The first strategy for anyone who is self employed including 1099 contractors such as real estate agents is to form an S-corporation if your net profit exceeds $50,000. Without an S-corp, all business owners/1099 contractors must pay 15.3% in social security and Medicare tax on their entire net profit. An S-corp allows you to split your net profit from your business into two parts, one being a salary you pay yourself through a W-2 and the other portion through a K-1. You would have to pay Social Security and Medicare tax on the W-2 income but not the distributions you take through the K-1. The IRS requires you to take a “reasonable salary” through the W-2 before distributing income to yourself through a K-1. Depending on how conservative or aggressive you want to be, you can take 75% of your net profits as a salary or as low as 10% if you feel you can justify it to the IRS in the event of an audit. If you’re feeling generous, you can always pay more to the government to fund Social Security and Medicare. Generally, the higher your income is, the more justifiable it is for you to take a lower percentage as a salary. For example, if you made 1 million dollars a year in net profit and took 10% or $100,000 as a salary and the rest as a distribution through a K-1, it is more reasonable than someone who made $100,000 and took 10% or $10,000 as a salary and the rest as a distribution.
There are a number of costs associated with running an S-corp. First, the bookkeeping requirements are more strict since S-corporations are under a bigger spotlight by the IRS. You can keep track of your income and expenses through an excel spreadsheet that you can find by clicking on the spreadsheets tab at the top of this page but that is only feasible if you do not have many transactions in a year. If your gross income or assets exceed $250,000, you would also have to report your balance sheet when filing an S-corp which is a lot easier to keep track of and generate through bookkeeping software such as Quickbooks or Xero rather than excel. You can also hire an accountant to manage your books if it makes sense financially and saves you money and time. Second, the cost of filing an S-corp return is much higher than just filing a personal tax return. It can cost anywhere from $900-$1200+. Third, you would have to purchase payroll software to run payroll on yourself at least once a year to generate a W2 when paying yourself a salary. This can cost anywhere from $20-$50/month. Once you factor in bookkeeping, payroll and the higher cost of a business tax return, you have to decide if creating an S-corp is worth it. Many people try to write off fictitious business expenses to avoid the dreaded 15.3% tax as much as possible but fail to realize that if they try to get a loan or purchase a house, it would be impossible to get a mortgage when you write off too many expenses and have too low of an income. When running a business, you should also have a separate business account. At the end of the day, all of this can be worth it and save you thousands. If your net income is $100,000 and you take an aggressive approach of paying yourself $25,000 as wages and $75,000 as a distribution, you would save $11,475 on the 15.3% Self Employment tax for social security and Medicare minus the cost of the tax return, bookkeeping and payroll.
2. Business Losses
Turning a hobby into a business to take business losses is an aggressive but legitimate tax strategy as long as you follow IRS guidelines. In the event of an audit, you have to prove that you intended to turn a profit and that you ran the business in a business like manner and not as a hobby or a way to reduce taxes. This means you must have a separate business bank account, LLC, EIN, be on top of your bookkeeping, have a business plan to legitimize the business and a profit motive. The benefit of this strategy is that you can turn what once were personal expenses into business expenses such as gas, vehicle expenses and repairs, utilities, supplies etc. Taking business losses against other income would reduce your tax liability and can even lower your tax bracket to where you are eligible for new tax credits such as the American Opportunity Credit. Although this is a perfectly viable strategy according to IRS guidelines, beware that if you run a sham operation for the sole purpose of reducing tax liability and not to turn a profit, you will have to pay back penalties and interest in the event of an audit.
3. Rental Losses
This strategy is similar to that of business losses except it is a lot less aggressive since many rental properties have a loss on paper through depreciation. You can be cash flowing on your rental property while still taking a tax loss through depreciation. The limit on losses is $25,000 if your adjusted gross income is $100,000 or less as a single individual and $150,000 if you’re married. This is where tax planning plays a significant role. If you make more than $112,550, you should consider contributing to a 401k and/or HSA to reduce your gross income to $112,550 or lower. The standard deduction for 2021 is $12,550 for a single person so this would bring your AGI to $100,000 and allow you to deduct up to $25,000 in rental losses. If you don’t qualify for rental losses due to an income limitation or have more than $25,000 in losses, then you must carry forward those losses to future years until you sell your property to claim the losses. To claim 100% of the losses for the current year, you must qualify as a “real estate professional” which basically means you are in the business of real estate in some form or fashion such as by being an agent, broker, flipper, property manager etc. If you are not in the business of real estate, then you may qualify through other tests but it would be an aggressive tax strategy that you must bear the risk in the event of an audit. If the IRS determines you do not qualify as a real estate professional to deduct the losses, you will most likely have to pay back the deduction with interest and penalties but will not face criminal charges as long as you are not committing blatant tax fraud. To reduce risk, you can always take a more conservative approach to tax planning and avoid taking rental or business losses altogether. Trump has used the S-corp, rental and business loss tax strategy and Biden has used the S-corp and I am sure, the rental loss strategy as well.
4. Gifting Capital Assets to Avoid Capital Gains
The capital gains tax rate is 0% for single individuals with income up to $40,000 + the standard deduction of $12,550 so a total of $52,550. It goes up to 15% for income between $40,001-$441,450 and 20% for anything above that. If you’re planning on selling stocks, crypto, investment property or any other capital asset and expect to pay capital gains tax, you can transfer the asset as a gift to anyone other than your children and avoid paying capital gains tax if their total income is less than $52,550 after including the capital gains. For example, lets say you buy bitcoin for $10,000 and sell it for $40,000, you have a capital gain of $30,000. If you have another job making $100,000, then you would owe 15% on the $30,000 of capital gains. On the other hand if you have a family member or friend who only makes $20,000/year, you can gift them the bitcoin to sell and they would owe 0% on the sale because their total income would be $50,000 which is below the $40,000 + standard deduction amount.
5. Four in One: Retirement Accounts, Vehicle Tax Credits, 529 & Charity
Retirement accounts such as 401ks, SOLO 401ks for business owners and IRAs are a great way to reduce your gross income allowing you to qualify for more tax credits and deductions while also saving for retirement. There are hybrid and electric vehicles that qualify for a nonrefundable tax credit of up to $7,500. For example, if you owe $4,000 in taxes, the $7,500 will bring you to $0 in tax liability but nothing more which means you do not get to use $3,500 of the credit. Teslas are no longer eligible for this credit as they have sold more than 200 thousand vehicles. You must check online and with your dealer to make sure the vehicle you purchase qualifies for the credit. The government is incentivizing people to be more environmentally friendly by providing tax credits for certain vehicles as well as for solar panels. The vehicle tax credit is geared towards more high income earners. You should also NEVER make a purchasing decision solely based on a tax incentive. Purchasing a $50,000 vehicle just to get a tax credit that you may not 100% benefit from may not be the smartest choice. The 529 plan is similar to other retirement vehicles such as a 401k or IRA except this plan must be used for elementary, secondary or college educational expenses. Earnings in a 529 plan are tax free when withdrawn and used for educational expenses. You can also deduct contributions in some states such as Arizona which would save you taxes at the state level. In 2021, you may deduct $300 for charity as an above the line deduction without having to itemize. In Arizona, you may also receive a charity tax credit up to $400 for individuals and $800 for married filing jointly that can be carried forward for 5 years which would save you money at the state level. The Arizona charity credit can only be claimed through cash donations.
If you have any questions or need any help, you may reach me at 480-779-8579 or email me at [email protected] S.L Tax & Accounting is the best Laveen, Tolleson and South Phoenix Arizona tax preparation and accounting business providing the best service.