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W2 vs 1099 vs K1: It’s Tax Day!

That's the progression

It's how it's set up. If you're an entrepreneur, you'll know about K1s soon enough. It's how the moderately rich, as well as the richest of the rich operate, mostly. Now let me tell you exactly how it works. First, dispense with the notion that those overseeing your tax code haven't an out for themselves.

You get your first job. You get a W2 in January. Celebrations. And if you're "lucky," the scheme says that if more of your own money was witheld than the thousands of pages of regulations dictate—that costs you $300-$400 in preparer fees should you wish to trade that for a few dozen hours of your "worthless time"—you'll get a refund. You get your own money back at zero interest. BIDNITMAN!

If you're "unlucky," you have to pay $1—so you didn't loan the Feds any money interest free over the year. But most people love a huge refund; it's part of the general social anesthetic and amnesia. Well, since America is a socialist country, now, that's all baked into the cake. The Fed is just like your best friend, helping you every day to live your life at the socialized expense of other people. Give 'em a loan at zero interest, just like your best friends.

There's one thing about a W2, however. You and your employer split the Socialism Security bill. It's on the order of 15ish% on the first $110,000 of income (0 thereafter, so if you make lots, no big). If you're an entrepreneur and have no employer, guess who pays the whole bill? You do. Great incentive to go out and start a business. On the other hand, for anyone you employ—in addition to all the other stuffs—you're going to have to pay that other half of the Socialism Security as well. Because that's what those who issue a W2 to people (employers) have to do.

So, if you are an entrepreneur, it might just be best for you to deal with everyone you can as independent contractors like yourself—on 1099—and everyone just pays their own Socialist Security Tax...that's that tax where old people who didn't see to their own old age can live at your expense because you still draw a W2 paycheck (note to old people: what you paid was consumed by far older people back when you were young; your "moral high ground" in this Ponzi Scheme is that you were stolen from, and so that entitles you to steal from young people just building their lives; be sure and thank your grandchildren and great-grandchildren).

A 1099 scheme is a best-of-worst way to get started, in spite of the tax disincentive. Most people just learn to live with that. Factor it, but when operating small, it's more important not to get bogged down. You have a lot of flexibility, all income you make in no matter what endeavor falls under the same umbrella. Unless you're an accounting obsessive, you can make that burden less onerous on yourself than with an incorporation scheme.

Often, people just starting out buy into the silliness over incorporating, justified by a whole lot of utter bullshit (by sellers of turn-key filing services). If you aren't very well into the multiple 6 figures ($100-200K +++) it's usually bullshit. Until you are very well into the money, the extra tax compliance will far outweigh any advantage to incorporation. Trust me. Been there, done that.

If you're tired of an employer and want to strike out, start as a 1099 entrepreneur. Don't bother forming a corporation. There will never come a time when flags pop out and it's too late to incorporate. Just like filing bankruptcy, you can always file for a corporate entity. Wait until necessary (I'm speaking practically, legally, of course—it's all total bullshit on principle grounds of freedom).

Once you have either made some serious money, have a business plan that contemplates it from the outset (e.g., involving Angel or VC investment), or already have a mature company, here's how you save TONS on taxes just like all the rich people, Congressmen, Senators and so on, do—while making regs over taxes for you.

But First! Contemplate this. What is all the political wrangling always about? It's about the "income tax." What do they mean? First, know that the tax code contemplates two distinct kinds of "income." One is the one everyone is familiar with. It's your paycheck (W2). It's also anything you earn as a contractor or entrepreneur (1099). The tax code differentiates that as "direct income." You could call it "sweat of brow" income, that's pretty much what it is. You are earning it directly, i.e., time, effort, piecemeal or contract.

And guess what? That's what the hoopla is always about (except Capital Gains, which is a big diversion, but I'll get to that).

What is never talked about? Indirect Income ("passive income"). This sort of income—90-100% of what guys like Warren Buffet make—incurs 0% Socialism Security tax or anything else like Medicare or any of that other stuff. It's about a straight 15% tax. The catch is that is has to be truly indirect....basically, income on various investments, or you're "cheating" to report it that way. Here's examples of truly indirect income.

  1. Dividends on stocks & bonds not wrapped in an IRA, 401K, Insurance policy or any or the other differed income strategies (you pay direct income taxes on that later, as distributions).
  2. Dividends or profit distributions from companies you're closely tied to. Maybe, you even started the company.
  3. Various other things like mineral rights, royalties and so on you may receive.

The biggie for you is #2. Here is your path to "the flat tax" of about 15%, that the very rich have always been doing. Yes, they pay W2 taxes on anything they make in that realm, but for most, it's a small percentage, so it's pocket change. Take a modern President. He makes about a half mil per year as a W2, pays all the taxes, people swoon, etc. Now, those millions he's going to make later in speaking engagements, book deals, consulting fees and so on? They'll all come under some tax structure like an S-Corp, LLC, perhaps even a C-Corp, but it won't be ex-pres running the deal DIRECTLY, and 100% of the millions that pass through to him will be indirect income. He's merely a stockholder in his own corporation collecting dividends.

BTW, movie stars and other high value folks have been doing this sort of thing forever.

Here's the challenge, though. You have to be big enough, enough activity that you can legitimately claim that you don't run the thing as top employee (and you can't be technically an employee at all). When I reorganized as an S-Corp in 2006, I had already hired a guy at $110K per year to run everything, fired myself, and I was in the office max once per week (justifiable, and I KNOW IRS audits). So, this is a path to lower taxation number one, and to let you know what a sucker they take you for, number two.

However, you can easily start getting savings now if you have a small business that makes decent money. Form an S-Corp or LLC. Take a guess on what proportion of what you get is the result or your own daily management efforts (W2, 1099, full brutal tax), and what proportion is as dividends or recompense from a growing investment (K1). Many go with 20% as 1099 and take the other 80% as K1.

Oh, yea, Capital Gains tax is how the rich people keep you distracted from indirect income. Look at it this way. They, or family, or a trust have been making income off an investment for eons (K1 and similar variants). It has paid for everything, taxed minimally (yes, tax guys, I know there are technicalities, here). Best you not know how little. Instead, depending on what side of the red or blue isle you reside, let's make a big deal about selling that asset that's been making money with little tax for decades, and what tax is payed on that single event at sale. Been working to keep you distracted forever. Try even to Google up much info about indirect income and taxation. I've been living that "dream" since 2006.

Now, better get that return stamped in time, all you voting taxpayers. The well being of the world depends on it.

Comments

  1. Ok, question. What about if I form an LLC to buy rental property and have no employees or partners and the closest thing to an “employee” is the management company I hire to collect the rent. What can I do to reduce my taxes, anything? From what I’ve read, rental income – deductable expenses = my income which I have to pay taxes on at the same brackets as W2 income since it’s a passthrough entity.

  2. Hear, Hear!

  3. Alex

    Chances are, depending on state (minimum $800 tax on LLCs in Ca) and the extra cost of compliance, it’s not going to make a big until you get to a number of properties all good posisive….I’m thinking 30k per year and up to make it worth it, off the bottom of my ass.

    But yes, scale it enough, the P&L is just that and what pops out is a straight indirect income. To make it squeaky clean, use management companies (an expense item). That’s what I did. I had 10 rentals and never managed one of them, ever. Worth it. I’ll take getting a call over replacing a dishwasher at a respectable 3pm the next afternoon than an irate tenant at 8pm right before American Idol comes on any day. :)

    • Hey Richard,

      I’m a huge fan of this site, it’s great! I stumbled across this post and was curious about the passive income aspect. How can giving a speech qualify as passive… doesn’t the ex-pres have to at least pay himself some kind of “fair” salary?

      Same goes for movie stars… how can they make passive income on income that only comes from their participation in a movie? Is this just a giant loophole they can exploit? I find it fascinating and would love to hear a little more about it! Thanks. Happy New Year!

      -Rob

    • Robert:

      It’s passive because you are a member (LLC) or shareholder (S-CORP) of the pass through entity. So, all net income after expenses passes through to the members or shareholders, same as if you were getting dividends from stock you hold. For tax purposes it’s treated the exact same way.

      However, if you do actually work for the company as well, then you are supposed to be paid appropriately for those services either W-2 or 1099, and that would be direct income. However, even essentially “sole proprietor” S-corps can effect some tax savings by having a bare minimum salary such that the company shows a profit, and that profit is passive income.

    • Thanks Richard. Our tax system is so F’d it’s comical. But at least there are ways around it!

  4. …Alex, justo be clear, what I’m talking about is a typical Sched C for any enterptise (one for each, basically a P&L) vs a K1 as a pass through via an S-corp, LLC, or pure dividends from a c-corp.

    Just keep in mind, this is all bullshit, Im an anarchist, and I know my enemy well.

  5. Gabriella Kadar says:

    Same crap in Canada. Except we get much more taxation on dividends, selling shares at profit and the rest of the various investments.

    There some passive aggressive stuff going on here. It’s now been acknowledged that people who have the choice only work for SO much because the tax rates zoom up at higher incomes. Sure, if some asshole like the CEO of the Royal Bank gets $12.5 million per year, he’s got whatever means to reduce his tax bill. But most ‘enterpreuners’ or self employed people don’t have this guy’s uber accountants and therefore, people just keep their incomes lower but comfortable just so they don’t work for next to nothing after tax. It’s not going over too well with the ministry of finance. They’ve finally ‘twigged’ on why it is that people aren’t all that enthusiastic about busting their balls to go that extra mile when most of it is taken away.

    Around here, when it’s a long week-end with a holiday Monday, most people take Friday off as well. You just can’t keep whipping people and expect them to enjoy it.

    Today wasn’t even a holiday and traffic to work in the a.m. was scant. Traffic coming home was non-existent. Either people don’t have jobs or the ones that do, don’t want to ‘overwork’. There’s no reward.

  6. I like these posts, especially because they’re not in my wheelhouse.

    I don’t think I’m 100% clear on when it makes sense to incorporate but I’m happy to gather that it’s later than I’d feared. The idea of running corporate books and filing corporate tax forms makes me crazy. I wanna be making way more than i am now before I get into that shit.

    Please keep these posts coming, Richard.

  7. One of the first things I did when I inherited my husband’s manufacturing co. in 2011 was to dissolve the C-corp and form an LLC (which files as an S-corp). Had there BEEN LLCs in 1961, I’m sure Michael and his dad would’ve formed the biz as an LLC and not a C-corp (with its obnoxious double taxation and onerous requirements!).

    (In the U.S.) company profits ‘flow through’ to my personal income (whether or not I take the $$ out as dividends), but it’s not taxed as salary, against which the IRS charges various employment taxes (Social Security, etc.). The IRS (allegedly) watches to make sure I’m paying myself (close to) a “normal” amount for the (managerial/production) work done, but I don’t have to have “corporate” meetings and piles of filings and so on. Yes, I pay an accountant, and yes I have to keep very good records, but it’s way less than a C-corp requires, and the benefits and protections of the LLC/S-corp are substantial.

  8. Yep, Elanor, that’s the way you do it.

  9. In Europe it’s even worse. It makes me slightly supportive of tax evaders. Why pay taxes to support this bunch of parasites calling themselves politicians? What do they give in return for taking the bulk of your money? Unfortunately it’s the weak who have no clue about the 50 way to screw the assholes.
    Perhaps we should return to feudal times. The tenth (10% !! the farmers had to pay to get protection by their lords) seems pretty affordable now that we keep about a tenth after deducting company, personal taxes, TAV, surcharges and whatever names they come up with to steal your money and put it in the hands of the parasites.
    Luckily I live in China, the purest capitalist country in the world, where socialism does not get a chance. At least you have a chance to be smart and thrive here.

  10. Yes, definitely bullshit. But thanks, I see I still have a little more to learn before I jump in. Are you talking about electing my LLC to be taxed as an S-Corp? Anyway I’ve got time, after all I’m just a mere 22 year old with $30k starting capital put aside burning a hole in my pocket :)

    I probably won’t even pay myself for a good decade as I both reinvest my profit and invest a portion of my day job income. Then I’ll “retire” and be able to afford grassfed :)

  11. Alex

    First, I believe LLCs and S-corps are taxed the same. They are pass through entities. That is, you are are taxed on the P&L profit of the business whether you take nothing or deplete assets and take more than the profit.

    It would be very difficult and quite aggressive as a startup where you may be the only person, to qualify anything as passive income. Once you have employees it can be done though. Best to just operate as a sole proprietor to start, then later claim some proportion as passive income. Then, when you have a lot and hire someone to run the thing entirely, it can all be passive and you’ve created a flat tax for yourself, just like all the rich people do, that deny you the same.

  12. …oh, btw, far easier to reinvest profits and not have it counted as income in a proprietorship (sched c) than an LLC or s-corp. in the later, capital expenditures are not P&L expenses, so you will be taxed on them, just as you will with the principal portion of loan payments.

  13. I see, guess I gotta hit the books some more. I forgot where I got the info from (multiple sources) but my understanding is that the IRS considers a single member LLC a “disregarded entity” and so even though my property is held under the LLC, all the profit and loss goes on my personal taxes under 1040-E instead of a Schedule C or P&L. However, I had not found whether the hiring of a management company changes that status. Obviously, I would rather you be correct than me once I grow big enough to claim passive income :)

  14. I guess my issue is that in our sue happy country, I’m nervous about just running my business as a proprietorship since it lacks the liability protection. Otherwise I would do that and use Schedule C to reinvest. But yes, if I did ever get big enough I would hire an actual manager/ceo, change the structure of the company, and would no longer be reinvesting the income but rather collecting as dividends so I wouldn’t have to worry about being taxed on capital expenditures.

    Only problem with that is they would want a decent salary and so I’d have to wait until I’m really big. My ten year plan would have me making six-figures after all other expenses and mortgage payments and everything and been paid for with the right property. If i wanted to hire someone to take over completely, I would have to extend that timeframe to cover the cost (and give them enough work to justify their pay since they would be doing what I was doing, sitting on my ass until I got a phone call to buy a new stove, and paying the bills. Maybe I would just pay the existing management company more money and have them take more responsibility).

    Oh well, all this talk means nothing until I get off my ass and start buying these houses :)

  15. As long as you’re talking about taxes, my 2c: Embrace paying them, while attempting to manage them. For YEARS I lamented paying taxes, and looked for ways to minimize what I paid. I still manage it (or have someone manage it) to pay the least I’m going to be held accountable for, but I changed the way I think about it.

    I made it a goal to pay the minimum legally required, yet have that minimum exceed my first professional salary. Once I made that goal, ALL of my values became aligned. I didn’t have part of my brain thinking “Make more money, and that’s more taxes, and that’s bad.”

    I don’t underestimate the ways in which my brain will pursue and fulfill my values, and I think there are subconscious components that will limit me if that would align with a particular value. One way to pay no taxes is to make nothing!!!

    So, from the time I made that my goal, it was only 2 years and I reached that point. Then I made it a goal to pay more in taxes than I EVER made as salary. Another 2 years. And I keep upping that number so I never have part of my brain thinking of my income in a restrictive manner to meet the goal of minimizing taxes.

    Do I hate them? Yes. Is it awful to see how my money is spent? Yes. Do I want to minimize what I pay? Nope. I just embrace it and as long as it’s being managed, paying a million bucks in taxes would mean fantastic things for me personally. I’m not there yet, by a long shot, but that will be a very cool day for me.

  16. Alex

    I had 10 properties before the bust. Each one a separate Sched C. All under management and three (in Phoenix) I never ever saw.

    I see absolutely no reasons to go to an LLC structure on rental properties until you have big assets that a clever tenant can use against you by planting mold & such. 99% of people are not like that.

  17. Bill:

    Somewhat, for me. Let me put it this way. When I got a big IRS audit, it was first personal, 3 years. I hired a tax attorney for that ($7K). Soon as the auditor learned I had a company, BOOM, 3 year audit on that. For that one, I used my in-house MBA controller and my outside CPA.

    The tax attorneys dispensed with the personal surprisingly quick (Steve Moskwtitz’s firm, Bay Area). Zero owed. Once that was done, I did a sit down with the same IRS guy in our conference room, with controller and CPA.

    “Yep, you see that I was involved in all manner of tax savings from corp structures to even offshore entities, bank accounts, debit cards…. BUT, I realized one thing. I’m spending a lot of time & effort trying to protect what I don’t actually have. So I poured that effort into my business instead.”

    Unless you really want to start a revolution rather than live your one & only life well, I say, make so much as to laugh at taxes.

    Right, Bill?

  18. @Alex – If you are worried about being sued, get a lot of insurance. Seriously. I’m talking a multimillion dollar umbrella.

    I know there is a big debate about whether to get a lot of insurance or do the LLC thing (rental income in an S-corp or C-corp is a bad idea, for multiple reasons, notably the potentially for voiding the S election in the former and the built in gains tax in the latter). I’m of the option that piercing the veil is pretty easy for smaller operations, which cancels out the limited liability and at a few hundred dollars per year, the insurance is a pretty cheap hedge.

    @Richard – LLCs are just a legal classification (at the state level). For taxation purposes, they can be treated as disregarded entities (and thus, reported on your personal return; can only be done with sole owners or husband wife ownership); as partnerships (the default for multiple owners), and ordinary income is generally subject to self employment taxes (but investment or rental income isn’t)); as S corporations, with the pass through (this status needs to be elected); or as C corps (again, needs to be elected).

    @Bill – I like that philosophy. Paying a lot of taxes is one problem I wouldn’t mind having (at least as far as I like paying taxes, which I don’t), as it would mean that I have a large income. And having a bunch of income makes a lot of things easier, including potential tax savings (as 5% of 1 million iS substantially more than a similar percentage of $10k).

  19. Richard:
    Yes! You can spend time taking your taxes from 25% to 18% of your gross, or you can spend your time doubling your income. One will leave me angry that I’m still paying 18%. The other will give me double the after tax income.

    And I love your last sentence! I’ve heard a lot of people talk about changing the world. I’ve done it myself. What problem-solver can’t spend a little time blathering on about how it should work? But unless I’m going to make those things happen, my time is MUCH better spent improving my lot within the constraints that I’ve decided not to devote my life to changing.

  20. Jay Jay says:

    Great post!

    One point I would add is that as of 2013, the tax rate for dividends and capital gains is ZERO for the first $72,500 in income for a married couple!

    That’s zero income tax, zero social security/medicare tax, and where I live, zero state and local taxes too.

    This has moved my retirement plans quite a few years forward.

  21. I would prefer a consumption based tax rather than income based tax. Income based tax disincentivizes production while consumption based taxes like VAT disincentivizes consumption, and encourages saving. Yes the saving shouldn’t be done in the system, but that is another question.

    If the government is minimal, VAT and possibly taxes on luxury items, and import duties on non-essentials, would be sufficient.

  22. Can I ask a question, what if you have allc and in it 50/50 with a partner and he takes it upon himself to write you off the business and put his girlfriend on with out your knowledge or approval what is this called???

    • Tina:

      It’s called theft. You’ll need a lawyer, but of course that depends on what the llc is worth. Are you getting distributions? Are you getting a K1 for taxes?

      Also, if he actually did this officially as in file documents and used an attorney, you may have a claim there, since the attorney would have been able to know this.

      Or, depending on your state, you might simply be able to go to the secretary of state where corp stuff is usually filed and inquire with them.