Marginal Tax Rates and Self-Employment Tax rates

[Wealthinvestigator]

I have a question for tax professinals out there. If I earn a yearly salary of $40,000 dollars and I flip a property and earn $38,000 dollars for the year. I will be subject to ordinary income tax rates and SE tax rates. Since I make a salary of $40,000 dollars, I will be taxed in the 25% marginal tax bracket. On the $38,000 I earned from the flip I will have to pay SE taxes that are approximately 15%. Do I have to pay an additional 25% (marginal tax rates) and the 15% (SE tax rate) on the $38,000 gained on the flip?

Thanks for the feedback

[Dave T]

I am not a tax professional. Since you have not received a response yet, let me take a stab at it.

The short answer is yes.

Look at your paycheck from your job.  You have withholdings for income taxes withheld every pay period.  Also, you have withholdings for social security and medicare taxes every pay period.  

Your income tax withholding is based on your gross pay and maybe you get a portion back as a refund when you file your income tax return.  The employee share of the social security and medicare taxes (the payroll taxes) are also computed on your gross pay and withheld from your paycheck.

The same thing happens when you are both the employer and the employee.  Your self-employment income is subject to both income taxes at your marginal tax bracket rate, AND the same social security and medicare taxes (payroll taxes) you see on your paycheck at work.  When your income is called self-employment income, we call these payroll taxes that you pay as both the employer and the employee a self-employment income tax.

You can use your 25% marginal tax bracket rate and the self-employment income tax rate of 15.3% to estimate the federal tax you might owe on your self-employment income at 40.3%.  However, in practice when you get done with all the computations and your deductions, the effective tax rate is often lower

If your state also has an income tax, then the state tax is in addition to the federal tax bite.

[mcwagner]

BUT

now that you've opened the door and will have to file a Sch C for the flip income, you want to be sure to include all of your other business expenses.  These reduce your taxable income and taxes.  Examples are business mileage (keep a log), cell phone, postage, basically EVERYTHING you spend on the business is deductible.  Once you have the door open, you want to shove as much through it as you can.

[Wealthinvestigator]

Thanks for the responses Dave T and mcwagner. I appreciate the responses. I will appreciate if both of you can provide me an answer to the follow question.

I have read that if the guarantee payment is involved in the L.L.C. partnership format the following applies:

1. The partner providing the services for the L.L.C. (managing the daily operations) receives the guarantee payment. The guarantee payment is subject to SE Taxes. His distribution allocation will be subject to taxation at his marginal tax rate.

2. The partner (passive investor) that is not involved with the day to day operations of the L.L.C., his distribution allocation will be subject to taxation at his marginal tax rate. (He will not have to pay SE taxes)
my $40,000 salary will place me in the 25% marginal tax rate, on a
$38,000 profit distribution, I will have to pay $9500 ($38,000 x .25) in taxes on the flip income and about ($40,000 x .25) $10,000 in taxes on my regular salary. (not taking in account deductions and other factors that might lower the income to be taxed).

I am the partner that is the passive investor in this scenario, I understand that I will have to pay taxes on my salary $40,000 because I will be categorized by the I.R.S. in the 25% marginal tax rate, but wouldn't the guarantee payment structure allow me to pay only 25% (my marginal tax rate) on my distribution profits ($38,000) from flipping the property, and not 40.3% since the partner that manages day to day operations pays SE tax on the guarantee payment he receives?

Thanks for the feedback.

[mcwagner]

that's the way I'd do it.  you seem to have a good understanding of the concept, provided that you are not active in the business.

but you're figuring your taxes based on your gross.  Business expenses (including the guaranteed payment, which is a business expense to the LLC) will reduce the LLC's passthrough income and then things like exemptions, itemized deductions, etc will further reduce your taxable income.  you may or may not end up in the 25% bracket and it won't apply to the entire gross; only to the taxable income.

[Dave T]

Wealthinvestigator,

If you are a limited partner in a true limited partnership, then you are correct.  Income received as a limited partner from a limited partnership is passive income taxed at your ordinary income tax bracket rate and not subject to self-employment income taxes.

Mark will have to answer for you whether the LLC treated as a partnership can be a limited partnership or whether it is really a general partnership with no "limited" partners.  It is my (perhaps flawed) understanding that even though one partner is specifically compensated as a managing partner in an LLC (partnership), the net active income earned by the partnership would still be distributed to all the partners as active income subject to ordinary income taxes and to self-employment income taxes.

 

[Wealthinvestigator]

Thanks for providing the feedback McWagner and Dave T. It seems that I am on the right course in understanding the dynamics of the SE taxes, marginal tax rates, and the role of the guarantee payment in the L.L.C.

[aak5454]

if I recall off the top of my head, there are a number test to be applied to determine whether income belongs on schedule C (one of those test being an hours/effort test, read instructions for SchC).  Also, I recall there being specific language about real estate activities that makes it difficult to push those into Sch C; especially if you had income from other sources.

It would seems this would go on Sch D as a short-term gain and no SE tax is due.  Your cost basis would be adjusted to include all expenses related to that investment activity.  For an LLC, you would get a K-1 and transfer the numbers.

[Wealthinvestigator]

I appreciate the additional information aak5454. Thanks.

[mcwagner]

flips (properties held for resale) do not go on D as they are not "held for investment" but rather are considered "doing business".  The property is considered inventory, and the income is ordinary, not capital.  SETax attaches.

i think the hours requirement you refer to applies to rentals.  If you spend more than 750 hours a year (among other measures) managing rental property, you may be considered a real estate professional and the income changes from passive to active (sch E to C)and SE attaches.

[aak5454]

I see what you are saying, so you would be classified with dealer status for that transaction.

Here's the link to what I was reviewing (look at p.2).

http://www.irs.gov/pub/irs-pdf/i1040sc.pdf.

Interestingly however, if you qualify as a passive activity, then you can possible could be able to take previously disallowed passive losses (you have to look at form 8582 which I think the passive allowance form).  It seems in some cases, this route is actually better as if you unlock large previously disallowed losses (which I happen to have)

This situation is of interest to me becuase I have a very similar situation (w-2 income, a flip held about 7 mn.<someone else managed all the contractors, I just wrote checks> and large disallowed losses on rental activities).  I'll have to ask my EA as she is suppose to call me this week about a couple of other things.

[mcwagner]

I see.  These passive activity rules are for general business.  Rental income is always passive unless you spend 750+ hours doing it and are therefore considered a "real estate professional".

It may be in the Sch E instructions or maybe the 8582.

[aak5454]

Rental income is always passive unless you spend 750+ hours doing it and are therefore considered a "real estate professional".

Agreed that rental income is almost always passive, but under this definition your "flip business" can also be passive and therefore those passive gains from the (passive) flip activity can offset previously disallowed passive losses from rental activity. (That's a statement and a question rolled into one, comments welcome).  Obviously I would need to study 8582 closer, but I have in past years been able to take accurred, suspended passive losses so I'm famarilar with how that works.  It looks like another way to unlock those suspended passive losses from rental activities.

[mcwagner]

flips could only be passive if you don' t materially participate, or are a limited partner, etc.  for most folks, this doesn't apply.

[Dave T]

If I may jump in here,

I see.  These passive activity rules are for general business.  Rental income is always passive unless you spend 750+ hours doing it and are therefore considered a "real estate professional".

Agreed that rental income is almost always passive, but under this definition your "flip business" can also be passive and therefore those passive gains from the (passive) flip activity can offset previously disallowed passive losses from rental activity.  

Rental real estate activities are, by default, passive income activities.  If you go back to the IRS instructions for Schedule C (1040), page 2, note that line G speaks directly to this question:

Line G

If your business activity was not a rental activity and you met any of the material participation tests below ..., check the “Yes” box.  Otherwise, check the “No” box.  If you check the “No” box, this business is a passive activity.[/list]This clearly says to me that you do not have an active trade or business IF your activity is managing your own rental real estate.

The tax code does make an exception for real estate professionals.  If you are already a real estate professional, THEN your rental activity is an active income activity.  BUT, to be a real estate professional, you have to first meet the material participation rules and the 750 hour/more than 50% tests in an active income trade or business.

The tax code defines a "dealer disposition" as

any disposition of real property held for sale to customers in the ordinary course of the taxpayer's trade or business.[/list]The tax code further prohibits investment tax treatments (capital gains, 1031 exchange, installment sale) for dealer dispositions.  This only leaves ordinary income tax treatment.  If done as a sole proprietor, then self-employment income taxes also apply.

It is my contention, that the IRS' definition of a dealer disposition is the definition of property flipping.  Therefore, property flipping is an active income trade or business which the sole proprietor reports on Schedule C (1040), never Schedule D.