Advising a client who is planning to become self-employed.

• Author: Ellentuck, Albert B.

Analysis

Self-employed taxpayers generally qualify for some tax advantages not available to employees, they may be able to contribute and deduct more for their retirement plan than when they were employees and their business expenses are not subject to the 2% of adjusted gross income limitation or the phase-out of itemized deductions. Self-employed taxpayers may also qualify for a home office deduction (which may turn out to be very small and not advisable if they Plan to sell their personal residence in the near future).

At the same time, self-employed taxpayers face some significant tax disadvantages they did not encounter as employees. SE tax for 1996 is imposed at 15.3% on the first $62,700 of SE income and 2.9% on SE income above that amount. (Half of the SE tax is deductible from gross income under Sec. 164(f).) Retirement plan contributions for the owner are not deductible in computing SE tax. Unless a corporation is set up as the employer, deductions for health insurance premiums paid on behalf of an owner and his dependents are limited to 30% of premiums paid for

Only 50% of business meal and entertainment expenses are deductible, auto expense deductions are subject to strict limits. Self-employed taxpayers have to pay quarterly estimated taxes.

Planning Hints

* Know the rules for rolling over retirement plan funds: On leaving a job, an individual will generally be entitled to immediately receive vested amounts in qualified retirement plan accounts. Most distributions from qualified retirement Programs (pension plans, Sec. 401 (k) plans, etc.) can be rolled over tax free into an individual retirement account (IRA). However, under relatively new rules, a "direct rollover" must be arranged, or the Plan administrator will be required to withhold 20% of the distribution for Federal income tax. Direct rollovers involve having the funds transferred directly from a former employers retirement plan into a designated IRA account. (The distribution check cannot be made out to the former employee to avoid the 20% withholding). Talk to the company benefits representative and to the financial institution or brokerage house where the IRA will be established. Inform them that a direct rollover is requested to avoid the withholding, and ask for the required forms and paperwork. Failure to arrange a direct rollover means having to come up with the "missing" 20% to accomplish a totally tax-free rollover.

* Make maximum use of the company's flexible...