Why mileage?

When it comes to cars, self employed individuals and small business owners usually have the same two questions: how much of the initial purchase can I write off, and should I keep up with mileage or actual expenses?  I will address the first question in a later article once Congress retroactively increases the depreciation limits for 2015.  The second question is a little more straightforward but with a few special circumstances to consider.  

Taxpayers that use a vehicle for business purposes and are not eligible to be reimbursed for their expenses can deduct either mileage or actual expenses on their tax return.  This is especially handy for self employed individuals that spend quite a bit of time in the car, such as real estate agents or commercial salespeople.  Often, taxpayers assume actual expenses will generate a higher deduction, but that is not always the case.  

Consider this: taxpayer drives a Toyota Camry that has a 17 gallon gas tank and gets 25 miles per gallon on average.  Assuming gas is $2/gallon, that means the taxpayer could drive 425 miles for $34.  The mileage rate for 2015 is 57.5 cents per mile, which means that same 425 miles would generate a $245 deduction using the standard mileage rate.  In this case, mileage is a much better method to use than actual expenses, and that will almost always be the case when the taxpayer has a fuel efficient vehicle in an environment of low gas prices.  

There are a few precautions to take when deciding whether to use actual expenses or mileage on a vehicle.  One is once the decision is made, it usually cannot be changed in the future i.e. a taxpayer cannot take actual expenses one year and mileage the next.  Another is the historical trend that the IRS is usually 1-2 years behind in aligning the mileage rate with expected actual expenses.  The mileage rate is designed to be one number that covers gas, maintenance, and depreciation on a per-mile basis.  From 2014 to 2015 the standard mileage rate increased 1.5 cents, while average gas prices decreased.  It can be expected then that the 2016 rate most likely will be less than 57.5 cents per mile due to the decrease in gas prices, but that will not necessarily be consistent with gas prices in 2016 (which could go up).

Mileage rates for 2016 are expected to be released close to the end of the year (December 2015).  My guess is 55 cents per mile.   

The "be your own boss" tax

Being your own boss can be fun and rewarding.  But, whether you own a small business, run a custom quilting operation from your home or write editorial articles for fun, taxpayers need to be aware of the self-employment (SE) tax.  

The SE tax is imposed on taxpayers that report SE income on their individual Form 1040.  The purpose of the SE tax is to recoup Social Security (FICA) and Medicare taxes from taxpayers that do not pay these through paycheck withholding.  When a taxpayer is an employee, it is their employer's responsibility to withhold these taxes from their paycheck and remit them to the government.  But, since self-employed taxpayers do not receive a "paycheck" per se, they must pay these taxes when they file their individual Form 1040.  

What types of income are subject to the SE tax?

Before calculating SE tax, the taxpayer must first determine how much SE income they have.  Common types of SE income include:

• Rental income
• Net profit from sole-proprietorship or single-member LLC (reported on Schedule C)
• Nonemployee compensation received and reported on Form 1099-MISC, such as contract labor, commissions, or bonuses.

Note that rental income is included above.  If rental income is passed through to the taxpayer on a Schedule K-1, then the K-1 should indicate whether the activity is passive.  If it is passive, then it is subject to the SE tax.  

How much is it?

As mentioned above, the purpose of the SE tax is to recoup Social Security and Medicare taxes.  The Social Security rate is 12.4% on all SE income up to $113,700, and the Medicare rate is 2.9% with no upper income limit.  The total amount of tax will be reported in the "Other Taxes" section of the Form 1040, but 50% of the amount reduces the taxpayer's AGI as an adjustment to income on page 1 of the Form 1040.  Here's an example:

Marty makes and sells custom coffee cups at his home.  He is not incorporated, and his net profit for the year was $75,000.  He will pay total SE tax of $11,475, made up of $9,300 in FICA (75,000 x 12.4%) and $2,175 in Medicare (75,000 x 2.9%).  He will get an adjustment to income in the amount of $5,738 ($11,475 x 50%)

But what if Marty makes really awesome coffee cups?  

Marty had the most successful year of his coffee cup career, showing net profits of $200,000.  Marty will pay total SE tax of $19,899, made up of $14,099 in FICA (113,700 x 12.4%) and $5,800 in Medicare (200,000 x 2.9%).  Notice how the FICA taxes are capped at $113,700, but Medicare is charged on the full amount.

Options to reduce or eliminate SE tax

Taxpayers can reduce their SE tax burden in various ways.  One way is through business structure.  Taxpayers that have substantial business income, such as Marty above, can consider incorporating and filing an S election.  As an S-corp, Marty could pay himself a reasonable salary for the year which would have the required payroll taxes withheld, and the remaining profit would be passed through to him on a Schedule K-1 as ordinary income not subject to SE tax.  If his salary was $100,000 and the other $100,000 was passed through to him on a K-1, Marty would save almost $10,000 in SE taxes.  Marty could also elect to be a normal C corporation, and all the profits from the business would be taxed at the corporate level.  Although this would eliminate the SE tax for Marty, corporate rates are not as favorable as individual rates and the taxpayer could end up paying more in corporate taxes.  

Taxpayers that generate SE income from their home should consider the Home Office Deduction.  The IRS now offers a simplified calculation for smaller operations, but taxpayers with a significant home office should go through the full calculation to reduce their SE income.  

Taxpayers can also reduce their regular tax burden associated with SE income by making contributions to retirement plans.  A traditional IRA is the easy way to go, but taxpayers with higher amounts of income and cash flow should consider a SEP (simplified employee pension).  The SEP will allow contributions up to 25% of SE income, with a maximum of $51,000.  However, the retirement contributions reduce the amount of taxable income, but not the amount of SE income.  In Marty's case above, he would have regular taxable income of $50,000 less after making a SEP contribution, but his SE tax would not change.  

Employee vs. contractor

A hot topic with the IRS right now is classifying workers between employees and independent contractors.  There can be both positive and negative results on how a worker is classified, both for the company/employer and the worker.  The IRS considers three factors when determining whether a worker is an employee or an independent contractor. Behavioral control

This characteristic deals with how the company/employer behaves towards the worker and the work they are performing.  If the employer/company has the right to direct or control how the worker does the work, then they are most likely an employee.  The business does not actually have to direct or control the way the work is done, as long as they still have the right.  Also, if the company/employer requires the worker to attend any kind of training, this suggests that the worker is an employee.  If the business does not have the right to direct how the work is done, but merely suggests timing and deadlines, then the worker is most likely an independent contractor.

Financial control

This characteristic deals with how the company/employer directs or controls the financial and business aspects of the work.  If the worker has a significant investment in their work, has unreimbursed expenses related to the work, or has the opportunity to realize a profit or loss on the work, then they are most likely an independent contractor.  Employees typically do not incur expenses that are not reimbursed by their employer, including significant investments such as vehicles or computers.  Employees also do not realize a profit or loss from performing their work since they are paid their same hourly/salary rate.

Relationship of the parties

This characteristic deals with the relationship the parties have and includes written contracts, benefits, the term of the relationship, and whether the services provided are a key part of the company’s/employer’s business.  If the worker is provided any kind of benefit by the company/employer, such as health insurance or participation in a retirement plan, they are most likely an employee.  If the services provided by the worker are at the core of the business’ operations, then they are most likely an employee.

The terms of the worker’s relationship can be easily defined in a written contract, which will also serve as evidence if the worker’s status is called into question.  The worker and employer/company can use the contract to pass or fail all of the tests listed above in order to classify the worker as expected.  A word of caution – if the signed contract says one thing but the actual work performed is different, the classification of the employee or independent contractor can be reversed based on what actually occurred.

In closing, with the IRS calling into question employment status more often, both employers and employees are encouraged to revisit their staffing arrangements and verify that workers are properly classified based on the characteristics above.