You'd only pay taxes if your revenue were more than your deductible payroll expenses (which as you say, you estimate to be 20% of your salary, which in an s-corp must be a "reasonable salary" for work performed).
There's no case where this law causes you pay tax on zero revenue. The problems require some revenue before they affect you, which might actually be another argument against it - you're disincentivized to create revenue from your early product if it's not going to be enough to cover your tax obligations.
The absolute worst case scenario would be having to pay taxes as if your revenue was nearly all profit - as if you had no expenses (or very few). As always, you only pay taxes on 'net income' - revenue minus expenses - this whole mess comes about by tweaking how expenses are calculated.
And that will be the case for me next year, so yes, this matters to me.
It is literally backbreaking for a friend who is self funding a team of engineers. The money to pay taxes literally doesnt exist. It was paid as salary.
I told him to ignore the accountants and simply not pay. Let the IRS come after him
But there's a very critical misunderstanding happening in a lot of comments here -the IRS taxes profit (net income), not revenue. Anyone with zero revenue is safe. Anyone with SOME revenue will potentially owe some taxes, and potentially in a very surprising (and unfair, I think) way. The basic example in the submission is quite correct.
>>>I told him to ignore the accountants and simply not pay. Let the IRS come after him.
This is a great way to end up both out of business AND in jail. It is not the smart play.
For the short term (contracting) I'm simply working as a Sole Proprietor, but I don't really have much work or significant income yet.
If I may make one suggestion: even if you want to be a sole proprietor, look into getting an LLC.
If you run into trouble with a client, a properly-done LLC can save your house or other large assets.
With a sole proprietorship, all of your personal stuff can be on the hook too.
It's essentially the same advice as keeping separate devices for work and for personal use.
LLCs also generally aren’t useful for protecting you from creditors, because any lender will require you to give a personal guarantee.
If you are really worried about protecting your assets, you can purchase liability insurance.
> As a software developer you’re unlikely to be sued over anything that can’t be classified as personal negligence or malpractice.
Unlikely doesn't mean never. And a client's definition of negligence might also be malicious.
It is difficult for a company to successfully show that your LLC was at fault for some large dollar amount of damages, but that you the sole decision maker running that LLC, weren’t at fault through negligence or malpractice.
My point is not that you shouldn’t bother to protect yourself if you are worried about the risk, but that insurance, not an LLC is the best way to do it. By all means start an LLC too if you want.
The common advice of that every tiny business setup an LLC because it will save your house is wrong because it is only applicable to very specific circumstances that don’t apply to most sole proprietors. It’s also dangerous because most people that take this advice take it face value. Then they go online, start an LLC, and believe they are protected from all personal liability related to their business. When in fact they are protected from a very small fraction of likely potential liability.
An LLC can protect your personal assets from enforcement of contractual obligations. Say for example you agree to indemnify your client against patent infringement, and then through no fault of your own some of your code coincidentally happens to violate someone’s patent (and the patent holder finds out and successfully sues or settles with your client).
But don’t sign contracts like that in the first place. And it’s a good idea for contracts to have a clause allowing both parties to terminate the contract and to not make promises in your contract you can’t guarantee.
If money went from the LLC into a "wage," it changed "hands." The IRS wants in on that.
If work went from the owner into an LLC, no money changed hands, and the IRS doesn't care.
But the very fact that people do S Corps shows that there is different tax treatment though.
And yes, I know you don't have an S Corp. I was wondering how you would pay yourself from such a corporation, considering you have zero revenue.
When you have a single-member LLC, you take "distributions," which basically means you withdraw money from the company and put it into your personal account. It's technically a dividend.
A single-member LLC and a single-member S-Corp are both essentially flow-through entities for a solo entrepreneur. However, they are ultimately taxed quite differently: with an S-Corp once you exceed the SSI threshold for the essentially mandatory portion of revenue you must repatriate to yourself as a salary, the remaining income can be repatriated as qualified dividend which is taxed at a significantly lower rate than directly passed-through income. With an LLC, it's all self-employment income subject to regular income taxation, meaning that in any realistic scenario, you're paying a higher effective tax rate with the solo LLC form.
So if I went the S Corp route, I'd actually have to pay taxes on 0 revenue.
This is false. The income tax on $0 revenue (meaning no revenue, not no profits) is the same: $0. (Note, however, that many states have "fees" assessed on business entities like S-Corps and LLCs, even single-member LLCs, and in such cases a minimum fee is owed regardless of revenue.)
But as a regular LLC, my own work (as the owner) does not count as anything taxable, so I'm safe.
This is also false. The work you provide to the entity as an owner is still an R&D expenditure. The difference is that with the S-Corp, the expenditure cost is clearly documented, while with the LLC you're pretending that the number is $0 and gambling on not getting audited. This only matters once you start generating revenue...
Either way, not all of your salary would be subject to capitalization. If you have revenue, you clearly spent at least some time and work on marketing and business development, and expenses for those non-R&D activities are not capitalized.
With the S-Corp, your salary offsets up to [your salary assigned to non-R&D tasks less 1/10 [see note] of your current-year salary assigned to R&D plus carried-over capitalization from R&D from prior years] in revenue each year, and after an appropriate amount of salary (generally the SSI contribution threshold for the year) the rest of that annual revenue can be repatriated to yourself as a dividend at lower tax rates. With the LLC form, since you aren't paying yourself a salary, you owe tax on 100% of the revenue arising from the software you develop without any deductions.
TLDR: If you actually care about tax, S-Corps are almost always the better option for the solo entrepreneur, and they're still the better option here.
NOTE: Capitalization is on a mid-year convention, so the first and last year you only capitalize 1/10th of the cost; and in the middle 4 years you capitalize 1/5th of the cost. So, for Y2, if you paid yourself $100 in salary both years, your total capitalization deduction would be $30: $10 capitalization for the Y2 salary and $20 for Y1 capitalization.
So if the IRS audits me, they'll say that my work is worth something and therefore, I have to pay taxes on it?
Sounds awful.
But I and the accountants I talked to don't think that's the case.
Also, I'm not going to take R&D credits, nor claim deductions from salary, so why would they care?
And I did the math: yes, an S Corp is technically better. But at the revenue levels I plan on seeing, the difference isn't that much (a few thousand), and any revenue gets taxed right away, which is more convenient for me. I'll take that instead of complicating my taxes.
Well, no...since you're not claiming to be making any revenue from that work, it doesn't matter. Whether you deduct 100% or 20% of your salary from $0 business income you still have $0 of taxable business income (and as an individual you don't get NOL carryovers so that amount is lost to you forever).
In fact, in the event of an audit, you'd likely get a refund since the IRS would determine that you're incorrectly calculating your tax liability by failing to capitalize your R&D expenditure (i.e., your flow-through revenue which is entirely treated as self-employment income). But, because this error affects other years' returns, which means that a one-return audit can turn into a multi-return audit. It also means you get put on a very special list of taxpayers subject to increased scrutiny (meaning, significantly more likely to be audited again in a future year).
But at the revenue levels I plan on seeing, the difference isn't that much (a few thousand), and any revenue gets taxed right away, which is more convenient for me. I'll take that instead of complicating my taxes.
Yes, the LLC is much simpler when it's a disregarded (single-owner flow-through) entity. But it's more complicated once you add other members or any employees. And as you've pointed out, you're already paying more in taxes.
My issue isn't with you choosing to use the LLC form because it's simpler, my issue is with you claiming that it's better for tax purposes on a numerical basis when it is clearly not.
The problem is, as this whole comment section shows, is that is it not clear.
Because it isn't, I decided to go with the simpler option because I don't plan on having employees.
There is no dispute amongst tax advisors about whether a single-owner S-Corp is better than a single-member LLC for tax purposes: the S-Corp is better. Hands down.
But the LLC is simpler because a one-person LLC doesn't exist for tax purposes, it's just an extension of its owner. The cost of this simplicity is significantly higher taxes once you make enough money for taxes to matter.
A regular single-member LLC, such as mine, is treated as one entity with its owner for tax purposes. The LLC's income is my income, and I just file a personal return for it. This can be bad because it puts you in a higher tax bracket.
An S Corp is a way around that. You have the LLC "pay" you a "wage," and you pay personal taxes on that, while the LLC pays whatever corporations have to pay.
But if your LLC does software, like mine, congratulations! You can only deduct 20% of that "wage."
I've been developing my software for years, and I am not done yet. I don't have revenue.
So if I went the S Corp route, I'd actually have to pay taxes on 0 revenue.
But as a regular LLC, my own work (as the owner) does not count as anything taxable, so I'm safe.
If you are going into freelance, perhaps as a consultant, keep this in mind. And do submit a comment.
Also, beware of accountants that will try to get you to do something that is not in your best interests. I had one or two try to encourage me to file as an S Corp, even though they admitted this could be a problem.