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2018 Tax Changes & Freelancing vs Incorporation
Question: There’s been so much talk about the Trump Tax Plan, but I have no idea how it affects me, my finances and my life as a freelancer. Does it really matter if I keep freelancing or do I need to make changes, maybe incorporate?
Answer from Richard M. Prinzi, Jr., CPA & Co-Founder of F-Sharp Tax Services: the 2018 tax change makes it more important than ever to incorporate!
As if you would need more motivation to incorporate, let’s look at the newest issue not yet discussed by many tax professionals: The biggest change freelancers will face after the 2018 tax changes relates to their audit risk. Filing taxes is an exercise in risk management. The tax code does not provide specific guidance on how to comply with every transaction you might encounter as a taxpayer. How to interpret the tax code and apply it to your personal situation is the subject of great debate among Congress, the IRS, the courts and tax professionals. Every year, the IRS and many companies that support the tax profession hire several different tax professionals to prepare a tax return for a fictitious client with a very detailed fact pattern. The results always vary greatly, even though the tax code and fact pattern are exactly the same.
One of the more frustrating question I get from prospective clients is: “How conservative are you as a CPA?” It is irrelevant how conservative we are; it is the client’s tax return we are being paid to prepare. If I chose to interpret every tax consideration in a way that require you to pay the maximum amount of tax, then why even prepare a tax return. Report your income and pay tax on 100% of it and save a few hundred dollars in tax prep cost. The alternative is aggressively finding every way within the law to minimize your tax bill by deducting and classifying everything in your favor. This will cost you more for tax prep but save thousands in tax. Neither will get you arrested – that is almost never an option if you file – but your risk of audit changes dramatically. Finding a place between the extremes is what a good tax advisor will provide. It should have nothing to do with their own personality.
If I gave you the odds of being struck by lightning on a sunny day, would you consider that before leaving the house? Probably not. If it is storming outside, your odds will go up, but will that factor into your decision to be a shut in? Maybe. Slightly, because your odds of encountering a lightning strike will go up. For most, they can perform the necessary risk/reward consideration based on their own experience. With taxes you should take advice from a professional with the greatest experience. Irrationally reacting to risk is a physiological condition sometimes requiring medication. The difference in the odds of winning mega lotto and the regular state lottery are negligible. You’re almost never going to win either, which is why the tickets are cheap. So, if you file your taxes with an irrational fear of risk, you probably are not working with a tax professional capable of communicating the risks vs the reward of choosing tax interpretations favorable to paying less tax. Many of the decisions that will save you huge amounts of tax dollars require you to decide to take the risk increase consistent with the difference in lotto vs mega lotto or lighting strike during a clear day vs a stormy day.
So how does 2018 change the game? Less taxpayers to audit means more risk for you. The 2018 reform will significantly decrease the number of taxpayers who itemize deductions. That will decrease the number of potential taxpayers to audit. The IRS has limited resources and employs those resources with the efficacy we have come to expect from a government agency. Simply put, with less taxpayers to select from, the IRS will focus more resources on the taxpayers who have the most potential to generate a tax change after audit. They are freelancers who file taxes under the individual tax code and freelance non-filers.
In brief, if you report $100,000 in gross income on an individual tax return, you will fall into the highest audit pool and increase your risk of audit significantly, because you earn twice the national average for individual taxpayers. If you report $100,000 of gross income as a corporate taxpayer, your risk of audit mathematically is similar to winning mega lotto and being struck by lightning on a sunny day. The same sunny day! A corporation GROSSING $100,000 is equivalent to a homeless individual collecting loose change on the street corner. The corporate audit department at the IRS looks at returns with under $10 million in gross the same as the individual audit departments views the homeless guy. What pool would you prefer to be in? The risk/reward analysis gets much easier when you understand the risk.
In my opinion the greatest risk to freelancers is filing as an individual, reporting expenses too conservatively or not filing at all, in that order. As crazy as it sounds, earning money as a corporation and not filing a tax return will still improve your odds of paying less in taxes than filing timely as an individual. While this is mathematically true, it’s not the advice I would give a taxpayer who can file a corporate tax return timely. Truthfully, it is also mathematically better to take clearly inappropriate and sometimes illegal deductions, but there are greater consequences to this plan than just paying some additional tax and penalty after an audit.
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