Breaking Up the Fog: Clearing Up 5 Tax Misconceptions
In San Clemente, California, we are spoiled by an abundance of sunny days. I moved to the Southern California from Boston almost nine years ago.
I still marvel at the sun’s therapeutic powers and have yet to take it for granted.
But we also have our fair share of grey days. May Grey and June Gloom are real phenomena.
A consecutive string of these foggy days feels like you are trapped in a season of True Detective.
Taxes work the same way in our lives.
January 1st rolls around and that thick cloud of tax season approaches. Emails flow in from our accountant. Tax documents begin to surface in late January and early February.
Business owners, you know this fog well. Taxes overwhelm and make no mistake you did NOT start your business to become a tax pro.
Allow me to help break up the fog on a few tax topics aren’t always clearly understood by business owners.
Rest assured, sunny days are ahead.
1. Self-Employment Taxes
Self-employment taxes apply to three broad categories of business owners:
Sole Proprietors – All profit
General Partners – The non-passive portion of their profit distribution
S-Corporations – The portion of income classified as salary
The 15.3% self-employment tax is made up of a 12.4% Social Security tax and a 2.9% Medicare tax.
You only pay Social Security tax on income up to $168,600 for 2024.[i]
You may the Medicare tax on all self-employment income with an additional 0.9% tax on income above $200,000 for single and $250,000 for married filing jointly.
The added burden of self-employment taxes lies in the fact that they are not technically payroll taxes so they are not withheld when you pay yourself. You need to account for self-employment taxes with quarterly estimated payments.
Last week I wrote about the nuances of making estimated payments and best practices to avoid underpayment penalties which are 8-10% for tax year 2024.[ii]
Work with a tax professional or financial planner on which Safe Harbor rule you should follow when making estimated payments. Your approach can change with inconsistent income from year to year.
One silver lining of self-employment taxes? You can deduct half of your SE taxes from your income.
As always, consult with a tax professional for guidance on your specific situation.
2. Separate Personal and Business Expenses
You may be tempted to use the same bank account and same credit card for business and personal spending.
Don’t do it.
Ultimately, commingling businesses and personal activity creates MORE fog for you and your tax preparer.
Using one card/account for both may lead to missed opportunities for deductions or worse trigger an IRS audit.
Lastly, if your business is set up as an LLC and you are commingling spending, you may be at risk of “piercing the corporate veil.” The LLC is in place to protect you from the liability of your business and vice versa. It’s essential to maintain that separation.
3. Business Profit is Taxable No Matter If It’s Pulled Out!
Regardless of whether you transfer money from your business bank account to your personal bank account, any profit earned by the business in a year is taxed.
You aren’t skirting any taxes by keeping funds in your business account. Remember this so that you are not caught off guard with a higher than expected tax bill come April.
4. LLCs are not Tax Saving Vehicles
There is a ton of misinformation around the utility of the Limited Liability Company classification.
To be clear, LLCs are legal structures not tax classifications.
An LLC is taxed by default as either a sole proprietorship (if single-member) or a partnership (if multi-member) though the LLC owner can elect to be taxed as an S-Corporation or in some cases a C-Corporation.
The tax treatment depends on how the LLC is structured and how profits are reported.
Limited liability is the benefit of the LLC not tax savings.
5. State Income Tax Deduction Limits
Currently, taxpayers can only deduct up to $10,000 in state income taxes from their federal tax bill.
However, many states offer business owners a workaround that allows them to pay the full amount of the state tax liability directly from the business BEFORE their income and expenses are passed through to the business owner’s personal tax return.
Why is that important?
Paying the state income tax at the entity level avoids the $10,000 state income tax deduction limit.
Instead of hitting the $10,000 limit, business owners can deduct the full amount of their state taxes at the entity level of their business. This allows you to use that $10,000 limit towards the property taxes on your home, for example.
In order to capture this benefit, you must abide by state-specific rules and procedures. More to come on this in next week’s post.
There are plenty more misconceptions but these five tend to come up repeatedly in conversations. If you need clarity on any other topics, I’m a complimentary Zoom call away.
Two Palms Planning LLC, doing business as Two Palms Financial, is a registered investment adviser registered with the State of California. Registration does not imply a certain level of skill or training. The content of this publication is for informational or educational purposes only. This content is not intended as individualized investment advice, or as tax, accounting, or legal advice. The information contained herein is based on current tax laws and regulations, which are subject to change. Although we gather information from sources that we deem to be reliable, we cannot guarantee the accuracy, timeliness, or completeness of any information prepared by any unaffiliated third-party. This information should not be relied upon as the sole factor in an investment-making decision. Readers are encouraged to consult with professional financial, accounting, tax, or legal advisers to address their specific needs and circumstances.
[i] https://www.irs.gov/businesses/small-businesses-self-employed/self-employment-tax-social-security-and-medicare-taxes
[ii] https://www.dol.gov/agencies/ebsa/employers-and-advisers/plan-administration-and-compliance/correction-programs/vfcp/table-of-underpayment-rates
