In the post Taxes and Financial Independence, I wrote about retirement funds, investment income, and other areas that allow you to either claim deductions on your taxes, or reduce your tax burden. What I didn’t cover were business entities that you can create in order to protect your income.
I realize this is boring as crap. At least for me it is. But if you get taxes right, you can save a ton of money, and get to FI that much faster.
I actually don’t mind paying taxes. I bet you’ve heard the Oliver Wendell Holmes quote that “Taxes are what we pay for civilized society”. I’m with him—I want to throw some money in the hat for garbage pick-up, police, libraries, schools…but then again, I want to pay as little as I need to.
Thus, here’s the scoop on the two main business entities that are relevant to you if you work for yourself, or if you own investment property.
LLC is the typical business type for rental properties, because LLCs are meant to cover “non-active” income. I.e., instead of working all day, you kind of sit back and collect rent, minus the odd afternoon spent fixing a tenant’s sink.
On personal taxes, rental income has the same tax rate as salary income. But, if you create an LLC for your investment property, you don’t have to pay Social Security (12.4%) or Medicare (2.9%) on rental income. That’s huge. An added benefit is the protection you get in lawsuits—if you have a litigious tenant, they can sue the assets owned by your LLC, but not your personal assets.
With an LLC, you can deduct pre-tax expenses, such as related travel, uniforms, computers, phone bills, advertising, promotion, gifts, car expenses, and health care premiums.
Besides the social security / Medicare break, you get the regular deductions that you’d get without an LLC. That means you can add furniture and appliances to the cost basis of the property and depreciate the proper amount each tax year. Same thing for improvements—like an addition, new AC, replace plumbing, renovating the kitchen—you can depreciate these. Materials, tool rental, and labor can also be depreciated. For repairs, such as repairing a roof, plumbing, electric, replacing a broken window, you can deduct the full cost of the repair in the tax year that the repair was completed.
S Corps are a business type that covers “active work”—anything you do that brings in income, as opposed to passive income you might get from a rental property.
As an S corp, you have to pay yourself a reasonable salary, for which you pay regular taxes, and distribute the rest of the income to yourself as profit. The profit distribution to yourself (or any other shareholders) is free from Social Security (12.4%) or Medicare (2.9%) taxation. DEFINITELY read more about what the IRS defines as paying yourself a “reasonable income”. It’s tricky because they don’t give us a dollar amount, or a percentage of profit. But they DO apparently do regular audits of S Corps because of the potential for abusing the tax benefit of income vs. profit distribution.
Like with an LLC, an S Corp allows you to deduct pre-tax expenses, such as related travel, uniforms, computers, phone bills, advertising, promotion, gifts, car expenses, and health care premiums.
Health Care Premiums and Costs
Whether your tax entity is an LLC, an S corp, or you file as a freelancer, you can deduct health care premiums. If you itemize your deductions (on Form 1040, Schedule A), you can deduct expenses you paid that year for medical and dental care for yourself, your spouse, and your dependents if your total medical expenses exceed 10% of your adjusted gross income. http://www.irs.gov/taxtopics/tc502.html. Yeah, more eye-bending reading.