Tag: C Corporations

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.

 

The Corporate side of the Tax Act

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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.

Think Before You Leap

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

Welcome to the last 7 days before Christmas.  I hope you find time to read my blog and many others in the next few days whilst you run about finding last minute gifts.  Or, if you are like me, an adrenaline junky who thrives on shopping in the last 14 hours – relax and go with the flow, until the 23rd – then let the coffee flow!

All evidence points to the Tax Cut and Jobs Act of 2017 becoming law this week.  Based upon the volume of questions we are already receiving, many people are already trying to plan how to take advantage of the upcoming changes.  But before you go down this path, it may be worthwhile to stop, take a deep breath and think strategically.

Converting to a Pass-Through Entity

The most talked about issue – besides the significant drop in tax rates for corporations – is the preferential treatment for pass-through entities, LLC’s, S Corporations, sole proprietorships and partnerships.  Some are already thinking of changing their business structure to take advantage of the potential tax savings.  My advice, slow down and think about it.

In some situations converting could cost you more than you save in taxes.  For instance, are you thinking of having to borrow money in 2018?  If so, converting to a flow though entity may cause you to either have to provide more documentation, incur higher loan costs or even outright denial of loans.  Lenders are notoriously hard on owners of pass-through entities so the conversion might toss cold water on some of your planning.

Retirement Contributions

Let’s say you are currently a C Corporation and are thinking that you want to take advantage of the upcoming tax situation and convert to an LLC.  If you are currently taking wages and maximizing your retirement plan contribution, this “little change” in your tax structure could cause troubles with contributions and the Company match.  This is because LLC’s and C Corporations have different technical rules about how “wages” are calculated and who ultimately takes the deduction for the match.  A switch to an LLC could cause a termination of your old plan and require you to set up a new one.

Are You Really Saving Taxes?

Let’s say you are currently working for your C Corporation and paying yourself $100,000 a year in salary.  This puts you in the 25% personal tax bracket.  Let’s also say your Company earns $50,000 in taxable income.  Will converting offer any tax advantage?

Probably not.  At $100,000, you are currently in the 25% effective tax bracket personally.  With this tax law change, you are likely still in the 25% effective tax bracket personally.  If you convert, then your Company would no longer owe taxes, because it passes that taxable income to you, but you would owe taxes at about 25% – which is 4 points higher than what you would have paid in C Corporation taxes (everything else being equal).  Think bigger picture – have your accountant prepare different cash flow models showing what happens to your income and taxes at various levels under the different tax structures.  Don’t assume that it will automatically be beneficial.

Thinking of Buying a House?

Now that there are caps and limitations on state and local tax deductions as well as the deductibility of mortgage interest, it may be a little while before lenders figure out how to determine your qualification.  In theory, most borrowers should not be negatively impacted by the changes in the tax act; the problem is that there is no longer a direct impact between a mortgage interest deduction and tax reduction.  There is a sweet spot for most tax payers where interest deduction can have an impact but knowing what that looks like will take time and effort to put into the forms.  Remember that the days of seeing a tax reduction from having a mortgage for the vast majority of us is gone so plan accordingly.

I will be writing more about the new tax law as we go forward and some things to consider for you and your business.  In the meantime, don’t fixate on these changes, this is why you hire professionals.  You worry about your business, we will worry about how changes will impact your finances.

Have a great Monday.

Consequences

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

Happy Wednesday.

Prior to my going to work in the private sector as first a business development and marketing director for a startup and then a controller, I worked with lots of small business owners.  Almost all were structured as S Corporations.  And they almost always got in trouble for unreasonable compensation issues.

Unreasonable compensation is an outlier issue.  What I mean is that, compensation is considered reasonable if it is likely someone would take that pay package in the real world.  With C Corporations, the unreasonableness comes when the owners receive W2 income that is not tied to their job performance and where it drives the Company’s profits to zero.  With S Corporations, the unreasonableness comes when owners don’t take wages and instead act as though the business earned all the profit.

An Example:

XYZ Corp. earns $1.0 Million before payroll to Owen, the 100% shareholder.  Owen wants to take all the money out of XYZ, and at the lowest possible tax cost.  This is a fair requirement and depending on C or S status, drives a particular approach and potential audit issue.

As a C Corporation, XYZ would not want to say that Owen didn’t earn a wage and issue a dividend.  First, XYZ would pay about $350,000 of tax on the $1.0 Million in profits (35%).  Then, Owen would receive the $650,000 and pay about $100,000 in personal tax on the distributions (roughly 15%, I rounded up for simplicity sake).  So, Owen would net only $550,000 out of $1.0 Million.

If XYZ paid Owen $900,000 in wages, the tax consequences are more involved but lower.  First would be the payroll taxes, which is equal to l.2% of the first $150,000 of wages for both Owen and XYZ, plus 1.45% each for medicare on all of the wage, roughly $25,000.  Total payroll taxes are $45,000.

Owen hates the idea of writing a check to the IRS in April so he has 35% withheld.  The total withholding is $315,000.

And XYZ earned a profit of about $50,000 (since the company’s payroll taxes and the wages paid are deductions) and owes about $7,500.

Total taxes when paid out in the form of wages and driving XYZ’s profits to near zero?  $370,000 and Owens net cash received is about $570,000 (rounded of course).  And if he took a dividend of the remaining $40,000 net cash in XYZ, he would net almost $600,000, or a total overall tax rate of 40%.

The IRS would prefer that XYZ have much higher profit and taxable dividends to Owen as the combined tax effect is higher.

But what if Owen elected XYZ to be an S Corporation?

Here the consequences are reversed.  If, as an S Corporation, Owen took the $900,000 in wages, the tax effect would be the same.  But, he personally would pay the tax on the $50,000 at his marginal tax rate – 35%.  The total tax bill would be closer to 45% which is not as good as being a C Corporation and paying wages.  But, what if he didn’t take a wage?

XYZ would pass the net income to Owen, $1.0 Million.  Owen would be taxed at 35%, or pay $350,000.  There would be no payroll taxes and there are no corporate taxes so that 35% is all there is.  Net cash to Owen is $650,000.

This is a far superior approach as it drives the lowest overall tax bill.  It is also fraught with serious consequences as it is likely even more “unreasonable” than the C Corporation paying everything out in wages.

Which brings me to a quick story.  A new client came to see us – a dentist.  Not surprisingly he was being audited for unreasonable compensation.  You see, the good doctor decided to pay himself $12,000 a year and claimed that his practice generated profits of almost $500,000.

His case wasn’t helped by the fact that 2 years earlier he was a sole proprietor and earned $300,000.  The year after that he was a C Corporation and paid himself $400,000.

He wanted to know what to do.  I gave him two choices.  Pay the firm $10,000 to fight with the IRS and most likely lose and have 100% of the profits taxed as wages or pay us $2,500 to negotiate a more realistic figure of about $200,000 for wages.

He wisely chose the later option.  We were actually able to make the case that a “reasonable profit” from the business was about $300,000 – taking into consideration the focus on non-dentist services offered and a return on his capital investment.  We also convinced the IRS to waive penalties and interest on the underpayment.

If (and possibly a big IF) the tax law changes for pass-through entities, this type of challenge will become even more prevalent.  So, if you own a pass-through entity, make sure your professional is looking out for your best interest, not just how much tax can be saved.  And if you would like to discuss your tax position with someone, feel free to send me a message.  Remember, pigs get fat and hogs get slaughtered.

Have a great day.