W-2 Precludes Self-Employed Status
Q. I work as a full time freelancer, yet I am paid like a regular employee, with taxes withheld and on a W-2 form at the end of the year. Under these circumstances, am I eligible to start a Single Employee Pension plan?
--M.H.
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A. No. The Internal Revenue Service doesn’t care whether your employers calls you a freelancer or not; as far as the IRS is concerned, you’re an employee and are not entitled to set up a pension plan as though you were self-employed.
Why? Even though your employer says you’re a freelancer, you do not meet the test of an independent contractor, such as working under your own direction and in your own shop. And your employers apparently know it. They are, after all, paying your Social Security, withholding and other taxes just as they do for all regular employees.
Why should your employers handle the case this way? After all, most of those who want to get around their responsibilities--such as employers of nannies and cleaning help--are looking to avoid paying payroll taxes.
You may feel your employer is trying to avoid paying you benefits, such as tax-deferred savings plans, medical insurance and paid holidays. But, in fact, employers do not owe their workers any benefits at all. However, if your employer offers benefits to others classified as “employees” who perform essentially the same tasks under essentially the same conditions as you, you should be getting them as well. The critical test is whether you work at least 1,000 hours per year for this employer. If you do, and the employer offers benefits to other workers, you are eligible for those same benefits.
In the meantime, if you are not eligible for a company retirement plan, you can deduct $2,000 for an IRA.
Taxable Gain on Loser Property
Q. I bought a rental property several years ago for $50,000 and later sold it for $80,000. I deferred the tax on the $30,000 gain by buying another rental property for $90,000. Now I want to sell this property, but can only get $85,000 for it. How do I account for my original $30,000 gain given the fact that I am suffering a $5,000 loss on the second property?
--E.S.V.
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A. You are liable for taxes on $25,000 plus any depreciation you have taken on the two properties over the years. How did we arrive at that number? Not the same way you might have. Assuming no depreciation, your basis in the second property was $60,000, the $90,000 purchase price minus the $30,000 deferred gain. You subtract that basis from the sales price, $85,000, to arrive at your taxable gain. Remember, these figures assume no depreciation.
Plan Stretches Too Far to Avoid Income Taxes
Q. I retired last year and began drawing Social Security. My wife, who turns age 62 this year, has continued working in our family-owned business. We expect to sell the business to our children this year, and although my wife will retire, she will not begin drawing Social Security. Our children will repay us for the business over many years in equal monthly or weekly installments.
Although my wife and I have traditionally filed joint income tax returns, we are wondering if my Social Security will be less subject to reduction or taxation if we begin filing separate tax returns and she declares the payments from our children. I expect that our combined income this year will be about $65,000.
--S.O.G.
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A. At best, your scheme is dubious; at worst, it could end up costing you more in taxes and estate planning hassles than you ever imagined possible. Clearly this is yet another case where taxpayers are better off accepting the potential tax consequences of their bounty of riches than trying to creatively fashion ways to elude Uncle Sam’s outstretched hand.
For starters, you must remember that your monthly Social Security benefit is subject to reduction only on the basis of earned income. If your children’s payments to you for the business are strictly that--and not disguised remuneration for your continued work there--these funds are not considered earnings for Social Security purposes and won’t affect your payments.
However, Social Security recipients with substantial unearned incomes do face taxation of their Social Security benefits under sweeping changes to the rules governing Social Security benefits approved in 1993. And you cannot escape these taxes by filing separate income tax returns if you have lived with your spouse during any part of the tax year. Social Security recipients filing separately and living with a spouse can still be subject to taxes on as much as 85% of their Social Security benefits.
Finally, have you considered the impact of community property laws and estate planning matters before deciding that your wife if entitled to exclusive repayment for the value of the business you sold to your children? According to our experts, your plan to avoid a few dollars in taxes each year would likely create a mess of your estate.
