10

Currently I have a full time job (IT industry) but from time to time I do a side project.

Most of the times my clients agree to pay me cash as the amounts are not large.

However, last year there were two projects that qualified for 1099 which at the end of the year greatly affected my tax return.

To give an example - if my tax return was $5k - after adding two 1099 (about $2k total for both) my tax return was $120.

I'd like to know which type of incorporation would be the best fit for me to allow me to keep my full time work and business separate.

  • 8
    So what you are saying is that you made $2,000 doing side jobs and paid $4,880 in taxes on the $2,000 you made? Sounds like either you need a new accountant or you need to stop doing side jobs :) – Eric Petroelje Aug 19 '10 at 20:46
  • Agree, Frank might need a sober accountant :). Unless there is more to the story I can't see why he should suddenly owe more taxes than he earned on the side, providing that the original tax withholdings matched reality in the first place. – Timo Geusch Aug 19 '10 at 22:05
6

You should look into an LLC. Its a fairly simple process, and the income simply flows through to your individual return. It will allow you to deduct supplies and other expenses from that income. It should also protect you if someone sues you for doing shoddy work (even if the work was fine), although you would need to consult a lawyer to be sure.

For last year, it sounds like your taxes were done wrong. There are very, very few ways that you can end up adding more income and earning less after taxes. I'm tempted to say none, but our tax laws are so complex that I'm sure you can do it somehow.

  • Note that an LLC does not allow you to deduct supplies and other expenses from business income, you can do that without an LLC too. – Hart CO Apr 18 at 21:47
5

A tax return is a document you sign and file with the government to self-report your tax obligations.

A tax refund is the payment you receive from the government if your payments into the tax system exceeded your obligations.

As others have mentioned, if an extra $2K in income generated $5K in taxes, chances are your return was prepared incorrectly.

The selection of an appropriate entity type for your business depends a lot on what you expect to see over the next several years in terms of income and expenses, and the extent to which you want or need to pay for fringe benefits or make pretax retirement contributions from your business income.

There are four basic flavors of entity which are available to you:

Sole proprietorship. This is the simplest option in terms of tax reporting and paperwork required for ongoing operations. Your net (gross minus expenses) income is added to your wage income and you'll pay tax on the total. If your wage income is less than approximately $100K, you'll also owe self-employment tax of approximately 15% in addition to income tax on your business income. If your business runs at a loss, you can deduct the loss from your other income in calculating your taxable income, though you won't be able to run at a loss indefinitely. You are liable for all of the debts and obligations of the business to the extent of all of your personal assets.

Partnership. You will need at least two participants (humans or entities) to form a partnership. Individual items of income and expense are identified on a partnership tax return, and each partner's proportionate share is then reported on the individual partners' tax returns. General partners (who actively participate in the business) also must pay self-employment tax on their earnings below approximately $100K. Each general partner is responsible for all of the debts and obligations of the business to the extent of their personal assets. A general partnership can be created informally or with an oral agreement although that's not a good idea.

Corporation. Business entities can be taxed as "S" or "C" corporations. Either way, the corporation is created by filing articles of incorporation with a state government (doesn't have to be the state where you live) and corporations are typically required to file yearly entity statements with the state where they were formed as well as all states where they do business. Shareholders are only liable for the debts and obligations of the corporation to the extent of their investment in the corporation.

An "S" corporation files an information-only return similar to a partnership which reports items of income and expense, but those items are actually taken into account on the individual tax returns of the shareholders. If an "S" corporation runs at a loss, the losses are deductible against the shareholders' other income.

A "C" corporation files a tax return more similar to an individual's. A C corporation calculates and pays its own tax at the corporate level. Payments from the C corporation to individuals are typically taxable as wages (from a tax point of view, it's the same as having a second job) or as dividends, depending on how and why the payments are made. (If they're in exchange for effort and work, they're probably wages - if they're payments of business profits to the business owners, they're probably dividends.) If a C corporation runs at a loss, the loss is not deductible against the shareholders' other income.

Fringe benefits such as health insurance for business owners are not deductible as business expenses on the business returns for S corps, partnerships, or sole proprietorships. C corporations can deduct expenses for providing fringe benefits.

LLCs don't have a predefined tax treatment - the members or managers of the LLC choose, when the LLC is formed, if they would like to be taxed as a partnership, an S corporation, or as a C corporation. If an LLC is owned by a single person, it can be considered a "disregarded entity" and treated for tax purposes as a sole proprietorship. This option is not available if the LLC has multiple owners.

The asset protection provided by the use of an entity depends quite a bit on the source of the claim. If a creditor/plaintiff has a claim based on a contract signed on behalf of the entity, then they likely will not be able to "pierce the veil" and collect the entity's debts from the individual owners.

On the other hand, if a creditor/plaintiff has a claim based on negligence or another tort-like action (such as sexual harassment), then it's very likely that the individual(s) involved will also be sued as individuals, which takes away a lot of the effectiveness of the purported asset protection.

The entity-based asset protection is also often unavailable even for contract claims because sophisticated creditors (like banks and landlords) will often insist the the business owners sign a personal guarantee putting their own assets at risk in the event that the business fails to honor its obligations.

There's no particular type of entity which will allow you to entirely avoid tax. Most tax planning revolves around characterizing income and expense items in the most favorable ways possible, or around controlling the timing of the appearance of those items on the tax return.

4

I have a very similar situation doing side IT projects. I set up an LLC for the business, created a separate bank account, and track things separately. I then pay myself from the LLC bank account based on my hours for the consulting job. (I keep a percentage in the LLC account to pay for expenses.) I used to do my taxes myself, but when I created this arrangement, I started having an accountant do them. An LLC will not affect your tax status, but it will protect you from liability and make things more accountable come tax time.

  • +1; Also, I believe keeping very good records (or better yet, separate bank accounts) protects your personal assets should your side business activities get in legal trouble. – Pete Aug 20 '10 at 15:39
  • 2
    @Pete Good records and separate accounts will help protect you from the IRS, but not the lawyers. As I understand it, if your business is not a separate entity, all of your assets are at risk. Including your house and your kids college fund. – KeithB Aug 21 '10 at 1:26

You must log in to answer this question.