Why the Self-Employed Are STILL Smarter Than You

January 7, 2011
Self-employed, Self-determination, Incorporate, Save Taxes, Make Money

Self-employed, kind of. Also he blinked when we asked permission to use the photo

This is an updated version of a post that ran on LenPenzo.com 11 months ago. We’re thinking of doing something similar every Friday, the argument being that a) of our 3 weekly posts, you probably pay the least attention to the Friday one and b) everyone else recycles content once in a while, so why not us? As it stands you’re still getting over 2000 words of freshness weekly. More importantly, we actually edit our stuff. Those 2000+ words are polished to a keen sheen before you get to read them. Otherwise, we’d be like that one chick who cranks out 20 blog posts a week and opens them with insight like “Thanksgiving is a great time to reconnect with family.”

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Who pays a greater share of his income in taxes – Warren Buffett, or his driver? (Actually, Buffett’s so eccentric he probably drives himself. In a 1970 LTD with 8 million miles on it.) Still, posing the question implies its answer. Details below.

Politicians may tout the virtues of our “progressive” tax system, but it doesn’t really favor the poor over the rich.

Nor does it favor the rich over the poor, not when 40% of federal tax receipts come from 1% of the population. Fairly or otherwise, the tax system favors the diligent over the unprepared. (As most things in life, so maybe the system is fair.) Specifically, the system favors independent businesspeople over salaried workers.

This topic requires a book-length explanation (such as the groundbreaking and heretical Control Your Cash), but to summarize, starting your own business lets you enjoy tax advantages wage slaves only dream of. Take two people in the same field, making like incomes, living in the same city (which means their costs of living should be similar), only one owns his own business and the other works for someone else. It’s eminently possible that the latter person’s tax bill is 9 times the former’s.

Declare your independence today, if your career lets you make a horizontal shift to entrepreneurship. If you’re an anesthesiologist, you can’t rent out an office and put up a sign that reads “Mepivacaine Administered Here—Happy Hour 4–7.”  But if you’re an accountant, real estate agent, home inspector, software engineer, attorney* or in any kind of creative profession, you can take advantage of complex tax laws.

This isn’t the kind of entrepreneurship that requires you to open a physical storefront and spend years building a customer base. These are changes you can make now that will immediately impact your bottom line.

I tried to go as long as I could without using the first-person pronoun, but my story illustrates the point. 5 years ago I was working for a decently-sized advertising agency as a senior copywriter, making somewhat more than the nation’s per capita income. One day I ran the numbers and realized I could make more money going out on my own.

I collected most of my new clients, other ad agencies, via word-of-mouth. But most importantly, I took on the very agency I’d left as a client. And charged them about 30% more than they paid me as an employee. There are two components to that: 1) they were underpaying me to begin with, but had to cough up once I exercised my leverage and threatened to walk and B) the daily rate they paid me after the switch was just for the services I rendered – nothing else. It included no employee benefits, no capital expenditures for a workstation, no space reserved for me at the office Christmas party (thank God), no food/clothing/transportation allowance, no 6.2% Federal Insurance Contributions Act tax, no unemployment insurance premium. The responsibility for all that now fell on me.

Which is wonderful. It meant that instead of my former employer enjoying all the possible tax deductions from my labor, I got to take advantage of them. My taxes got a little more complicated – I now had to keep more detailed records, and file quarterly instead of annually – but the benefits grossly outweighed the costs.

It’s easy to get started, but also easy to make mistakes. You don’t want to be a single proprietor. You want to found an S Corporation, a legal entity that protects you from creditors who are forbidden from coming after certain classifications of income. An S Corporation lets you separate your money between salary and capital gains, the latter of which is taxed at a lower rate.

Find a company that specializes in entity formation. It’ll cost maybe $400-500 for them to register you with the relevant state’s Secretary of State office. You don’t have to register in your home state, either. If you live in California or New York, you don’t want to—those states’ laws don’t protect you enough from creditors. Register in Delaware or Nevada or, failing that, your home state.

Once you incorporate it starts forcing you to think like a businessman. Your income will now be tabulated on IRS 1099 forms, rather than those infamous W-2s. As a practical matter, once you incorporate you’ll pay (correction: your company will pay) you a salary. What’s a reasonable amount to cover your annual living expenses— maybe $24,000? Then that’s what Employee #1, you, will receive and pay taxes on. After deductions, your effective tax rate on the salary will be close to 0.

But what about the rest of your company’s income? Legally speaking, the rest of the revenue your S Corporation takes in is not salary, but shareholder dividends. Which are taxed at a lower rate than salaries are. And you can now deduct all sorts of business expenses before calculating the net shareholder dividends you’ll pay taxes on. Go to IRS.gov and check out Form 2106. Your employer fills one of these out every time you go on a business trip, or eat a meal on company time, or buy anything related to your job. Your employer, not you, then enjoys the tax deduction.

(As for Warren Buffett’s driver, he probably makes around $80,000 a year, which would put him in the 25% bracket. Almost all of Warren Buffett’s income is in capital gains, and the highest long-term capital gains rate in the U.S. is 5 percentage points lower than the assistant’s marginal tax rate.)

*Leeches, all of you. Thanks for making the tax code so damn complicated in the first place. If not you, then your ilk.

**This post was featured in Tax Carnival #79: Filing season begins**

Filed Under: Capitalism, Economics, Education, Entrepreneurship, Finance, Net Worth Tagged With: , , ,

Dartboard investing only works when you stand inches away

December 27, 2010
Dartboard Investing

Those ancient Mayans had one messed-up clock

 

Every day, people miss out on great investments because they don’t know how to quantify risk vs. return. You need written investment criteria.  Here’s a sample.

If you don’t have the energy to click the link, it’s mostly a series of questions that read something like this:

What type of investment is it?
Real estate.

This is a straightforward question with a clear answer. Knowing what classification the investment falls into tells you how liquid it is and how much its value might fluctuate. If the investment were a stock it’d be easy to sell, though not necessarily for a premium. A plot of dirt, improved or raw, has tangible value. But selling it, even in a seller’s market, can burn a lot of hours.

If I bite, how will this affect my allocation?
Negligible.

You don’t necessarily want your eggs in a million baskets, nor in one, but you do need to know how many they’re in. And if the breakdown among the baskets gets out of proportion, you want to know that, too. Say your portfolio starts out with 33% in growth stocks, 33% in long-term notes and 33% in real estate. Six months later, if the percentages have changed to 5, 34 and 61, you’ll want to rearrange to keep things in balance (or ride the 61% component if so inclined.)

But what if this transaction did affect allocation? What would you do to balance the imbalance? You could sell an asset, buy other assets, or decide you’re going to live with a different breakdown.

What do you estimate the return will be?
4½–8%, plus however much the property appreciates, which we estimate will be nothing for the next 3-5 years.

We keep score when building wealth. Amazingly, some people haven’t figured this out yet or refuse to acknowledge it. If you think investing has an emotional component, and that either being a nice person or playing hunches is part of the game, please stop reading Control Your Cash and find something less demanding. Seriously. See, we said “please”. Didn’t hurt your feelings or anything. You should be happy.

What exactly is the investment?
A 2nd floor, 1-bedroom/1-bath 770 ft2 condo in an above-average part of town. The condo’s listed at $50,000 and approved for a short sale*.

Meanwhile, nearby condos rent for $650-750 a month.  Estimated annual expenses read like this. (This is something called an annual property operating data worksheet. Download it at your leisure.)

The above question is self-explanatory, right? And its relevance should be self-evident. If it isn’t, return to kindergarten and start over. We’ll be waiting.

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Anyhow, this investment allows for multiple variables that affect ROI (that’s return on investment, in case you forgot.) Variables include things like rents, and whether you can buy the property as owner-occupied, which means you should be able to get a cheaper loan with lower closing costs. Here’s what we mean:

There are two primary ways to buy this condo as an investment if you have neither the cash up front nor excellent credit. Find a partner, or incorporate.

1. Find a partner (a joint venture.)

An investor lends you $50,000 interest-free to complete the sale. You buy the house and live in it.

Nothing’s free, of course. Under this form of owner occupancy, you pay the investor 70% of the house’s net operating income (i.e., the rent.) Another 10% of the rent goes into a reserve maintenance account – out of which you pay for things like appliance repair. Which you shouldn’t need to if you have a home warranty. But there’ll always be some unexpected expense that a warranty won’t cover: stucco repair, interior paint, etc.

What about the remaining 20% of the rent? That’s yours to keep. Yes, under this arrangement you pay only 80% of fair-market rent. On the other hand, doing it this way you can’t write off your expenses on your tax return.

Who would work out a scheme like this? Lots of people. It’s a perfect vehicle for a father who wants to help his kid buy a home and still earn a return.

Or

2. Form a limited liability company (details here, here, here, and here.)

You and the person who’s lending you money are partners in the LLC, which becomes the official and legal owner of the property. Once you create the LLC and it takes ownership of the property, it’s the sole owner: nobody and nothing else. It’s not as if you own x% of the property and your partner owns 100-x%. The LLC owns it all. You own a particular share of the LLC, but that’s a different issue.

Each LLC has an operating agreement that lays out the details of the deal: such as who gets to write expenses off, how you’ll split profits when you sell the property, and specific duties for each partner. The LLC also protects you from unlimited liability in case a tenant or a visitor decides to sue. They can sue for $1 trillion if they want, and even have a case, but they can’t get more than your investment in the LLC.

With this example, the investor again lends you $50,000 interest-free. You find a tenant, charge her the going rate and again keep 10% in a maintenance account.

This scheme works for partners with disparate skills – e.g. one partner with the time and expertise to find the property (in this example, you) and the other with most of the money.

What’s the downside?

Property values could drop even further, meaning you might need years just to break even. If the property doesn’t rent immediately, your return will decline.

The renter might damage the property. This is why you qualify prospective tenants and collect a security deposit. If you really want to avoid headaches, spend 10% of the rent on a property manager. If you value your time at all, hiring a property manager will pay for itself quickly.

You and your partner might disagree on how to manage the place and, when it comes time, how to sell it. You solve this with an operating agreement, one that looks something like this:

That’s pretty much it. Just make sure that every conceivable subject of potential dispute finds its way into the operating agreement, and that you register your LLC in a state that’s business-friendly. That usually means Delaware or Nevada. Or failing that, your home state. (You can live and operate in, say, North Dakota but register in Maine if you want. It’s totally legal.) Just don’t register in California, and never New York: their LLCs don’t protect you enough.

The old pessimistic saw says you have to have money to make money. That’s not true if you leverage someone else’s.

*Selling a house short means begging the lender’s representatives to take less than they originally agreed to, on the theory that a wounded bird in the hand is worth more than a potentially rabid pair in the bush. Details here.

**This post is featured in the 1/4/11 edition of the real estate investing carnival**

**This post is also featured in the Carnival of the Road to Financial Independence**

Filed Under: Investments, Making Smart Choices, Math, Net Worth, Personal Finance Tagged With: , , , ,

GUEST POST: 6 Habits Of A Frugal Shopper

December 16, 2010

Every week, we get solicitations for guest posts. 99% of them are dreadful. Some are even belligerent. None of them are from someone who’s actually been to our site.

Until now. Mr Credit Card runs Ask Mr Credit Card, and has good opinions. By which we mean he largely agrees with us, which makes sense, because our opinions are rooted in truth.  We assume he’s a Brit, given that he doesn’t punctuate “Mr.” He also writes in the third person, like us…er, like the Control Your Cash authors. Anyhow, take it away, Mr Credit Card:

Today, Mr Credit Card is going to highlight some habits of a frugal shopper. Though he reviews and recommends the best credit cards, he also believes that unless you are frugal and pay all your bills on time and carry no debt, you have no business carrying a credit card. Here are some of his tips to pay less than “full retail” prices.

Everybody loves a good deal. But we shouldn’t buy stuff just because we can get a good deal or there’s a sale going on. Instead, we should only buy things we really need. But even then, you should always find ways to pay “below retail”.

1. Ignore the “original price” I can’t stand how most stores mark down prices. The big department stores are the worst here as they will always show an original price or a Manufacturer’s Suggested Retail Price that is much, much higher than the lowest price. Often I see 3 or even 4 prices, suggesting that it’s marked down several times. Who cares? Do you know what you can do with your “suggestions”? The only price that counts is the price you pay.

(Ed. Note: Any man who’s taken part in the following useless conversation, raise your hand: Q: “Honey, how much did that cost?”  A: “I got it on sale.”)

2. Always Compare Prices Just because an item is marked down, that doesn’t mean it’s even a good deal. I found what I thought was a good deal on Amazon the other day. No other retailer I searched for had this cordless phone system at a lower price after tax and shipping. Even eBay was a bust. The next day, I found the phone system in Costco for almost half of what Amazon was selling it for. Research all your major purchases. This was the exception, as I usually find lower prices at Amazon or eBay than most retail stores, but you never really know. EBay

(Ed. Note: How do you capitalize “eBay”, assuming you do, when it starts a sentence? Curse this stupid phenomenon of brand names that start with lowercase letters and have medial capitals.)

is especially good for low-price, highly-marked up items like computer and electronic cables and accessories. I can always find a cell phone recharger for $5 that costs $20 at the dealer.

3. Always Ignore Credit Card Rewards Credit cards rewards are great, but only if you pay off your balance in full every month. Even then, you can still be tempted to spend more. One of the funnier lines in a movie I once saw was when the ditzy teenager was questioned as to whether her parents mind her spending so much on her credit card. She replies, “So what, they’re getting frequent flier miles.” That statement perfectly encapsulates the entire premise of reward cards. The idea is to get you to spend more in order to earn your reward, which is usually worth 2% or less than your purchase. If you can’t understand why this is a bad idea, you should never, ever have a reward card.

(Ed. Note: Full disclosure, your regular blogger has an American Express HiltonHHonors card. Only because it had no annual fee and I stayed in Hilton hotels a few times a month anyway. The card gives me free hotel stays without giving me incentive to change my behavior: if I don’t have enough points for a free stay at the $89 Hilton Garden Inn while the Holiday Inn Express across the street is renting rooms for $79, you can probably figure out where I’ll stay.)

4. Pinch Twenties, Not Pennies I suppose if you have unlimited time on your hands, you can make a career out of clipping coupons. In fact, there seem to be people who do just that. For the rest of us with a job and/or a life, you have to prioritize where you save money. Go for the big scores. Spend your time and effort saving on big things.

5. Make Sure You Are Not Just “Saving Money” On Something You Really Don’t Need The whole idea behind coupons is not to let you spend less, but to make you spend more. When you see a coupon for some product, ask yourself if it was something that you were going to purchase anyway. If it was, great. If not, forget it. Ask yourself if there aren’t less expensive alternatives. Perhaps you can get the same item for less on eBay or Craig’s List?

6. Always Compare Total Prices We live in a world with little price transparency. Book a rental car if you want to see how your bill quickly becomes twice the price of the rental itself. Telecommunications companies are close behind with all of their tax recovery charges. Hey, I pay taxes too! Can I subtract a “tax recovery fee” from your bill? Even a straightforward online purchase might include tax and shipping.

Filed Under: Consumer Debt, Credit Cards, Economics, Net Worth, Shopping Tagged With: , , , , ,
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