Don’t Make This Basic Mistake With Your Tax Planning

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In yesterday’s blog (6/14/19), I started the story of multi-millionaire Karin Slaughter who got on the wrong side of the IRS. Her Tax Court case was recently decided and published.

Yesterday, I talked about one big reason WHY she made so much money as an author when so many others simply don’t.

It also set up for a rather complicated tax strategy and that’s what got her into trouble with the IRS.

Because she had spent time, energy and money in building a brand for her writing, she was paid for a non-compete with her publisher, she was paid for first right of refusal on first books and she received more money in royalties than other authors who had written the same number of books in the same genre. She also made much more for her books in 2010 than she did 20 years earlier. She spent the same amount of time writing. The difference was that she had built a desirable brand and people sought her books out to read.

Her tax team divided up the income she made into “earned” and “unearned”. The earned income was subject to self-employment tax. That is an amount that they arbitrarily assigned due to her writing. They then took the rest of the income as “unearned” and it was not subject to self-employment tax.

Since her income was so high, it was over the Social Security limit. (For 2019, that amount is $132,900.) Over that, and the only tax due is Medicare tax. That is 2.9%. The years in question were 2010 and 2011, which is before the Medicare surtax of 0.9% in 2012 kicked in. That would have been added in additionally for other years.

The amount of tax due, just for that Medicare tax was over $100,000 in each of 2010 and 2011. There was additionally penalties and interest, which were rather steep because the IRS called this a substantial underpayment and thus subject to a 25% penalty.

After fighting it all the way to Tax Court, it was determined that the IRS was mostly right.

She owed the additional Medicare tax. However they did reduce the penalties that she paid. So there was a slight win.

You can bet after this case was decided, that her other tax years will be under audit and there are more taxes due.

The sad thing is that this could all have been avoided, or at least mostly avoided.

The problem was that she operated as a Sole Proprietorship, Schedule C. If she had instead had an S Corporation, she could have avoided self-employment tax completely. There is payroll tax due on the payroll that she draws, but it wouldn’t have been everything and so there would have been a big tax break.

Sometimes in thinking outside the box, it’s easy to forget to also look inside the box.

Tomorrow (6/16/19) we’ll talk about how to make best use of the 20% income deduction when you’re deciding which is the best  business structure.

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