Should a wedding band form a corporation?
Q. I’m in a wedding band and it’s my only job. I earn about $100,000 a year. I’ve never created a company for myself or for the band. Would that be smarter for taxes? Most of the payments we get are cash or check.
— Boy in the band
A. We love to hear stories about people who can earn a living doing what they love.
In order to answer your question, we’re going to assume your customers make a single payment to the band, the band then pays out the funds to its members, each member files his own tax return and the band does not file a tax return.
If that’s the case, each band member a self-employed musician, said Bernie Kiely, a certified financial planner and certified public accountant with Kiely Capital Management in Morristown.
Kiely said this type of business is called a sole proprietorship.
A sole proprietorship is an unincorporated business that is owned by an individual, and the owner of a sole proprietorship is known as a proprietor.
“Proprietors file a 1040 federal income tax return which would include a Schedule C `Profit or Loss From Business,'” he said. “You should report all your income on line #1 `Gross Receipts or sales.’ When I say all I mean all — cash, checks and credit card receipts.”
Kiely said when the IRS audits a sole proprietorship, it examines all your business bank records. They compare your total deposits to line #1 to see if you reported everything. The IRS then looks at your personal bank records, too.
“The auditor wants to make sure you aren’t skipping the business account — and tax return — and depositing money directly into your personal bank account,” he said. “This is how many sole proprietors get jammed up with the IRS. They deposit business funds directly into their personal checking account.”
Part II of Schedule “C” is for expenses. Business expenses are the cost of carrying on a trade or business.
These expenses are usually deductible if the business operates with the intent to make a profit, Kiely said. To be deductible, a business expense must be both ordinary and necessary.
An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business, he said.
An expense does not have to be indispensable to be considered necessary.
Kiely said he has fresh flowers delivered to his office every Monday.
“I can run my business without fresh flowers, but I like them and my clients like them so I can deduct the cost of these flowers as a business expense,” he said.
Revenues minus expenses equals your profit or loss. If you have a loss you can deduct itagainst other income.
If you have a profit you must pay two types of taxes, he said. The first is plain old income tax — the same tax you would pay if you worked for someone else and received a W-2 form. Employers deduct federal and state income taxes from their employees’ paychecks. They also deduct Social Security (6.2%) and Medicare tax (1.45%).
“Social Security and Medicare Tax are collectively known as Employment Taxes,” he said. “After the employer deducts your Social Security and Medicare, it must match your contributions and then send the money to the IRS. So the government collects 12.4 percent in Social Security and 2.9 percent in Medicare tax — half from the employee and half from the employer.”
The fact that you are self-employed does not mean you can escape employment taxes, Kiely said.
The second tax you have to pay is called Self-Employment Tax (SE Tax).
He said you calculate your SE Tax by using form “SE.” Because you are both the employee and the employer, you have to pay both sides of Social Security and Medicare tax. Because part of the SE Tax is the employer’s portion, you do get a tax deduction for that part.
You ask if creating a “company” for yourself would be smarter for taxes.
“The short answer is no,” Kiely said. “You are currently deducting ordinary and necessary business expenses. That is all any entity can deduct.”
To further understand Kiely’s answer, let’s define what a “company” is. A company is a business. Right now, your sole proprietorship is a “company.”
“What some people mean when they say `company’ is a corporation. A corporation is a separate legal entity,” Kiely said. “It has shareholders, employees and it files its own tax return. A corporation can deduct ordinary and necessary business expenses just like a sole proprietorship can.”
Kiely said there are two major reasons someone would want to incorporate their business. The first is to protect oneself from legal liability. The second is to get financing by selling stock to the public.
He offered this example: Let’s say you own a bus company. Someone could fall getting on or off your bus. If that happened, you could be sued.
“I hope you had enough forethought to carry liability insurance,” he said. “But what if your bus was in a catastrophic accident and the jury awarded much more than your insurance will cover? You could lose everything — your house, your car and your savings.”
This is where a corporation could help.
The injured party would not sue you personally, but they would sue your bus company, Kiely said. If the insurance won’t cover the claims against you, your company would lose its buses, office furniture, and more. But you would not lose your home and savings.
What kind of legal exposure would a musician have?
“If your audience does not like your music, the worst that could happen is you don’t get paid,” Kiely said. “Being sued is highly unlikely.”
A licensed professional like a physician, a lawyer, a certified public accountant (like Kiely) or an architect can’t hide behind a corporation to protect themselves from professional liability.
Kiely said there is one questionable tactic some misguided business owners try.
The owner of a sole proprietorship must pay Self-Employment Tax on 100 percent of its profits. The proprietor can incorporate the business, making an S-Corporation election.
“An S-Corp is a corporation that passes its profits through to its shareholder(s),” he said. “The shareholder(s) pay income taxes, not the corporation.”
Kiely said an S-Corp is called a “pass through entity.”
The scenario some people use is they pay themselves little or no salary. Then the profit from the business passes to them on a form called a “K-1.” The profit from an S-Corp is by law “passive income,” Kiely said. Only “earned income” is subject to payroll taxes, so “passive income” is not.
If the musician in question tried this gambit they would save Self-Employment taxes, Kiely said.
But he said there are two problems with this strategy.
“First, if you don’t pay into the Social Security system, you won’t be eligible to collect Social Security benefits when you retire,” he said. “Speak to some retirees about how they would get along without their monthly Social Security checks.”
The second problem is the IRS would probably state that the musician’s income is 100 percent earned income. The more the musician plays, the more they earn. The less they play, the less they earn, he said.
One final thought: Before you go through the time and expense of forming a corporation please consult with a CPA or an attorney, Kiely said.
“Once you form a corporation there are tax forms, fees and New Jersey’s minimum corporation tax that must be filed and paid every year, even if the corporation has no income,” he said. “Talk to a pro first.”
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Karin Price Mueller writes the Bamboozled column for The Star-Ledger and she’s the founder of NJMoneyHelp.com. Click here to sign up for the NJMoneyHelp.com weekly e-newsletter. Like NJMoneyHelp.com on Facebook and follow it on Twitter.