In yesterday’s article: A Discussion on Income I gave you a definition income, as defined by the IRS. At the top of the list was compensation. Let’s start at the beginning of this list with Compensation.
Compensation is actually a subcategory of a bigger concept known as “Earned Income.” Basically, earned income is:
· Wages, salaries, tips, and other taxable employee pay;
· Union strike benefits;
· Long-term disability benefits received prior to minimum retirement age;
· Net earnings from self-employment if: (get used to the Ifs)
§ You own or operate a business or a farm or
§ You are a minister or member of a religious order
§ You are a statutory employee and have income
In any discussion on taxable income determining what a person’s earned income would be is paramount to most discussions. Don’t believe me? Well here are some facts: the calculation of earned income will determine the amount of money that you can put into your 401(k), if there is no earned income, there is not retirement plan. You can’t make a tax deductible contribution to a Traditional Individual Retirement Arrangement (IRA) without earned income. In the case of the self-employed, you can’t make that hefty contribution to you Simplified Employee Pension (SEP) IRA without earned income. For those with lower incomes; the more earned income that you have, the higher the Earned Income Tax Credit. As you can see determining what your earned income is for any given year, is where we start.
Instead of the long boring, and confusing definition of earned income, I like mine; earned income is income that is subject to Social Security and Medicare Tax. Using that definition, most people derive their earned income from wages from their employer. For example, you work for XYZ Corporation as an employee. For consideration, they pay you $50,000.00 per year. Your earned income in this scenario is $50,000.00. Easy, right? Just like any good tax law here comes the “if.” If as part of your compensation package you are given “fringe benefits” of $5,000.00 that is included in that $50,000.00? The $5,000.00 you are given is for health insurance under an IRC §125 Plan (commonly referred to as “Cafeteria Plan.”). That $5,000.00 is NOT considered earned income because you didn’t pay Social Security and Medicare Tax on the amount.
If you are self-employed that opens up another can of worms. Self-employed persons that report their income on Schedule C or sometimes Schedule E are considered self-employed by IRS definition. The net taxable income that these people make is subject to self-employment tax, which is Social Security and Medicare Tax. However, if you are a shareholder in an S-Corporation, a limited partner in a Limited Partnership, a manager in a Limited Liability Company (sometimes), then the IRS does not consider you self-employed and the income that you earn through those vehicles is not earned income.
Earned income can also arrive from active participation in a business such as a limited liability company or limited partnership. If you are a managing member in a limited liability company, which is taxed like a partnership, or a general partner in a limited partnership then the income that you derive from that vehicle is earned because it is exposed to self-employment tax.
As you can see, determining what the sources of earned income are is an important determination.
For more information visit www.smalleynco.com
If you have any questions you can email Craig W. Smalley E.A.
Author of the books: It Starts With an Idea – Tax Tips for Small Businesses available on Nook and Kindle, The Ultimate Real Estate Investor Tax Guide, available on Nook and Kindle, The Complete Guide to the New Tax Law – American Taxpayer Relief Act of 2012 available on Nook and Kindle, Everything You Wanted to Know about the IRS – Audits, Appeals and Collections available on Nook and Kindle, Tax Avoidance is Legal! The Complete Guide to Individual Income Tax available on Nook and Kindle, The Complete Guide to the Affordable Care Act’s Tax Provisions available on Nook and Kindle, The Complete Guide to Retirement Plans for Small Businesses available on Nook and Kindle, The Complete Guide to Estate, Gift and Trust Taxation, available on Nook and Kindle, and The Complete Guide to Hiring an Accountant, available on Nook and Kindle.