A Little Bit About Sole Proprietorships, Part 2

19162227Sole proprietorships get a lot of bad press. A lot of accountants and attorneys like to run down sole proprietorship’s. But I don’t mind sole proprietorships — I operated my business as a sole proprietorship for a long time.

Here are some of the advantages of operating as a sole proprietor:

  • They are easy to get into. There’s no real paperwork to fill out. You just start conducting business.
  • They are simpler to administer and therefore your accounting and legal fees will generally be lower.
  • As your business grows you can always convert to something else. As you go up the ladder from sole proprietor to corporation, it’s easy. But it’s hard to go down the ladder from a corporation to a sole proprietorship.

There are also plenty of disadvantages:

  • The self-employment tax is a big hit because that’s 15.3% on top of any income taxes that you will owe.
  • You are not considered an employee of your sole proprietorship (except for self-employment tax purposes) so any money that you take out of the business is not deductible as wages.
  • Meaning, you are taxed on your net income even if you take no money out of the business. So say you have $50,000 of net income from your proprietorship but you live on savings or you live on your spouse’s income and you take no money out of your sole proprietorship for yourself. It doesn’t matter — you still pay taxes on $50,000. And even if you withdraw all $50,000 for yourself, that withdrawal is not deductible as wages, so you’re still paying tax on $50,000.
  • There is no way to split income. That’s a benefit of being a sole proprietorship – you get to keep it all. But it’s also a downside to being a sole proprietorship — you are taxed on all of it.
  • The tax treatment of health insurance is also much less “tax friendly” when you are a sole proprietor compared to when you are a rank-and-file employee. A full discussion of health insurance is another discussion for another blog post.

 

A Little Bit About Sole Proprietorships, Part 1

When we talk about sole proprietorships, there are a lot of clichés that get thrown around — things like “hang out your own shingle”19162227 or “you and your business are one.”

Sole proprietorships are easy to form. In many cases there’s no special paperwork that has to be filled out — you just start conducting business.

Business income and expenses are reported on the business owner’s tax return on an attachment called schedule C, attached to the owner’s personal 1040.

The business owner will pay income tax on the proprietorship’s net income. Business owners also pay self-employment tax.

What is self-employment tax?

Self-employment tax is something that surprises a lot of newly self-employed people — they know about income taxes but a lot of times they don’t think about the self-employment tax and this can be a big deal because it can cause a big tax hit.

If you ever worked at a job and you looked at your pay stub out, you probably saw amounts taken out for FICA taxes. Self-employment taxes are the self-employed person’s version of FICA taxes.

When you’re an employee, 7.65% of your wages are withheld for FICA taxes. Your employer kicks in another 7.65%.

When you are self-employed, for purposes of FICA taxes, you’re considered both employer and employee so you will have to pay 15.3% (7.65 x 2) self-employment tax on your tax return. This is in addition to the income tax that you will owe.

In Part 2, I’ll look at the advantages and disadvantages of being a sole proprietor.

Things Tax Preparers Say: S-Corporation Compensation (Again!)

ID-100264846This really should be filed under “Things Tax Preparers DIDN’T Say”.

And again it’s about S-corporation compensation.

SCENARIO:

S-corporation owner hasn’t been paying himself a salary despite having large corporate net income, and despite taking large withdrawals of money from the corporation. Those withdrawals had always been called “shareholder distributions.”

On the owner’s personal return, all of the corporate net income was reported as ordinary income. He also makes contributions into an IRA.

PROBLEM:

The salary issue is the obvious problem here. But it’s not the only problem.

Normally, contributions into a traditional (pre-tax) IRA are deductible on your personal tax return. But that’s only if you have “earned income.”

Pass-through income from an S-corp is not considered earned income.

He had nothing else happening on his tax return other than the S-corp and IRA parts.

Because he had no earned income, his deposits into the IRA were not deductible.

Worse yet, because he had no earned income, he also owed an excise tax on those IRA contributions because he made “excess contributions” into an IRA.

So to recap: he was working in his S-corp “earning” all of the income the corporation generated. He was reporting this income as ordinary income on his personal tax return. But because he wasn’t paying himself a salary, he had no “earned income” under tax law, so he was reporting all of this income on his tax return, not getting the deductions for the IRA contributions, and paying an excise tax on the IRA contributions as well!

And his accountant had never said a word to him about the need to pay himself a salary or the issue with the IRA.

Things like this don’t shock me anymore.

It would be one thing if the accountant had brought these issues up but the client decided to just keep doing things the same way (this does happen).

But in this case the conversation had never, ever happened.

And since I’m on a roll, I’ll continue with my rant even though the word count on this post indicates I should stop.

HERE’S A BONUS PROBLEM:

The bonus problem is: the propensity that we tax folks have for saying the following: “Oh well. The client gave us financials that showed $0 of compensation. We prepared the return based on that information. Our engagement letter states that we will prepare the return based on the information the client provides, without review or audit. If tax advising is desired it will be given under a separate engagement agreement. If the client doesn’t ask for help on the S-corp salary or IRA issue, it’s not our problem.”

Sure, that’s what our insurance providers make us say in our engagement letters. But I don’t think that absolves us from at least MENTIONING the salary issue, and bringing the IRA issue to the client’s attention.

But I suppose this is a topic best addressed in its own blog post.

Image courtesy of Stuart Miles / freedigitalphotos.net

Entrepreneurial Maturity

I wish I could take credit for the term “entrepreneurial maturity” but I can’t. Credit goes to Jason Jones, a licensed public accountant who offers CFO services to businesses. In writing about his challenges in working with businesses, Jason says:

(T)he challenge I immediately discovered was in finding small business clients who had the entrepreneurial maturity to realize what they needed to know financially in order for their business to thrive and survive, and who had a strong awareness of their own conscious incompetence accordingly.

All too often, I got referrals from professionals and inquiries from prospective clients, only to engage in power struggles with the client in formulating business/financial strategies, which were often rooted in a combination of unconscious incompetence (they don’t know that they don’t know) and “Founder’s Syndrome” (since they’re the founder/owner, they know everything about the company they need to – they often hire “yes men” to help reinforce their flawed way of thinking). But I digress.

In other words, a business owner who has entrepreneurial maturity knows what they don’t know.

The challenges Jason writes about in his blog post are the same challenges I have faced in working with some small businesses. Here’s an example of a real conversation that took place with a business owner who’s business was always struggling with cash flow in its first couple of years of existence. The owner had been complaining that his advisers weren’t asking the right questions, so I was trying to be proactive:

Me: “Let’s look at where the money is coming from and where it’s going and start setting up strategies.”

Business owner: “Well, a growing business consumes resources. No business in its first few years has a big profit margin. That’s just the way it is.”

Period. Conversation over.

No review of finances was done.

ID-100260221This owner would go on to periodically complain about how hard it was to run a business, and how no one was helping him.

That’s an example of an owner who hasn’t matured enough to realize that he was talking to a knowledgeable professional who was trying to help him. Instead, the owner made a declaration that indicated he knew all about it and nothing further needed said. Yet, this same business owner still complains that the professionals around him aren’t giving good advice.

This scenario happens far more than it should.

As a professional, it’s hard to deal with.

I like working with startups, especially the people who started like me — on the side, from scratch — and have grown. But logically, these are the folks who have the least entrepreneurial maturity.

Sometimes I catch myself lacking in entrepreneurial maturity too.

I’m not sure what the solution is.

Time. Experience. A realistic view of the struggles of running a business.

And an acknowledgment that as business owners, there are things we won’t know.

Image courtesy of Stuart Miles / freedigitalphotos.net

IRS Says Online Sorority Is Not Tax Exempt

computer-room-415141_1280Tax law says certain clubs and social groups are exempt from income tax. This can include college sororities. But according to the IRS, this doesn’t apply to sororities created by online schools where the sorority members never meet face-to-face.

Background

A national, for-profit college (the IRS ruling didn’t say which one) started an online sorority. Reading through IRS Letter Ruling 201434022, it appears that this sorority operates similar to other sororities, except almost all activities take place online.

Section 501(c)(7) of the Internal Revenue Code says organizations organized as a club for organized for recreation is exempt from paying income tax. This would seem to apply to a sorority, but the IRS relied on a series of old revenue rulings from the 1950s thru the 1970s, and a court case from 1965, in ruling that an online sorority doesn’t qualify for tax-exempt status.

What is “Social”?

The IRS ruled that because the group didn’t have face-to-face meetings, it didn’t qualify. From the ruling:

Commingling and the promotion of fellowship are not a material part of your operations. Commingling is a necessary and material part in the life of an organization exempt under Sec. 501(c)(7) and is deemed present if such things as meetings, gatherings, and regular facilities are evident…. Face-to-face interaction is important for members of a social club. Organizations that do not afford opportunities for this personal contact among members are not entitled to exemption under Sec. 501(c)(7), even though they may be organized not for profit with no part of their earnings inuring to the benefit of shareholders.

In reading through the rest of the ruling, it appears to me that the IRS may be open to saying an online group could qualify for not-for profit status if there are recreational aspects to the group and/or if the group forms local chapters that engage in periodic group events and activities:

While you engage in some face-to-face interaction at your conferences held once a year, the majority of your activities are performed in an individual capacity and over the Internet rather than face-to-face. Additionally, the topics discussed at your face-to-face meeting and over the Internet pertain more to your organizational aspects rather than the promotion of any recreational or other nonprofitable purposes. Further, you do not expend money on social or recreational purposes.

Conclusion

It looks like the group has the right to appeal this ruling. If I were them, I would immediately update bylaws and create local chapters that have periodic meetings and social outings and see if that would help get the not-for-profit status approved.

Image courtesy of user “Stux” on Pixabay.com