Category: Income Taxes

Update on Converting

~ C.O.R.E. Beliefs ~ 1 Comment

Well, it appears I misread the tax law change.  Personal Service Corporations (PSC or professional corporations) are in fact subject to the new 21% tax rate.  Because they are no longer at 35%, the benefit for converting to an S Corporation may no longer be valid.

Now, this is not 100% certain by the way.  The problem is that the writers used the term “amend” versus “strike”.  And they amended the original paragraph which contained the tax brackets to state only the 21%.  The problem is the next subsection.

That next subsection says that certain qualified corporations pay tax at 35%.  Not the highest tax rate but codified at 35%.  But, one way to read the change is to strike-through all the language in code section 11(b) and replace it with the 21% tax rate.

I know.  YAWN.  Except that we are trying to get some planning into place and an S election has to be filed relatively quickly.  And the devil to planning is in the minor nuances of things like “amend” versus “strike”.

For want of a nail a horseshoe was lost and because of the loss of one little nail a certain general was executed.

If in fact this reading holds true, I am not convinced a C Corporation should convert to S Status.  I actually think that it may be better on net cash flow to be a C Corporation.  This is especially true where the pressure is on to pay out disparate compensation to the owner/operators.

Take a medical practice, for instance of 4 doctors, each owning 25% of the outstanding shares.  Lets say that each gets to take, in the form of wages, 50% of the net collections on their patients.  Then they would look at the profits at the end of the year and issue a bonus with 80% of that pool of money being paid to them.

Under old law, this was important because the medical practice was a PSC under 448(d)(2).  As such, any taxable income was taxed at a flat rate of 35%.  They didn’t want any amount of money taxed at that level unless it was coming to them.  And they sure as heck didn’t want it as a dividend as it would first be subject to 35% corporate tax and then the 15% qualified dividend tax – or 50% overall.

But if in fact the PSC is taxed at 21% then I am not sure that paying it all out in wages is the best approach.    That is because the total tax rate for most people on taxable profits in a C Corporation will be the:

  • Corporate rate of 21%
  • Qualified dividend rate of 15%
  • Total tax rate of 36% on corporate taxable income when paid as a dividend
  • And you eliminate 1.45% Medicare tax

Again, there are more caveats, conditions and restrictions but it should be close to this result because there is a preferential treatment of capital income.

Each business has to be analyzed for its unique interplay between shareholder and company but generally speaking it works out that paying about 80% of the pre-officer compensation profits as wages and then issuing a dividend on the remaining cash (after tax) generates a little more net cash flow to the shareholder/employees.  More net cash flow is what this is all about.

The only scenario where being an S Corporation delivers superior net cash flows is when the shareholder/employee doesn’t take a wage: But the difference isn’t so large that it is worth the risk of being audited for unreasonable compensation (and losing).

Lets take a doctor practicing in a PSC where she is the sole shareholder.  The Corporation nets $500K of taxable income before shareholder compensation.  Under old law, the net cash after all taxes (including payroll taxes) was about $290K if we made sure that all the income was treated as wages to her.

Under the new law, the net cash is about $360K if we treat the income as wages to her.  But, we see a slight savings by only paying her $400K in wages and then taking the dividend of the remaining cash after tax.

Why is this important?  Because it used to be we had to get PSC taxable income really close to zero – which was challenging at best because you can’t always predict collection patterns. But now, with the tax rate at 21%, the practice does not have to be as accurate, which will reduce the amount paid to accountants to calculate the bonus and we can leave a little more profit in the business to pay out as a dividend and no money is really thrown away.

So, if you are already going through the motions of converting to an S Corporation – wait, you were crazy enough to take tax advice from a blog???? STOP the madness.  Talk with your accountant about the right way to approach this.  Have your tax professional help you analyze the various options.  If you like, I can send you my clunky tax comparison workbook so you have something to play with to help you see the cash savings possible.  And if you are looking for a new tax professional to assist you, feel free to write and we will be happy to offer you our best advice.

Have a great day.

 

Is it Time to Convert?

~ C.O.R.E. Beliefs ~ Leave a comment

One of the vexing questions is, “Is it time to convert my C Corporation to an S Corporation?”  This is most likely the year that it would be best to convert given the changes to the tax law that took effect yesterday.

Beginning with tax years beginning on or after 1/1/18, most C Corporations will be subjected to a flat tax of 21% of taxable income.  If you are a professional type of business, one where the shareholders also work and capital isn’t a major contributor to profits, it appears you are still subject to the 35% tax rate.  Although in truth, your taxable income is probably close to zero since all of the shareholders want a share of the income they generate. No matter how one cuts it, a percentage of zero is, well, zero.

This being said, it is possible that the new Tax Cuts and Jobs Act does change the rules for PSC’s.  I doubt it though as it would make personal income potentially subject to a lower tax rate just because you kept the earnings in the business.  The pass-through part of the new tax law denies the 20% deduction for personal service entities so it is unlikely that PSC’s as C Corporations get the lower rate as well.

Moving on.

Since all the income is passing to you currently as wages, nothing has to change for the conversion.  You would keep the same basic overall compensation plan, with some minor tweaking most likely.  You would likely keep the same benefit plan, although where and how it is deducted will change.  The only real change is who reports the taxable income and then pays whatever tax is calculated.

On the Corporation side, you will need to have a business valuation performed.  I would recommend getting one, even if you have a working buy-sell agreement.  This is going to be the value that is treated as C Corporation gain assuming the Corporation sells its assets to a buyer.  If you are unlikely to sell all the assets of the business (as a whole), then it won’t matter.

If you sold the assets and goodwill today as a C Corporation, by the way, the Company would be subject to a maximum 21% tax rate on the sale.  The Corporation would then liquidate by paying all the cash out to the shareholders.  Most well-structured firms will have very little in the way of intangible assets that are controlled by the Company so the gain will be the depreciation recapture from the sale of the tangible assets.  In other words, minimal gain.

Given the tax law and the remoteness (but not impossibility) of the opportunity for Congress to rewrite taxes, this should be a fairly straightforward exercise.  Definitely check with your tax professional – or feel free to contact us for help – to make sure you structure the transaction correctly but otherwise, give this serious consideration.

For those professional businesses structured as C Corporations for reasons other than “it was the way to do it way-back-then” I would still consider changing your tax structure.  The cost might be a little higher but probably worth it in the end.  So, if you have any of these issues:

  • Foreign ownership (non-us citizen)
  • Ownership by other entities like corporations or partnerships
  • More than 100 shareholders
  • Defined benefit plan (pension targets to the shareholders)
  • Major capital investments which generate profit

Then an S Corporation will likely not work.  So, instead of converting to an S Corporation, you may wish to consider:

  1. Setting up a Limited Liability Company structured as a Partnership
  2. Appraising your assets and/or value the business
  3. Selling your assets to the LLC
  4. Creating new compensation agreements with key employees

As an LLC(P), all of the income which flows to you will likely be treated as self-employment earnings.  Which, by the way, was how you were originally taxing it as a C Corporation.  The key difference is that you, not the LLC(P) will pay 100% of the tax.  It is the same total tax though.

The C to S Conversion is set in the IRC so the steps are pretty straightforward.  The concept of Corporation to Partnership conversion is not codified so therefore the risk is higher.  Properly documented though, there are not a lot of pitfalls.  It is always the lack of documentation and simple greed which gets deals like this in trouble.

So, if you are a C Corporation it may be time to seriously look at converting to a pass-through entity.  For some professional firms, the fear has been increased risk but the case law for LLC(P) and S Corporation legal jeopardy has been pretty well litigated and the track record shows that, again with proper documentation and a sound business approach, most risk is mitigated.  And with this hurdle addressed, perhaps it is time to seriously consider the benefits of restructuring.

Oh by the way, you only have until March 15 to file the paperwork to request permission to become an S Corporation.  So there is not a lot of time to hem and haw.  If you have been thinking about it, then this might be the right time to get it done.

Have a great day.  As always, if you would like the name of a professional to assist you, please contact me through our website.  As we focus almost exclusively on HOA and Condo audits, we do not prepare taxes ourselves but we can assist you in documenting and analyzing the conversion and how best to approach the steps.  We look forward to the opportunity to be of service to you.

 

Quantifying Entity Elections

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The new tax law, the Tax Cuts and Jobs Act of 2017, has created a new set of expectations when it comes to choosing the correct entity for your business.  But one of the things it didn’t do, as far as my analysis can tell, is eliminate the “unreasonable” compensation issue for S Corporations.

I have run several different scenarios comparing the tax and net cash flows for a somewhat typical small business.  I compared the following tax effects:

  • C Corporations paying most of the profits in the form of wages to the owners
  • C Corporation paying nothing but dividends to the owners
  • S Corporation paying wages to the owners of most of the profits
  • S Corporation paying no wages to owners
  • An Operating partnership

Hands down, the continued superior driver of net cash to the owners is driven by the S Corporation paying no wages.  Hands down.  For most small businesses making reasonable profits, the most tax advantageous manner to do this is electing to be an S Corporation and then not paying anything to the owners.

This is so even if the business does not have any other employees so that it can take advantage of the Qualified Small Business Credit of 20%.  This credit is capped at the amount paid in total wages.  Given the rather insignificant differential in tax rates of C Corporations at 21% and the individual rates of ‘Middle income” taxpayers at 22%, there is no marginal difference as far as income tax goes.  The game continues to be the avoidance of payroll taxes.

Hopefully the following scenario will help.  Lets say two friends, Will and Fred, decide to form a fishing guide business called, Will and Fred’s Amazing Adventures.  The Company does $1.0 Million in Revenues, $300,000 in payroll for guides and helpers and a net profit, before paying anything to Will and Fred, of $300,000.

  • As a C Corporation paying $250,000 in wages to Will and Fred, the total taxes paid are $99,000 and net cash to Will and Fred is $176,000 – or $88,000 each.
  • As a C Corporation paying no wages and issuing dividends instead, the Total Tax is $107,000 and net cash to Will and Fried is $200,000 – or $100,000 each
  • As an S Corporation paying $250,000 in wages to Will and Fred, the total taxes paid are $98,000 and net cash to Will and Fred is $201,000 – or $100,000 each
  • As an S Corporation paying no wages and instead paying all earnings as distributions of “profits”, the total tax is $53,000 and net cash to Will and Fred is $247,000 – or $123,000 each
  • As a general operating partnership, total taxes are $90,000 and net cash to Will and Fred is $210,000 – or $105,000 each

A really aggressive tax practitioner would work with Will and Fred to be taxed as an S Corporation and not pay wages.  Most slightly less aggressive practitioners would have them set compensation at $25,000 each.  Zero is hard to defend whereas $25,000 is hard to beat – for the IRS.  I will save that debate for another day but the point is, there is still no disincentive to not pay  wages to the owners.

It is true that there is still better net cash flow to the owner by being treated as an S Corporation than by being taxed as a C Corporation and paying the same wages but no one will say “Gosh that’s good enough for me!”.  Taxpayers will strive for the lowest tax effect and highest dollar return and that still points to S Corporation treatment and low officer wages.  And we are talking about a 20% increase in net cash and a 30% reduction in taxes – no one is going to sneeze at that opportunity.

In summary, the best advice for Will and Fred would be, in the following order:

  • Be an  S Corporation and pay themselves reasonable, but low, wages
  • Be a general partnership
  • Be an S Corporation and pay themselves almost all income as wages
  • Be a C Corporation paying themselves almost all income as wages
  • Be a C Corporation paying themselves no wages and taking all income as dividends

Yes, there are other things to consider – such as health insurance and retirement – but for strictly tax purposes this is how I would advise the owners of Amazing Adventures.

Have a great day.  If you have any questions, feel free to write and ask and if you are interested in discussing how we might be able to help with tax planning and business strategy, feel free to contact us and learn more about how we can work with you.

 

 

The Corporate side of the Tax Act

~ C.O.R.E. Beliefs ~ Leave a comment

IT is not every day I elect to write this blog before my CORE beliefs missive.  But there are some provisions of the new tax act that have an impact to clients that I think has not received enough attention.  The tax changes for corporations can be found in Subtitle C – Business Related Provisions.

Tax Rates

Most Corporations will be subject to tax at 21% of taxable income.  It is a flat tax so every dollar of taxable income is taxed at the 21% rate.  For those Corporations where income was managed to a lower bracket, like 15%, this is no longer effective.  So, some Corporations will pay higher (although in the scheme of things, really small dollar truth be told) but overall Corporations will pay less.

Professional Service Companies

We have several clients who were structured as C Corporations which are also treated as Professional Service Corporations (PSC’s).  These have always been subject to a flat rate of 35%.  From what I read this has now been reduced to 25%.

Effective Date

Sadly, while this tax law will likely take effect 1/1/2018, it is for taxable years BEGINNING after 1/1/2018 so if you have a fiscal year that doesn’t end by 12/31/2017 you will not be able to see any advantages of this until the next fiscal year.  So, June 30 clients you are not going to see the benefits of this tax law until the next fiscal year beginning 7/1/2018.  There is a special provision for certain asset purchases, however, which takes effect as of 9/27/2017.

Qualified Real Property

An interesting change is adding specific real property to the defining of property subject to the new $1,000,000 section 179 limit.

(f) Qualified real property.—For purposes of this section, the term ‘qualified real property’ means—

“(1) any qualified improvement property described in section 168(e)(6), and

“(2) any of the following improvements to nonresidential real property placed in service after the date such property was first placed in service:

“(A) Roofs.

“(B) Heating, ventilation, and air-conditioning property.

“(C) Fire protection and alarm systems.

“(D) Security systems.”.

The key term is nonresidential – so rental homes and apartments won’t qualify but if you own a commercial building in an LLC and lease it to your Company it will.

Use of Cash Method of Accounting

Raises the income limit to $25,000,000 so many very large “small” businesses will not have to do the mandatory switch-over to accrual.   By the way, this limit also is for Unicap rules under 263(a) and the use of the percentage of completion method for construction.

Special Write-off of Fixed Assets subject to MACRS

All purchases between 9/27/2017 and 1/1/2023 are subject to 100% expensing.  Notice that includes purchases in 2017 that occurred after 9/27.

Limitations on Interest Deductions

This doesn’t seem as straightforward as it sounds.  Interest deductions on borrowed money will be limited to the interest income recorded PLUS 30% of adjusted taxable income (taxable income before accounting for interest) PLUS flooring interest.  Although there appears to be an exception:

(3) EXEMPTION FOR CERTAIN SMALL BUSINESSES.—In the case of any taxpayer (other than a tax shelter prohibited from using the cash receipts and disbursements method of accounting under section 448(a)(3)) which meets the gross receipts test of section 448(c) for any taxable year, paragraph (1) shall not apply to such taxpayer for such taxable year. In the case of any taxpayer which is not a corporation or a partnership, the gross receipts test of section 448(c) shall be applied in the same manner as if such taxpayer were a corporation or partnership.

So, if you are under the $25,000,000 ceiling discussed earlier, this doesn’t apply.  So, small real estate developers, it doesn’t seem like you have to worry that the interest you pay will not be deductible.

Loss Carryback and Carryforward

There is no longer a carryback of losses.  They are carried forward indefinitely.

Like-Kind Exchanges

1031 no longer applies to all property. It is now only applicable to real property.  It is a big deal but not as big as it seems since 1031 was almost exclusively used for real estate.  But I have had clients with large investments in equipment that we ran through the 1031 exchange because of the deferred nature of the activity, plus the equipment was sold to one party and purchased from another.

Fringe Benefit Deductions

This is potentially a bigger issue than reported.  If you provide food as a working condition fringe, you no longer get to deduct the expense; this includes the operation of the cafeteria and kitchen.  Same for transportation and commuting benefits you paid for employees.  This includes parking.

Domestic Production Activities Credit

No surprise here that this is being eliminated since tax rates are going down.

Carried Interest Rule

This rule was modified to require that the investment be held 3 years before any payments received are treated as capital gain.  This is a minor change since most investments of this nature are held over a year anyway before the arrearage of the performance fee is paid.  This will change how some investor/developer deals are structured – maybe.

Using Gift Cards and Cash for Employee Awards

Beginning 1/1/2018 you will no longer be able to keep “safety bonuses, etc.” out of wages.  If you give your employees anything with value it must be included in their W-2 and subject to appropriate taxes.

I still need to get through the various business tax credits but I think this gives you an idea of the major changes in store for businesses – especially those treated as a C Corporation.  I should finish this sometime around Christmas.

Have a great weekend.