Friday, January 4, 2008

Special for the self-employed: HSAs, SEPs, and whether it's better to be a Sole Proprietor or to LLC/S-Corp

So. Today I spent a mind bending, and highly informative, 90 minutes with a tax advisor. I needed more information on my tax situation, and I wanted to know if it was better for me to LLC or S-Corp myself, or to remain the Sole Proprietorship that I already am.

I also learned some sneaky tricks, with HSAs and SEPs (Health Savings Accounts and Simplified Employee Pension plan). With an HSA, you fund it, and then reimburse yourself for medical/dental/eye care costs not covered by the insurance. This is also highly relevant to me, as I learned that any non-premium healthcare expenses are not deductible in my taxes (I thought they were). However, with an HSA, the money you put in is not taxed, and when you reimburse yourself for a healthcare expense, you are not taxed on that money. The amount you can contribute each year is dependent on the amount your insurance deductible, and depending on your healthcare needs, this can be quite a significant tax savings. Also, unlike flexcare accounts, the money deposited does not have an expiration date. Instead, you can put it in to an interest-bearing account and let it sit there gathering interest until you actually need it. Interesting tidbit: even buying small things, like Neosporin or cough drops, is covered by an HSA!

With the SEP, it’s a bit more complicated. For someone self-employed (e.g. ME), an SEP is a way to get the dual action of investing in two retirement accounts each year. This is a similar idea to a permanent employee contributing to both an IRA and a company-sponsored 401k in the same year. One of the big pluses to the SEP is that the contribution limit is much higher than an IRA. To wit, one can contribute 25% of their income, or $46,000, whichever is lesser. So even if you're uber-successful and earning $300k per year and are locked out of contributing to an IRA, you can still contribute to an SEP. In addition, it is possible to fund an SEP up until October of the following year! For example, if you realize you are going to have a banner year [before submitting your taxes on 15 April], you can have your CPA complete (NOT file) your taxes and submit your tax payment. Then, when you contribute the forecasted amount to your SEP account (no later than 15 October), your CPA can then file your taxes (if you contribute more, you will also receive a refund, because SEP contributions garner a tax break). My advisor today noted that if you haven’t already maxed out your IRA, it’s not really beneficial to take so much time to fund an SEP (though there's nothing that says you can't) – it’s better to do this if you realize you are going to have a significant amount of income that would allow you to do this (aka a windfall, or more money than you know what to do with) in addition to fully funding an IRA. SEP funds are taxed when they are withdrawn, so self-employed folks get a tax break the year(s) they contribute to an SEP. Many thanks to the patient and unfathomably knowledgable Jonathan at H&R Block who spent 90 minutes explaining and re-explaining everything until I properly understood this (and everything else)!

Back to my original question to Jonathan: is it smarter for me to LLC/S-Corp or remain a Sole Proprietorship? The answer is a little fuzzy. I’m right at the breaking point for whether or not incorporating makes a noticeable difference in my tax bill. As it stands with my projected income for this year, I could have an extra $600-800 at the end of the year if I LLC/S-Corp myself. "That’s great!" You might think. However, with that savings comes an inordinate amount of paperwork (payroll taxes, social security payments, FICA, etc – yippee!). This is also based on a projection of what I hope to earn this year, which is about 30% more than 2007. For me, I also have to take into account that my contact at my primary client is in negotiations with the other executives to make me a full-time, permanent job offer. While I’m loathe to give up my freedom, I’m keen to have a steady, full-time income (for a couple years anyway)…so I will consider any offer they make (I already know my No, Maybe, and Yes prices).

On another note about tax implications of LLC/S-Corp'ing, you can lower your taxes this way: give yourself a reasonable (stress the reasonable) salary, and then everything else is profit. You will not pay taxes on the profit. Again, you have to have a reasonable salary -- $1 is not a reasonable salary. Definitely talk to your tax advisor on this one so that you fully understand how this works, but know that this is a good way to minimize your tax bill.

More information about SEPs can be found at: the IRS website about SEPs.

The appropriateness of a Sole Proprietorship vs LLC/S-Corp is something that an individual should talk to their tax advisor about. The above is what I learned today and how it reflects on my personal situation, and I will likely make a decision in the next month or so, based on whether or not I receive and accept the possible offer from my primary client. As to the HSA and SEP information, that is for all us freelancers out there (though definitely talk with a tax advisor before setting up either account, so you know exactly how it works, and how it will work for you and your personal financial situation).


Anonymous said...

Make sure you check what the tax rate is for your net profit in your state for an LLC. The amount
I was going to save with and LLC ended up going right back to the state, so really it is not worth it. Taking write-offs for mileage and home business use are the two largest deductions that I have.

Anonymous said...

The statement that you do not pay taxes on the profit is not correct. You still have to pay income taxes. If the LLC is a "disregarded entity" you pay taxes on the profit indicated on Schedule C. If the LLC is an S Corp, or you just form an S-Corp, you pay taxes on the "partner's share" of the income that is reported on the K-1 from the S-Corp. What you CAN reduce is the amount of self-employment taxes that you pay. For example, you will pay SS and Medicare taxes on salary, but not on "dividends" paid by the S Corp. Just remember that the IRS is wise to this scheme, and will look to see if you are trying to avoid payment of SS and medicare taxes by paying yourself a salary that is too low.