 Income tax 2022-2023, business expenses, employees pay. Let's do some wealth preservation with some tax preparation. Most of this information comes from the tax guide for small business for individuals who use Schedule C, Publication 334, Tax Year 2022. You can find on the IRS website, irs.gov, irs.gov. Look at support accounting instruction by clicking the link below, giving you a free month membership to all of the content on our website broken out by category further broken out by course. Each course then organized in a logical, reasonable fashion, making it much more easy to find what you need than can be done on a YouTube page. We also include added resources such as Excel practice problems, PDF files, and more like QuickBooks backup files when applicable. So once again, click the link below for a free month membership to our website and all the content on it. At the income tax formula, we're focused on line one income. Remember in the first half of the income tax formula is in assets and income statement, but just an outline, other forms and schedules flowing into these line items. One of those, the Schedule C having business income minus business expenses, gives us in essence the net business income that flows in from the Schedule C to line one income of our income tax formula. Page one of the form 1040, we note that the Schedule C flows into the Schedule 1, which flows into the first page of the form 1040 line number eight. The Schedule C is the profit or loss from business. It has two parts or it has an income statement structure, income minus the expenses. And we're focused here on the expense side of things. More specifically, employees pay, which could result in payroll expenses and payroll tax expenses reported on the Schedule C. Now note that if you don't have any employees, then you will generally not have to deal with the problem of payroll expenses or payroll tax expenses reported on the Schedule C, which might seem obvious. However, you might ask, what about me? I put a lot of my own time into the business. I am I an employee of my own business. And the answer from a payroll perspective is no in that you don't have to process a payroll and give yourself basically a W2 and do the whole withholding routine for yourself for your own time. However, yes, in a sense, you are treated as both an employee and employer of your own business with regard to the equivalent of payroll taxes, which is self-employment tax. In other words, the income minus the expenses is the net income from your Schedule C, which is subject to self-employment tax, both the employee and employer portion as we've discussed in prior presentations, which is similar to the payroll taxes for Social Security and Medicare where the employee pays half and the employer pays half. So in that sense, you're still dealing with the payroll taxes, but in the format of self-employment tax as opposed to processing a W2 for yourself. Now, the other reason that's a little bit tricky is because if you had a different type of entity, say a corporation, possibly an S corporation even, then the corporation is a separate legal entity. So in that case, you may well have to be issuing yourself a W2 after you set up a corporation because it is a separate legal entity that you're even though the S corporation might be a flow through type of entity. So, but we're focused mainly on the Schedule C here. So you want to keep those two things separate. If you have employees, then you got to deal with the payroll. If you don't have employees, then it's generally going to be a little bit easier, but you're not going to be escaping the equivalent of payroll taxes to yourself because you'll be paying the payroll taxes in the form of self-employment tax on the net income. Also note that if you're a sole proprietor business and you're the one with a vision of what you're doing, you might have questions going forward as you're growing in terms of should I be pulling people in as contractors to work for me? Should I be pulling people in to work for me as employees or should possibly I pull people in as equity partners and have a profit sharing kind of system? And there's pros and cons to any of those types of arrangements. If you have someone as an employee, then you have more control over their day-to-day operations and they're generally going to be more dedicated long-term employee versus a contractor, which might then be going from might not be as long-term, but it'll be easier to pay a contractor. You want to make sure that the structure that you have set up is correct in terms of if the IRS came back and asked or audited whether or not someone is a contractor or an employee, the IRS always trying to lean towards someone being an employee, so you'd have to prove that if someone is a contractor that they qualify as a company. You're certainly qualified. Contractor versus an employee. But employees also are the people that are most likely to cause lawsuits and that kind of stuff as well. So it's pros and cons of having an employee. And obviously, if they're employees, you have to deal with payroll processing, which is a pain, a significant added pain with the withholdings, the 941s and the 940s and all that kind of stuff. If you pull someone in as a partner, then you can have an equity sharing system, but you're going to be moving generally from a Schedule C to have to be reporting that partnership return. So that's a little bit more difficult. And because it's going to have to flow through from the partnership return to each individual's 1040s with a K1. And a lot of times people don't have the same vision in a partnership. So a lot of times a sole proprietor actually works quite well with one person leading the way because they have the vision of what they're doing until they get to a certain size where then they might have to expand at some point. So you want to be careful pulling on partners who might then have a different idea of where the direction is going to be going within the business. So you got to be careful of that, although sometimes in a partnership situation, you can get more capital into the business in a partnership. Sometimes then you can have a profit sharing instead of paying them as a contractor, which could be a little bit easier in some cases as well. Also just realize that if you're dealing with payroll, you want to question how am I going to be putting the payroll on the books. It's not something you want to kind of mess up. It's not like a tinkering thing. Some things you can tinker until you get it right. Payroll, you want to really get it right the first time because fixing it becomes a problem. And again, the employees are some of the most likely problem areas in terms of lawsuits and things like that. So you want to have your payroll as organized as possible. You might do it in your own accounting system. Even if you only have a couple employees, you might hire a third party to help process payroll, specialize in payroll. If you're a bookkeeper that does taxes too, then you want to consider, am I going to help people out with their bookkeeping? If I'm going to help them out with their bookkeeping, then do I want to take on payroll? Do I want to be working with other payroll providers as well? All right, just a couple things to keep in mind. Let's get into it. Employees pay. You can generally deduct on Schedule C the pay you give your employees for the services they perform for your business. The pay may be in cash, property or services. Now note, if there wasn't any complexity with the government getting involved with the payroll and all that kind of stuff, it would be a very easy transaction, just like a contractor transaction, right? Just like paying the utility bill. You would just cash goes out and you would have a wages expense. But the wages expense here is going to be more complex because you have to deal with the withholdings, both voluntary withholdings, which might be like a 401k or possibly some other kind of retirement healthcare or something like that, and mandatory withholdings, which are going to be their payroll taxes, which makes, again, the payroll processing a little bit more tricky. As a tax preparer, you might want to take on, I think it's a good idea to take on the added task of kind of checking the payroll. In other words, the amount that's reported on the Schedule C, you can tie out to the 941s to see if it matches the 941s, the payroll tax on the 941s, and the W2s, and the payroll reports, right? Because it should. Because you would think that if they processed payroll, they would have been processing the 941s or the 940s, and your expense, you should be able to tie into the amounts that are on the 941s and the 940 and the W3 and the W2. All right, so to be deductible, your employee pay must be an ordinary and necessary expense, so that's the same rule as usual, and you must pay or incur it in the tax year. So in addition, the pay must meet both of the following tests. The pay must be reasonable. The pay must be for services performed. Normally, if it's an arm's length transaction, then it's going to be reasonable pay generally because there's two people negotiating. The pay must be for services performed. Obviously, if there's pay for something other than services, it doesn't look like a market type of transaction. Those kind of messy situations happen when family members are working together, for example, and the pay structure gets kind of funny, and reasonable pay also. If it was an S corporation, if you had an S corporation, there's an issue with paying yourself enough money because the government is actually going to be suspicious that you try to underpay yourself in that situation if you had an S corporation because the Social Security and Medicare is going to be paid on the amount you pay yourself, as opposed to the self-employment tax, which is on the Schedule C that's reported on the net income. One reason people try to set up S corporations sometimes because they might be able to report less income to themselves and pay less Social Security and Medicare taxes, although the IRS's position is they try to take the position that all your income should be wages to you, so they have that kind of interplay. But you can see this whole, it has to be reasonable pay in general. So, Chapter 2 of Publication 535 explains and defines these requirements. You cannot deduct your own salary or any personal withdrawals you make from your business. So you might think that's unfair again. You might say, well, why can't I deduct my own salary? I put a lot of personal time into this or the money that you took out, that's the withdrawals. You can't deduct the withdrawals from the business and the general idea would be, well, if you deducted your own expense, that would be like issuing yourself a W-2, paying yourself. So it would just be a wash, right? Because you would pay yourself a W-2 and then you'd have to record it as income on Line 1 of the 1040. So that's not how it usually works with a Schedule C. With a Schedule C, you're just going to take the net income is the amount that you're going to be paying the taxes on. Now the withdrawals, you can't deduct withdrawals because withdrawals are not expenses. So if you look at the normal accounting system, a withdrawal is going to come out of the balance sheet side of things because the income statement measures performance, income minus expenses. And then the draws, and then that accumulates in the net income of the business which is assets minus liabilities is the equity of the business. So when you take the money out, you're taking it out of the retained earnings, out of the balance sheet. You can't record it as an expense when you draw money out for personal use because it's not a business expense. Now you're taking it out of the business for personal use and personal use isn't deductible as a business expense. So as a sole proprietor, you are not an employee of the business. So you don't issue yourself a W-2 although you do get treated somewhat like as an employee because you're still subject to social security and Medicare which are basically the payroll taxes. I'm losing my voice. Hold on, it's okay. Kinds of pay. Some of the ways you may provide pay to your employees are listed below for an explanation of each of these items. See chapter 2 of publication 535. Okay, so once we have set up our employee-employer situation for our Schedule C type of business, the normal type of pay will usually be cash payment or some kind of direct deposit which is clearly something that would be included as pay, something that would be an expense to us for payroll expenses, something that would be income W-2 income to our employees. However, we can imagine many other ways that an employer would pay the employee other than just cash and one of the goals that you might have then is try to look for ways that you can legally pay from an employer to an employee so that the employee can get the benefit without having to pay the payroll taxes, right? Because the pay that we're given to the employee will be W-2 pay. It's going to be included on line one of the W-2. Generally, we will have to make withholdings on it and that means that they're going to be paying a substantial amount of tax to it. Is there any way that we can pay them with like fringe benefits or something like that, like possibly a retirement plan or something like that where we can give them the same amount of money, but it goes further because they don't have to pay the taxes on it. That's one of the things you always want to kind of keep in mind. Could you get a tax benefit? It's not just helpful to the employee to do that. It's helpful to the employer because you're basically paying them more if you're able to pay them without them being subject to the payroll taxes. Now, you can also imagine many other forms of pay that happen if you got paid in like a car or something like that rather than cash that the IRS would clearly be saying, well, no, you still paid them and therefore that should be recorded in income. So those types of things don't work. You would have to find something that you legally are paying like a retirement plan where there's a tax benefit. Okay, keeping that in mind, things, kinds of pay, some of the ways you may provide pay to your employees are listed below. So awards is one of those types of things where, you know, if it's a substantial amount of rewards then that could still be an income item. Bonuses are going to be possibly income items. Education expenses, you may be able to look into whether you get it like a benefit for certain amounts of education expenses but generally it could be an income item and there's questions there in education expenses. Is it something that you're educating them to do the job type of thing or is it something that you're educating them so they can do another job or something like that? Fringe benefits, we'll take a look at later. Loans or advances, you do not expect the employee to repay if they are for personal services actually performed. So if you loaned, you know, an advance or something like that that you're not going to get back is basically, you know, like a payment. Pre-property, you transfer to an employee as payment for services so if you give them something other than money that's not a way that you can kind of get around having to record, you know, the payroll taxes generally. Reimbursements for employee expenses, sick pay, vacation pay. All right, so here's the fringe benefits. A fringe benefit is a form of pay for the performance of services the following are examples of fringe benefits. So benefits under qualified employee benefit programs, meals and lodging, the use of a car, flights on airplanes, discounts on property or services. Employee benefit programs include the following accident and health plans, adoption assistance, cafeteria plans, dependent care assistance, education assistance, group term, life insurance, welfare benefit funds. Now, so once you have the payroll basically set up, you can dive into some of these different components in terms of what kind of benefits you might be able to provide your employee. As a tax preparer, if you're doing taxes, then remember that if your major goal is just to perform the taxes, then you might not be diving as much into some of these details that deal with payroll. You might have other networks that you can work with with regards to those details or you might be picking up more of this stuff which is more bookkeeping type of stuff oftentimes. The tax code impinging greatly on bookkeeping with regards to employees because of all the requirements with the tax code and the withholdings and all that kind of stuff. So your question then would be am I just doing the tax preparer the data input, meaning all this stuff I'm assuming is already been properly done and properly populated on the income statement that I'm basically just plugging into the Schedule C or am I getting more into the weeds with the planning and discussing these kind of benefits that could be beneficial in an employee or situation which generally does add more value which could result in higher profit margins if you're picking up more clients that you could do that kind of consulting type of work with. It depends on your business model as to whether you want to be doing that or if you want to be advising other people and working with a network that might help to do that such as a payroll provider or something like that. So you can generally deduct the cost of fringe benefits you provide on your Schedule C in whatever category the cost falls. So for example, if you allow an employee to use a car or other property you lease, deduct the cost of the lease as rent or lease expense. So now it's a fringe benefit. They're basically using the car. So it's not like you already have the car expense is going to be involved. So you're going to record it as lease expense because that's going to be the normal way that you record the car that the employee got use of as a fringe benefit. So if you own the property include your deduction for its cost or other basis as a Section 179 deduction or depreciation deduction tip. So you may be able to exclude all or part of the fringe benefits you provide from your employee's wages. That's the point, right? If they can get fringe benefits they go further than wages. That's why things get kind of a little bit messy because notice that people, taxes always mess things up, right? So now you've got taxes and people look for ways to get around the taxes which are like the fringe benefits and now you're getting paid with tickets to football games and stuff like that which is like why don't you just pay me money? Because if you pay you money then you have to pay taxes on it. So now you've got all this whole industry of fringe benefits kind of pop up because of the complexity of taxes. So now the thought is what can I give someone that give them the same value without having the taxes so the money goes further than it otherwise would because of the taxes. So for more information about fringe benefits and the exclusion of benefits you can see publication 15B.