Sole Proprietor on Payroll?

A good question today for discussion:
“My husband is self-employed with no other employees.  I generate his paychecks.  This year, he has been doing a few jobs outside of our county; therefore, the local tax amounts vary from county to county.  The payroll program I use is a very basic program so there are not a lot of different options to use.  (This is a new program I started using this year.)  To keep local taxes correct, I have to issue him a check for each job completed outside of our county.  When I generated a paycheck to him for a small job in a different county, ($300 paycheck), I noticed there were no federal withholding taxes.  I didn’t know this before, but it appears tax calculations are different based on daily, weekly, monthly, etc. pay periods.  I played around with this in the program and noticed the variance each time I changed this option.  With the flexibility of him being self-employed, I generate a paycheck on an as-needed basis to cover our personal needs.  It is never a fixed amount and the frequency varies. Taking the issue of local tax variances out of the picture, I am now worried if the federal and state taxes are being calculated correctly because of the varied amounts and time frames of the paychecks.  I don’t know whether to choose the option of him getting paid daily, weekly, bi-monthly or monthly. The federal and state withholdings changes in each of these categories.  I feel that it is incorrect to have no federal withholding if I generate a paycheck to him for only $300.00.  Can you help?”

A.  Your question contains one of the most common misconceptions of those who are self-employed.  You did not state if you were an LLC, S corp or a C corp.  I assume by your use of the words “self-employed” that you are simply a Schedule C filer with the IRS.  Most of the included fact pattern is actually irrelevant to answer your question.  Simply put, schedule C sole proprietors do not receive paychecks.  The profit earned from the business each year is the “paycheck” for your husband for tax purposes.  You will pay income taxes based on the profit of the business, less any allowed personal deductions on the form 1040.  Self-employed individuals make estimated payments to the IRS based on their estimated tax liability each year.  These estimated payments are made on a quarterly basis.  Your CPA or tax adviser should be able to look at your situation and determine what estimated payments are required.

While you do not have employees now, it is important to note that when you do have employees, you should match your pay frequency with the way you pay.  If you are having employees work in a different city each day, and your payroll system cannot accommodate multiple city tax rates, you would pay based upon a daily frequency for federal, state and local purposes.  If you pay daily and use any other table, the amount of wages will be too low to trigger withholding for federal and state in most cases.  If you think about it, $300 per day is about $81,000 when annualized (assuming a 270 day work year).  If you annualized $300 using a weekly table, it only adds up to $15,600 of gross wages.  There must be a low-cost system available that could handle such a problem when you get to the point of actually having employees and needing it.

——-
Samuel Kerch, CPA

Yikes, A Big Tax Bill!!!

Q. My husband works for a large company, and I receive disability and do not work.  We just had our taxes done this week and got quite a shock!  We had a federal income tax refund of over $4000, but owed state tax of $1000 and local taxes of $600.  We are in PA.  How can we adjust our withholding so that this does not happen again next year?

A.  When payroll people hear the Pennsylvania, they run screaming from the room.  The local tax debacle there is the stuff legends are made of.  In most states, when someone has too little withholding, an employee can simply get a copy of the state’s W-4 equivalent, and reduce the number of allowances claimed.  This has the effect of increasing the amount of income subject to tax and thus increasing the tax withheld.  Unfortunately, in PA, there is no W-4 equivalent.  PA is calculated as a flat percentage of taxable income, 3.07% to be exact.  I’m not sure where to point you on this one.  Did you have non-wage income like dividends or capital gains that were not taxed?  Do you have a small business on the side where there were no estimated payments made?  Perhaps the payroll system at your husband’s employer has a way to allow for additional withholding beyond the standard percentage.

For the local tax, there is again no W-4 equivalent in most cases.  However, there is very likely an obvious cause for this under withholding.  In PA, employers are required to withhold where the employee works.  If he works in a different jurisdiction than the one he lives in, then the withholding rate will be lower.  He will have the non-resident rate applied to his wages.  In most cases for PA, the resident rate is 1% (could be higher) and the non-resident rate is half of that.  Therefore, he could have only half as much tax taken from his check as was required.  If an employer opts to withhold at the higher resident rate, it is called courtesy withholding.  Not all employers wish to do this because of the extra record keeping requirements.  Check with your employer to see what is possible with regards to increasing the local tax withholding as well.

A Huge Tax Bill!!!

Q. I utilize the withholding calculator on the IRS website to ensure my W-4 amounts are correct. This has gotten me very close to the amounts figured on my 1040 for the past 5-6 years since I’d begun utilizing the calculator.  I do a final check with the calculator after the last pay date in the year (in this case, on 12/28) to get a rough idea of what to expect come tax time. On my final 12/28 check, as on the bi-monthly checks, it showed that I would be getting a refund of just under $2K. Since the withholding calculator accounts for mortgage interest but not real estate taxes, I assumed the refund would be even greater. However, when I fired up my 2009 copy of HR Block’s tax software, I was shocked and horrified to see that it calculated an amount owed of almost $6000! Sure that it must be incorrect, I downloaded Intuit’s Turbo Tax, and that showed I owed even more. I went back to my printout from the 12/28 visit to the IRS withholding calculator utility, and the values entered were within $200 of the actuals. What factors could the withholding calculator not be accounting for that could cause such a vast difference in liabilities? I ran my expected 2010 numbers through so I could fill out my 2010 W-4 correctly, and was presented with an equally low liability and high number of withholding allowances, which I am now concerned are incorrect. My situation is pretty vanilla: Married filing jointly, only one income, one child dependent. Claiming mortgage interest credit, and the associated taxes paid to taxing authorities and nothing else.

A. The answer to your question is truly impossible to solve using a forum like this because I can’t possibly know everything about your financial and tax situation.  What I can tell you is the the IRS withholding calculator and the official IRS W-4 form are designed to recommend withholding settings that will slightly overpay your liability if completed properly.  Judging by your statement that it has always been relatively close until this year, there must be something affecting either your tax prep software, or your values from the withholding calculator.

There are two possible causes for your dilemma.

1- The Making Work Pay Credit gave an $800 credit to those who utilize the married withholding tables.  The problem is that if both spouses work, they would both get the credit on their withholding.  Certain individuals are actually not eligible for the credit and the withholding tables don’t account for this either.  This could cause huge under withholding problems such as you described.

2- Which leads to the second solution. The Making Work Pay Credit problem was a hot topic of discussion all year in tax preparation and CPA circles.  It created a serious problem for two-income families.  Had you been utilizing the services of a tax professional over the years, you would have been notified of this potential problem and been able to appropriately adjust withholding for one or both spouses.  Turbo Tax and the Block product are designed to simplify the tax preparation process.  They cannot use the judgment that a tax preparer can.   While they are both great products, everyone has to admit that we have very complex tax laws in this country.  There simply is no substitute for the advice and assistance of a professional tax preparer or CPA.

I would recommend making an appointment as soon as possible.  $6000 is worth the extra effort to get this right.

New Homebuyer Credit Form

The IRS issued the new form 5405 for those wishing to claim the Homebuyers Tax Credit on their 2009 tax returns.  The new form is for those who have not yet claimed the credit using an amended tax return 1040-X.  Now required, an executed copy of form HUD-1.  This documentation is required simply to reduce the fraud that was occurring in this program during 2009.  When you visit your tax preparer, you will need to bring a copy of this document along with your other standard supporting paperwork.  Inclusion of this document in your tax return filing means you must file on paper and cannot use e-file.  Unfortunately, this also greatly increases the time before you can get your refund.

On a side note…

The IRS is requiring tax preparers who file more than 10 returns to file all of them electronically next year.  However, if Congress comes up with another idea that ultimately requires paper filing like this one, which directive am I to follow?  As a preparer, I am attempting to get all my clients on e-file.  Why is there no provision to attach scanned documentation to a return that is filed electronically?  We all have scanners and the reduction in paper and handling time would be significant if all supporting documentation could be included via pdf at the time of return submission.