SALT Limitation Issues

I went into the ITS offices yesterday.  We had a meeting with a client and also it gave me a chance to catch up with the other John.  He attended a tax update workshop last week and we wanted the chance to compare notes.  One thing that caused us a good deal of chuckling is the state and locate tax (SALT) limitation and how it is going to be applied.

Lets say you live in a state that taxes income – say like Oregon.  You make $100,000 a year as an engineer.  You live in a modest home priced at $500,000.

  • Your Oregon income tax withheld is $10,000
  • Your Property tax is $6,500
  • Total SALT is $16,500, capped at $10,000

Oh, but wait.  Your actual Oregon income tax is $9,000 when you finally get to filing the return.

So, lets start with the easy question:

Which part of the $10,000 SALT deduction is the actual deduction?

Why does it matter?  Well, lets start with the fact that you reached the $10,000 limit with your income tax withheld.  If the rule states that you first apply the SALT to income tax and then property tax, your $1,000 overpayment would be taxable income in the next year.  Recovery of a deduction rules.

But if the property tax is deduction first, then you only used $3,500 of your income tax to reach the cap.  So, did you really have a $1,000 overpayment?  Do you still need to recapture that overpayment in the next year?  The state of Oregon is still going to issue the 1099.

Oh wait, how about we pro-rate?  $10,000/$16,500 is (hold on had to dig out the calculator) 60.1%.  So does this mean that you only report 60.1% of the refund as taxable income next year?

Yes, in case you are curious, it seems that the code rewrite is somewhat silent on this trivial matter.  Which means we have to await a ruling from our friends at the IRS.

The same IRS that is getting its budget slashed again for 2018.

Speaking of the IRS, I think the rush to prepay property taxes has been overblown.  There are several problems with all the handwringing but not least of which is, the IRS doesn’t know what your property tax bill is.  This is one of the few items of deductibility where a form is not sent to the IRS.

So, this is going to be an audit issue.  It will most likely start by some enterprising young IRS employee programming an algorithm to look for property tax deductions that are more than 50% higher than the amount deducted in the prior year.  Sounds simple enough.

Nope.  I remember doing some basic research on this wayyyy back in college and there is no such thing as a simple command for the IRS database.  Problem number 1.

Problem number 2.  Assuming they deal with #1 they will send out a ton of notices to people who bought their first home in 2016 and who only deducted a fraction of the property tax.  Knowing the IRS, it will not be a pleasant little letter asking for a reasonable explanation of the deduction and, please disregard if you feel you received this notice in error.  Nooo, it will be a CP2000 notice of deficiency.  Awesome.

Problem number 3.  All these people who got all these notices will send a response back to the IRS.  The IRS computer system cannot read and respond, only a human.  Did I mention that the IRS is getting their budget cut again?  Where are they going to get all these highly trained tax experts who can review a client document and respond effectively?

Look, don’t take this as advice.  Lord knows I don’t want anyone thinking that they can rely upon my little missive to get them out of tax trouble.  But the truth is, anyone who prepaid their taxes is probably safe.  Make sure you have a copy of the check and the payment receipt.  DON’T MAKE IT UP!  If you didn’t prepay it then don’t think you can claim the deduction but if you did, I don’t see the IRS going out of its way to deny the deduction.  It is, after all, a one time deal and frankly…

They need to put their very limited resources into writing the rules to help poor taxpayers figure out how the SALT limitation is going to actually work.  Oh, and rules for every other piece of code section that got put into this major rewrite. The SALT issue is not the worst unknown lurking in this, unfortunately.

Have a great day.  As always, if you would like to discuss this or any other issue feel free to contact me.  And if you are looking for some great tax advice and planning, let me know and let me see what me or my network of great accountants can do for you.

How to Use Your Tax Windfall

One of the most important things to be thinking about, even as a small business, is how to use the cash from paying less taxes.  Oh sorry, this assumes you are a C Corporation.  S Corporations are probably out of luck on the tax savings side – but that will be tomorrow’s blog.

First, keep in mind that from a banking perspective, your company won’t change.  That is because bank’s typically measure you according to EBITDA – or Earnings Before Interest, Taxes, Depreciation and Amortization.  If you have bank covenants with any time of earnings ratio it is based on this, not net profit after tax.

This being said, you should have additional cash flow.  Assuming you are profitable.

An example might help.  Lets say your business has EBITDA of $1,000,000.  From this:

  • Interest on your bank loan is $100,000
  • Depreciation and amortization is $100,000
  • Earnings before taxes is $800,000

Under old law, your tax would have been about $240,000.

Under the new tax law your tax will be $168,000, or a savings of about $72,000.

Honestly, the one thing you may want to avoid is increasing an expense by paying out a bonus, increasing wages, etc.  Paying out that $72K will reduce your EBITDA which could cause a covenant violation.

You also probably can’t issue a dividend to the shareholders because there is another covenant prohibiting such a move.  The bank wants its money first – which is only fair.

So what should you do?  Keeping idle cash around seems foolish, especially if you have a line of credit or term debt.

Ah yes, the debt.

Small businesses should seriously consider using the free cash flow from the reduced income tax rates to pay down debt. I would recommend freeing up the Line of Credit first and then start paying down the term debt.

The sooner you get that debt down the sooner you can start paying dividends – which as my blog yesterday pointed out, might be a better choice than taking payment as wages.  You will need to work with your accounting professional to ensure that this is the most effective way of getting money out to you but it may work out best that way.

Make sure you are on top of your loan covenants before you make big decisions on how to spend the tax savings which start this year.  And, everything else being equal, paying down bank debt will improve your ratios – anything else you do might impair them.

Have a great day.  If you are looking for an accounting and tax advisor who can help you navigate these times, feel free to contact me for a free consultation.

Update on Converting

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?

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.