How I Wound Up With a $35,000 Tax Bill and How You Can Avoid the Same Mistake

Authors note 20Sept18: Some of the information in this article is wildly inaccurate. I’m going to leave it up because it is part of a larger story that I’ll post later.

TL;DR: Instead of forming an LLC, form an S-Corp and pay yourself on W2.

The limited liability company (LLC) is a popular form of business. It’s also a young form of business. The first one was formed in 1977 by Wyoming state legislation. It didn’t become a popular entity until the late ’90s, however. That popularity was driven by the increasing ease with which anybody could start a business. The accessibility afforded by the internet meant no inventory and no building lease. Just offer a service, put up a webpage, and shazam, you were in business. Obviously, with its simple corporate structure and tax treatment, the LLC was and still is popular with sole proprietors. However, starting an LLC may not be the best move for a small business.

You will want to talk to attorneys and accounts about this stuff. That said, just because you talk to a professional doesn’t mean you get good advice. That was my situation for years. It wasn’t that my people were incompetent; they simply never explained things in a way that made sense for my business. In retrospect, that was my fault. I got locked into an operational pattern that was working and had no impetus to question the status quo.

I run Mass Street Analytics, Inc. For seven years, I’ve helped companies build efficient, cost-effective, highly scalable data systems. For three years of that time, I operated as a contractor. I was just like everybody else; take a contract and hope you get hired at the end. The problem was, for various reasons, I didn’t want to stay at any of the places where I contracted. Mostly it was because the problems that I was presented with were dull, routine, small in scope, and didn’t offer any real intellectual challenge. To this day, most clients only tap about 20% of my capability, and that is 20% max.

Eventually, I realized that the market was pushing me towards freelancing, so I went all in. I formed an LLC and I haven’t had a real job since 2006.

Mass Street is what I like to call an elastic firm. We scale with client needs. We have the capability to throw 40 people or more on a project if need be. Mostly it has been just me. At its peak, there were three of us. Currently, it’s just me and an intern, and we’re a 100% remote team.

I have the same problems that every freelancer/business owner has; cashflow. It’s highly volatile and you have to save for the lean times. Sometimes I’m baller, pulling in upwards of $20,000 a month and making it rain. Other times, I pull in $0 and I eat moldy bread and drink rain water. At all times I have to be careful and make sure I have four months of runway. This can get tricky around tax time.

Because of this, for years, my strategy was to get my tax bill, asses the tactical picture from a cash perspective, and pay the bill when I was comfortable doing so. This means I never paid on time, always took an extension, and usually had to pay a penalty. I considered the penalty, which runs about $3000 every year, to be the cost of doing business. Obviously, I wasn’t okay with it and made moves to stabilize my cashflow. Those efforts are another story for another time.

When you talk to tax experts, they typically say, “Pay yourself a salary.” I could never get a good explanation for this recommendation and it didn’t make sense for my situation. Why would I pay myself a salary in those months when I don’t have any revenue? Unfortunately, everybody kept using the word “salary,” and as I am super literal, I didn’t even consider that paying myself hourly was an option. Turns out, it is.

You have to form an S-Corp to pay yourself. You can’t do it with an LLC. So I converted my LLC to an S-Corp and now I pay myself an hourly rate and when I’m not on contract, I live off owner draws. For those confused about the mixed approach, ideally, I’d prefer to live off of my hourly wage, but I’m not comfortable doing that, yet. In any case, taxes are taken out just like any other W-2 employee, which significantly reduces my year-end tax liability.

The irony of all this is I wouldn’t know any of it if 2017 hadn’t happened.

For years, the rate that I charge for my services has steadily increased. I’ve doubled it year over year several times and it has increased by 500% over a five-year period. Based on everything I knew and understood, my expectation was that I’d reach a point where it would level off and that would be what I would make forever and ever. I had no idea that as a young, continuously employed tech professional, the demand for my services would decrease. In 2017, decrease they did… right off a cliff.

These are my full year revenues for the life of Mass Street.

2016 caught me completely off guard. I had no idea that I could make that much, and that number is 100% me! I had no other employees generating revenue. So I figured this was the new reality; time to expand! I hired a sales guy and I was off and running.

And then 2017 hit. Not just in Kansas City, but across the board, projects dried up. There were some direct hire roles, but these positions and their salaries were for n00bz. I spent most of the year on the phone with recruiters trying to figure out what the hell happened. To this day, nobody knows. I had to let my sales guy go, my other employee got hired away, and there I was on my own with few leads on a revenue stream.

I understand why people who hit the lottery then go broke. When you come into a lot of cash and you’re not used to it, you have no idea what to do with yourself. This is especially true in my case, where I don’t forecast revenues for reasons and the year-end number is something of a surprise. While I was in it, I had no idea that $170,202.00 was going to be the final figure.

So now I owe taxes on that amount AND there is no cash coming in. 2017 was NOT fun.

At the end of the year, I landed a decent contract, but with a firm that demanded that I have an S-Corp before they would pay me on 1099. I didn’t think it was worth the risk because the contract was short so I came aboard as a W-2 employee. When the contract got extended, I went down the path of forming an S-Corp and reworking my contract. I’m currently in the process of bringing Mass Street back to financial health. Personally, I’m doing fine but the company did take a beating. Fortunately, I don’t do debt so we’re not in any kind of danger of shutting down. In the grand scheme, a $40k tax bill isn’t that big a deal when you have proper cashflow. I’ll have this mess wrapped up and out of my life by Christmas.

So if I didn’t have a huge year followed by a bad year, I wouldn’t have discovered the proper reasoning as to why I should have formed an S-Corp to begin with, or if I did, I wouldn’t have discovered it this soon.

My taxes are prepared by Rebecca Hart at Johnson County Tax Group. I was going to attempt an explanation of what she told me about the tax advantages of an S-Corp, but I’ll let you read what she wrote:

“On the salary [there is that word again] that you pay yourself, you will withhold Federal and State taxes based upon the W-4, along with FICA/Medicare at 7.65% — you will need to match that 7.65% when you pay your quarterly payroll taxes. The distributions from the S Corp will be taxed at capital gains rates, which are typically lower than the individual Federal tax rates. I hope this makes sense. Also, I want to make you aware of the new tax law: [owner] distributions will be eligible for a 20% tax deduction.”

So there you have it. This whole time I’ve been doing it wrong. Don’t be like me.