not familiar enough.)

But once you start getting K-1s, you may need to upgrade to a CPA or EA who does lots of returns like yours.

BTW, one other thing that dawns on me based on your remark above... you're probably also missing or omitting the 'unreimbursed partnership expenses' deduction.

Late postscript: One other idea that's too late for 2016 but an idea for 2017 maybe or for 2018... if the SE taxes really fry you, you could hold your partnership interest through an S corporation. Even if you don't play the salary game, this will possibly/probably have effect of making your pension and health insurance expenses deductions for both income taxes and SE taxes. You'll surely know how this will work. But I'll include a link to blog post I did in case someone else wants more info:

http://evergreensmallbusiness.com/s-corporation-partnerships/

[SeattleCPA]

I might. I've got another week and a half to keep messing with it. If I file an extension I'll have to pay the estimated taxes by the 18th anyway. Which means I'm going to have to work my taxes up until then regardless. So if I'm going through all the work of preparing the return, I might as well file it, and if the CPA thinks it makes sense to file a 1040x go with that.

But I have a week to think about it.

Downside is there aren't many CPAs I can go to. I mainly do bankruptcy work, as it relates to tax indebtedness (not preparations, returns or planning so much). So I get to see all the returns that every CPA in the area messed up. Sadly the list that I haven't seen large errors from is fairly small. Of that small list, I typically send current clients to them, so it might make things a little odd for me to go to them personally. Just more to think about.

I would think it'd be fine to approach someone you work with. That's a great way to see what's what.

Would also suggest the possibility that (a) clients get what they pay for so it's likely like low quality work you see was low price work and (b) you never know when you see a messy tax return whether the client or the CPA is responsible.

[specialkayme]

But once you start getting K-1s, you may need to upgrade to a CPA or EA who does lots of returns like yours.

Something I think I muttered to my wife when I sat down to do our taxes the other day, lol.

It was surprising to see the income disclosed on the K1 as higher than what I actually received, considering the addition of employer covered heathcare, retirement, and a few other items that I've never seen on a W2. I think I got it all covered now, but would be well worth the money to have someone more experienced than I do them from here on out.

BTW, one other thing that dawns on me based on your remark above... you're probably also missing or omitting the 'unreimbursed partnership expenses' deduction.

Not a bad catch, but I don't have any. The firm reimburses me for just about everything. And those reimbursements aren't covered in the K1.

Late postscript: One other idea that's too late for 2016 but an idea for 2017 maybe or for 2018... if the SE taxes really fry you, you could hold your partnership interest through an S corporation. Even if you don't play the salary game, this will possibly/probably have effect of making your pension and health insurance expenses deductions for both income taxes and SE taxes. You'll surely know how this will work. But I'll include a link to blog post I did in case someone else wants more info:

http://evergreensmallbusiness.com/s-corporation-partnerships/

Intriguing concept. And I'll have to read the article once I get a moment. I might have to run some ideas back once I have.

[specialkayme]

Would also suggest the possibility that (a) clients get what they pay for so it's likely like low quality work you see was low price work and (b) you never know when you see a messy tax return whether the client or the CPA is responsible.

Very true. But I can say that I get to not only see the end product (and often the interaction along the way) but the bill. I'd say probably 30% of the problem prepares are the bargain CPAs or EAs. 60% are the mid grade, average to slightly above average CPAs that simply don't have the time to fully review everything they put out. 10% are the top tier CPAs who, quite frankly, aren't top tier at all and just get paid for it.

All off the top of my head numbers here. Don't hold me to it. I also have a VERY jaded view on this sort of stuff, mainly seeing everyone else's nightmares and problems and not seeing many successes.

[DavidAnnArbor]

I think but am not totally sure but by filing Married File Separately, disqualifies you for the Child Tax Credit and the Additional Tax Credit.

[Finallyunderstand]

I don't know if the OP has this option but for 2017 I incorporated myself as an S-corp and I'm the sole employee of the S-Corp.  I pay myself a "living wage" (and that is defined loosely by the IRS).  I chose $30k/yr as my living wage.  The money earned above that is given out as a dividend.  This will allow me to reduce a LARGE portion of my SE tax.  Last year my income was around $240k (less some deductions, etc) and I paid SE tax of $20k.   Assuming income stays the same, 2017 should reduce my SE tax by $10-13k.   I didn't do the actual math so I'm sure my numbers are off but you get the idea.  Just throwing it out there in case you have the option to be a partner with an S-Corp status.  I'm not sure how Law Firms work or if they would allow this.

This approach also requires setting up a payroll and paying payroll taxes but that hassle is worth the savings.  Lower savings at lower incomes may not find it worthwhile.

EDIT: "living wage" should read "reasonable wage" as pointed out by a following poster

[Heroes821]

I don't know if the OP has this option but for 2017 I incorporated myself as an S-corp and I'm the sole employee of the S-Corp.  I pay myself a "living wage" (and that is defined loosely by the IRS).  I chose $30k/yr as my living wage.  The money earned above that is given out as a dividend.  This will allow me to reduce a LARGE portion of my SE tax.  Last year my income was around $240k (less some deductions, etc) and I paid SE tax of $20k.   Assuming income stays the same, 2017 should reduce my SE tax by $10-13k.   I didn't do the actual math so I'm sure my numbers are off but you get the idea.  Just throwing it out there in case you have the option to be a partner with an S-Corp status.  I'm not sure how Law Firms work or if they would allow this.

This approach also requires setting up a payroll and paying payroll taxes but that hassle is worth the savings.  Lower savings at lower incomes may not find it worthwhile.

S-corp wage needs to be a reasonable salary for your work, not a living wage.  A doctor that is performing his work as a doctor can't pay himself a living wage of 30k when clearly his industry pay is significantly higher.  Be very careful of potential audits.  If $240k  is your standard business income and your Reasonable salary is only 30k this might raise some eyebrows.   I'm sure actual CPAs here can give more concrete advice.

[specialkayme]

I think but am not totally sure but by filing Married File Separately, disqualifies you for the Child Tax Credit and the Additional Tax Credit.

I believe you're right, along with a number of other disqualifications (like purging you out of IRA contribution deductions if you make more than $10k).

Last 3 years, the extra tax payments by filing MFS were less than the increased IBR payments if I had filed MFJ. In 2016 my wife was out of work for 4 months (unpaid maternity leave), so when I ran the numbers last night comparing MFJ and MFS, it looks like 2016 might make more sense for me to file MFJ (looks like MFJ would decrease tax liability by ~$3,600 over MFS, but would increase IBR payments by ~$147 a month, or $1,764 for the year, for a net savings of ~$1,800). But who really knows, as my IBR calculations almost never come the same as the student loan company's. And I suspect 2017 will be back to MFS, sadly.

[specialkayme]

I don't know if the OP has this option but for 2017 I incorporated myself as an S-corp and I'm the sole employee of the S-Corp.  I pay myself a "living wage" (and that is defined loosely by the IRS).

I'm going to look into that some more, for sure. Not now, but in the coming months.

Right now my partnership agreement is with me individually, so it would require the execution of a new partnership agreement and the consent of the other partners. Which I may not be able to get anyway. But assuming I did, I'd have to make sure this is ok with the Bar (something about having an entity as the partner of a legal field may not work out with their ethics opinions, but I'm not 100%), and ok with the malpractice carrier.

The other problem is the partnership agreement is all encompassing, and covers all income I make from any source. In the past, they had a partner that started another law firm on the side, and funneled cash out. So I highly suspect that my S-Corp AND I will have to be a party to the partnership agreement. Which then begs the question of what consideration is being received by me for entering into the agreement (if all the cash will be going to the S-Corp). But some questions for another day.

I don't think I'll be able to get away with paying myself a salary of $30k, but I could probably pay myself a salary equal to my base pay, and pay myself dividends on anything received as a distribution. Some years I could get no distribution. Most probably a few thousand. Some years (in the past, not when I was a partner) the distribution was several hundred thousand dollars. So it could save me some significant SE taxes in the future. If I can do it.

[DavidAnnArbor]

A traditional IRA deduction if you can make one, would save you at least a $1000 in taxes, or more.

[Jrr85]

I've worked at a law firm since 2011. First real professional job. Through 2015 I was a w2 employee. 2015's AGI ended up being about $85k. January 1 of 16 I was asked to come on as a junior partner. Moving from w2 to k1. Realizing I'd be responsible for SE taxes at 7.5%, I negotiated a base salary of $97k, which after above the line deductions should have gotten me to about the same place I was when I was a w2 employee. Plus the upside of potential (but not guaranteed) distributions.

2016 is the first time I'm itemizing deductions (home interest and RE tax deduction put me over the edge), and in 9/16 we had our first daughter. So I assumed the two would probably make a wash on the SE taxes, and I'd probably pay the same in taxes in 15 that I did in 16.

I ended up paying about 17.5% in taxes in 2015. Uncertain of how everything would shake out, I paid estimated taxes of about 19%. Ended up doing a first draft of taxes last night, and looks like I'm going to end up paying taxes at a 28% rate.

Just venting, but man that sucks. Better deductions than last year, plus a kid, and I'm still seeing a 60% tax increase. Seems like SE tax payers get screwed.

That seems pretty reasonable ballpark?  Your 17.5% tax rate as a W-2 employee was probably around 25% once you account for the employer side of FICA (which economically you're essentially paying as an employee or a partner).  It should take a pretty big jump in income to push your effective tax rate up 3%, so maybe you're still missing something, but it's not like you're crazy far off. 

[specialkayme]

A traditional IRA deduction if you can make one, would save you at least a $1000 in taxes, or more.

MFJ, correct. MFS, incorrect, and will cost you $330 in penalties if you have $10k or more in income. While if you put that into a 401(k) during that time period would have saved you the taxes. Also, if you're MFJ and have more than $118k in income, you'll still incur the penalties. That's assuming you have a 401(k) available (or similar device).

It all depends.

[Finallyunderstand]

I don't know if the OP has this option but for 2017 I incorporated myself as an S-corp and I'm the sole employee of the S-Corp.  I pay myself a "living wage" (and that is defined loosely by the IRS).  I chose $30k/yr as my living wage.  The money earned above that is given out as a dividend.  This will allow me to reduce a LARGE portion of my SE tax.  Last year my income was around $240k (less some deductions, etc) and I paid SE tax of $20k.   Assuming income stays the same, 2017 should reduce my SE tax by $10-13k.   I didn't do the actual math so I'm sure my numbers are off but you get the idea.  Just throwing it out there in case you have the option to be a partner with an S-Corp status.  I'm not sure how Law Firms work or if they would allow this.

This approach also requires setting up a payroll and paying payroll taxes but that hassle is worth the savings.  Lower savings at lower incomes may not find it worthwhile.

S-corp wage needs to be a reasonable salary for your work, not a living wage.  A doctor that is performing his work as a doctor can't pay himself a living wage of 30k when clearly his industry pay is significantly higher.  Be very careful of potential audits.  If $240k  is your standard business income and your Reasonable salary is only 30k this might raise some eyebrows.   I'm sure actual CPAs here can give more concrete advice.

$240k was my income last year.  Not the standard by any means for my industry.  I am in the top 3% in my area in my profession in regards to income.  Standard/average income for my industry nationwide is actually around $50k so if needed I can bump it up.  The S-Corp idea, wages, and guidance did come from my CPA so I'm following his lead as he does this with many many clients.  I also live in a LCOL so $30k is reasonable not only for an average person in my industry but also average person in my area.  Average income for my county is under $40k per capita.  Yeah an audit would suck but the gains outweigh the potential monetary penalties.  I paid over $60k in taxes last year even after taking into account tax saving measures so hence the need for S-corp. 

[Heroes821]

Snip

Yeah I just felt compelled to point that out since a lot of the s-corp things I've been reading have suggested salaries higher than that.

[Finallyunderstand]

These two links can be helpful regarding S-Corp rules and average S Corp salaries

http://evergreensmallbusiness.com/s-corporation-salary-rules/

http://www.scorporationsexplained.com/average-s-corporation-salaries.htm

[SeattleCPA]

These two links can be helpful regarding S-Corp rules and average S Corp salaries

http://evergreensmallbusiness.com/s-corporation-salary-rules/

http://www.scorporationsexplained.com/average-s-corporation-salaries.htm

Thank you Finally. Let me also point to this blog post which discusses the salary levels that people often consider as very unofficial safe harbors:

http://evergreensmallbusiness.com/safe-harbor-s-corporation-salaries/

BTW, that Warren Buffet pays himself $100K a year seems, er, ironic or something.