[[Independent Consulting - the setup]]
[[Some Tax Basics For IT Consultants]]
As I mentioned in my [[Independent Consulting - the setup|previous post]], I received a great offer a few months ago to become an independent consultant. After determining I wanted to go corp-to-corp (vs 1099 or W2) the next step was to pick my entity setup. Before you choose an entity you should understand the [[Some Tax Basics For IT Consultants|tax ramifications]] of those entities. Here are the basic choices with what you need to know if you are going to hang out your own shingle:
These are the simplest entities to setup, maintain, and handle for taxes. They are also the cheapest to form in regards to "renewing" your entity. But all income is then subject to [[Some Tax Basics For IT Consultants|Self Employment (SE) taxes]], by default. This rate is about 15% of your net profit. Ouch. It's better to form an LLC but elect to have it taxed to receive C or S Corp treatment. An S Corp election makes sense if you want to save on the SE taxes. A C Corp election makes sense if you want to get the most deductions for fringe benefits. I chose S Corp election since that seems to be the consensus election for single-person independent IT contractors such as myself. Hopefully this is the right decision for my bottom line.
At this point I'm not really sure why anyone in my situation would pay the extra fees and be saddled with the extra burdens of going the full S Corp route. A full S Corp requires additional fees to setup, is harder to dissolve, and requires extra paperwork that must be updated regularly (shareholder minutes, operating agreements, etc). Simply electing to have your LLC taxed as an S Corp seems to be "good enough" for tax purposes.
An LLC is merely a separate entity for liability purposes. By itself it's rather simple.
Only S Corps give you a way to take home some money without paying FICA (Medicare/Social Security). This is where the S Corp shines. The S Corp's earnings are reported on your personal return and FICA is only subject to the salary that you pay yourself. So the "distribution" of profits from the S Corp are not subject to FICA. You want to make these distributions as large as possible vs your salary, but you must still pay yourself a "reasonable" salary according to the IRS. If you pay yourself a dollar in salary and take the rest in distributions to avoid FICA the IRS will certainly not appreciate it.
However, "reasonable" in the context of a salary is open to interpretation. There is an interesting story
about how John Edwards, the VP candidate in 2004, made millions in S Corp profits in the 1990's as a lawyer, yet only gave himself a $360K/yr salary. That saved him about $750K in taxes in 1995 *alone*, more than twice his salary. The IRS was OK with it because a successful attorney can be expected to make about $360K/year.
You make the LLC S Corp election using IRS Form 8832
. This needs to be done very quickly after forming your LLC. Once you do the election to be taxed as an S Corp then S Corp taxing rules take over. This becomes confusing. When you read about self-employed individuals paying SE taxes you know they didn't take the S Corp election, since you become an "employee" of the S Corp and SE taxes are no longer required. More to come on that. So any advice you read regarding independent contracting, LLCs, SE taxes, etc needs to be scrutinized. Is the advice really for a self-employed individual, or for an owner/employee of an S Corp?
So why not just go S Corp directly and skip the LLC? LLCs are easier to dissolve if I later go back to being an employee and LLC annual expenses are much lower. There is also far less paperwork regarding Operating Agreements, shareholder minutes, etc. An LLC is mostly a pass-through taxing entity that still gives you the benefit of the "corporate veil". An S Corp is a true "corporation", an LLC is not. The IRS and states require all corporations to hold shareholder meetings and document important decisions with minutes where business decisions are made. This seems ridiculous for single shareholder S Corps but it is necessary.
One drawback to an S Corp is that since you will be an employee then your entity will need to provide unemployment compensation insurance to you (it isn't much). The paperwork is also more of a burden, but, if my calculations are correct, I should net *at least* an additional $4500 in tax savings. We'll see if I'm right. Granted, that missing FICA money lowers my Social Security payments in later life, but I really couldn't care less.
Personal Services Corporation
When you are a C Corp you need to be very careful that the IRS doesn't classify you as a Personal Services Corporation. A PSC is a corporation where the bulk of its income is generated by consulting services of the employee-owner. PSCs are taxed at a flat 35%. An S Corp can never be declared a PSC. This is last, and probably most important reason, why an independent IT contractor should form a S Corp.
When would a 1099 make sense instead of a separate entity?
...maybe when you have a lot of legitimate business expenses that relieve the SE burden. As a data architect consultant I really shouldn't have *that* many expenses. If your spouse's employer is covering your health insurance then the reduction in SE taxes for health insurance premiums isn't available to you so S Corp might be overkill. Also, if for some reason you don't want to contribute to a retirement plan then again an S Corp wouldn't make sense since you are not reducing your SE tax.
Next post...[[Tax Procedures]]