STOP GIVING AWAY 15% OF YOUR PROFITS
- Sam Hasbrouck
- Jun 21, 2022
- 4 min read
If you are working as a real estate professional, there is a good chance you are subject to the dreaded self-employment tax. Chances are you are paid as an independent contractor (1099) and not an employee (W2).
As an independent contractor you are considered self-employed and there are two types of taxes you will pay:
Income Tax
Self-Employment Tax
Income Tax
Income tax is paid by self-employed individuals and employees. This is what most people think of when they think of paying taxes as they are all familiar with wage withholdings on paychecks and owing taxes or receiving a refund come tax time.
Sole proprietorships, partnerships, and LLCs are known as pass-through entities because
the profits or losses from the business "pass-through" to the owner's personal tax returns.
When you are self-employed, you will pay federal and state* income tax on your net
business profit (revenue - expenses). How much you will pay is based on your tax bracket,
which currently ranges from 0% to 37% for federal income taxes.
* some states have no income tax
Self-Employment Tax
Self-employment tax goes towards Social Security and Medicare. The total is 15.3% with
12.4% going towards Social Security and the remaining 2.9% going towards Medicare. As a
self-employed individual, you must pay this 15.3% tax on YOUR net profit up to the annual cap which is set at $147,000 for 2022.
This is almost always the largest expense you will have as a self-employed real estate
professional and is often a huge shock the first time you file a tax return after you start your real estate career.
Employee vs. Self-Employed Taxation
Employees also pay into their Social Security and Medicare through payroll taxes. Payroll
taxes are also 15.3% (same as self-employment tax), but there is one major difference.
When you're an employee, your employer pays half of your payroll taxes (7.65%) and you
pay the other half (7.65%). When you're self-employed, you pay the entire 15.3% yourself.
How Can an S-Corp Help Lower Self-Employment Taxes?
Creating an S-Corp or an LLC taxed as an S-Corp is a very common strategy used to reduce self-employment taxes for real estate professionals. Unlike an LLC treated as a sole proprietorship, S-Corp owners do not pay self-employment taxes on the total business profits. Instead, the IRS allows them to pull out profits in two ways. The first is as wages and the second is distributions.
The advantage of pulling profit out as distributions is that they are NOT subject to self-employment taxes as long as you pay yourself a reasonable wage!
In our prior conversation we discussed the 15.3% payroll tax and explained that half of the tax is paid by the employee and the other half is paid by the employer:
When you elect S-Corp status with the IRS, the business is technically your employer. This means the business pays 7.65% of your payroll taxes - and writes that amount off as a tax deduction along with your wages! You, as the owner and employee, will pay the other 7.65%. Keep in mind that you only pay this tax on your "reasonable compensation" and not the net profits.
Example:
Jill is a real estate agent with net income of $125,000. As a sole proprietor all of her net income is subject to the 15.3% self-employment tax - a staggering $19,125... yikes!
On the other hand, John worked with the team at ZanderFi to create an LLC and elected to have it taxed as an S-Corp. Like Jill, he too has net income of $125,000 and with the assistance of his CPA they determined his reasonable salary to be $65,000 - this means he will only pay the self-employment taxes on the $65,000 salary - for a total of $9,945 which amounts to a savings of $9,180 over Jill!
Pitfalls of the S-Corp Election
We've shown you how forming an S-Corp can save you thousands in taxes every single year. So, why is it that only 15% of real estate professionals have taken advantage of the
S-Corp tax structure?
Let's break it down:
Setup Costs - You will have to pay a CPA, attorney, or online service to complete the majority of the setup which will cost you some up front investment.
Bookkeeping and Payroll - You will need to open up a business bank account, setup payroll software, select and maintain a bookkeeping system or software. You will also need to make sure you separate all personal and business expenses (no more charging your groceries on the business card)!
Additional Tax Return - Your S-Corp is a separate entity and as such, a separate tax return is required each year. This return is more complicated than what you previously filed on TurboTax last year so it's time to buck up and pay a CPA to prepare your returns.
Uncle Sam Wants His Money - Service providers like real estate agents are more likely to be scrutinized by the IRS when using the S-Corp structure because most of your earnings come from personal efforts and not that of other employees or contractors. This is why it’s crucial that you work with a tax professional to research and document the reasonable compensation you decide to pay yourself.
Other Taxes & Fees - The IRS will require you to pay Federal Unemployment Tax (FUTA) of 6.2% on the first $7,000 you pay yourself. Most states will subject your wages to State Unemployment Tax (SUTA) and some localities will also hit you up with local employment taxes. Many states also impose ongoing fees for your LLC/P.A. such as annual reports and/or franchise tax fees.
The Bottom Line
Creating an LLC/P.A. and electing to be taxed as an S-Corp can significantly lower your taxes every year. But with that savings comes greater responsibility and additional costs and requirements so it may not be for everyone.
You must weigh the additional costs and requirements against the actual tax savings you will receive. In most cases, this strategy will work better for higher income earners. Before you make an S-Corp election you will want to discuss the advantages and disadvantages with a qualified tax professional.
How ZanderFi Can Help
ZanderFi is an exclusive membership club for highly successful real estate professionals.
Membership will grant you access to a virtual finance team that will handle company formation, S-Corp election, bookkeeping, taxes, payroll and more all in one online platform.
We only allow membership if we can guarantee a tax and time savings that is significantly higher than the fees we charge. As such, our members save over $10,000 in self-employment taxes and more than 100hours of back office work... Every. Single. Year!
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