2022.07 Vol.2

But Why?

I really wish I could flush every bit of tax code knowledge out of my head. I value still knowing all 151 original pokemon over any tax code. But it turns out there are fairly high incentives for playing the game. So I have to write it down here.

For over a year now I have been working as a contractor. From a tax perspective, this is categorized as a “sole proprietorship” by default. Sometimes just knowing these words are helpful, I wasn’t sure what the tax code considered me if I just did nothing. A sole proprietorship brings new, fun, tax responsibilities if coming from working for a big corporation.

Corporations handle a lot of tax stuff for you and just give you a “W2” form at the end of the year. By handle, I mean they calculate how much tax the state and federal government want of your salary and automatically send it to them for you. The W2 is just the bookkeeping “proof” you can use to tell the IRS “yea man, my taxes are already paid”.

As a contractor, I take payments directly from my employer. They aren’t sending any to the IRS for me and definitely don’t want to calculate my taxes for me. But the IRS for sure wants me to pay. What’s more, they don’t just want me to pay them what I owe at the end of the year. They want me to pay every quarter. So I have to estimate what I’ll owe for the year, but make quarterly payments a.k.a “Quarterly Tax Estimates”.

There are two major factors contributing to a sole proprietorship tax estimate. The first is pretty obvious, the income tax bracket. The other was not as obvious because it was another thing that big corp was “handling” for me and that is Self-Employment taxes. These cover a whole suite of things, but currently comes out to 15.3% of your income.

So now we get to the fun part. Why did I create an LLC in California and register it as an S Corp?

It turns out that a corporation allows you to avoid that 15.3% tax on a portion of your income. How do we get there and how much does it help? A corporation is a legal “entity”, which lets not think too hard about right now, it just means the it can have a bank account which I happen to control. Now instead of having my contract employer pay me directly, they pay my corporation (different bank account). Now we are at the part where I can avoid that 15.3% tax. I become not only the owner of my corporation, but also an employee. I pay the only employee (me) a wage out of the corporations bank account. This wage is subject to the 15.3% tax, but the rest of the non-wage can be distributed to the corporation owner(s) (me again) and it is not subject to that tax.

So why wouldn’t I just make my wage $1 and avoid the tax almost entirely? Well the IRS thought of that and made a rule that you have to pay yourself a “reasonable” wage. What is that wage? Well, at this point I’ll just drop some cover-my-ass language and say talk to a CPA.

These are the tools I used for my corporation. None of them are that cheap, but they save a bunch of time and keep the tax code cognitive load down. If you are making a sizable amount as a sole proprietorship, it will probably easily be covered.

• corporation registration and legalese - zenbusiness
• employee payroll - gusto
• corporation funds bookeeping - quickbooks

It’s fine to just forget all of this now. I wish I could.