Author: Leon Clinton

Are you loving the 21 percent corporate tax rate and now keeping more money inside the corporation?

If so, beware of the accumulated earnings tax. You can easily overlook it. You likely don’t have the proper documentation to avoid it. And it’s expensive.

The accumulated earnings tax is a 20 percent corporate-level penalty tax assessed by the IRS, as opposed to a tax paid voluntarily when you file your company’s corporate tax return.

To trigger the tax, you need to suffer an IRS audit that notes your failure to pay dividends when

• the corporation’s accumulated earnings exceed $250,000, or $150,000 for a personal service corporation, and
• the corporation cannot demonstrate an economic need for the “excess” accumulation of earnings.

Here’s the question: Why do you need more than $250,000 ($150,000 if you are a personal service corporation) in accumulated earnings?

If you can answer this question to the satisfaction of the IRS, you have no problem.

But don’t wait for the audit and the question. Be proactive. Get your reasons and dollar amounts into the corporate minutes. Here are some prompts to get you started on why you need to keep the earnings in the corporation:

• You need the money to pay a deceased shareholder’s death taxes, funeral, and administrative expenses under IRC Section 303. After all, shareholders do die.
• You need the money to shut down operations, sell the business, and otherwise deal with corporate needs caused by the owner’s (shareholder’s) death.

Let’s move away from death. The IRS in Reg. Section 1.537-2 gives you a nice list of reasons for accumulating C corporation earnings, as follows:

• Provide for bona fide expansion of business or replacement of plant
• Acquire a business
• Retire indebtedness of the corporation
• Provide for investments in or loans to suppliers or customers if necessary to maintain the business of the corporation
• Provide for reasonably anticipated product liability losses

From this same regulation, the IRS lists the following as likely unreasonable reasons for accumulating the earnings:

• Making loans to the shareholders
• Making loans to other corporations and business entities owned by the shareholders
• Investing in properties unrelated to the corporation’s activities
• Investing in securities unrelated to the corporation’s activities
• Citing needs for unrealistic contingencies and hazards

If you would like to discuss the accumulated earnings tax, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• August 1, 2022

I know you report your business on Schedule C of your Form 1040.

Have you noticed that the self-employment tax significantly drains your cash? The S corporation may plug a good chunk of that leak because only the W-2 wages that the S corporation pays to you would suffer federal employment taxes.

Here’s the big picture: The S corporation

• deducts the W-2 wages;
• passes the remaining taxable income to you—the shareholder who reports the income on his Form 1040; and
• makes cash distributions to you—the shareholder.

The passed-through S corporation taxable income increases the tax basis of your stock; therefore, distributions of corporate cash flow are usually federal-income-tax-free.

This tax regime places S corporations in a potentially more favorable position than equivalent businesses conducted as sole proprietorships, single-member LLCs that are treated as sole proprietorships for federal tax purposes, partnerships, and multi-member LLCs that are treated as partnerships for federal tax purposes.

That’s because S corporations can follow the tax-smart strategy of paying modest salaries to shareholder-employees while distributing most or all of the remaining corporate cash flow to them in the form of federal-employment-tax-free distributions.

If you would like to examine the potential tax savings available to you with a switch to the S corporation, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• July 28, 2022

Are you considering joining the Great Resignation and becoming self-employed to be in charge of yourself?

Yes?

Okay, but before leaping, consider the tax implications. This self-employment thing may not be as rosy as it appears.

Here’s the big picture.

Don’t Believe the Hype

Despite what some may believe, becoming self-employed won’t allow you to

• write off all your meals as a business expense,
• deduct the cost of taking your friends to sporting events,
• deduct all your transportation expenses, and
• write off the entire cost of owning or renting a residence that contains your home office.

Sorry about that.

While there are some tax advantages to being self-employed, they are underwhelming and should not be the main reason for deciding to go out on your own.

The big non-tax disadvantage is you’ll have to pay for things that were formerly provided by your employer, such as

• health insurance,
• retirement plan contributions,
• a company car (if you were lucky),
• company-paid business trips that included elements of pleasure,
• meals when you worked late at the office, and
• so forth.

And there is one big tax disadvantage: the dreaded self-employment tax.

Now, some details on the tax issues most likely to affect you as a self-employed taxpayer.

The Dreaded Self-Employment Tax Can Be Really Expensive

The self-employment tax is how our beloved U.S. Treasury collects Social Security and Medicare taxes on non-wage income from business-related activities. For 2022, the self-employment tax rate is 15.3 percent on the first $147,000 of net self-employment income (e.g., net income from Schedule C multiplied by 92.35 percent).

That 15.3 percent rate is composed of:

• 12.4 percent for the Social Security tax component of the self-employment tax plus
• 2.9 percent for the Medicare tax component.

Above the $147,000 threshold, the Social Security tax component goes away, but the 2.9 percent Medicare tax continues before rising to 3.8 percent at higher self-employment income levels (above $200,000 if you’re unmarried or $250,000 if you’re a married joint-filer). The 3.8 percent rate consists of the “regular” 2.9 percent Medicare tax plus the 0.9 percent additional Medicare tax on higher earners.

Side note. The additional Medicare tax applies to an employee’s W-2 income in the same manner that it applies to self-employment income. It kicks in at the $200,000/$250,000 levels.

Once you’re in the 3.8 percent bracket, it continues to hit your net self-employment income up “to infinity and beyond,” as Buzz Lightyear would say.

Key point. When you were an employee, your employer paid half of the 12.4 percent Social Security tax and half of the 2.9 percent Medicare tax. You paid the other half. Your employer took what you paid from your salary. But now that you’re self-employed, you cover both halves out of your own pocket.

Bottom line: If you make good money, the self-employment tax can be a big number. You’ll need to include what you owe for self-employment tax with your quarterly estimated federal income tax payments to avoid an IRS underpayment penalty.

If, after reading the above, you are ready for self-employment, call me on my direct line at 408-778-9651, and let’s talk about getting you set up with some tax deductions to offset your tax bite.

• By Leon Clinton
• July 21, 2022