Income Tax 2018: Strategies for High Income Sole Proprietors
As we head into the second half of 2018 and with tax season well behind us, I am reminded of an old saying, “you can never be too prepared.” With that said, if you are a sole proprietor or an owner of a single member llc , you may want to dig into these strategies as your income starts getting clearer at the end of the year. And as always, please consult with your tax professional before implementing any strategies.
Disclosure: MyLife Financial, LLC is not a Certified Public Accounting firm nor are any of its representatives Certified Public Accountants. You should seek a tax professional to adjust for any changes in tax legislature.
Qualified Business Income Deduction
The Tax Cut Jobs Act brought forth some changes to the tax code. It doubled the standard deduction for everyone, got rid of some itemized deductions, and brought on Section 199A deductions for small business owners. What does this mean if you are self-employed? It means you can deduct up to 20% of your net business income at the end of the year, with some restrictions of course. Say you made $100,000 at the end of 2018, you would only have to pay tax on $80,000.
What to look out for: Remember those restrictions? For one, you still must pay Self-Employment tax on your entire net business income. But the biggest caveat comes to those who are in the service industry. There are income limitations that phase out this deduction. If you are in the service industry, this deduction starts phasing out at $157,000 if you are single and $315,000 if you are married.
Switch to an S-Corp
Many times, sole proprietors may start off by simply filing an assumed name certificate with the county otherwise known as a “DBA” (Doing Business As) and after a few years in business, change their entity to a limited liability company (LLC). As an added step to help ease the burden of paying self-employment tax, some should consider switching their tax status to an S-Corp. By switching to an S-Corp a sole proprietor can separate their wages into two categories, business income & employee income. The later is responsible for self-employment taxes while any distributions from the former is not. For example, say you made $150,000 for the year. If you remain a single member llc or are doing business as an assumed name, you end up paying self-employment tax on all net business income. However, if you elect using the S-Corp status, you can reduce the amount of self-employment taxes you owe by paying yourself a fair wage and only being responsible for taxes on your employee wages.
What to look out for: You must pay yourself a reasonable compensation or it may raise a red flag to the IRS. What does that even mean? The definition of “reasonable compensation” is still vague. It can depend on your industry, the services you are providing to the S-Corp as a member or non-member, and capital & equipment. These can be very subjective so discussing this strategy with an experienced tax professional is recommended.
Establish a Solo 401(k)
One of the best ways to save taxes in 2018 as a sole proprietor is to establish a Solo 401(k). In 2018, you can defer up to $18,500 as an employee. That is $13,000 more than an IRA, $6,000, more than a SIMPLE, and without the income stipulations of the SEP. What better way to reduce your taxes than to defer and grow your nest egg. After all, we all end up retiring at some point of our lives. A great way to maximize the contribution to an Individual 401(k) is to become an S-Corp. You would be able to defer $18,500 as an employee and as an employer, up to 25% of the compensation you pay yourself.
What to look out for: With a Solo 401(k), the business cannot have other full time W-2 employees. This retirement plan is set for family owned businesses like husband and wife. For individuals who are not set up as an S-Corp, there is a special computation to help figure out your elective and non-elective deferrals; this is like figuring out your employee and employer deferrals.
There you have it folks. Happy tax planning for the remainder of 2018. There is still plenty of time to implement the strategies mentioned above.
MyLife Financial is a fee-only financial advisory firm providing objective and independent advice virtually. Our clients are busy professionals that face daunting questions of how today's financial decisions will affect their long-term financial success. Everything written is strictly for informational use only. Please seek the advice of your CPA, Attorney, or financial professional before implementing any strategies.
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