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Here we are in our form 1040 example problem using LASERT tax software you don't need tax software to follow along but if you have access to it it's a great tool to run scenarios with you can also get access to forms instructions schedules at the IRS website irs.gov irs.gov standard starting point Adam tax man just trying to avoid a dang tax man living in Beverly Hills 90210 single file or no dependence starting with W2 income which we will shortly change to Schedule C or sole proprietor income 100,000 standard deduction 13,850 gives us the taxable income 86150 which we can mirror in our income tax formula 100,000 deduction 13,850 the taxable income 86150 tax calculated by the software 14266 on page two of the form 1040 14266 okay that's our standard starting process let's go back to the first page now we want to be thinking about what happens if we change from that W2 income once again to a Schedule C type situation in a prior presentation we saw that there's a lot of different things that are impacted as we do so our major focus this time however is to focus in on the self-employment tax which will be calculated which is really important and something that we want to be comparing to what would happen if we were in a W2 situation so remember if I go back on over here and if we were in a W2 situation how do we deal with our taxes well the government of course will go after the employer in order to induce them to withhold our money as the employee so if we made 100,000 for example then we would have federal income taxes that would be withheld based on the W4 which is a complex calculation not only that however we would also have withholdings for social security and Medicare which you can see are much more simple calculations they are basically flat tax calculations although not that simple because there is a cap on social security and there's a bit of a progressive kind of nature to the Medicare and we also have the complication of this is only the employee portion which is also kind of matched by the employer so the employer is also paying 6,200 and is paying 1,450 the amount represented on the W2 represents your amount that you paid you didn't actually physically write a check because the IRS forced the employer to make you pay but it's still in theory came out of your paycheck whereas the other 6,200 was paid in theory by the employer I say in theory because when you work this all out economically obviously wage rates change and so on and so forth to compensate for the taxes so real wages are a little bit different to calculate but in any case so you can see that that the 100,000 times the 0.062 is going to be that 6,200 and if I have 100,000 times the 0.0145 that's where we get the 1,450 now remember that if you go too high if you go over the cap say 200,000 then the social security got capped because it capped it at income of 160,200 why does it do that because the social security more and more in the United States is being thought of as like a 401k plan from the federal income tax system which is kind of strange instead of like a safety net type of program and therefore the tax is quite high and the more money you put into it under that thought process the more money that you should get out of it that's the general idea now again from my standpoint I would think the general idea would be just like with federal income taxes we pay as little as we're legally required to pay even though the social security unlike federal income taxes could result in benefits that come back to us at retirement time due in part to the fact that the social security really in my mind should be more of a safety net program number one number two I don't trust the government to manage the money because they aren't managed the money well and number three it looks like we're on a path towards the government being insolvent in some part and the hugest piece of the pie for the government spending is social security and Medicare which is which means that we're going to hit a wall at some point so I wouldn't depend on it I would rather keep the money if I was legally able to do so pay for my own retirement and and and instead of instead of paying into social security or pay for paying to the government so they can fund the military or something as opposed to the social security which seems not to be working well so that's the general theory that I would think let's go back to the 100,000 now just realize that if the employer paid part of that when we go to the schedule c business we're going to have net income of the 100,000 let's say and we're going to pay not only the employee portion but also the employer portion so that means if you're moving from a w2 situation to a schedule c if you have the same amount of net income as gross income you're going to be paying twice as much or about almost twice as much as of social security now again you're going to get deductions and stuff like that so that might not you know so there's pros and cons to go into the schedule c but the self-employment tax is a crucial part to keep in mind so let's see that let's say if I delete this and say instead of having the income there we're going to go and say we have a schedule c business and so now we're going to say let's say that the gross receipts were 120,000 again and our expenses were 20,000 and so remember that in a w2 business if I had 20,000 of expenses normally I can't deduct them because the idea of being an employee would be that the employer would be paying for those kind of things typically so by being self-employed I get these deductions possibly that is good right because now I'm not going to pay social security tax on 120 but rather on the net 120 minus the 20 but the net we're saying still comes out to 100,000 so let's go to the forms I go to my schedule c we've got an income statement 120 I get the deductions which are great and remember if the deductions were greater than the income which could often happen for startup businesses then I'm not going to pay social security because I'm going to have a loss not only that but I might be able to take the loss against other w2 income so we'll talk more about that later but in this case I got the same amount of the 100,000 as before so let's see what the self-employment tax now I've got the self-employment tax which is the equivalent of the social security which is basically being calculated at the 14129 now remember prior the the half of that would have been if I said if I said we had these 0.062 plus 0.0145 that gives us the 0.0765 total between social security and Medicare if we were an employee if I take that times two then this is going to be the rate if you think of me as both the employee and employer and if I multiply that times the 100,000 I get something similar to this not exact notice it's not exact because you have this little bit up top we might go into that in a little bit more detail but the general thought process is you're basically paying like both the employee and employer portion of your self-employment tax now let's go back to the Schedule C and just remember the thought process on why this might be they usually when they put in laws for the government they think of the big companies like a C corporation and then they have to shore up what they're going to do for like the sole proprietors so if this was a Schedule C like a I'm sorry a a C corporation a separate legal entity that pays taxes on the corporate level they would have their own kind of income statement and even the highest people on it the ceo's and so on would be receiving wages right they'd have wages that they would be receiving and that means that even them would be paying social security and Medicare through the payroll tax system and that means that they would have the wages the withholdings would be included in wages they would also have their portion of the taxes as a deduction on the C corporation tax return which would then result in the net income which would be paid on the corporate level right so the net so the net income would not be assigned to an individual that would be paid on the individual tax return and thought of as income to them the net income would be on the corporate level and all the all the workers including the ceo and whatnot would be paying social security and Medicare through the wages and then the net income who owns the business the shareholders so the shareholders have a problem then when they want to draw the money out of the business because when they draw the money out of the business it's going to be a dividend and so with a dividend you don't have payroll taxes but possibly more income taxes so you end up with a double taxation with regards to income taxes and that's the issue that happens and that's why like flow through entities happen like as corporations and LLCs attempting to get liability protection with a separate legal entity and allowing the flow through possibly avoiding the double taxation resulting and trying to pull money out in the form of dividends now the issue there then is like well if you're if I don't have any employees then the government's going to say well you are you must be the employee of the government of the of the business because you're the one doing all the work right so you must be so we're going to treat you as the employee not only that but we're going to treat you as the employer so any earnings that you have from the government's perspective they're going to say that's like earnings to you you say well do I have to then file a w a w2 to myself no that would be quite tedious to do that would be a pain to do so it's actually easier to say okay there's the net income and then the government's going to treat me as an employee of myself take that and treat it for self-employment tax which is of course pulling into the schedule s e and then calculating the tax both the employee and employer portion now half of the taxes if we compare this to a schedule c you'd say well uh if if I wasn't you know if it was an employee situation I would get to deduct the wages for the for the wages here and and I would also get the employer portion of the payroll taxes that I would get to deduct now I don't get to deduct the wages because they're wages to myself right so they're already income to me in this case because I'm not being taxed at the corporate level but the the payroll taxes that that I have to pay the the employer half of the taxes I should get a deduction for because the c corporation would get a deduction for that so okay so that they would say okay well we can deduct half of the self-employment tax to be fair so what I would think I would get to deduct it on like tax line line 23 but I can't deduct it on line 23 why because then that would make the 100,000 go down resulting in a circle reference and I had to get to this number in order to calculate the self-employment right so that means that half of this self-employment I get to deduct but not on the schedule c it's got to be somewhere else we're going to put it on the schedule one so that's why when we go to the form 1040 if I go to page 2 we can see that 14 129 is pulling in not simply as federal income taxes but as other taxes which is something that we don't normally see when we just have a w2 situation that doesn't mean they're not paying the tax because remember if you're in a w2 situation you are paying the tax but you're usually only paying half of it because you're you are the employee and not the employer portion here you have to pay both and it's being calculated on the form 1040 as opposed to as part of payroll taxes reported to you on the w2 reported by the corporation on their payroll tax forms the 941s so then this is going to be the the income tax the federal tax and then here's the other tax half of that tax is then ultimately going to the first page of the form 1040 that 7065 which is coming from the schedule one page number two there's the 7065 which is coming from the schedule se so that's the that's the general outline all right let's go back to the schedule see now remember that this kind of leads us to think that a sole proprietor is just one person that doesn't have employees which isn't the case you could still have employees it's just that you as the sole proprietor the owner of the business are not one of the employees you don't give yourself wages typically because your payroll taxes will be calculated based on the net earnings of the business if you need other people to come into the business you could hire them possibly as contractors or as employees just like any other business based on the rules as to whether they qualify for a contractor or an employee how much how much supervision do you have over them and their work and so on and so forth if you have employees then you've got a process payroll which looks similar to a to a corporation a C corporation so comparing to a C corporation again if we hire employees in a C corporation you have the executives that hire the staff right and and then and but on a C corporation both the executives and the staff are getting paid w two wages because the corporation is a separate legal entity here the books are separate separate in nature because we keep the books for the business separate from the personal but we ourselves are not employees of the business in that we're not issuing ourselves we're like the executives and the owner of the schedule C sole proprietor business we don't issue ourselves a w two typically but if we hire other people we're going to be giving them the w two and having to follow the normal process for payroll which is pretty much standardized from that point across different types of business entities we got to do the withholdings and the whole payroll thing which is a whole thing in and of itself obviously for federal income taxes we're going to summarize that data and that detail so that we can get the deduction for the wages and the relative payroll taxes for the employees that we have not including ourselves and then the net income that we get we'll have to play self-employment tax treating ourselves as both employee and employer which will then pull over to the schedule s e so that's the basic idea now notice if if your income gets high over this threshold let's say your income goes up to uh over 200 000 select 220 000 and i go back on over so so now i have then 200 000 net income if i go to my schedule s e now it has to break out between the social security and the medicare because there's going to be a cap on the social security calculation because we've gone over the cap so we have that same kind of cap situation now again the general strategy it seems to me is for social security just like for federal income taxes when we're paying into it i'm going to pay as little as i'm legally required to pay even though i'm paying into a benefit program which could pay out in the future because i would rather say for my own retirement it's safer and the government's going bankrupt i wouldn't depend on it if i if i couldn't there are strategies however or sometimes when you might need to you might think about putting more money into the social security somehow so again if you had like a spouse that was was a homemaker and then the children left or something like that and then that now those two spouses are working in the business and so on then you might say hey look i don't want to have all of my social security going to going to one person's uh social security number because that means that i'm only going to get social security benefits going to one individual you might want to say if married i'm going to split it out between the two individuals which we talked about a little bit in a prior presentation which could be complex in terms of how you can file the tax return do you need a do you need a partnership tax return do you need community property laws we could split it evenly or can you file two schedule c's uh basically but from a self-employment tax situation because that's really the issue is the self-employment uh the question is would i want to do that if i could like would that even make sense well if i'm making something over this threshold 160 200 the answer might be no because if i split it up then then i have two people to hit that cap meaning i'm going to still keep on paying into the system over and above the cap of 160 200 which i don't want to do i don't want to pay any more into the system than i'm required to pay because i'd rather say for it myself instead of relying on the benefit program to pay out at retirement however if i'm under 160 200 then it shouldn't have an impact generally on my federal income taxes and if i'm already maxed out if one person one spouse is already maxed out in their social security benefits calculations it might be useful then to allocate some of the income if it's okay to do so given the circumstances of the business to to a spouse if they're working in the business as well because then you might not be paying any more taxes into the system but having one person uh having more qualifications to get possibly more benefits after at retirement so those are just a couple things to think about also just realize you have complexities in the social security calculation if you also had uh w2 income so let's probably let's bring this back to 100 000 and let's say that we had w2 income as well of of uh let's say 100 000 right so now i have a total of of 200 000 on the income let's do w2 and then i'll put that over here so so now if i go into the form 10 40 i have w2 income and i have the 100 000 that's that uh is flowing in uh as well actually it went down i brought it down to 80 000 here so so so now the question is well now uh hold on a second let me make it let me go up a little bit more let's go back let's say this was 100 150 000 okay so then i'm going to say okay 150 000 w2 income 80 000 so now we're at 230 000 now the issue here is that this is all being applied to one social security number which we saw should have a cap on it but it's coming from two income sources and and note that one income source the w2 income i would only be responsible for paying into social security half the employee portion as an employee whereas this 80 000 i would have to pay twice as much the employee and employee or portion so so in those situations of course tax software is quite helpful to help you to to calculate and make sure that you're properly allocating the cap because if it wasn't for software to help you to do that it's quite likely that you could end up paying more into social security than the cap is allowed right that kind of thing can happen if you have one person that has two w2s that has a lot of income because then again the second w2 doesn't know that the first one cleared the cap so you're going to have too much that was paid into social security similar situation here if you paid based on the cap of any one source you would have too much paid into the social security so i won't go into the we're going kind of long so i won't go into the details of the calculation here but just be you know just be aware of that situation as well with the social security it's not allocated you know per tax return it's allocated per social security number and if you have multiple sources of income subject to social security tax and the combination of that income goes over the threshold of of the cap for social security then you're going to want to basically double check and make sure that you haven't overpaid into social security which again is something the software is usually helpful with