Will Bachman: Our guest today is Jonah Gruda, a tax partner at the accounting firm [Mazars 00:00:04] USA LLP. In this episode, we discuss a wide range of tax related topics relevant to independent professionals. We cover differences between various structures including LLC, S Corp, and C Corp. Before our conversation, I thought that LLC was the obvious choice for most independent professionals, but Jonah made me realize that there are many factors that go into the equation, and you really want to sit down with a professional to figure out what structure is right for your particular situation. We discussed bookkeeping. We discussed how to hire a subcontractor, various deductions to keep in mind, and some nexus issues you want to be aware of.
We also discuss the implications of the new tax law. The short answer is that there is going to take some time for the IRS to issue guidance to resolve some of the ambiguous or even contradictory aspects of the law.
To get in touch with Jonah, you can visit MazarsUSA.com. You’ll find his contact info by searching for him on the firm’s website.
I hope this episode answers some questions you may have about the tax side of running your own firm and raises awareness of important points that maybe were not top of mind.
Jonah, it’s great to be here in your office. Thank you so much for agreeing to be on the show. I’m really excited for our discussion today.
Jonah Gruda: Well thanks for having me, Will. It’s an interesting time to be a CPA, certainly with the passing of the TCJA, which everyone’s talking about-
Will Bachman: Otherwise known as the “guaranteed lifetime employment for CPA Act.”
Jonah Gruda: That’s right. It’s interesting. If you work for a mid-size and large-size firm, it’s the only thing that we’re talking about these days. If you’re a small shop, I think you might be a little nervous of how this is going to play out. A lot of the changes really impact a lot of low income and middle income tax payers, and it actually makes their lives a lot easier, but for some consultants and business owners, it actually makes things way more complicated.
We were thinking that … at least, the president said that we’d be doing our tax return on a postcard, but I don’t think that’s the case.
Will Bachman: Well it could be a very, very large postcard.
Jonah Gruda: Very, very large postcard, front and back.
Will Bachman: Folded up.
Jonah Gruda: That’s right.
Will Bachman: Okay, so today the goal is we’re going to talk about … For consultants that have been doing this for a while as well as for people that are just leaving a W-2 job and getting into independent consulting or as an independent professional for the first time, we’re going to do a few things.
We’re going to talk about, first, just the tax structures that exist. So, how do you decide between LLC, LP, S Corp, C Corp, what all those things even mean, and then we’ll get into some quick topics around bookkeeping, and then get into some of the implications of the tax law. That was kind of what I was thinking. Does that work for you?
Jonah Gruda: Yeah, I think that makes sense. I think what would be important as we unpack this is to maybe set the stage of some general understanding of the different entity comparisons that we have, why one may be beneficial over the other, and maybe some of the unique implications those have on freelancers and self-employed individuals, and then we could put into context of the new law and maybe some thoughts and planning that those entities might be afforded with the new rules.
Will Bachman: Awesome. Let’s start with the basics. For someone who’s new, LLC, LP, S Corp, C Corp, or even just trying to operate without anything just on your own Social Security number, for someone who’s starting out, explain what these different structures are and help walk us through.
Jonah Gruda: Yeah, so those are all good questions. We often think of corporate structures and [pass-through 00:04:07] structures, and there’s probably five main ones that we tend to talk about: self proprietor, partnership, C corporation, S corporation, and the limited liability company. Those tends to be the ones that everyone’s thinking, “I need to form a company. I’m going to work for myself. I’m going to be self-employed.”
They afford different legal protections, administrative burdens, accounting issues, and certainly tax issues. I’ll maybe just go through each of them very, very basically, at a basic level.
Going from sole proprietor, it’s basically disregarded. It’s not a legal entity. It has the same legal status of the owner, so any of the liabilities of doing business as a sole proprietor are completely attached to that of the individual. There’s no liability protection whatsoever.
Moving to the limited liability company, you could have a single member limited liability company, which for federal income taxes tends to be a disregarded entity. All the income and deductions get taxed at the individual owner level. However, it offers a legal status separate and apart from the owner, so there’s a legal division between the entity and the individual.
That same legal separation also applies with the S Corporation and the C Corporation. Those are regarded entities, the C Corp and the S Corp, and even a partnership in some extent. So those are separate entities apart from the owner, so from a legal perspective, those structures generally have more protections from a sole proprietor.
Moving along, your sole proprietor and your single-member LLC and your S Corp tend to be taxed at the owner level, meaning all your net income is taxed at the individual level as opposed to a corporate level. Of those five entities I mentioned, the only one that’s a separate taxable entity is a C Corporation. The C Corp pays taxes as a separate legal entity, whereas the LLC, the S Corp, and the sole proprietor tend to pay taxes at the owner level. That has its benefits and drawbacks depending on the situation you have.
Sole proprietor is very, very easy to set up. You could just get a DBA and an EIN number and start operating, if you want. Partnerships, C Corporations, S Corporations, and LLCs tend to be a little bit more administratively burdensome. You need either articles of incorporation or articles of organization. With a partnership, you need a partnership agreement, and you usually need the assistance of an attorney and an accountant to help you with that.
There’s issues of management and continuity of life, which are an issue, but I think it’s beyond the scope of what we need to discuss today. With an S Corp, you could have a hundred owners. Sole proprietor is just one owner. Partnerships, C Corps, and LLCs could have unlimited owners depending on what your goals are.
There’s some limitations on eligible owners. There are limitations on S Corp, but partnerships, C Corps, and LLCs, anyone could really own them. There’s transfers of ownership issues. There’s issues with the ability to raise capital. Those are some of the main comparison items in terms of choice of entity, but I think what most people that might be listening today are interested in is, “Do I want to be a corporation, or do I want to be an LLC?”
Those are the two big ones. So both offer some benefits. I think we could talk a little bit about that after we move along to the next section, I think.
Will Bachman: Okay, cool. So let me reprise. So sole proprietor, you could actually get an employer identification number, or EIN, which I wasn’t aware, and not have an LLC. So instead of getting paid to your social security number, you could paid to an employer identification number, but you don’t actually have an LLC. Didn’t even know that was possible. An LLC does give you an employer identification number, and it gives you that legal liability.
Jonah Gruda: Yeah, it’s separate steps there. Anyone could go onto the IRS website right now and get an EIN number as a sole proprietor.
Will Bachman: For their business. Make up a business name.
Jonah Gruda: That’s right, and it’s relatively easy. It’s free. It takes about ten minutes, and you could have your own tax ID number separate and apart from your social security number by the end of this podcast. One does not preclude you from doing anything else. You could become an LLC or an S Corp and go through the same process. The LLC is more of a legal form as opposed to an operational form.
Will Bachman: Got it. So, for listeners who haven’t done it yet, were maybe just thinking about going into the infinite route, what does it take to get an LLC? How much, roughly, should they expect to spend?
Jonah Gruda: That’s a good question. I should say that LLCs are really governed by state law, each state has its own rules and requirements. In New York State, you have a registration requirement. You have to be published in two journals for a specific period of time. That tends to be the most costly part of the process. There are online legal services that you could do that. There are also small attorneys and larger attorneys that’ll do it as well.
Will Bachman: By the way, just as a benchmark, it did that and it cost me around 12 hundred, 15 hundred bucks, so it’s not super cheap.
Jonah Gruda: No, and that’s probably on the lower end. I’ve seen as much as 4, 5, 6 thousand dollars. Again, there are documents that forming an LLC will have. You need to have articles of organization. Sometimes you need to have minutes. There’s other administrative things that tend to happen, but it is a fairly easy process. You could do an S Corp yourself. You need to register with the Secretary of State, file some documents online. If you’re providing a service that’s governed by the New York State Board of Education, like accountancy, health care, mental health services, any of those types of jobs, you also need to register with your local licensing board, but anyone could do it that has the time and the wherewithal to read the instructions. It’s not an overly technical process.
Will Bachman: One question I’ve been asked a few times is, “Hey, I’m setting up an LLC. What state should I register in and should I register at my own state or Delaware?” Does that make a difference from a tax perspective?
Jonah Gruda: It can, and it can make a difference from an operational perspective. Each state has their own filing requirements for their businesses. Some states impose franchise taxes for the right to do business in that state. If you’re an LLC registered in New York state, you have to pay a $25 minimum tax, so to speak, for being an LLC. As you perform services and generate income, that fee could go up. If you’re a Delaware LLC, let’s say, you may not have that filing requirement. That doesn’t impact your income tax filing requirement. You’re generally, with certain caveats, going to file income taxes in the state where you’re doing business, performing services, paying services where you have an office, things like that.
There’s a much more complicated calculus to decide, “What state should I register in,” whether you should register in the state that you live in and are doing business in or you should use a favorable state that has its own benefits for businesses like Delaware or Nevada, Alaska, Texas.
Will Bachman: Before we move on, just S Corp. What is an S Corp?
Jonah Gruda: An S Corp is actually a C corporation that has made an election to be taxed under the S Corp rules. At the very, very basic level, an S Corp is a flow-through entity. An S Corp is taxed similar to an LLC, but it gets a little more complicated. It is a corporation, so it’s a separate entity apart from its owner. However, unlike a C corporation, it’s not a separate taxable entity. All the distributive share of income from an S Corp flow to the individual owner. You own share in an S Corporation, so you own stock. You get a K-1 from an S Corp, like you would do from a partnership, and that K-1 gets reported on your individual tax return. However, there’s an interesting quirk with S corporations that make it unique from the other entities.
There’s been a concept since the ’50s. An S Corps something that we like to call “reasonable compensation.” One of the few [gimmies 00:14:09] in the tax code that the distributive share of income from an S Corp that flows to the individual is not [inaudible 00:14:14] to self-employment taxes. If I make $25,000 of net income as an S Corp, that flows to me as an individual. I pay ordinary income taxes on that, but I don’t pay payroll taxes on that. However, if I get $25,000 distributed to me from an LLC, I’m going to pay ordinary income tax, but I’m also going to pay self-employment tax for that income, which I get to deduct one-half of that.
The government says, “Look, if you distribute out all your income as profit, I could take all that cash out on a tax-free basis.”
The government is almost at a tax detriment by not getting payroll taxes. What they tell you is that you need to pay reasonable compensation to your owners who have an S Corp. Now, there’s no bright-line test. It’s been litigated in the courts for a number of years. Anywhere from 28-35% is a good barometer. It could be more depending on the industry and the geographic area. It could be less. So you need to pay yourself a salary out of the S Corp, and then the net will get distributed to you and taxed at your ordinary rates, but that net amount won’t get [severaged 00:15:35] to payroll taxes.
Will Bachman: Okay, so let’s say that the S Corp total profits before we pay the salary was $200,000. Let’s say that we say that the reasonable compensation would be … I don’t know, should we make the numbers easy …
Jonah Gruda: Say sixty thousand.
Will Bachman: Sixty thousand. Okay, so we have two hundred thousand total after we pay all the other expenses before the salary thing, and then we say the salary is sixty thousand, and the net profit is a hundred and forty.
Jonah Gruda: So you could take that one forty out in cash as an owner distribution. Maybe let’s go backward, if you don’t mind, with that example. So let’s say you’re an LLC and you’re an S Corp. For the listeners, I’m making a chart.
Will Bachman: Yeah, we got a chart going on. This’ll help me.
Jonah Gruda: Let’s say your income after expenses and salary is, for the LLC, $200,000, okay? That’s after expenses and things like that.
Will Bachman: Yeah, they’re all your expenses, all your office expenses and everything else.
Jonah Gruda: That flows to the individual owner as $200,000, and you’re going to pay ordinary taxes at the highest marginal rate today plus 15.3% of payroll taxes.
Will Bachman: 15.3% payroll tax, okay.
Jonah Gruda: You get to deduct one-half of that, though, on your individual return.
Will Bachman: Okay.
Jonah Gruda: Reason being is when you’re an employee, you pay payroll taxes. The company that gives you your W-2 pays payroll taxes, and then you pick up the other half. Since you’re, in effect, the employer and the employee … I don’t like to use those terms of an LLC, but it makes it simple to understand … You’re severaged to both, but you still get to deduct one-half later on, on your tax return. So that $200,000 is severaged to ordinary income, plus payroll taxes.
Will Bachman: Which is $30,000, let’s say.
Jonah Gruda: Yeah, give or take.
Will Bachman: And that’s state tax?
Jonah Gruda: That is payroll. That’s FICA and Medicare. Medicaid.
Will Bachman: And does that top out at something?
Jonah Gruda: Yeah, there’s a limitation. I need to check the threshold for 2017, but the maximum Social Security is 127,200. Then there’s no maximum from the high income. It’ll be … It’s 1.45 and then 6.2%. There’s a cap at the 6.2% of the first 127,200 of wages, then anything beyond that will still get taxed at 1.45.
Will Bachman: Okay, great. So there’s some payroll tax that you’re going to have to pay as an LLC, and then if we go over to the S Corp example …
Jonah Gruda: Right. As an S Corp, if you make $200,000, you technically could take that $200,000 out as cash. You could distribute the cash to yourself and only pay your ordinary income tax on that, but the government says, “No, you can’t do that.”
Will Bachman: Oh, I see.
Jonah Gruda: So it makes you say, “Okay, $200,000. We need you to pay yourself a reasonable salary since you’re avoiding payroll taxes.”
So maybe you pay yourself a salary of $60,000, pay payroll taxes on the 60, you get a deduction for that, so the 140 gets taxed to the individual owner of the S Corp at just the ordinary rates.
Will Bachman: Okay, got it. So the benefit of the S Corp is that it lets you avoid paying payroll taxes on some portion of your profit, basically.
Jonah Gruda: I wouldn’t say that that’s the sole benefit, because you still-
Will Bachman: One benefit.
Jonah Gruda: That’s potentially a benefit, because you still want to make sure that you have a good amount paid into Social Security for when you retire as well, right? You don’t want to short-change yourself, but that is one of the biggest attractive factors to folks of using an S Corp is that potentially, at times, you save in the payroll tax arena. But we need to be wary. You need to pay yourself a reasonable compensation.
Will Bachman: Okay, so that’s the S Corp. And then the C Corp, that one is double taxation, so your business actually pays its own tax return, and then you get dividends from it, but then you would have to pay off taxes on that.
Jonah Gruda: That’s right, and that affords itself some interesting benefits, because the corporate rate just went down from 35% to 21%, so it may make C Corps a little bit more attractive. However, there is anti-abuse provisions by not taking out profits from a company. If you’re trying to convert a service income that normally would be taxed as compensation at the highest rate and just leave it in as corporate profits, the IRS might say you’re accumulating income and not distributing it out, which they don’t want. You could get a penalty for that.
But you touched on an important thing of the double taxation, so you have a maximum corporate rate in 2018 of 21%, and a maximum capital gains rate of 20%, plus a 3.8% net investment income tax, or the colloquial is “Obamacare.” So, you potentially have a 21%, plus 20%, plus 3.8%. You’re effectively getting taxed at 44.8% plus whatever state you’re operating in by operating as a C Corp. That assumes you’re also in the highest marginal bracket. The corporate rate is 21%, but you could have an individual that’s in the 12% bracket, and so their dividend rate is 15%. A lower-income tax payer would have 21% plus 12 plus 15. Brings it down a little bit.
You have to think, “Does the individual need all that money out, also, as service income? Maybe they could pay themselves a smaller salary from the C Corp.”
If someone’s making $200,000 a year, maybe they only give themselves a $60-70,000 salary, let’s just say, from the C Corp.
Will Bachman: Okay, so the C Corp, it does have double taxation, but you-
Jonah Gruda: That’s only if you bring the money out.
Will Bachman: But when you actually bring the money out, you get taxed again on it.
Jonah Gruda: That’s right. That’s the double taxation, but if someone has income from other sources, let’s say, or they have a considerable portfolio, or they have a different arrangement with other consulting jobs or freelancing jobs, and they have the C Corp, but they have income from another source, maybe they don’t need to pull the money out. They’re saving that way, and you have to look at the time value of money, what your exit strategy is. There are other tax benefits on the estate planning side and the exit strategy side that might make a C Corp more attractive.
Generally, if you need 100% of the money you’re making, the C Corp may not be the most beneficial for you.
Will Bachman: So if you’re basically just doing it for income, and you’re taking most of it out, probably not the right choice.
Jonah Gruda: Yeah, probably not, but it very well could if you’re in a lower bracket, if you have debt on the books. There are new rules with the ability to deduct interest expense, or if you have assets used in the business. There are new expensing provisions and bonus depreciation provisions. It’s not cut and dry anymore. It used to be, years ago, “Be an LLC. Don’t put real estate in a C Corp.” But, I think, those thoughts are still important to think about, but it’s important to just go through the modeling, and it’s a little bit more complicated today.
Will Bachman: Cool, so I guess where I’m landing on all this, Jonah, is it sounds to me like it’s not as simple and cut and dry as, “Hey, for everybody here’s probably the right solution,” but there’s a whole bunch of factors to think about when you’re doing the structure. There’s the legal liability. There’s how much do you actually need to take out of the business now. There’s what jurisdictions you might be operating in. There’s, “Do you want the administrative hassle of all these articles of incorporation type stuff?”
So there’s probably not just one answer that we can confidently say, “90% of people should do this.” It really sounds like if you’re planning on doing this as a business for a few years, you probably want to talk to a professional to sort out all these different issues and do some modeling and so forth.
Jonah Gruda: Absolutely, and I would encourage people to really think about this. I’ve seen clients in the past, “Oh, I set up an LLC,” without really thinking about these types of things, so there are a lot of unintended consequences from rushing to make these entities a reality for them. It’s almost as if right when you’re starting your business, you almost need to think about how you intend to finish, because that’s also going to be part of the analysis as well.
If people are thinking of making this jump into legal formation and going out on their own, it would be important for them to really think outside the box and really sit down and spend some time writing, “What are my goals? How I’m going to operate? How much money do I think I’m going to plan to make? What are my expenses going to be?”
Like you said, “Where am I going to operate? Do I need any equipment? Am I going to take on any investors? Am I going to ask for money? Am I going to have partners? Am I going to have employees? Am I going to have contractors?” We’ll get to that in a little bit.
So it’s not just, “I want to be a legal entity because I want to start working for myself.”
It affords a deeper discussion with yourself and certainly with an attorney and an accountant.
Will Bachman: Okay. That’s super helpful. I think one differentiation, which maybe we mention now before we go onto the next chunk would be: I think one of these offers your ability to create a defined benefit plan, which I guess a lot of people might do a self-employed SEP IRA, which is pretty good. It lets you put away up to, I think, 50 or 60 thousand dollars a year pre-tax, but if someone’s doing really great and they can put away more than that, they can think about a defined benefit plan, which is a little bit more complicated, but you can put in a little more money.
Jonah Gruda: Yeah, and interesting enough, defined contribution plans and defined benefit plans are even more important under the new tax law because we have income thresholds that would allow certain taxpayers to get a 20% deduction of their qualified business income. So using those plans are a tool to help bring your income down within those thresholds. But a very basic level, there’s two types of plans. There’s defined contributions plans and defined benefit plans.
You could put the maximum amount into a defined contribution plan in 2017, $54,000. Not a small sum of money. A DB plan or a cash-balance plan, you could well over $200,000 into a defined benefit plan. Now, you need to have the liquidity to be able to do that, and that also reduces your taxable income. You get a deduction for that. There are certain thresholds and limitations on how those contributions are calculated. With a defined benefit plan, you need to have W-2 wages. You need to have earnings, a certain amount with a SEP IRA. You need to have earnings as well. It’s really 25% of your W-2 earnings. There’s also non-deductible IRAs, but all these plans are good for both retirement, potentially putting in pre-tax dollars at a higher rate when in retirement when you start taking required distributions, the theory being you’re going to be in a lower rate.
If you think you’re going to be in a higher rate in retirement, maybe you put in taxable contributions now, don’t take the deductions with certain types of IRAs, so when you pull the money out, it’s not taxed later on. But using those types of plans really have a lot of flexibility with … You could use them in almost all those types of entities, but there are certain thresholds and limitations that would preclude you from using some versus the other.
Will Bachman: And with the defined benefit plan, the one where you could put in up to 200 thousand or so, is that one eligible for all these different formats, or would you have to have an S Corp or a C Corp to do that?
Jonah Gruda: You could use it with an LLC. Partnerships and LLCs tend to use DB plans the most. Again, there are restrictions on income testing and discrimination rules on using it, but you tend to see DB plans used the most with LLCs and partnerships.
Will Bachman: Okay, great. Let’s move on past this structure discussion and talk a little bit about … For someone who’s setting themselves up for the first time as … They’ve figured out their structure, let’s say, and now they’re saying, “Okay, I’ve been an employee all my life. What am I going to have to show my accountant at the end of the year to prepare my taxes, particularly in terms of tracking expenses?” It’s usually a little bit easier to track revenue. Usually fewer line items. Fewer checks coming in than all the small little payments going out, so what’s your advice for someone who’s going to be running an independent consulting business, let’s say, of how do they track all their expenses, what would you want to see. Also, give some guidance on what sorts of expenses are legitimate business deductions that people can be looking for.
Jonah Gruda: Another good question. Don’t throw your receipts in a shoebox and give them to me, please. With the use of technology today, it makes it very, very easy to run your business from an expense-tracking and a revenue-tracking standpoint. It’s easier than it ever was, and there’s so many free pieces of software that folks could use out there, that you could use through your phone, your iPad, your computer, and then softwares that you could purchase. I’m not going to recommend one over the other. It really depends on the volume, the types of expenses that you’re using. A lot of the software out there … You could take pictures of receipts and it will categorize it for you on your phone, and you could get real-time financial statements from it.
What an accountant is going to want at the end of the year at a minimum is how much you made and what were your expenses broken up into a couple different categories. How much did you spend on advertising? What were your business meals? You’re not allowed to deduct entertainment expenses anymore. How much did you spend on gas? How much did you spend on traveling? When folks are thinking about this, think about what you’re spending on in support of the business. I know that’s a broad stroke, but think about whatever cash [outlays 00:31:33] that you’re putting out there in anticipation of generating revenue, those are what we call trader business expenses, for the most part.
I’d rather get from my clients more than less, and we can have a conversation on things that I don’t think are kosher. Certainly, again, entertainment’s disallowed. Years ago, we would see clients expensing their Knicks tickets. Now I don’t know why anyone want to still go to a Knick game anymore, at least of late, but what was the business purpose? Okay, maybe there was bonafide business purpose. “I was taking out a prospective client. This is what we talked about. This is who came and this is the result.”
What I would encourage folks to do is keep a contemporaneous log of those business meetings that you’re spending money on for meals or other meetings ant things like that. That way, if you ever get audited, it’s the tax payer’s responsibility to provide support, and we have this concept of contemporaneous recordkeeping. So if you’re traveling and you want to deduct auto, keep a log of your miles, who you met with. It seems cumbersome, but with technology, I think, it’s very easy to save that information.
I have clients now that at a minimum just have an Excel profit and loss statement, and they give me their check register or their 12 bank statements, and it’s easy to pull out how much money they made, and then I go through all their checks, and they’ll tell me, “Hey, this was for I bought a new computer. This was office supplies I purchased. This was I cut myself a check.”
Then we’ll put together a very basic balance sheet of basically cash you had at the end of the year, any loans and any money that’s due to you, and at a very basic level and P and L, a profit and loss statement. How much you made, what you spent, what did you make at the end of the year.
Generally, that information is going to be used to prepare your tax returns, and, again, depending on whether you file as an individual, which would go on your 10-40, as a partnership, which would go on your form 10-65, an S Corp, which would go on your form 1120-S, that information would be the same on any of those. Some of the software that you could buy, and even some of the free software, will download your bank statements everyday in real-time and will categorize it for you after it learns who the vendors are. If it sees that you’re always spending $25 at a Staples, it’s going to automatically put that into office supplies, so it makes it very, very easy. You could check it on your phone. You could even give your accountant online access to that, and they can make any adjustments that they need, so it makes it very easy.
People have said, “Do I need to keep all these receipts? Do I need to keep all those statements?”
If it makes you feel better. Frankly, I don’t think there’s a real need for it since you could get everything online. Use a credit card that’s just for the business. Have it in the business name. I think it’s important. Also, it gives another air of legitimacy to it. Have a bank account in the name of the business. Again, legitimacy. You always want to show that you’re in this business for a profit-motive. Reason being is if you’re generating losses, if this is an actual business that you’re active in, you could deduct those losses on your tax return.
But you’re always at risk with the IRS coming back to you and saying, “This is a hobby, and we’re not going to let you deduct those losses.”
It’s really a facts and circumstances analysis. If you make models in your free time of, let’s say, dollhouse parts or something like that, and you sell it, but in one year you spent way more on equipment and you generate a $5,000 loss, IRS says, “Wait a second. This isn’t really a business.”
So some of the things that get you to that level for the services … Look, if I have a business credit card, a business business account. I have a business plan. I have books and records. I’m keeping contemporaneous records. They’re going to see. “You know what? This is a business,” because not all businesses make a profit. You could still be cash-flow positive in a business and have a tax loss because of depreciation, interest expenses, things like that. The more recordkeeping you could do, it just gives you another leg to stand on in the event of an audit.
Will Bachman: Let’s talk about nexus issues, which is probably really easy for consultants not to be aware of. If you do work in another state, another city, what are some implications that you need to talk to your accountant about?
Jonah Gruda: Another good question. States want their money, so each state has their own sales and use tax issues. Each state has their own nexus issues. A lot of the states used to have a three factor formula of how they tax income. Do you have payroll? Do you have rent? Do you have fixed assets in those states? But at a very basic level is think about, “Where am I performing those services and where am I earning my income?”
Will Bachman: So let’s take a real simple example. Let’s say someone lives in New York City and they do a project for four months of the year, and conveniently one-third of their income that year was from projects in San Francisco. What would that person need to beware of?
Jonah Gruda: There’s a potential for California filing requirement. You also need to look of how you were paid. Who was paying that person? Is the check being cut from a company out in New York and it was paid to New York, or did someone receive the service income while they were actually in California? Did they get a 1099 that shows its California source? If it is, you’re definitely going to have a filing requirement. There’s a little bit of gray area, but it’s really facts and circumstances. But the thing to keep in mind is if you’re earning income, if you’re performing services in a state, you may have a state filing requirement. Each state has their own rules and thresholds on what and how they’re going to tax that income.
Will Bachman: So let’s say it meets the threshold. Let’s say it was a client that only has operations in California, and you did a project there, and the 1099 says that. What are the implications. Are you going to have to end up … And you live in the New York City, let’s say. Are you going to have to end up paying more tax, or is it that you just are going to have to file a California state taxes and that somehow gets a credit against your New York? How does that all work out?
Jonah Gruda: Yeah, you actually picked two great states, because if you’re a New York City resident, your tax is very high. If you’re a California resident, your taxes are very high.
Will Bachman: I’m not sure those are great examples.
Jonah Gruda: It makes the analysis a little bit easier. If you’re earning income and you have a filing requirement in that state, you’re obviously going to pay income tax to that state on just that prorated share of income that you’ve earned in that state. So in this case, if one-third of my income was generated in California, I’m going to pay California tax on one-third of my income. However, I’m a New York City resident, so I’m going to pay tax to New York on 100% of my worldwide income from all sources. The good thing is you are allowed a credit on your New York State taxes for taxes paid to other jurisdictions.
The reason why I said, “Oh, this is a good example,” is the highest New York City, New York State rate is very similar to the highest California rate. It’s just about a dollar-for-dollar credit. The rub is, “What if you’re performing services in California and you live in Florida, where there’s no state taxes?”
Well, you don’t get a credit, so you’re out of luck there. Or you live in a state that has a 5 or 6% tax rate, and you pay taxes to California. You’re not going to get the full credit, because you can’t get accredited taxes more than your state tax liability is.
Will Bachman: For that work?
Jonah Gruda: For that work.
Will Bachman: So it’s not like you could get a credit against all of your tax for the two-thirds of the year. It’s for that part of the year, your tax would have been $100, but now it’s $150, so tough luck. You’re going to have to pay $150.
Jonah Gruda: Think about it this way. The states don’t want you to pay tax on the same income twice.
Will Bachman: Gotcha. Alright. But then it doesn’t work well for the other direction. If I’m in New York, and I go do work in Florida, I guess, where there’s no state tax, it’s not like I pay zero for that third of the year and I get to-
Jonah Gruda: No, New York’s still going to tax you on 100% of your income.
Will Bachman: Okay.
Jonah Gruda: Because your taxed at basically where you’re a statutory resident or your domicile, basically.
Will Bachman: So it’s never going to lower your state tax, but it could increase your total taxes paid.
Jonah Gruda: It could increase your total state taxes paid, but remember: it could also mitigate your resident state taxes as well, because you get a credit.
Will Bachman: Okay, so I guess this is an important thing for anybody who’s doing work in a different state, any kind of alarm bells should ring, and you should be talking to your accountant about that.
Jonah Gruda: Yeah, keep a record. Keep a calendar. Outlook, on your phone, Excel. Every time you get paid, write a little memo or a note on the back of it or something. “Project XYZ in San Francisco. These are the dates.”
And then you and your accountant … Well, the accountant could help you make the determination of your filing obligations.
Will Bachman: Great. Some big deductions for independent professionals that they might not be aware of. We already talked about SEP IRA, where you could put in a lot more than typical personal IRA, up to, you said, I think 50-something-thousand.
Jonah Gruda: Yeah, for defined contribution plan, it’s 54 thousand. You could even have a simple 401K. You could put $18,000 into. Much, much higher for a defined benefit plan. SEPs, you could do $6,000. Besides that, there’s something called section 179, which is another great freebie. Certain qualifying assets that you purchase to support your business, you can write off the cost 100% in the first year you place those assets in service, so if you bought a computer or you bought a monitor, any type of production equipment or equipment that you need to support. Let’s say that you bought something that’s $30,000. Normally, you would have to recover that cost over the useful life of that asset.
IRS allows you to say, “Okay, I spent $30,000.” You could expense $30,000. That’s a big one to look at. Why it’s also important to keep good records of what your purchases are. Those are really the big ones. Think about anything that you’re spending money on in support of the business could potentially be a business deduction. The big one that’s disallowed now is entertainment. How that’s defined is going to be potentially a term of art. We don’t know, but that’s the big one. You used to be able to deduct one-half of your meals and entertainment expenses, now you can’t.
Will Bachman: You just referred to the new tax bill. Let’s move on to that. We also have some questions from listeners here that we’ll be asking. The first was around timing of when all these details will be worked out. So, tax law came out, not necessarily all the guidance. Jonah, what’s your expectation on when the defined detail and guidance is going to be available?
Jonah Gruda: You’re really putting me on the spot. We had a house bill in November. A senate bill shortly after that. We have midnight corrections and edits in the margin, and it was signed into law January 9th. The biggest tax overhaul that I think this country has seen was in 1986, and I think that took just about two years go through and vet it all out. This bill went through committee as part of the budget reconciliation process, and as such you didn’t need the full 60 votes to get it passed. We had 51 votes, I think.
There hasn’t been a lot of discussion. I mean, there’s been a lot of discussion, but there hasn’t been a lot of debate on what the legislative intent of some of the statutes are, so we really haven’t had a chance to say, “Put it through its paces.”
We have a 500-page bill. We have more than 500 pages of commentary from the senate and committees that provide some examples, but it’s like Alice and the rabbit hole. We go deeper and deeper. We need technical corrections for obvious sections of the bill that are technically incorrect or technically ambiguous, maybe. Technical corrections is a legislative process that can’t go through the budget reconciliation process, so depending on how good the administration is and how both sides come together, we may not get technical corrections. We need regulations to see how some of the statute gets applied in certain very specific circumstances. We need what’s called the “blue book,” which talks a little bit about legislative intent, but it’s basically the Joint Committee of Taxation, the senate’s committee on the tax bill, which goes a little deeper on how some of these rules apply, what they mean in literal language.
I think, if anything, we might start getting notices from the IRS on how their interpretation is. That’s not authoritative, but at least kind of gives you some idea of how Treasury is leaning. Here at our firm, my phone is ringing every day. I’m getting emails every day on, “Hey, what does this mean? Do I need to restructure? I’m starting a new business. What do I do?”
I have to tell them, “We just don’t know.”
I have my thoughts on what they mean, but I could be wrong tomorrow. One of the biggest things that everyone’s talking about is this 199A deduction, this 20% deduction of your business income. However, it’s not afforded to everybody. It’s only afforded to a qualified trader business. Well, what’s a qualified trader business? Interestingly enough, the term “trader business” only appears in the Internal Revenue Code in four different spots, and there’s no bright line definition of what’s a trader business.
One statute, one part of the law, defines it separately from the other, so we just don’t know. All business get this deduction, which is this 20% deduction, except for specified service businesses. The IRS says, and I’ll quote, “A service business is a business involved in the performing of services in the fields of health, law, accounting, actuarial sciences, performing arts, consulting, athletics, financial services, and brokerage services.”
And then, the last bullet, just to put the nail in the coffin, that makes a very, very big gray area is: “Any business where the principal aspect of the business is the reputation or skill of one or more of its employees or owners.”
Now if anyone knows what that means, I want them to call me immediately. We need guidance on what that means. We do have a little bit of a carrot, right? If you’re a married taxpayer, and your total taxable income is under about $415,000, you still get the 20% deduction, it’s just prorated a little bit. If your income, and you’re a married taxpayer, and you are one of these service businesses, is under $315,000, you still get the 20% deduction. But if you’re a specified service business and you’re over that income limit, you don’t get the 20% deduction. If you are a qualified business, and you make over that threshold, then there’s another limitation. There’s a wage limitation. There’s a basis limitation of assets that you have, of how they limit that 20%.
This is brand new and there’s a lot of ambiguity. We don’t know how losses apply from one business offset income of another. We don’t know how interest expense with tiered partnership works. These are complicated issues, so we need to really understand what the intent was with the drafting. It basically drops the highest marginal rate down from 37% to 29.6%, which is a lot closer to the corporate rate.
If the corporate rate is 21%, and you have the 23.8% net investment income tax, federally you get to 44.8%. But now, the highest rate potentially for flow-through entities, whether you’re an LLC, S Corp, or sole proprietor, it’s 29.6%.
Will Bachman: It sounds like no matter how much we ask or how many advisors you ask right now, basically there’s just no guidance. The guidance doesn’t exist explaining these issues.
Jonah Gruda: Yeah, and there I just give some caution. There’s a lot of material out there. There’s commentators, there’s bloggers, there’s other law firms and accounting firms that are putting things out, and I’d just be weary. Anyone that says they have the answer, I would just give a pause to that, because we just don’t have any guidance yet. It’s unclear whether income refers to the taxpayer’s taxable income from all sources or just qualified trader businesses. My guess is that it refers to all sources. I don’t know.
I mentioned about tiered partnerships. We need some real guidance. However, one of the big things that I’m sure people have been talking about is this loss of your state and local tax deduction.
It used to be if you’re in a high tax state like New York, New Jersey, Connecticut, where housing prices are through the roof, and you pay a lot of state income taxes, you would get that deduction. I know that was one of my biggest deductions. Putting AMT aside, because while we thought they were going to eliminate the alternative minimum tax, we still have it, but it’s a much higher threshold, which means less people, much less people, are going to be affected by it. But now you’re only allowed to deduct state and local taxes up to $10,000.
If you’re paying $15-16,000 in a high-tax state, you lose that. The benefit of that 20% deduction, if you qualify, is huge.
Will Bachman: So we’re losing that deduction, and it sounds like on the other question about the specified service businesses, right now there’s just not clear answers that any advisor could give because the technical guidance is not there yet.
Jonah Gruda: Yeah, I mean you could … I wouldn’t say Congress is ever efficient on anything, and unless you really understand the legislative intent, you can’t interpret it. Interestingly enough, “what’s a specified service business” references another esoteric section of the tax code, which actually included architects and engineers in that as a service business, but in this writing the 199A excludes architects and engineers from the definition of a service business. What that means is if you’re an architect or an engineer, you automatically qualify for the 20%.
Will Bachman: One question I’ve heard some people ask is, “What about income that’s coming from intellectual property that my firm has created?” So maybe I’m doing consulting services, but what if my firm has created intellectual property and we have separate revenue coming from that. Maybe you developed a training module, or something, and you get revenue whenever that training module is delivered by someone.
Jonah Gruda: That’s a good question. I’ve never really thought about that, but thinking out loud, I would imagine if you’re receiving royalty income from use of your intellectual capital, potentially that income might be, because looking at what’s a specified service business, I don’t see that in the definition. It makes it even more important for good recordkeeping in terms of analyzing your revenue streams is, “What’s service income? What’s not service income?”
So maybe in that situation there would be an opportunity to get the 199 deduction, but remember, if you’re not a service business now, and your total income is over the threshold, over the 315, you’re only able to get that 20% up to 50% of the W-2 wages that that business pays out or 25% of your W-2 wages plus 2-and-a-half-percent of the unadjusted bases of your assets. Let’s say, in your example, Will, you did get royalty fees from the use of intellectual capital and you generated income, but because you are sole proprietor or one of these other types of flow-through businesses, you didn’t really pay out wages and you had no hard assets, you’re limited to zero.
You may not get there in the end anyway.
Will Bachman: Got it. Any other major changes that people should just be aware of that we haven’t talked about yet from the new tax law?
Jonah Gruda: Again, this is the biggest sweeping change in over 30 years. There’s a lot of complicated things. In terms of the listeners on this call, I don’t think that there’s many changes in the law that really impact them on a day-to-day. One of the other major changes is the business interest limitation. They’ve limited that to a 30% limitation of your income. You could opt out if you’re a specified real estate trader business. If you’re a small business, you don’t have that limitation. There’s new depreciation rules as well. I’m not sure that’s going to really impact the freelancer independent contractor. I will say the individual mandate was eliminated, but that only goes into effect next year, so you still have to have health insurance for 2018, or else you’re going to get the penalty.
Will Bachman: Most people probably want to have health insurance anyway.
Jonah Gruda: Most people want to have health insurance. But I think the biggest change is really this 199A deduction. It really affords a huge, huge deduction for certain taxpayers if the requirements.
Will Bachman: Great. Jonah, this was awesome. Thank you so much for taking some time out to walk us through all these aspects, and what’s the best way for listeners to get in touch with you or your firm?
Jonah Gruda: Oh, it was my pleasure, thank you for having me. I’m a tax partner at Mazars USA LLP. They could look us up on the web, and my bios on the list of partners there.
Will Bachman: Jonah, thank you so much.
Jonah Gruda: Thanks for having me, Will.