Grant Baldwin
Today we are joined by my buddy Josh Bauerle. Josh is a CPA and tax wizard. So we’re going to be getting into all of that today of talking about taxes, talking about deductions, talking about tax entities or business entities, and when you should be a sole proprietor and LLC.
All the stuff that we’re supposed to know, but none of us really have a clue on. Josh actually knows something about that.
First of all, give us a nutshell of your business, what you do, and maybe even a snapshot of how you got into it.
Josh Bauerle
I’ve been an accountant for close to 10 years now. I’ve been a CPA for about five or six years and worked all over the place: fortune 500 companies, CPA firms, financial advising. I finally realized I just hated being an employee and started my own business, JVB Business Solutions at the time.
We structured it to work entirely with entrepreneurs, especially small business owners, because when I was at those CPA firms, I saw that those were the people that got screwed over by CPA firms because they’re not paying $50,000 a year fees to the firms. So they get the college intern doing their tax return and are still paying $2,000 a year for it.
When I started my own business, that’s the way I wanted to target. I wanted to give them service that was affordable and still good quality service, so they didn’t have to go to a chain tax shop and still pay crazy fees for it.
Early on, I started working with John Lee Dumas, of Entrepreneur On Fire, and got exposed to his audience. Soon we started working almost entirely with online entrepreneurs, or location independent entrepreneurs.
So that’s where we are now, working entirely with them, but I work so closely with John that we actually changed our name to CPA On Fire to align with that and I guess take advantage of that branding.
Grant
That’s so adorable. In fact I’ve had a CPA for the past several years and our business has continued to grow and expand and we recently started working together. So I’m excited to connect with you and definitely have you on the show here.
Let’s start with this, before we get into more of the tax stuff, one of the questions about business entities a lot: “Should I be a sole proprietor?” “Should I be an LLC?” “Should I be one of these other acronyms or terms or phrases that I’ve heard before?” So why don’t you give us a high-level view? What’s the difference and what should entrepreneurs and speakers be?
Josh
This is a super important question for two reasons. One, legal liability and two tax liability. I’m not an attorney, so we’re just going to stick to the tax liability today. There’s three main entities that I think most entrepreneurs should be choosing from: a sole proprietor, an LLC, or an S Corporation.
Some people notice I left the C corporation off. I don’t believe it’s a good choice for 99% of small business owners. If someone is telling you it is, they’re probably giving you bad information and want to make money off you.
So we’re going to talk about those three. Let’s start with the sole proprietor, which is essentially no entity at all. It is essentially, you and your business are one and the same. You never went and registered with your state. You probably don’t have a separate tax ID number. It’s just running off of your social security number. And for some businesses that’s completely fine, especially if you don’t have any legal concerns.
What’s going to happen is, let’s just use round numbers here to make it simple, your business brings in $150,000. You have $50,000 in expenses, so now you have a $100,000 net income. That’s what you’re going to be taxed on. It’s going to be just like you made that money personally.
Once people step up a little bit, especially if they have a partner, maybe they have some legal concerns, they go and form an LLC, a limited liability company, and the idea behind that is mostly for legal protection.
What surprises people is, when it comes to taxes, there’s actually zero difference between a sole proprietor and an LLC. In fact, if you’re the only owner in that LLC, the taxes work exactly the same way. They get reported on the same form. It’s all done on your personal tax return.
All taxes are paid personally. In essence, your business owes zero taxes. What happens, once again, you make $150,000. You paid out $50,000 in expenses. The $100,00 net profit flows through to you personally. You pay the taxes on it. So here’s a kicker with it.
As both a sole proprietor and an LLC, not only are you going to pay the ordinary taxes at whatever your ordinary tax rate is, they’re also going to turn around and crush you with what they call self-employment tax. This is an additional 15.3% tax on top of what you’re already paying. So if you’re doing some numbers in your head right now, that $100,000 net profit just incurred an additional $15,000 tax. You’re going to get crushed on that.
The next level up and where you can finally start saving some taxes is an S corporation.
It’s going to work exactly the same way as the LLC. All that money is going to flow through to you personally. You’re going to pay all the ordinary taxes on it, but you’re not going to get hit with those self-employment taxes. We’re talking potential huge savings there right now. If you’re thinking that sounds too good to be true, you’re partially right.
What the IRS is going tolet you save the 15% on self-employment taxes. But you have to take a salary on yourself. And on that salary you’re going to pay payroll taxes, which is, guess what, 15.3%, same as the self-employment taxes. But there are still some savings there because what you’re going to do is keep your salary as low as possible so that your tax savings come from the difference between those profits and your salary.
There are some guidelines there. It’s not like you can make your salary $10 and take the rest of the distributions. What they say is it has to be a reasonable salary. What we usually recommend, it depends on a lot of factors, is 25-50% of whatever that net income line is.
If we go back to the $100,000 net income mark, maybe we make your salary $40,000, now you’re saving 15% on that $60,000 difference. That’s still a pretty substantial tax savings at that level.
The big question always then is, what happens to the other $60,000? Now I can’t take it out.
The beautiful part of it is you can still take that out. It’s what they call a tax-free distribution. You’re still paying the taxes on it because you pay taxes on all profits, but you can take it out of the company and incur no additional taxes. So it’s a pretty great system.
We just ran through a bunch of numbers there, a lot of confusing stuff. Anything you want me to break down further?
Grant
Let’s back up a little bit. You said you got the sole proprietor, you got LLC, and then you’ve got the S Corp. I personally have experienced all three. We’re currently in S Corp.
Let’s start by talking about the first two there, the sole proprietor and the LLC. So you said in terms of the taxes, there’s not a lot of differences. So the only difference is going to come legally. I know you are not a lawyer. I’m not a lawyer, we can’t give legal advice, but what would be the nutshell legal differences between the two?
Josh
So essentially what an LLC does is separates you and the business. As a sole proprietor you and the business are one in the same. The general idea behind an LLC is it creates a layer of separation. So if someone gets mad at you, Grant, and says that you gave horrible speaking advice and they got booed off the stage and they sue you. They’re suing the LLC and not Grant.
Grant
So they can’t come after my home or my personal assets basically.
Josh
Yeah, that’s a general idea behind it. An attorney will still tell you that there are dangers there, but generally speaking, the idea of it is to protect you there.
Grant
So at what point then, for an entrepreneur or a speaker in general, should we consider moving from a sole proprietor to an LLC? And what exactly would that entail?
Josh
So basically if you have any legal concerns at all, it’s time to start considering the LLC because as a sole proprietor you have zero protection. So if you’re in a line of work where you think that could be an issue it’s time to start considering the LLC.
It is something you could do yourself. There’s tons of guidelines on the internet. I would certainly recommend hiring either an attorney or a CPA to set that up for you. It’s basically filing paperwork with your state and forming the LLC.
In most states we’re talking $100-$200 to pay their fees to do it. In some states like California, it’s going to be significantly higher, but for the most part, we’re not talking a huge sum of money. Obviously going to have to pay someone to do it for you if you go that route, but we’re probably talking $1,000 or less altogether.
Grant
I remember when I first filed it in Missouri, when I was living there. I remember filing it just through the state and it was no more than a couple hundred bucks. It didn’t seem like it was that complicated. I don’t remember having an attorney involved with that. It was just, filling out some documents online and so, this is subjective, but it wasn’t that difficult.
Josh
Yeah, and I would say for a lot of people, that will be fine. If you’re in a business that you think there’s significant legal concern, it probably would be worth it to have an attorney create an operating agreement and make sure you’re completely protected there.
Grant
Maybe people that are listening are an LLC and they like the idea of saving 15.3% of their self-employment tax. So at what point should we consider switching from an LLC into an S Corp? Is there a revenue threshold, or what should be some of those benchmarks we should be looking for?
Josh
This is the big question. You don’t want to make this move too soon because there are expenses involved with maintaining that S Corporation. The big one being putting yourself on payroll and paying a payroll company for that.
So our general guideline is once you hit $30,000 in net income, and again, by net income we mean after all expenses are accounted for. Once you hit that $30,000 level, it’s time to start considering it. Once you hit $40,000, it’s probably time to put that into action.
Grant
So if my speaking business did $50,000 in gross revenue, I subtract out my expenses of $20,000, I’m left with $30,000 net, then I should start looking into it.
Josh
Yep. It’s time to start considering it then, and you’d probably be pretty close to wanting to make it happen.
Grant
So what is the process of switching? If I’m an LLC or a sole proprietor and I want to switch to an S Corp, what would that involve?
Josh
Yeah, so the cool part is an S Corp actually isn’t an entity by itself. Basically it’s just a tax election. So you start out as either an LLC or a C Corporation, and then you just file a form with the IRS saying you want to be taxed as an S corporation.
So if you’re a sole proprietor, the first step is forming the LLC. I should have mentioned that before, but that’s also one reason I do recommend Sole proprietors move into an LLC. It creates that flexibility where you can go to the S Corporate any time. Once you’re the LLC, basically all it is filing a form with the IRS Form 2553 to be taxed as an S Corporation.
Grant
2553, we all knew it was that form. We knew exactly what you were talking about.
Okay alright, so let’s shift gears a little bit. In fact I did an episode recently, episode 38, where we talked a little bit about business structures and entities and what my evolution was in business. So people can certainly go back and listen to that one. Although I’m not a tax professional. So it’s great to hear Josh and his perspective on this stuff. That definitely will help.
Okay, let’s talk about the tax side of it. So let’s imagine I go to a speaking gig, I get paid $2,000, my travel expenses are $500. I have $1,500 left over. What do I do now? How do I figure up taxes? I just want to make sure that come April 15th or quarterly taxes, the money’s there. So what do I do and how much should I set aside? How much do I owe?
Josh
That’s a tough question to answer because contrary to popular belief, the tax code doesn’t work like: I made $200,000, that means all of my income tax is in the 35% tax bracket. You work your way up through the tax bracket, so your first maybe $18,000 is taxed at 10% and your next —I’m just making these up— $35,000 is taxed at 15%. So it is tough to just say, “set 25% aside, and you cover your taxes.”
But that is a number I actually recommend start with, 25%. And again, we’re talking net income here. So after you factor in your expenses, that’s what you’re going to pay taxes on.
Grant
So in that example, if I’ve got a $2,000 speaking check that comes in, I had $500 in travel expenses. Am I paying the 25% on the full $2,000 or on the net $1,500?
Josh
On the net $1,500, that’s what you’re going to make taxes on.
Grant
So in that case we would be setting aside $375, if my math is right. If I set aside that $375, do I just write a check or what happens from there?
Josh
This is a big question too. There’s a couple different options. You can pay them all at the end of the year, which is not what the IRS wants you to do, generally speaking. If you’re going to owe over $1,000, they want you to pay estimated taxes.
There’s a lot of confusion around estimated taxes. Most of the people I talk to who are just starting in this think that they’re actually filing a tax return every quarter. All estimated taxes are saying is, “Hey, Dear IRS, I made $10,000 this quarter. I anticipate owing $2,000. Here’s my check for that amount, $2,000.” All it is is sending them a check in a voucher. It’s not filing any type of tax form,
Grant
And I will tell you that you want to get into the habit of doing this. I’ve got these dates on my calendar every single quarter. It’s January 15th, April 15th, June 15th, and September 15th.
You want to etch those dates into your brain. We did a tax episode back in episode 33, if you want to listen to that one again.
I’ll walk through more in depth on my personal process of what we do, but basically every other week we’ll take whatever revenue has come in from those past two weeks. We will subtract out any of the expenses, like Josh was talking about there. And then on that net amount, like you said, we set aside 25% and we put that in a separate tax savings account, and we literally call it the tax savings account. It’s out of sight, out of mind. I found that if the money is just sitting in my regular business checking account, I think of it as available money there.
But I do not want to think of it that way. I want to make sure that this is already set aside for the government. I’m going to be writing a check and I need that money there. So we put all that money in that tax savings account.
Then once a quarter when that check comes due for paying your quarterlys, then we just transfer all the money back to our business checking account. Basically drain that amount, write the check to the federal government as our quarterly estimate.
So would that be a fair way to do it?
Josh
That’s a perfect way to do this. It’s exactly how I do it in my own business. I completely agree about putting it in a separate bank account.
With any business, cash that’s available tends to get spent, so make it unavailable. I’m sure there’s some people listening out there— I have a lot of clients that feel this way— that think if the IRS isn’t going to make it mandatory that they do this, they don’t want the government having their money.
They’ll pay a little bit of a penalty not to do it. If that’s you. Still put this in a separate bank account. I see people all the time, come to tax time, I tell them they owe $20,000 and they have nothing.
So put that aside. It’s a mandatory expense in your business. It never sees you personally. It goes right into that account.
Grant
Yeah, you don’t want to get to a spot where the money comes in today and I don’t have to write the check for a couple months, so I’ll spend it on something else and then I’ll just make it up instead of the aside somewhere else.
You’ll start to kill yourself cash flow wise. Just set that money aside. It’s out of sight out of mind. It is not there. And it is frustrating when you have to write that significant check come quarterly time, but you want to be in that spot so that you don’t get to the end of the year and you’re filing your taxes and you owe thousands or tens of thousands of dollars that you just don’t have.
Anything else that we need to talk about as it relates to quarterlies and paying those estimated taxes? What about state taxes? Do I need to do the same with state taxes on paying estimates?
Josh
Absolutely. The state taxes are a part of that as well. If you’re going to owe them over $1,000 they’re going to want you to pay estimates. Do it the exact same way. Most states you’re talking under 5%. So if you put that 25% aside, I usually include that as state taxes as well.
If you’re in a higher income state, maybe you’re in California, maybe you set aside 30% instead of 25%. But you’re just sending them that check every quarter, or at the very least, keeping it in a separate account, ready to pay it at your end.
Grant
Or you can do what I did and move to Nashville, Tennessee where they don’t have state taxes.
They do have a different self-employment business tax. It cancels that out nonetheless. But obviously every state is different, so you want to make sure that you check with someone who is familiar in your state with what the state tax laws may be.
So we’ve talked a little bit about paying those quarterlies. Let’s talk about deductions in business. Being self-employed, I’ve heard that there’s some things I can deduct, some things I can’t. There’s a lot of subjectivity to this, and a lot of it depends on the industry, but let’s just go over some high level views of deductions. What’s deductible and what’s not for most entrepreneurs?
Josh
Here’s the rule. If you follow this rule, you’ll be 90% of the way there. If you spend money on something and you can prove that it either increased your income or decreased the expenses you spend in your business, there’s a good chance we can deduct a portion, if not all of that.
If you live by just that rule, you’ll be most of the way there. What’s so great about being an entrepreneur is that this can include personal expenses that were personal before you had a business. So your cell phone, you had it before you had a business.
You still use it personally, but it’s absolutely necessary for your business. So now we can deduct that in your business. Home internet, if you run an internet based business, is absolutely deductible. Whether you use it personally or business or both. That’s where I see people not taking advantage of things, they’re not turning these personal expenses into business expenses.
Even vacations. This is one of the best strategies we give to people. You plan to go to San Diego, California for your vacation this summer. You look up a couple conferences while you’re there that you have to attend there, and now a portion of your vacation becomes deductible. This certainly isn’t something where you want to push the rules and make up things that aren’t actually happening.
If you’re going to do this, you’re going to actually attend this conference and make it something that actually does help your business. But as long as you can answer that question I talked about, and you can say, “this gave me this idea, which improves my business”, it’s a very legit tax reduction.
Grant
So you mentioned your cell phone and home internet, what would be some other really common deductions? What about even things like mileage and cars and gas? How does that work?
Josh
Yeah, absolutely. So your car can potentially become a tax deduction on what you’re using it for business. So the big mistake is a lot of people think that if they have an office they can deduct driving to and from the office. That portion is not deductible. But if you have to drive to a client’s office, if you have to drive somewhere to pick up supplies, if you have to drive to meet someone at a restaurant, that is all tax deductible.
There’s two ways to do it. You can go the hard route of monitoring every single expense with your car, whether it’s business or personal for the whole year. Then you take the percentage driven business versus personal, and then you take that percentage of the tax deduction. So you spend $10,000 on your car for the year.
You drove it 30% for business, now you have a $3,000 tax deduction. If you’re super organized and you’re constantly keeping receipts, that could be a good way to do it.
You may get a little bit more of a deduction. The easier way is to take the IRS standard mileage deduction, which in 2015 was 57 and a half cents a mile. So if you drove 10,000 business miles, you have a $5,750 deduction from your taxes.
Grant
That’s what I do personally. I’ve got an app that I use on my phone. And I’m just getting in the habit of it. In fact, before I had the app, I had a spreadsheet I made, like a printed out one. So every time I’d get in the car, I’d write down the beginning mileage, and then when I got back I’d write down the ending mileage. So this works really well. I do an abundance of lunch meetings with clients, potential clients, coworkers, and colleagues.
So if I’m going to a lunch like that, then I’m going to be writing that down, if I’m going to the bank to make a deposit, if I’m going to the post office to mail something. The other thing that’s really valuable, especially with speakers is if you’re doing any type of speaking gigs, that you are driving to those gigs, and especially if you are driving a long distance.
I might go speak at something and I had a four or five hour drive. That whole drive, all the mileage there and home, is deductible. So you want to make sure that you are tracking that and that you’re keeping good records on it.
Josh
Yeah, absolutely.
When it comes to any type of tax deduction, when it comes to the IRS in general, documentation is the biggest thing that we always say. Real estate, they always say location. When it comes to the IRS, it’s always documentation.
Grant
It just sounds harder to say though.
Josh
For us accountants, It’s a phenomenal joke. We crack up.
Grant
It kills every time. All right. We touched on travel there in terms of driving. But as speakers we have a lot of travel involved, meaning airfare, rental cars, hotel meals, it’s done a little bit differently.
So talk us through that as it relates to travel for speakers.
Josh
Any travel you’re doing directly for speaking is certainly 100% deductible, flights, hotels, mileage, any of that stuff. One important thing to note here is whether the company you’re speaking for reimburses you or not. Just to give a brief overview on this, there’s a few ways they can do that.
If they reimburse you, they can record that reimbursement amount on your 1099, and then it’s going to show as income.
So you’re going to have to turn around and deduct those expenses on your tax return. What a lot of them will do is just give a reimbursement, not report it on your 1099 and now you’re not going to be able to deduct that.
Either way, it works out exactly the same. But you need to know ahead of time what they’re doing so that you know what to do on your taxes.
Grant
You brought up a key thing there, 1099s in general. As speakers, whenever you are going to speak at a different organization, company, college, high school, whatever it may be, you are basically an independent contract.
You’re not an employee of theirs, so they’re not sending you a W2 at the end of the year. They’re sending you what’s called a 1099 form saying that they hired Grant and they paid Grant X amount of dollars for his services. They’re sending that 1099 to me, and they’re also sending that to the government saying how much they paid Grant, so the IRS can make sure Grant files that on his taxes.
As your speaking business grows, by the end of the year you start getting a lot of 1099s. We’ve had, 30, 40, 50, 1099s some years that we’re accumulating from all these different organizations that we’ve worked with. Therefore, I have to make sure that’s all categorized and filed correctly.
Josh
Another important note on 1099s, especially if you are a sole proprietor or the only owner in an LLC, if they send you a 1099, you actually report that 1099 separately in your tax return. So where a lot of people run into problems is they’ll report the income, but they don’t actually show it as a 1099 they received.
So now the government sends you a nice notice saying, “Hey, you had this $30,000 1099 that you didn’t include on your tax return, so please send us the $5,000 for that.” But you did include the income. You just reported it directly on the business return, which is fine, but now you’re in a little bit of a battle with the IRS proving that’s what you did.
The 1099 is an important note. If you are an S Corporation or an LLC with multiple owners, that’s not as big of a deal because you don’t report those 1099s directly. But as a sole proprietor or single member LLC, it’s a huge issue.
Grant
Let’s talk about this for a second. I’ve heard of varying things from varying speakers and varying CPAs, but I’ve heard that, for example, right now I’m in Tennessee and if I go to speak in Ohio any income that was earned, any check that was received from speaking at that gig in Ohio, I need to be paying state taxes to Ohio for that. Can you talk us through that and how that works?
Josh
Yeah, thanks for using Ohio. No one ever uses this example. So this actually is, like you said, a very confusing issue with a lot of different advice on it. Technically speaking, where you perform the work is the state that considers that income taxable.
So if you live in Tennessee, you come to Ohio, you do a speech here, Ohio takes the taxes on that income. Now most states have a minimum threshold of whether you have to actually file a tax return.
For a lot of them it’ll be your standard deduction, which is going to be around $6,000. So for a lot of states, if you didn’t make over $6,000, you’re probably going to be fine. But not all states are like that. So that you can do one or two things.
You can look into each state’s rules that you’ve spoken in or you can just file in every state just to be safe. And I’ve seen people do it both ways.
Either way is fine as long as you’re making sure you’re covered for those states that you actually do have to report and pay in.
Grant
When you’re getting started, you probably are doing just a lot of local stuff. You’re doing a lot of stuff in your home state. But when you start doing more states, I think this is definitely where it’s worth getting a CPA involved.
The past couple years we’ve had to file state taxes in 25 states, something like that. It just becomes a lot. So a lot of those places, like you alluded to there, Josh, we may not technically owe anything. We’re just supposed to file just to say, “Hey, just a heads up, we earned X amount in Ohio.”
And some places do want a little cut of it, and sometimes it’s a very small cut.
So we just finished tax season here and at the time we’re recording. We wrote probably 20 small checks. Most of them are under $100. It can become a lot to keep track of, and I think that’s definitely where you want to get a CPA or a tax professional involved with it.
Josh
Yeah, and here’s to add another layer of confusion with it.
So you live in Tennessee and you paid those taxes to maybe Utah, but your business still runs in Tennessee, so Tennessee needs you to report that in your Tennessee return as well. But go ahead and take a credit for the taxes that you paid for Utah. So it’s just moving money all over the place, showing different credits and who paid what. So yeah if you’re speaking in different states, hire someone to do this for you.
Grant
Taxes are a necessary evil and even though I’m a bit nerdy and geeky —I did my own taxes through TurboTax for years and I didn’t mind doing it— you do get to a point where it becomes very complicated and very confusing. It’s definitely good to have an expert like Josh on the team who can help you with that.
So, Josh, as we wrap up, any final words of wisdom, any other things we need to be aware of or considering whenever it comes to taxes and business entities in general?
Josh
I think the one thing we didn’t really touch on is bookkeeping or record keeping. I already said documentation is super important and a lot of people in their first few years in business think they’ll just tell their CPA they made $2,000 net income and that is what gets reported.
And it’s not quite that simple. What you’re going to actually have to do is tell the gross amount of money that you made.
Then break your expenses down by individual categories, so advertising, office expenses, meals and entertainment, travel, whatever. It has to be broken down by these categories.
A lot of people run into trouble when they get to March and they’re about to file their taxes, and they haven’t done any of this. Now they have to pour through 12 months worth of records and separate all of that into these various categories.
So one of the best things you can do for yourself early on is to get some type of accounting system software.
If you want to use a spreadsheet, that’s fantastic, if you have the discipline to do it. I even have a free spreadsheet on my website that you can download and use. But for most people, you’re probably going to want to use some type of software, whether it’s QuickBooks Online or Zero, or any of the various ones out there.
We’re probably talking $30 a month or less. What it’s going to do is sync directly to your bank account.
Every time you spend money or money comes in, it’s going to automatically pull in there. All you’re going to have to do is go into the software there and say “this $250 was spent on a flight.” So it gets coded to travel. Then at year end, you have a nice, neat profit and loss statement breaking this down for you in tax season. Pretty simple for you.
Grant
You have to keep on top of these things, whether it be that you’re syncing up with your bank accounts through some type of online tool, or you are manually entering it in some way. You are always keeping track of these expenses, so that whenever it comes tax time, you’re not scrambling and handing a tax professional your shoebox of receipts. That is a mess for you. It’s a mess for them.
As the business owner, you have to keep track of your money.
You have to keep track of what’s coming in. You have to keep track of what’s going out. And I’ve always been ridiculously anal on this stuff because cash is the lifeblood of your business, so you have to watch this stuff.
Joshua if people want to find out more about you, what you’re up to, where can we go?
Josh
Go to my website, cpaonfire.com, or if they want to ask a few questions they can always reach out to josh@cpaonfire.com.