Many folks pursuing financial freedom include business income as part of their strategy. That business income could be a side hustle in the gig economy, a rental property, a passive investment, running your own small business (part-time or full-time), or some combination and/or multiples of these. But what impact does the bottom-line profit or loss of each venture have on your greater tax picture?
Well, it depends.
Steps to completing your tax return
Before jumping into different ways business income can impact your taxes, it is important to highlight the basic steps involved in completing a tax return. Conveniently, these steps will allow you to complete different sections of the Form 1040:
Add up all your income items—wage income from a W-2, interest income, capital gains, business income, rental income, retirement income, Social Security benefits, lottery winnings, etc. (The Internal Revenue Code defines gross income as “all income from whatever source derived,” unless specifically excluded by law.) This is your total income.
Add all your adjustments to income—student loan interest, traditional IRA contribution deduction, etc.
Subtract your adjustments to income from total income to get adjusted gross income.
Subtract either your standard deduction or the total of your itemized deductions from your adjusted gross income, and then subtract your qualified business income (“QBI”) deduction if applicable. (More on that later.) The result is your taxable income.
Your standard deduction is a flat amount based on your filing status.
Itemized deductions include deductible medical expenses, certain state taxes, mortgage and investment interest, charitable contributions, and some other deductions.
Your taxable income and your filing status determine your tax liability.
From your tax liability, subtract any tax credits you have (such as an education credit or the child tax credit), and add any additional taxes (like self-employment tax or the net investment income tax), to get your total tax.
Add up all your withholdings, estimated tax payments, and refundable tax credits to get your total payments.
Compare your total tax with your total payments. If your total tax exceeds your total payments, you have a balance due. If your total payments exceeds your total tax, you have a refund.
Calculating your business income
On the tax forms, you will notice that “business income” literally refers to a business reported as a sole proprietorship on Schedule C (including a single-member LLC). There are separate places to report rental income, your share of s-corporation or partnership income, farm income, and other types of income. All of these are just different types of businesses, so when I refer to “business income” it includes business income of any type, wherever and however reported.
You need to figure out your business income before you can complete your personal income tax return, because your business income is just one piece of your personal income. Partnerships and s-corporations are referred to as “pass-through entities” because any profits pass through to your personal return rather than the entities themselves paying taxes directly.
If your business is not a pass-through entity, its profits and losses will not impact your personal return, and this article does not apply to that business. This could be the case if your business is tax-exempt or a c-corporation. Even then, you may have income from that business (such as dividends or a W-2 salary) that represents personal income.
If you are treated as a partner in a partnership or an s-corporation shareholder, you will receive a Schedule K-1 showing your share of the business profits to include on your personal tax return.
At its most basic level, if your business shows a profit, this will increase your total income, which will increase your tax liability. All else being equal, this means a higher balance due or a lower refund. On the other hand, if your business shows a loss, this decreases your total income and thus your total tax, resulting in a lower balance due or a higher refund.
Tax brackets are marginal
If your business makes a profit, multiply that profit by your marginal tax rate. Be sure to do this for both federal and state taxes!
You can also do this to understand the impact of any additional income item, business or otherwise.
Self-employment tax
To the extent your business income represents self-employment income, you will also need to compute self-employment tax at the federal level. This is 15.3% of your business profits, subject to certain adjustments and limitations. (Check out Schedule SE and its instructions for more details.)
When you are self-employed, you are both the employer and the employee. Think of yourself as wearing both hats simultaneously. Self-employment tax consists of employee FICA taxes (6.2% for Social Security and 1.45% for Medicare)—just like you see on your pay stubs and W-2s—plus the employer match.
Generally speaking, you have self-employment income if your profits flow from Schedule C (business income) or Schedule F (farm income), you are treated as a general partner in a partnership, or you receive guaranteed payments from a partnership.
Business losses might be limited
On the other hand, your business might show a loss for the year. It happens, particularly when a business is new or there is an economic downturn.
Like with business profits, multiply your deductible business losses by your marginal tax rate to understand its place in your overall tax picture for the year. There is no self-employment tax for years in which your business shows a loss.
Notice the key word there: deductible. Not all losses are fully deductible, and some are not deductible at all.
This arises most commonly with passive activity losses. In short, you can only deduct passive losses to the extent that you have passive income elsewhere to offset those losses. (Active losses are generally fully deductible.) Unused passive activity losses carry forward to future years until you either have passive income to offset those losses or you dispose of your interest in that particular activity.
Rental properties have a special $25,000 per year allowance, limited at higher income levels, meaning you can deduct up to $25,000 of passive rental losses each year even if you have no other passive income if you meet certain requirements. The special allowance for rental activities is a per-year limitation, not a per-property limitation.
Assume you have a rental property that generates a $37,000 loss. You deduct $25,000 under the special allowance provision and carry the unused $12,000 forward. The following year, your rental property generates $8,000 of income. You deduct $8,000 of your prior-year losses against that income, showing a $0 net profit, and carry the remaining $4,000 forward. In the third year, your rental property shows a $3,000 loss. Combined with the $4,000 in prior-year losses, you have a $7,000 net loss. Since this is below the $25,000 special allowance, you deduct the $7,000 net loss in full, and have no remaining unused passive activity loss to carry forward.
Assume instead that when your rental property generates a $37,000 loss, you sell the property at the end of that year. Because you no longer have an interest in that activity, you deduct the $37,000 loss in full.
The other instance in which a business loss is not fully deductible is a basis limitation. You cannot deduct losses greater than your adjusted basis in a particular activity. Keep updated records of your basis in a partnership or s-corporation at the end of each year.
Assume you invest $20,000 into a partnership, and your share of partnership losses is $24,000 in the first year. You can only deduct the first $20,000 of losses.
Qualified business income deduction
The qualified business income (“QBI”) deduction allows you to deduct up to 20% of your total business profits. If your business generates a $20,000 profit, or you have multiple businesses generating that amount combined, the QBI deduction is worth up to $4,000.
Notice the “up to” there. It is not automatic. Your deduction is limited at higher income levels if your business is a specified service trade or business (“SSTB”). Your deduction is also limited if your business has QBI loss carryovers from a prior year.
Assume that your business shows a $6,000 loss in its first year. Because your business did not show a profit, there is no QBI deduction. You have a $6,000 loss carryover for QBI deduction purposes. In its second year, your business generates a $20,000 profit. Your net profit for QBI deduction purposes is $14,000, so your QBI deduction would be worth up to $2,800.
Paying the extra tax burden
Nobody enjoys paying taxes. However, I would rather have the extra money on which I owe tax than not have the extra money in the first place. And after all, taxes are the price we pay for living in a civilized society. Part of living a less taxing life, though, is minimizing that burden, both mathematically and logistically.
Federal taxes are a pay-as-you-go system. If you wait until the end of the year to pay your entire $85,000 tax liability you will face an underpayment penalty on top of that amount for not paying your $85,000 throughout the year. The underpayment penalty motivates people to pay their taxes as they go; otherwise, everyone would wait until the end of the year to pay their taxes, many folks would be unable or unwilling to meet their tax burden, and the system would collapse.
Most of us pay our taxes throughout the year via payroll deductions. Business owners can do the same! If your side hustle will increase your tax liability by $6,000 for the year, ask your employer to withhold an extra $500 per month in taxes from your paychecks. Alternatively, if you pay yourself a salary from your s-corporation (including an LLC taxed as an s-corporation), then you can set your withholdings accordingly.
At bottom, your tax return compares your total tax liability to your total payments. Payment of any extra tax liability due to a particular endeavor does not need to come from that same endeavor. Ultimately, the government just wants its money!
The second option is to make estimated tax payments. If you know your sole proprietorship will add $80,000 to your yearly tax bill, you can pay that in $20,000 quarterly installments. (If your sole proprietorship is adding that much in taxes, we should have a conversation about how restructuring it can save you money!)
Most folks find that making large quarterly estimated payments is difficult and disruptive. Adjust your withholdings elsewhere to make up the difference, or set up the payments on a monthly automatic schedule instead. You will pay the same in taxes overall, but it is still less taxing logistically!
You can also mix and match. For instance, you might pay the extra $80,000 mentioned in the previous paragraph through $24,000 in extra pension withholdings, $12,000 in extra W-2 withholdings, and the remaining $44,000 in monthly or quarterly installments.
Example
Here is a hypothetical scenario to put a lot of this together. You are the sole owner (member) of an LLC that has elected to be taxed as an s-corporation. Because your LLC is now an s-corporation for tax purposes, you must pay yourself a reasonable salary.
You expect your business to generate $200,000 of income. You determine that $90,000 is a reasonable salary, you will owe an extra $45,000 of income taxes due to your business income, and that you will pay the extra $45,000 income tax through payroll deductions from your s-corp.
Besides income tax, you will also deduct $5,580 (6.2% of $90,000) for Social Security and $1,305 (1.45% of $90,000) for Medicare from your paycheck. This leaves you a net paycheck of $38,115 (i.e., $90,000 – $45,000 – $5,580 – $1,305), which you pay to yourself in twelve equal monthly installments. You will owe the government $45,000 of income tax, $11,160 of Social Security tax, and $2,610 of Medicare tax, for a total of $58,770. (Remember the employer match on Social Security and Medicare!) You schedule the $58,770 to be automatically withdrawn from your business bank account in twelve equal installments on the 15th of each month. Every three months, you file quarterly payroll tax forms with the IRS. At the end of the year, you file annual reconciliations and W-2s. (State and local taxes, and unemployment tax, would also apply, but we are ignoring them here for the sake of simplicity.)
Your business tax return will show the following:
Income = $200,000
Officer salary = $90,000
Payroll taxes = $6,885 (employer match on Social Security and Medicare; the employee taxes portions are included in the salary!)
Other expenses = $0 (unlikely in reality, but $0 for the sake of this example)
Net profit = $103,115
Your personal tax return will show the $90,000 of W-2 income, $103,115 of business income from your Schedule K-1, and $45,000 in W-2 withholdings. You will also be eligible for a QBI deduction of up to $20,263 (i.e., 20% of $103,115).
Conclusion
Business profits and losses are part of your overall income, just like your wages, interest, or capital gains, but with some extra nuance. Be sure that you plan accordingly. Rest assured that you are not alone in this, either. I work with all types of business owners to help them live a less taxing life, so reach out to me today.
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