Atlanta Financial Blog

Financial Planning for Contractors

Chris Blackmon, CFP®, CPA
August 13, 2019

Are you considering taking the next step to work for yourself? Working for yourself as a business owner or with others in a contractor or consultant role can be very financially rewarding. It can also provide you with a sense of self-pride not found while working as an employee for someone else. While there are many benefits, there are several key decisions that must be made to operate successfully in this new environment. The most commonly asked questions are:

• Should I form an LLC?
• Should I make an S-Corp Election?
• How do I pay my taxes?
• How do I save for retirement without a 401k?
• How can I protect my family now that I don’t have employer benefits (or group benefits)?

Should I Form an LLC?
LLC is a popular ‘buzzword’ in our current entrepreneurial landscape and many people form Limited Liability Companies (an LLC) without understanding what they are doing and evaluating whether they truly need a separate entity. There are times when an LLC is needed for legal separation of the business from the individual who owns or operates the business. One should consult with their attorney regarding the legal needs of an LLC and whether this legal structure provides the desired legal protection.

From a tax standpoint, forming an LLC does not necessarily affect how you are taxed. A single-member LLC is taxed as a disregarded entity for IRS purposes. This means that John Doe Consulting Firm, if owned solely by John Doe, will report income on Schedule C of his tax return whether he forms an LLC or not. From a tax standpoint, forming an LLC on its own does not affect the way you will be taxed.

There are tax savings that can be achieved through having your LLC make an S-Corp election. In this tax and legal structure, you, as the owner, work for your LLC and pay yourself a reasonable salary. For example, if after deducting all expenses (including John Doe’s salary), the consulting firm shows a profit, any profits not needed to keep the business running can be paid out to the owner as a distribution. He will have to pay income tax on the distribution, but neither the business nor the owner will have to pay payroll taxes on the distribution amount.

Should I Make an S-Corp Election?
If you have formed an LLC, you have the opportunity to make a S-Corporation election. This means you will pay yourself a salary from your business and receive additional earnings from the business above your salary as distributions (not subject to FICA taxes.) This can provide significant tax savings depending on the business income and where you set your salary.* Before the new tax law in 2018, this previously was an easy decision from a tax savings perspective. Now with the introduction of the 20% pass household income may limit your deduction. Making a S-Corp election also comes with the additional burden of filing a separate tax return and formalized payroll, likely at additional costs.

To make a S-Corp election advantageous:
• You need to have stable and predictable cash flows.
• You should have an advisor perform a cost-benefit analysis of tax savings versus additional administrative costs and should also consider whether tax section 199A is applicable (the pass-through deduction which may allow 20% of your income to be excluded from income tax.)

How Do I Pay Tax?
While working as a W2 employee, income tax (as well as FICA) was withheld from your regular paycheck and any amount owed or to be refunded was determined when filing your tax return. When working for yourself, you are responsible for making estimated tax payments regularly throughout the year. You will pay 14.3% of your net earnings (up to the Social Security wage limit) in self-employment tax (FICA tax), plus your income tax responsibility.

A tax professional can assist you in determining the appropriate percentage to pay. Estimated tax payments are scheduled to be made on April 15, June 15, September 15, and January 15 (of the following year.) Estimated tax payments can be made online by creating a profile at www.eftps.gov or by mail with a Form 1040-ES voucher and check. Even if you have formed an LLC and made an S-Corp election, you should determine whether your K-1 income would warrant the need for estimated tax payments.

How Do I Save For Retirement Without a 401k?
As a self-employed person, you must be proactive in continuing to fund retirement. Using tax-qualified savings plans will make your job easier, since these give you a taxdeduction equal to your contributions AND allow your savings to grow tax-deferred. The most popular options are:

  • Individual Retirement Account (IRA)
  • Self-Employed Pension (SEP IRA)
  • Solo 401k

An IRA is an account set up at a financial institution that allows an individual to save for retirement with tax free growth or on a tax-deferred basis. This can provide more control and increased investment options. An IRA can be used in conjunction with either of the other two plans noted above. The negative to only having an IRA is that the limit on contributions for those under age 50 is $6,000/year ($7,000 for those age 50 and above). IRA contributions must be made before April 15th the following year. Without additional savings, these amounts may not allow you to reach retirement goals. IRAs can also be used to consolidate old retirement plans from previous employers.

A SEP IRA provides the ability to save more than an IRA while allowing flexibility for the owner. Contributions can be made from the business entity up to 25% of W-2 earnings or 20% of self-employed earnings. There are no costs to administer a SEP IRA as this type of plan can be easily established by your financial advisor, and contributions can be made for the prior year until the time you file your tax return.

A Solo 401k plan acts similar to the 401k plan you may have had at a larger employer and may allow you to save more money than a SEP IRA or traditional or Roth IRA, but does have administrative costs with forming the plan and annual filing requirements. Once again, your advisor can assist you with establishing a Solo 401k if this is the right type of plan for your circumstances.

There are also Deferred Compensation and Cash Balance plans available for those looking to save in addition to retirement savings discussed above. For a more comprehensive understanding of tax implications and contribution limits please visit: https://www.irs.gov/retirement-plans.

It is extremely important for your long-term financial success that you have a retirement plan in place, and fund it regularly just as you would working for a larger company that provided a 401k plan or other comparable plan. A discussion of your goals with a financial advisor is the best way to determine the appropriate retirement plan.

How Can I Protect My Family Now That I Don’t Have Employer Benefits (or Group Benefits)?
Many employees of companies have a variety of types of insurance provided for them (health, life, and disability). All three types of insurance could have their own dedicated discussion. Many employers provide short-term disability with an option to purchase long-term disability. While short-term disability is important, if you have built a sufficient nest egg, a short-term work interruption is unlikely to financially ruin you or your loved ones. However, a long-term disability can bankrupt your family. Long-term disability is typically most affordable through an industry group or trade association you belong to (for example, the American Institute of CPAs or the National Association of Realtors, etc.) If that is not an option, long-term disability insurance should be purchased through an individual plan. Plans will vary in price based on the type of industry you work in and how much coverage you obtain. Disability insurance is typically purchased with after-tax money, and benefits are provided tax-free. One of the most important things to understand is how the policy defines disability (are you protected if you can’t work in your current occupation or just if you can’t work at all in any occupation?). Other policy features you will want to consider include whether the policy covers partial disability, how long benefits will be paid and if the benefit increases with inflation.

Many employers provide group term life coverage with an option to purchase additional coverage. While life insurance purchased through an individual policy can be more expensive, sufficient term life insurance can usually be purchased at a relatively low cost. If you took on any debt to start your business, it is likely life insurance is needed to cover those debts. Other items to consider are any other debts you may have (a mortgage for example) and providing a nest egg to provide income for your surviving family. Because the need for disability and life insurance fluctuates based on your financial stage of life and family circumstances, these should be reviewed regularly with your Financial Advisor.

Owning and running a business can be complicated and stressful, especially in a field that ebbs and flows like construction and real estate. But planning for the financial issues you face doesn’t have to be if you have the right guidance from a trusted advisor. If you don’t currently have an advisor to guide you through these issues, or you aren’t sure of the advice you are receiving, please reach out to me.

*Salary must meet reasonable compensation standards from the IRS (https://www.irs.gov/businesses/smallbusinesses-self-employed/paying-yourself).

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