BiggerPockets Money Podcast - 528: The Small Business Owner’s Guide to Taxes, LLCs, Deductions, & Audit Risks

Starting point is 00:00:00 Many of you have started a small business this year, and that's super exciting. But if you're used to working as a full-time employee for somebody else, the transition to business owner can be overwhelming, especially when it comes to keeping track of your taxes. That's right. So to help ease your way through the transition that can be very unpleasant for a lot of these small business owners, we have Brandon Hall, CPA to real estate investors on the show to walk us through the different business and tax structures that you have and options that you have and choices that you can make as a real estate investor, small business professional. We'll talk about things like estimated taxes, deductions you can and shouldn't take, and then we'll have a fun little lively discussion about

Starting point is 00:00:41 rep status and all the landmines there. And Mindy, before we get into this episode, I do want to remind everybody that if you are struggling with tax strategy frameworks, filing, bookkeeping, all of those types of things, and you have any real estate related interests, we have created a tax finder on Bigger Pockets with dozens, hundreds of real estate-specific tax professionals. You can find those at BiggerPockets.com slash tax finder, or if that's too hard to remember, you can find them at BiggerPockets.com slash tax pros. All right, Scott, and our listeners, hello, hello, and welcome to the Bigger Pockets Money podcast.

Starting point is 00:01:15 My name is Mindy Jensen. And with me, as always, is my always pays his taxes co-host, Scott Chinch. Thanks, Minnie. Great to be here, as always, with my counterpart or extension, Mindy Jensen. Mindy, as always, we're here to make financial independence less scary, less just for somebody else to introduce you to every money story and every tax disaster because we truly believe that financial freedom is attainable for everyone no matter when or where you're starting. And as long as you pay the IRS. Brandon Hall, welcome to the Bigger Pockets Money podcast. I'm so excited to talk to you today. Thanks for having me, Mindy. I'm excited to be here. Brandon, we are going to talk about businesses. And today, you are in the hot seat. To start off, can you give us a walk through a. the different types of business structures that you can set up your small business as.

Starting point is 00:02:01 So we'll do just typical businesses, real estate enterprises, landlords are maybe a little bit separate. But your typical structure is just, you're just going to start off as a sole proprietor. So if you do nothing, then when you go to file your tax returns, you're going to fill out a Schedule C. It's going to be tied to your Social Security number, all those 1099 payments, the W9, everything is tied to your Social Security number. And you're just operating like as bright and Hall. And there's nothing wrong with that, depending on where you're at in the life cycle. You should at some point move that into an LLC structure, typically a single member LLC, so disregarded for tax purposes. But that's where you kind of get that asset protection. You get

Starting point is 00:02:44 the EIN. You can go get a bank account. And you can, you know, you can, you're easier to lend to. a lot of benefits if you are running a business and then that business is run through an LLC in terms of legitimatizing yourself from a business contract perspective. From a tax perspective, it's disregarded. It's the same as if you are running a sole proprietorship. So no change there. And then if you're an LLC, you can tax yourself as an S corporation or a C corporation. And that's when we start getting a little bit a little bit more complex, right?

Starting point is 00:03:21 So a lot of sole proprietors will set up an LLC, tax themselves as an S corporation to avoid a portion of the self-employment taxes that they are paying on the income that they're earning. So if you are running a sole proprietor, the sole proprietorship, or if you're an LLC, any dollar that you earn up to $156K is taxed at a 15.3% rate. That's self-employment taxes. That's the benefit of being a sole owner. You get this extra tax liability. And that is on top of your federal rate and your state.

Starting point is 00:03:59 And I just want to call it that that is also being paid if you're an employee. It's just being paid by your employer as part of payroll tax. That's why that exists, right? Yeah. So if you're in, and honestly, like a lot of what I have found is that a lot of business owners didn't even realize. I mean, everybody, everybody's heard of Social Security and Medicare tax, but you don't really like look at your tax turn at the end of year and add 7.65% to it, right? You just go, yeah, my tax bill was X. But we're all paying this 7.65% tax on every dollar that we're earning. Your employer just pays an additional 7.65%. But if

Starting point is 00:04:32 you are the employer and the employee, then you get to pay the full 15.3. So you're going to pay 15.3% on every dollar that you earn as a sole proprietor or as an LLC that's single member disregarded. if you tax yourself as an S corporation, then you can pay yourself a W2 wage. And that is subject to that 15.3% tax. Whatever profit is left over is not. So the remaining profit left over is not subject to this 15.3% tax. You do get some tax savings if you're running an S corporation. But then you get into like, how do you actually run an S corporation appropriately?

Starting point is 00:05:12 And how do you avoid audits or how do you win an audit? The big thing there is reasonable compensation. And that is like a two-hour episode on how do you determine reasonable compensation? Because it's not $1 like all the headliners would tell you. Well, great. Well, I think what we're trying to get here is to help someone who's like contemplating this. Right. So again, if you're W&2 employee, this is not really relevant to you right now.

Starting point is 00:05:36 Remember this episode and come back to it when it is time for it. If you are a real estate investor, we're going to talk about that in second here. And you're owning landlording rental properties. we can get into the nuances there. We've already covered touch a little bit about it. But if you're trying to start your own business and you're going through these options, you have the, you know, the LLC versus the S corp and the C corp, you know, you have decisions to make. And can you provide us with like some general guidelines to steer people in the right direction,

Starting point is 00:06:02 even if they aren't the BL and all and all in every situation is unique? Yeah, yeah. And I think general guidelines are always dangerous. So take this with a grain of salt. My general guideline is if you are going to gross 40 to 50, 50K a year or less running your business, you should not be setting up any sort of complex entity structures. You can absolutely set up an LLC, but that's as far as I would take it.

Starting point is 00:06:29 If you feel like you need the asset protection that comes with that, then set the LLC up and run your business through an LLC, otherwise just run it as a sole proprietorship. If you are going to scale your business up more than that, and you're going to do it consistently every single year, right? So this becomes a little more than maybe a side hustle or a hobby. Now we're targeting 100K, 200K, 500K, 500K. Go ahead and set up an LLC and run your business out of an LLC. So get your EI and get your business bank account, set up your W9 to show the EIN instead of your social security number and and running out of an LLC. The reason that I say that is when you tax yourself as an S corporation, the

Starting point is 00:07:13 The ability to tax yourself as an S corporation is powerful. There's a lot of limiting issues that come with that too. So don't just go and tax yourself as an S corp just to save money on tax. But the ability to tax yourself as an S corporation, you get a lot of flexibility with the timing if you have an LLC set up. So when I set up an LLC, from that date, I can tax myself as an S corporation. I cannot tax myself as an S corporation if the LLC set up. does not exist. So here's an example. Let's say that I'm going to make $100,000 in net income in

Starting point is 00:07:49 2024. And that $100,000, if I were running it through an S corporation, I might be able to save, I don't know, $10,000 in self-employment taxes. So I'm going to set up an LLC on January 1st, 2024 if I can because I can get to December 2024 and if I hit that profit target, I can retroactively tax my LLC as an S-Corp starting January 1st, 2024. But if I wait until November 2024 to set my LLC up, then I can only retroactively tax my LLC as an S-Corp starting November 24. So only until, only since that LLC has been set up, which means only the income earned in November and December is going to enjoy that potential sheltering, which really there wouldn't even be that much to shelter at that point.

Starting point is 00:08:41 So the earlier that you can set an LLC up, the better from this taxing as an S-Corporation perspective because you can retroactively tax your business as an S-Corp. But again, that threshold for me is kind of like that 50K threshold of really starting to get serious about this stuff. And there's even some cases where you might be. netting 100 or more and not want to tax yourself as an S corporation. My business is not taxed as an S corporation, right? So we gross millions of dollars a year. I don't tax my business as an S corporation. And I have many reasons that I do not do that. So you really have to have to sit down and go through

Starting point is 00:09:24 the pros and cons before jumping into that type of a structure. Because once you're there, it's really hard to unwind from it. All right. Brandon Hall just broke down for us the different business structure. you can explore for your small business. Now, stay with us because after the break, he'll walk us through how to estimate quarterly taxes. Tax season is one of the only times all year when most people actually look at their full financial picture, including income, spending, savings, investments, the whole thing. And if you're like most folks, it can be a little eye-opening. That's why I like Monarch.

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Starting point is 00:11:51 At this point, I've logged over 229 audio book completions on Audible alone, and I still regularly re-listen to the highest impact titles. Lately, I've been listening to Bigger Leaner Stronger for Fitness, the Anxious Generation for Parenting Perspective, and several Arthur Brooks' audiobooks that have been excellent for mental well-being. What makes Audible so powerful is its breadth. Beyond audiobooks, you also get Audible Originals, podcasts, and a massive back catalog across business, health, parenting, and more.

Starting point is 00:12:19 All accessible in one app. If you're looking to turn everyday moments into real progress, Audible has been indispensable for me over 10 years. kickstart your well-being journey with your first audiobook free when you sign up for a free 30-day trial at audible.com slash BPMoney. Welcome back to the Bigger Pockets Money podcast. So we have these different structures. I've now set up a business.

Starting point is 00:12:43 I've decided to incorporate it to an LLC. Like, what is the checklist? What are just some of the items that I definitely need to be done? Otherwise, I'm wasting my time setting up the structure in the first place. So first thing you need is an operating agreement. And a lot of people that set up LLCs don't actually have an operating agreement. You have to have an operating agreement. You have to have an EIN that's an employee identification number that takes five minutes to obtain from the IRS.

Starting point is 00:13:12 And you need a business bank account. I would say those are the big three. You can go and register with your state secretary of state. And then you have to look at any sort of like revenue departments that you have to register with, employee way withholding departments that you have to register with unemployment departments. So depending on the type of business that you're running, also depends on what type of payroll or if you need to register with the various payroll departments. So just be aware of that. But the basic level, just again, it's LLC is registered with the state. We've got an operating

Starting point is 00:13:47 agreement. We've got an EIN. We have a bank account. And if you don't have those three things, you're wasting your time because you're going to just have ads and complex in your life that is not going to add any value to anybody in any sense, any protection whatsoever. It's just going to add some unnecessary complexity and maybe some expense to your life. If you don't have it. Is that right? Oh, yeah, yeah, 100%. And I think most people setting up LLCs get the EINs.

Starting point is 00:14:10 They get the business bank accounts, but they forget to have an operating agreement. And that's the big one. It's like, well, if you don't have an operating agreement, you might as well just not even do this thing. So make sure that you have an operating agreement 100%, otherwise you're just wasting your time and your money. Okay, so is an operating agreement something that you can, like, boilerplate language, you can download from the internet? Or is this something that you get from your CPA or your attorney?

Starting point is 00:14:33 So, so CPAs cannot write operating agreements for you. You do have to be an attorney. So, well, really, nobody, anybody that's not an attorney cannot write operating agreements for you, technically speaking. You can write your own operating agreement, though, right? Yeah, just you can't pay somebody that's not an attorney to do it. That's unlicensed practice of law. And the state bar associations are super hardcore about protection. that, which means that if anybody is a non-attorney telling you that they can do it for you,

Starting point is 00:15:00 proceed with caution. Everybody's Google in their operating agreement template right now because they don't have their operating agreement set up for their LLCs. They don't want to pay a lawyer. Yeah. I mean, look, like, could you do all of that? Could you get a template? Could you write your own 100%.

Starting point is 00:15:15 You can do whatever you want, your life, your business. What I have learned to do is to reduce my legal costs. I have learned to any sort of contract that I need written, I will build the framework. So the key points that I need to be input into that contract, I'll bullet point them out, rather than having an attorney start from scratch because that's when it gets really, really expensive when the attorney is like, oh, well, how do we want to build this thing? And here's a million different ways we can do it. So I always start with a framework.

Starting point is 00:15:46 I hand it to the attorney and I say, I need a contract for this purpose. and it gives them a really good starting point to build on. But if you want to write your own, if you get templates, I would I would a thousand percent recommend that you pay a thousand bucks for an attorney to review it. They'll apply state law to it. And that is the key. You need to make sure that your operating agreement is written in accordance with the states that you are actually operating in. And you have certain provisions in there that are needed.

Starting point is 00:16:16 Yeah. And key terms for an operating agreement might include. things like who owns the business, right, in there? Who gets to make decisions about various things in the business? What are the exits of the business? How would it be dissolved? And how would, if there are multiple owners of the business, how would they, how would different owners be able to exit their interests in the

Starting point is 00:16:38 business in various capacities, right? What are some other terms that you would? Yeah, how do we split profits? How do we allocate losses? When do we do capital calls? Who has to do capital calls? Um, waterfall agreements, prefs. I mean, everything related to the P&L is going to be, is going to be in there.

Starting point is 00:16:56 When do we make distributions? How do we make distributions? But the exits are key to. It's, you know, it's not simply like, what happens when we sell? But what about when somebody dies? What about when somebody gets divorced? There, there's a whole bunch of provisions that you can think through. And if you are partnering with somebody, by the way, so we've been talking about you

Starting point is 00:17:15 just doing it all yourself and being a sole prop. Man, if you're partnering with somebody, you can. You got to sit down and really go through all of those things. Hey, I love your wife. But what happens if she doesn't love you at some point? What are we going to do? And the better way to do is you're not even negotiated against your partner's wife. You're negotiating against their unborn child's future ex spouse.

Starting point is 00:17:38 That's how I like the payment. Because that person is not going to be reasonable in 25 years. And you want to make sure your agreement is structured to protect you from them. Right, right. Yeah. So who is, what kind of attorney am I? looking for to help me set up my operating agreement? I would say just general business attorney. You know, you don't need like a litigator or anything like that. But just a general business attorney

Starting point is 00:18:01 would be a good place to start. Although what I do with the law firm that I use is, so my point of contact is the general business attorney. And he works with firms of my size. So that's the other key too, is to make sure that like the attorney that you're working with actually works with businesses like yours, which can be really hard to fact check and verify, by the way, but you do have to check references and call the clients and that type of stuff. But my general business attorney, like, we'll build an operating agreement and then I'll have him run it by his litigators. Like, okay, how would you litigate against this operating agreement if you were to do so? And that helps strengthen it at the end of the day, at least I think it helps me sleep better at

Starting point is 00:18:42 night. Yeah. So I would like to throw in my own two cents. If you don't think you can afford an attorney to write up your operating agreement, then you cannot afford to have a business at this time. I think that's a great framework. And I look forward to seeing hotshot lawyers challenge that in the comment section. But like, that's right. Like, if you, if you can't afford to put together an operating agreement, you have no assets to protect. Yeah. I think that that's important in, in various aspects of life, but absolutely business. There are certain things that are just the cost of doing business. And they might be annoying.

Starting point is 00:19:17 They might be something you want to or feel like you could deprioritize, but you really shouldn't. And getting that operating agreement written is certainly one of those things. Bookkeeping is another one of those things. But that's a different story. Let's get into the mechanic. By the way, lawyers for this stuff, like, this isn't solved problem. Like, you're not going to spend $10,000 of your operating agreement.

Starting point is 00:19:37 You should spend $800 to $1,500 at max for a business that's small. you're just getting started with this. And someone will have language that has probably solved 85% of what Brandon just talked about. And there will be decisions for you to make on the remaining balance of this. So this is not, like, don't ever think that too much on that front if you're listening to this for the most part, for most typical types of businesses. Let's talk about once you set up an entity, you now are, you, and you have your EIN from the federal government. The federal government is going to expect a tax return from you and other things to be completed. your secretary of state is going to require,

Starting point is 00:20:14 at least in Colorado, expects you to stay, keep your entity up to date. What are, can you give us a, a kind of guidance on what the timeline of key milestones or, you know, events that someone has to be keeping track of in order to keep their

Starting point is 00:20:28 entity in good standing? So at the state level, and the state level is probably the most critical one to be totally honest with you. Your, your entity always needs to be in good standing at the state level. And typically that is an annual filing requirement. Now, the date is different per state. So I don't know how to guide on that aside from make sure that you know what the date is and put it in your calendar like six times that week that you get that annual report in if you have an annual report.

Starting point is 00:21:01 Some states allow you to file an annual report with the federal tax return or with your 1040. but you have to be aware that you can actually do that and a lot of people are not. So my suggestion is just make sure you've got that state annual filing on lockdown. From the federal perspective, if you are a single member LLC, again, it's disregarded for tax purposes. So you don't file anything separately with the IRS. You do have an EIN. The EIN will show up on your Schedule C instead of your Social Security number, but you don't file any sort of separate forms.

Starting point is 00:21:36 If you have a partner, whether the partner be a third party, a friend, a family member, a spouse, a child, now you have to file a partnership tax return. That's a Form 1065. And that is due on 315, March 15th every single year. You only have to file if you have activity, though. So that's the other key. Like, I could go and create 100 different partnerships, but do nothing in them. And I don't actually have a filing requirement. So that is a caveat.

Starting point is 00:22:06 out there. S corporations are also due on March 15th, but then C Corpsps are due April 15th. And you can extend the LLCs, the S-Corp's, the C-Corps. You can extend them for six months, like you can your regular individual tax returns. But that's when that deadline is. Okay. So we've talked about entities at length here and the tools and use cases for them. this is a DIY project to a certain extent. You got to get basically familiar with this before you allow an attorney to pull you into one of these, you know, Malt series LLCs or whatever. Those can be the right approaches,

Starting point is 00:22:45 but you should be able to know enough to be dangerous and get a couple of opinions that make sense for you before hearing from those guys on there. They make it like an understanding incentives that go along with all this stuff. I want to go and talk about another context construct here for folks. Again, if you do think about starting a small business, or investing in real estate and you begin to generate profits outside of the payroll system, there are other considerations that you need to think about, such as paying estimated taxes here. So for a business that generates income, nobody is collecting the taxes from your paycheck automatically.

Starting point is 00:23:19 And there's, you know, you set aside that. Can you walk us through the framework for how to think about this and any recommended tips or tricks for making sure you don't fall into the wrong side of the IRS for this as a small business owner? Yes. The simplest tip that I have is every dollar of income that you earn as a business owner, take 30% of it and put it into a separate bank account and don't touch it. Even if you don't pay estimated taxes, right? Because there's varying schools of thought, although that's super expensive to do these days with 8% interest rates. Take 30% and put it into a money market account and do not touch it until 415 where you have to make your payment because at least you will have capital to knock the majority, if not all of your tax bill down, the worst thing, the worst thing, especially in real estate, is when flippers or developers take all their profits and they roll into the next deal, right? They're trying to get the compounding effect going faster and faster and faster. Some think they're doing a 1031 exchange and they're sorely misguided, but they roll them all into the next deal.

Starting point is 00:24:22 And then 415 comes and they owe 600K in taxes, but they're all, all that money is tied up in real estate and they have no real liquidity options at that point. Those are always sad stories. So just make sure that you're withholding that 30%. But if you want to get a little more strategic about it, you can take your 30% each quarter and cut a check to the IRS and state. And again, you're going to be pretty close to good, if not totally good, just with that simple methodology. But if you want to get a little more strategic about it, you hire an accountant to do a quarterly tax estimate for you. And basically what they'll do once a quarter is they'll sit down with you. They'll look at all of your income streams.

Starting point is 00:25:04 And they'll say, here is how much you owe the IRS right now. And you go cut that check based on the last quarter of earnings. And that is a way to stay on top of your tax bill and mitigate penalties and interest. And that service, this like the past 12 to 24 months has really started to pay for itself. So before 2022, nobody really bought that service. because interest rates for like 3%. So, you know, not a big deal. If I don't make my payment to the IRS, it doesn't cost me anything.

Starting point is 00:25:37 But now it's costing a lot more money. So people are buying this, hey, can you help me estimate my quarterly taxes so I can make an accurate payment and reduce or eliminate penalties and interest? Is there any formula to who owes estimated quarterly taxes? Like who is required to pay them and who doesn't? because I got caught up back when I was 17, I had to pay estimated quarterly taxes and I didn't. And then I got a big old fine, which was not easy to swing at 17. You must have had a good thing going as a 17 year old to have this problem, Mindy.

Starting point is 00:26:11 I had an awesome thing going as a 17 year old. All right, stay tuned and come back next week. And let's hear about Mindy's 17 year old side hustle where she had a big quarterly tax estimation problem. Well, I mean, it was big in exchange. for my, I think I had to pay a $2,000 fine, and that really hurt at 17. I mean, I don't want to pay a dollar of fines, but so who has to pay estimated quarterly taxes and who does not? So in general, if you pay, so let me back up.

Starting point is 00:26:44 If you, it gets a little complicated if you have a W-2 job and you're kind of building a business as a side hustle. You, the general rule is that you should always pay in 90%. of the total tax that you're going to owe for the current year. And the only way that you're going to be able to estimate that is if you run those ongoing estimates, right, which you don't necessarily need a CPA to do. Like you could use smart asset or a calculator like that to keep tabs on. But that's what you would do is every quarter you would say, here's my projected income

Starting point is 00:27:16 for the year. So my total tax bill and I need to be paying a quarter of that every single year between my W2 withholdings and estimated taxes from the business income that I'm earning. The other way to do this is if you pay 100% of the tax that was on last year's return, then you're good to. And that's divided by four, right? So that's each quarter. So as long as you're paying 90% of this year's tax or 100% of last year's tax,

Starting point is 00:27:43 then you shouldn't be subject to the penalties or the interest or the underpayment penalties specifically that you might have been subject to. So your estimate is only as good as your projections, right? So if you have a very variable income, you could run into a problem no matter what, right? I'm with this. So it's just, yeah, it's at the end of the day. But the way I do it is I just list all my different sources of income, like, hey, dividends here. If I'm going to realize the capital gain, I'll list that. I'll add up the appropriate tax rates. So long-term capital gain would be 20% plus another 4.55% for Colorado state tax. I put this all into a spreadsheet, multiply it out for the end of the year, and then set aside the funds that I'll need chunks of those into a separate savings account. which I call my tax savings account. I probably should do it in a money market because I get a few extra basis points of return. And I just keep it there.

Starting point is 00:28:35 And then at the end of each year, I'm generally a little bit more conservative and can take some of that money out and put it back into investments. But I like that. Last year, I actually screwed up and got a small refund. So I'll take that. But I like to pay a little bit. I like to just, just like the perfection is being within 10%, but closer to the bottom of that 10%, but closer to the bottom of that 10% and owe the rest of it at tax time for me.

Starting point is 00:28:58 Let's move into another area here. So suppose that I have federal and state taxes, which everybody who's listening to this podcast probably is aware of at this point. But there can also be city taxes. And when we're a small business owner, we begin to introduce a really bad kind of salt into our world. Can you explain what salt is and the pain that goes along with this? Yeah. So salt is state and local income tax. And when you are, when you're running a business, you can end up with state nexus

Starting point is 00:29:34 depending on what type of business you run and where you are conducting that business. So like e-commerce businesses, for example, the Wayfarer versus United States basically found that e-com businesses are doing business in all these different states that are selling their products in. even if they don't have a physical presence in that state. So that means that all those states and those localities can now go and collect tax from that business. This can get pretty gnarly, pretty fast, depending on what states you're talking about.

Starting point is 00:30:05 So Ohio, for example, has RITA taxes. Basically, every jurisdiction has its own separate tax rate, which is separate from the state rate. Pennsylvania has something very similar. So various states can have. a state tax, a city tax, and a local tax on top of that. And you could be subject to all three. And you really have to like, you really have to work with either an accountant or you have to be really good at DIYing your research to understand what your exposure is. Because that type of

Starting point is 00:30:42 stuff can come back to buy you multiple years down the road if you're not careful. Let me give you an idea of how gnarly, as you put it, this world can be. So like bigger pockets, right? We sell, I'll just one example. We sell e-books, right? So in some states, you pay state and local tax on the sale of a item like a physical book. Like you go buy a book from a bookstore. There's state tax that's applied to that. Some states consider an e-book to be a physical piece of property that then has to have state tax charged on it. Some states consider that to not be a physical product. Some states will say any service essentially that's provided digitally will be like,

Starting point is 00:31:29 so like every state and many of these cities have different jurisdictions. And then when you get over a revenue threshold from customers in that specific state, you create nexus, which means not only are you supposed to be charging sales tax on there, but you also now have to file a tax return for your business in that state. if you're a partnered business, for example, in there. So, and then by the way, you reach that nexus in several different ways in many states. So in like California, if you hire an employee, you automatically have nexus in California. And then you are now subject to paying tax on all the revenue you generate in California

Starting point is 00:32:06 on there in that scenario. If you sell more than like, I think it's 500,000, don't quote me on that, in California and revenue, you also create nexus in California. It might be, I forget the exact number. here for that. But like this is where you get to really get into like some big trouble. And like that's something that if you're a business owner and you're starting to expand into another state or you're starting to see your business mature a little bit, you really got to be on top of this stuff. Otherwise, you could be accruing a huge liability for state and

Starting point is 00:32:36 local taxes. That's going to come back and bite you real hard in a couple of years. Also applies to real estate investors. If you buy a rental property out of state, you now have state taxes that you have to file for. Now, generally, you're not going to owe any tax because rental real estate produces a tax loss. But there are absolutely situations where, I mean, you, most states have like a gross revenue filing threshold. So it's not necessarily based on net. So even though I have a rental that produces a loss, I might still have to file with that state. But even still, like in future years that you cash flow, you could also be subject to those state taxes. We're partnerships. We're talking about

Starting point is 00:33:16 LLCs and partnerships, you could be filing in states where you are doing no business, where you have no assets if a partner lives there, right? So New York, New Jersey, all the syndicators and the funds, well, they bring on New York, New Jersey people that you're filing now, the entire partnership now has to file in New York, New York, New Jersey, even though they don't have any assets in New York, New Jersey. Short-term rental owners, not only are we talking about income tax, but we're also talking about lodging taxes, sales taxes. So yeah, if you're running off platform, not through an Airbnb or VRBO or similar, you have to go and figure that out for yourself too and make sure

Starting point is 00:33:57 that you're emitting the appropriate tax. Yeah, these local jurisdictions can be very painful if not appropriately planned for and dealt with. So definitely don't take that piece of it lightly if you're doing business in multiple states. Yeah, salt, salt ain't fun. But if you have large, complex salt problems, you also probably have very good business problems. So, but just something to be aware of as you, as you built in these businesses and as you think about hiring, right? Like, you definitely should be aware of what that is going to, what consequences are going to happen to your business in terms of tax preparation and tax payments if you hire your first, when you hire that first employee in California, for example. Like, that's something you really got to be thinking about as an employer.

Starting point is 00:34:47 California is a state you don't want to mess with. If you're doing business in California, do not mess with California. Get it right. I don't live there, but I definitely contribute to their quality of life. Yeah, same. That is a state where, you know, we were talking about setting up LLCs and, you know, yeah, you don't have to. No, if you're doing business of California, get it right from the very beginning.

Starting point is 00:35:07 All right. We're going to take a quick ad break. And when we're back, we're talking deductions. Tax season is one of the only times all year when most people actually look at their full financial picture, including income, spending, savings, investments, the whole thing. And if you're like most folks, it can be a little eye-opening. That's why I like Monarch. It helps you see exactly where your money is going, and more importantly, where your tax refund can make the biggest impact. Because the goal isn't just to look backward, it's to actually make progress. Simplify your

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Starting point is 00:38:12 You might be tempted to let Taco Bell's new Lux Value menu go to your head. Because 10 indulgences for $5 or less makes you feel fancy. Like you might think you need cloth napkins. Well, you don't. Just use the ones that come in the bag. Don't let the Lux go to your head.

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Starting point is 00:39:03 If you're looking for a tax professional, this is the simplest way that you will find credible tax professionals who understand real estate. Go to BiggerPockets.com slash tax finder to find your perfect tax match. All right. Let's talk about tax deductions here. So, again, LLC is a pass-through entity, but I think a lot of people have a lot of misnomer about how a business can then expense personal items and those types of things. So walk us through some of the general frameworks. What's true? What can I believe here? What should I be thinking about and doing from day one?

Starting point is 00:39:39 And what are some of the shenanigans that you have to kind of steer your clients away from? Because they take this the little too far and get too giddy about it. Yeah. So the general rule is that in order for an expense to be a business expense, it needs to be ordinary and necessary for your business. So any expense that you have, you can kind of pass through those two filters. is this ordinary, meaning that are other businesses like mine deducting this same thing in order to run their business? And is it necessary? Is it necessary for my business to deduct this thing to run my business? So for example, meals are an ordinary expense for most businesses.

Starting point is 00:40:22 Extravagant meals are not necessary expenses for a lot of businesses, right? Maybe you're an HVAC contractor. Why do you need an extravagant? meal that costs $1,000 per plate. You know, you probably don't unless you're an HVAC contractor in super, super, super, super rich areas and that's your go-to-market strategy. But that's how you kind of evaluate that, right? So home office, yeah, if you have a, if you have a legitimate business need for a home office and you work out of your home office and you use it exclusively for that business,

Starting point is 00:40:55 that's where everybody blows it up as the exclusivity piece, then you can absolutely deduct the cost of a home office. I'm sitting in mine, right? What does it exclusively mean? Exclusively means that this is all you do in this home office is business. And that, that was my butt. What if you also do your morning yoga in that office? Like, how, what is the, what is the cutoff there? You're, you're probably going to be fine. The, the challenge is when I have a, if you have a separate room and like, like, I have a door, right, that, that I can close. I can basically prove if I were to ever be audited that I do use this as an exclusive home office or exclusive use. I'm not really like, I don't have like a bunch of personal stuff. I don't have exercise bikes in

Starting point is 00:41:41 the background. It is business, right? Where people screw this up is they have like a little corner of a room that they use as their home office. And there are, there are, there is authority that says that you can potentially do this. But where they screw it up is they have a little corner of a room. And room and they've got a bunch of personal papers on there. And it's not really, it's not really for business use. They don't even need a home office for their particular business. Maybe it's more of a hobby than it really is a business anyway. That's where people mess this up. So it's, it's, it's claiming additional tax deductions, uh, from the wrong source, if that makes sense. Like a home office, I don't think of it as like a tax strategy if that makes it. It's not really like,

Starting point is 00:42:27 like this cool, great thing to deduct additional. dollars. It's just if you have one, deduct it if you're stretching to prove it, don't. Because again, now our hassle bar is increasing. We're increasing our hassle, but the reward is pretty low. Maybe the best way to kind of like think about this is can you give us an example of a client who was clearly taking this to an outrageous limit and you had to walk them back? And can you give us an example of someone who wasn't taken enough? There was a time where there was an investor that had an RV and they were traveling around in their RV and they said that half of their RV was their home office. But the RV, that half of the RV was also where their bed was and their dressers.

Starting point is 00:43:09 They changed clothes there. I think they had like a like, I don't know, it's like a bunch of cookware and crap like that. Not a home office, right? Like it's it's your personal living space. That's not a home office. On the flip side, I mean, we have, we have a lot of investors actually that, that we say, hey, you can take this home office. You can claim an extra a few thousand dollars. You know, it's not much, but it's something because you do have a big enough home and you do work out of this one space. And it is its own separate room. And it's a very easy, like, when at that point, it's not something that we're stretching. So that actually happens pretty frequently. I would say that happens more often than it does not. most people aren't claiming it because they think that it increases audit risk, but it's not going to

Starting point is 00:43:56 increase your audit risk. But it is something that under audit would be looked at. So you just have to be prepared for that. Okay, let's say that I have done my taxes and I have claimed, I have a split level house. I have claimed this entire level as my office. But it really isn't a home office and I get audited and I, they come in and they're like, no, that's not allowed. What happens to me if I take more deductions than I should have? Yeah. And let's also zoom out in the context to answering that question and just talk about like, okay, what's going to flag the audit?

Starting point is 00:44:32 And then what is life like while I'm being audited as part of Mindy's great question here? What flags the audit is generally speaking for real estate investors? It's either you're just unlucky or in that, and that's frankly like a lot of it. Or it's you're showing non-passive losses. like losses from your rental real estate, but you have W-2 income. That's typically going to be the flag. And then through that process, and this is why, like, if you get audited, stop talking,

Starting point is 00:45:03 hire an accountant that understands how to work this process because the words that you use are very important to limiting the scope of the audit. If you use the wrong words, the auditor goes, oh, yeah, thanks for reminding me about that thing. And now we're going to go look at that thing, too. to be really careful if you are facing an audit, make sure that you have professional help. But in terms of getting pulled for an audit, it's really just you're either unlucky or you have these large losses while you have W2 income. Now, every year, the IRS will kind of put out, here's who we're looking at over the next

Starting point is 00:45:37 period of time. And they do update taxpayers with that. And I will also say with the advent of AI and the IRS's multi-billion dollar investment into AI, I think that the audits, I have nothing to point to for this theory, but I believe that the audits will become less, less just like rolling the dice. They're going to become a little bit more targeted. So I would expect like short-term rental owners, real estate professional folks,

Starting point is 00:46:09 real estate developers and flippers to maybe see an uptick in audits as AI is further developed in this examination process. That's great you mention that because I want to spend the second hour of this podcast talking about rep status and all the shenanigans people get themselves into on that front. I could talk. That topic, man, we could sit down and have some beers and talk for hours to all sorts of stuff. Real estate professional status and people want to claim it and you got a whole can of worms you open there. I think we'll talk about this in the past. We'll talk about it again in the future. But we're not going to cover that today. just know that if you have a W2 job that's not in the real estate field, please don't claim reps status and just save yourself a bunch of trouble.

Starting point is 00:46:50 The other part is what actually qualifies as a real property trader business. And the regs are pretty clear. And I think some accountants don't read the regs. And when I say treasury regs. So Mindy just declared her holes top of the floor there. She claimed rep status. She is declaring a big loss from rental property. She has a big W2.

Starting point is 00:47:12 IRS has flagged her because the AIA machine is like, Red flag, red flag, red flag, I'm after it. Mindy's also spoken, you know, started trash talk in the IRS agent, and now they opened a whole can of worm. She's hired you. How do you advise her out of this situation? What do we do? So, so basically what we would do is we go, okay, Mindy, you claimed all these things.

Starting point is 00:47:33 We have to figure out how hard we want to push, how hard we want to fight on all of these things. So send us all your documentation that you have to substantiate X, Y, and Z. So send us your home office documentation. Send us the vehicle that you purchase, the GWagon. I like to write about this on Twitter every once in a while I always goes viral whenever I do. It's like, here's what happens when you're right off a GWagon. So send us all the information about that, all your mileage logs, like everything. If you're a real estate professional, send us your time log.

Starting point is 00:48:00 Do your credit card statements and bank statements align with that time log, meaning I say that I'm at a rental property on a Saturday? But my credit card statement says that I'm in London traveling. You know, like, do all of our documents tie out here? So we're going to have that conversation. Then we're going to go to the auditor. We're not going to tell them that we have all this information. We're going to go and we're going to figure out what do they want to see specifically. And they're going to start saying, well, I want to see a reps log.

Starting point is 00:48:27 And then we're going to say, here's our reps log. As fast as we can do it, right? Because we're trying to build credibility with the auditor. We don't want them to be digging through every single piece of information. We want them to look and go, wow, these guys are really. really well documented. So, okay, I'll like audit a few of these and I'm going to move on. And that's the game, right? And through that process too, we might say, okay, Mindy, as a real estate professional, you took, you took, you had 10 rentals and you did cost segregation studies and you did

Starting point is 00:48:56 bonus depreciation and you took losses from these 10 rentals. Did you make a grouping election, Mindy under section 1469 dash nine? And Mindy, most likely, maybe not you, but most of the people that we do this with go, what are you talking about? And so we'll then go and look through all their prior tax returns and we'll go, Mindy, you did not do the grouping election. If the IRS figures this out, then you lose because you have to materially participate in every single rental separately if you don't do the election. So, Mindy, when we're talking to the IRS, don't you dare say the word group. Don't mention it. Don't mention the regs. We're going to stay as far away from this as possible. And we're going to, we're going to do this little song and dance. And hopefully, maybe,

Starting point is 00:49:37 maybe Mindy will just say, you know what, screw the home office. Here, Mr. Arditor, you can have the home office. We will, you have to win something for your boss. So you have home office, but we're going to keep this grouping thing secret. What is, what is winning and losing mean? Winning, winning is not losing bad. Yeah. Yeah.

Starting point is 00:49:57 But like, tell me, like, what is the, what is losing look like? Like, am I going to go to jail? I'm sorry, Mindy. Is Mindy going to go to jail? Is she going to go? No. You don't have to fear that unless you're committing fraud. If you are committing fraud, you should fear jail and you won't know that the IRS CI, their criminal investigation unit,

Starting point is 00:50:17 is onto until it's too late. So they'll actually start investing. The auditor would refer the case to the CI. They will start their investigation during the audit and then you'll realize it later. So as long as you're not like doing really wacky stuff and by wacky, I mean like, you know, I've got fraudulent, like the whole like loan, the ERTC credit and stuff or, or I've got part, I've created sham partnerships that I've prepared my own tax returns for and they've got $200,000 tax losses that have no actual basis in reality. So that's like you're not going to get, you're not going to get thrown in jail for messing up a real estate professional status or short term rental or something like that. But if you, if you don't have substantiation for it,

Starting point is 00:51:07 And we can't prove it to the auditor, then the auditor is going to reverse that deduction, right? And through that reversal, you're going to owe the back taxes. You're going to owe the interest on the back taxes. And you're going to owe most likely a 20% accuracy-related penalty. And that is where it can get pretty painful, pretty fast. When people say, oh, well, like, if it gets reversed later, no big deal, I'll just pay the bill. It's the bill, the original bill that was now, mind you, three years. ago. So we've got three years of interest that has accrued. And interest is 8% right?

Starting point is 00:51:41 8% now. Yeah. So super expensive. Is there a legitimate way for W2 employees to also claim passive losses? Only so so being a W2 employee is not necessarily the the issue, right? That's going to that could be a trigger for the IRS audit. But the real issue is are you a full time or a part time W2 employee? If you are a full-time W-2 employee, no chance that you're going to qualify as a real estate professional, meaning that you spent 2,000 hours a year working for somebody else. Because to qualify as a real estate professional, you have to spend more time in real estate than you do any other job that you might have. And so even if you could justify, even if you do work an additional 2001 hours in real estate,

Starting point is 00:52:29 you have to justify that to the auditor. And the auditors are not like, I mean, they're smart people. Don't get me wrong. But they're not like, I'm working 80 hour a week people. And then even if you lose, which you would, because they're going to say, I don't believe you. Then you have to go and argue in tax court. And the tax court judge is not going to believe you. Many people have tried every single one has lost in tax court.

Starting point is 00:52:50 So the way for W2 employees, if you are a full-time W-2 employee to use losses from rentals is to buy a short-term rental because short-term rentals are a carve-out to real-s professional status, which means that you don't have to spend more time in the short-term rental than you do at your day job. You still have to materially participate, which is a lift, but it's not qualifying as real estate. This is good because I wanted to spend a third hour today on the short-term rental loopholes and deductions and how to use the offset other games. So, this is perfect. I got lots of thoughts on that one too. Yeah. Braina, where can people find out more about you? You can hit us up at www. www.the real estate CPA.com.

Starting point is 00:53:32 You can also find me on Twitter. I've been trying to build that account. It's been a lot of fun because Twitter is its own special place or X, I guess. And it's at B-Hall CPA. Well, thank you very much for the very fun discussion. I can see that you are a little salty about some of those practices that have been discussed and bandied about here in the real estate tax advice world. And really glad to get your opinion here, had a lot of fun and good animated discussion.

Starting point is 00:53:56 So thank you very much. And I hope you have a great rest of your week, Brandon. Thanks guys for having me on. All right, Scott. that was Brandon Hall and that was a lot of information that we just dove through. What did you think of the show? I think it's super fun. I spent like 10 years learning a lot of things about real estate and some percentage of it was allocated to tax strategy. We've gone through a lot of transitions for tax bills and all those types of things here at bigger pockets. So I've developed a lot of frameworks around this. I hope that folks can tell that while I'm not a tax professional, I have kind of gathered a lot of this and known enough to be dangerous. If that's not you, Again, the shortcut that we want to shamelessly plug and self-promote here is the BiggerPockets tax finder, BiggerPockets.com slash tax finder where we have curated a network of real estate-specific tax professionals

Starting point is 00:54:43 that can help you with tax planning, strategy, bookkeeping, and of course, filing here. And God forbid, if you need it, defending yourself from the IRS audit or way worse, that CIT, and that sounds super scary. I do want to put a shout out here for that last bit. If you know somebody who works at the CI team, we would love to have them on the episode here. We think we're doing the IRS a favor because we're going to scare so many listeners into filing their taxes and paying them on time and avoiding those things. We would love to hear horror stories there and those types of things. And I think it would be fascinating to get a look from the inside from the IRS if anybody was willing to ever do that.

Starting point is 00:55:20 And you can email Mindy at BiggerPockets.com or Scott at BiggerPockets.com to discuss your job at the CI department. And we can navigate a lot of things to get you on this show. We're just trying to present this information so our listeners can make an informed decision. All right, Scott, should we get out of here? Let's do it. That wraps up this episode of the Bigger Pockets Money podcast. Of course, he is the Scott Trench. And I am Mindy Jensen saying best wishes little fishes.

Starting point is 00:55:49 Bigger Pockets Money was created by Mindy Jensen and Scott Trench. Produced by Hajar Elda. Editing by Exodus Media, copywriting by Nate Weintraub. And lastly, a big thank you to the Bigger Pockets team for making this show possible.

BiggerPockets Money Podcast - 528: The Small Business Owner’s Guide to Taxes, LLCs, Deductions, & Audit Risks

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