Tax Savings Tips: July 2022
Self-Employment Tax Basics
If you own an unincorporated business, you likely pay at least
three different federal taxes. In addition to federal income taxes, you must
pay Social Security and Medicare taxes, also called the self-employment tax.
Self-employment taxes are not insubstantial. Indeed, many business
owners pay more in self-employment taxes than in income tax. The
self-employment tax consists of
·
a 12.4 percent Social Security tax up to an annual income ceiling
($147,000 for 2022) and
·
a 2.9 percent Medicare tax on all self-employment income.
These amount to a 15.3 percent tax, up to the $147,000 Social
Security tax ceiling. If your self-employment income is more than $200,000 if
you’re single or $250,000 if you’re married filing jointly, you must pay a 0.9
percent additional Medicare tax on self-employment income over the applicable
threshold for a total 3.8 percent Medicare tax.
You pay the self-employment tax if you earn income from a business
you own as a sole proprietor or single-member LLC, or co-own as a general partner
in a partnership, an LLC member, or a partner in any other business entity
taxed as a partnership. (There is an exemption for limited partners.)
You don’t pay self-employment tax on personal investment income or
hobby income. For example, you don’t pay self-employment tax on profits you
earn from selling stock, your home, or an occasional item on eBay.
The tax code bases your self-employment tax on 92.35 percent of
your net business income.
That means your business deductions are doubly valuable since they reduce both
income and self-employment taxes. In contrast, personal itemized deductions and
“above-the-line” adjustments to income don’t decrease your self-employment tax.
Some types of income are not subject to self-employment tax at
all, including
·
most rental income,
·
most dividend and interest income,
·
gain or loss from sales and dispositions of business property, and
·
S corporation distributions to shareholders.
You calculate your self-employment taxes on IRS Form SE and pay
them with your income taxes, including your quarterly estimated taxes.
Self-Employment
Taxes for Partners and LLC Members
Here’s a question: Does a member of a limited liability company
(LLC) or a partner in a partnership have to pay self-employment taxes on the
member’s or partner’s share of the entity’s income?
Incredibly, the answer is not always clear.
If you are a general partner in a general partnership, you must
pay self-employment tax on your entire distributive share of the ordinary
income earned from the partnership’s business. General partners also must pay
self-employment tax on any guaranteed payments for services rendered to the
partnership.
Partnerships generally are not required to pay guaranteed payments
to the partners. Guaranteed payments are like employee salaries; the
partnership pays them without considering the partnership’s income. They are
often incorrectly called “partner salaries.”
If you’re a limited partner in a limited partnership, you don’t
pay self-employment tax on your share of the partnership’s profits. But you do
pay self-employment tax on any guaranteed payments you receive.
That’s all well and good. But what about LLCs? They are the most
popular business entity in the U.S. today, with an estimated count of 21
million. It is not always clear when LLC members (owners) pay self-employment
tax.
LLCs are state law entities not recognized for federal tax
purposes. In other words, they are always taxed as something else. The tax code
taxes the single-member LLCs as a sole proprietorship unless the owner elects
taxation as a corporation (which is rare). Thus, owners of single-member LLCs
file Schedule C and pay self-employment tax on their net profit. It couldn’t be
simpler.
LLCs with multiple members are treated as partnerships for tax
purposes unless they elect taxation as a corporation. If a multi-member LLC is
taxed as a partnership, should its members be treated as general or limited
partners?
Under proposed IRS regulations:
·
Members of member-managed LLCs cannot be treated as limited
partners and must pay self-employment tax.
·
Members of manager-managed LLCs can qualify as limited partners,
provided they work no more than 500 hours per year in the LLC business.
·
Members of service LLCs engaged in health, law, engineering,
architecture, accounting, actuarial science, or consulting must be classified
as general partners.
Fortunately, you don’t have to follow the proposed regulations.
The IRS has not finalized them and says it won’t enforce them.
You can look at U.S. Tax Court rulings instead. The leading case
says an LLC owner may be treated as a limited partner only if he is a passive
investor who does not actively participate in the LLC business.
New 62.5 Cents
Mileage Rate
The
IRS noticed that average gas prices across the United States exceeded $5.00 a
gallon and took action.
Small
businesses that qualify to use and do use the standard mileage rate can deduct
62.5 cents per business mile from July 1 through December 31, 2022. That’s up 4
cents a mile.
This
brings up a practical question: what do you do if you track business mileage
using the three-month sample method?
Three-Month
Sample Basics
As
a reminder, here are the basics of how the IRS describes the three-month test:
·
The
taxpayer uses her vehicle for business use.
·
She
and other members of her family use the vehicle for personal use.
·
The
taxpayer keeps a mileage log for the first three months of the taxable year,
showing that she uses the vehicle 75 percent of the time for business.
·
Invoices
and paid bills show that her vehicle use is about the same throughout the year.
According
to this IRS regulation, her three-month sample is adequate for this taxpayer to
prove her 75 percent business use.
Sample-Method
Solution to New July 1 Mileage Rate
To
use the sample rate, you need to prove that your vehicle use is about the same
throughout the year. Your invoices and paid bills prove the mileage part, and
your appointment book can add creditability to consistent business and personal
use.
Keep
in mind that the sample is just that—a sample—it’s pretty exact for the three
months but not that exact for the year, although it must adequately reflect the
business mileage for the year.
If
you have a good three-month sample, you take your business mileage for the year
and apply the 58.5 cents to half the mileage and the 62.5 cents to the
remaining half to find your deductions.
For
example, say you drove 20,000 business miles for the year. Your deduction would
be $12,100 (10,000 x 58.5 cents + 10,000 x 62.5 cents).
Mileage
Record for the Full Year
If
you have a mileage record for the entire year, no problem. Your record gives
you the mileage for the first six months and the last six months.
Paying Your Child:
W-2 or 1099?
Here’s
a question I received from one of my clients: “I will hire my 15-year-old
daughter to work in my single-member LLC business, and I expect to pay her
about $12,000 this year. Do I pay her through payroll checks and file a W-2?”
My
Answer
Yes.
And W-2 payment is essential. If you pay her on a 1099, she will pay
self-employment taxes.
When
you pay her on a W-2, neither you nor your daughter pays any Social Security or
Medicare taxes, and in most states, you also don’t pay any unemployment taxes.
Key
point 1.
Your single-member LLC is a “disregarded entity” for federal tax purposes. It’s
taxed as a sole proprietorship (unless you elect corporate treatment). In this
instance, you are the child’s parent, enabling “no Social Security or Medicare
taxes” for both your child and your proprietorship.
Key
point 2.
Your daughter has a $12,950 standard deduction. This means she also pays zero
tax on earned income up to that amount.
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