I’m programming a spreadsheet for a friend. I’m currently trying to model the tax rate on this LLC, which will likely be taxed as a partnership (the LLC considered a “disregarded entity”). There’s a mess of details to consider, but I feel like I’ve got everything worked out so far through various carefully programmed IF statements. That is, except for deductions. My friend tells me that there will be loads of deductions available for this hypothetical business, so much so that the effective tax rate tends toward 10 - 0%.
Questioning how this may be possible he says that he thinks “payroll is completely deductible”. I’m not sure how to interpret this. Do I subtract all of pre-tax payroll from taxable income to calculate Adjusted Gross Income? That seems like a very large deduction. Is only a portion of payroll deductible?
I’ve never even filled out a tax return, so this is all new to me. Thanks for whatever info you can provide.
Gross pay that is paid to employees is deductible as well as the related payroll taxes, unemployment insurance, worker’s comp and any other benefits he might provide like health insurance.
Make sure he doesn’t consider the money he pulls out as “payroll” unless he is treated as an employee himself. In which case, its a deduction for the business but also income to him personally.
The big picture idea is that businesses pay taxes on profit, not on revenue.
So at a high level, you take all the revenue, subtract everything that was spent to create that revenue (which includes everything you paid your employees), and what’s left is profit. And that’s what gets taxed.
Yes, there are a million details and a bunch of special cases to consider, but that’s the guiding doctrine.
The usual way folks get into trouble is they think that just because the business spent money, it’s a legit business expense and therefore reduces taxable profit. An example: Yes, the business owner could take a vacation to Hawaii & have the business write a check to pay for it. But unless that trip was actually furthering the goals of the business and had little or no recreational value, it isn’t a legit business expense.
Partnerships don’t have tax rates. The partnership passes income/loss through to the partners using Sch K-1 and the partners pay tax on it. So, let’s say the partnership has a measly $1,000 of profit per partner. One partner is rich and has lots of other income; he pays 33% tax on his $1,000. Another is poor and has plenty of deductions; he pays 0% after his deductions on his $1,000.
Also, AGI only refers to individuals, not partnerships. A partnership has net income. Actually, it’s more complicated than that because partnerships pass income and expense items through with the same character. (i.e. interest is passed through as interest, rental income as rental income and ordinary net income as ordinary income.)
Payroll is a deduction for the company. If the payroll is to the partners, then it should be guaranteed payments, not payroll. (There’s a big difference - no W-2, no withholding, etc.) Guaranteed payments are passed through on the K-1 and are taxable to the partner who received them, in addition to other income that may be passed through.
So, anyway… I’d let the spreadsheet focus on calculating net income. Don’t waste your time with tax rates because they’re not relevant at the partnership level.
Implementing these measures as carefully as I could the spreadsheet looks pretty solid. However, we notice that the AGI tends to be negative! Substantially negative too, even if we only include the hypothetical of payroll / commission.
As it’s currently programmed, this makes it so we have a negative tax rate of between 0 and -10%. This corresponds to a and AGI between -$28,000 to -$100,000. These are both substantially negative AGI’s
To clarify, I calculate the owner’s AGI as follows:
AGI = Taxable Income - Deductions
Taxable Income = Owner’s Salary + Owner’s Share of Profits
Owner’s Share of Profits = 70% of Overall Profits
Where could there be a mistake? Is there necessarily a mistake in the calculation method? Could it be that we are approximating payroll in an unrealistic manner?
How did you calculate “Profits”? Presumably this would be revenue - costs, including payroll. If that is the case, you don’t include payroll in “Deductions”.
As Baracus says, it sounds like you’re taking deductions twice.
The owner’s profit = gross receipts - deductions. If you substitute that into your AGI equation for taxable income, you get salary + gross receipts - deductions - deductions.
On the other hand, it’s not so unusual for businesses to run in the red, or for owners to have enough itemized deductions to reduce taxable income to 0 or less. I just finished a tax return with $240,000 of net operating losses over 3 years. Obviously, neither the tax nor the tax rate ever become negative, but you can be paying 10% on $0.