The Tsunami Situation (Debt Report)

Houston, we have a tax problem. 

The tax filing extension deadline was September 15 for S-corporations (and LLCs that have elected S-corporation tax status). As a business owner, my personal taxes are integrally related to my business taxes, so we handle all of the returns at the same time. On September 14,  my accountant informed me that I’m looking at yet another personal tax bill. 

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My 2018 outstanding tax obligation is: $3,238 to the IRS and $2,819 to the state.

Shit.

Since 2014, a couple of years into my entrepreneurial journey, I have always had a tax bill at filing time – a bill that I never had the resources to pay in one lump sum. Every year,  I’ve found myself on some payment plan – usually with both the IRS and the state. 

Apparently, 2018 is no different. 

W-2 “Employee” Income

A few years ago, my accountant and I discussed potential ways to remedy my consistent tax problem. I filed with the IRS the election to have the business taxed as an S-corporation. The business is registered as a limited liability company (LLC). Single-member LLCs will, by default, be treated entirely as pass-through (disregarded)  entities for tax purposes, or can, alternatively, elect to be taxed as an S-corporation by filing IRS Form 2553. 

S-corp tax status offers the benefit of reducing the amount of the owner’s income that is subject to the self-employment tax. The owner of an entity taxed as an S-corp is deemed to be an employee of the company (and is supposed to pay him or herself reasonable compensation) and only the wages paid to the owner/employee are subject to the FICA tax.  The FICA tax funds Social Security and Medicare. By being an employee, the business owner treats themselves as a true W-2 employee, including doing the payroll deductions that go along with employee compensation. In addition to the W-2 wages, a business owner can also receive distributions from the business. The distributions, generally, are not subject to FICA taxes.  This allows a business owner to reduce his or her FICA tax obligation while still complying with the law. An owner of a business taxed as an S-corp is likely to pay themselves W-2 wages and take money out of the business in the form of distributions. 

Setting myself up on payroll was something that I hoped would put some structure around the freestyle nature by which I had been handling income I was paying to myself out of the business. As an employee, I’d have to pay myself reasonable compensation. With the W-2 status, I would be paying taxes out of each check I received from the business. That would mean that I’d be paying taxes throughout the year, instead of leaving the payment to tax time – when I was not likely to have the money to cover the whole obligation. 

Oh, how I thought I had figured it out this year because, in 2018, I paid taxes consistently through the compensation I paid myself through the payroll service I’ve set up for the business.

Side Hustle Income – The Challenge Is Real

Though I did better than in years past, I didn’t do well enough. I thought that the money I paid through my W-2 income would cover any additional taxes that I might owe from other income. It was wishful thinking because, frankly, I didn’t do the math. 

In 2018, I had some significant side hustle income. I taught a course on a national platform and earned just over $21,000 for the 9 months during which I taught the program. I also earned just under $8,000 in businesses with my attorney colleague (yes, the one I mention in my post titled  I Used to Have A Job). 

I didn’t reserve any funds out of these payments for taxes. Of course, I know, as do most self-employed persons, that I should set aside some funds when I earn the money so that I don’t get jammed up later. You would think that, after owing outstanding taxes every year since 2014, that I would have changed my program and developed the discipline to stop this crazy cycle. 

Well, we often know what to do, but don’t go about doing it. That’s why people are fat, broke and baby mamas and baby daddies several times over. Because I was so disorganized and wasn’t paying close enough attention to my finances, I felt that I needed all of the side hustle money that was coming in. I needed it to live. To pay bills. I figured that I’d just have to deal with the consequences later. Hence, I find myself here – yet again – facing a tax bill of several thousands of dollars. 

This is a pervasive problem among business owners and people who are self-employed. I have colleagues who either don’t pay themselves as a W-2 employee of their company (even though they are supposed to) or don’t make the quarterly estimated tax payments that are supposed to be made by the self-employed. The quarterly estimated payments requirement includes all contractors and others who get paid 1099 income, like real estate agents, financial advisors, insurance sales folks and the like. A former client of mine operates a business bringing in several millions of dollars annually, and avoided paying taxes for years because the bill surpassed the $300,000 mark. He knew that he’d have to pay it, eventually, but he struggled for a while to prepare himself to have to write such a hefty check. He had allowed the problem to become too severe. So many others do, as well. I’m not talking about the tax evaders à la Lauryn Hill, Pete Rose, Wesley Snipes and Mike “The Situation” Sorrentino. I’m talking about people, like myself, who are so wrapped up in living from day-to-day that they neglect to exercise the financial discipline that they should. 

There’s a reason the IRS requires employers to withhold funds from employee wages; without that requirement, many, many people would not have the discipline to pay their taxes in a timely fashion.

Separate Tax Snowball

In my debt repayment journey, I’m employing the debt snowball method. The debt snowball method, as opposed to the debt avalanche method, has a debtor focus on the repayment of debts that have the lowest balance, as opposed to those that have the highest interest rates. Once the debt with the lowest balance is paid off, the minimum payment for that debt gets added to the minimum payment for the next debt in line – the debt with the next lowest balance. 

For me, the debt snowball method is the better choice, simply because my journey is likely to be long. I’ve got over $300,000 of debt to tackle! I need to see some results that will help me want to continue on the journey. By getting rid of some small debts first, I’ll have the little wins along the way that will help me feel like I’m actually making some progress. 

With the way my payment plan with the IRS is set up, it doesn’t fit cleanly into the traditional debt snowball format. Each month, I pay the IRS a lump sum of $550. Unlike credit card debt, each IRS debt year does not have a minimum payment. Instead, I just have one minimum payment (the $550) that goes toward the payment of my overall tax debt. The IRS applies the entire payment to the oldest tax year’s debt. Here’s how my tax balances look today, not accounting for the new 2018 taxes owed. 

Right now, the entire $550 monthly payment goes only toward the reduction of the 2015 balance, while the 2016 and 2017 balances continue to go up on account of interest (and probably some penalties as well). 

When I finish paying off the 2015 bill, the $550 payment will then start to go toward the 2016 bill, while the 2017 balance will continue to increase. Each month, the increase in the 2016 and 2017 bills goes up. For example, between the months  of July and August, the balances increased by $55.25 and $58.29, respectively. Then, between the months of August and September, the balances increased by $62.10 and $65.29, respectively.

Even though the next lowest balance  in my debt snowball – after paying off the IRS 2016 balance – would be the debt to my mom for the plane ticket, the $550 payment will go to the other IRS bill instead of the next debt up in my snowball. For that reason, I treat the IRS debt as if it has its own, separate snowball. 

Dave Ramsey would say that all of the tax debt should be at the front of my debt snowball, even though the balances aren’t the lowest balances for all my debt. His position is, basically, that it is best not to mess with the IRS and to get them repaid as soon as possible. According to him, they should be an exception to the normal debt snowball rule that debts should be paid off in order of the lowest balance to the highest. 

According to me, however, I need to feel like I’m making progress. I can’t be buried in these payments to the IRS and not feel like I’m making any traction. From a purely financial perspective, I get what Dave is saying. From an emotional perspective, I need to do what I gotta do to stay motivated and intense about this. I’ve got to pay some little debts off while making the payments to the IRS under my payment plan.

Knowing Better and Doing Better

I am determined that I will conquer this in 2020 and that 2019 will be the last year for which I will be unprepared to pay all of the taxes I owe at tax filing time. 

I’m also thinking that while I continue to make the $550 payment, I should make small payments on each of the other years so that the balances don’t continue to increase. 

What do you think about that? Should I stick with a focus on the one payment (just 2015), or start making the additional payments to the later years, while paying on the oldest year?