Will You Need a Tax Preparer Next Year?

One of the big “selling points” (to use the term very loosely) of the new tax act was that it would make tax filing simpler for the vast majority of people.  Oh, but if that were true.

Put it this way, if you are currently paying over $500 for tax preparation you will likely still need to see a professional to ensure that you are in compliance with tax law.  Your taxes are not simpler to calculate and you are likely faced with a monstrous number of choices that some professional guidance is warranted.

As discussed previously, if you are in business for yourself and live in a high tax state, It is unlikely that you can easily file your own taxes.  I mean, except for those engineers and frustrated accountants out there who think that the real magic is in dropping numbers into boxes and creating an Excel spreadsheet to do the calculations.  That is the easy part.

You are facing a daunting array of choices and options – from filing as a C Corporation to the amount of wages you should pay.  Do you take bonus depreciation or regular?  Each decision has current and future ramifications that can benefit or hurt you.

Will you need a tax preparer?  Most likely.  Oh, not if you are a W-2 employee for a company and have a modest lifestyle.  Let’s face it, $12,000 of itemized deductions is hard to get over as a single person.  Property taxes, state taxes and mortgage interest will likely be only about $10,000 at best.  Your taxable income will be higher but your bracket will likely be lower – which is the tax reduction you were promised.

If you are a sales professional who used to have a fairly outsized unreimbursed employee expense deduction you will likely no longer need an accountant to prepare your taxes.  You may want to talk with one though to help you renegotiate your compensation package because the loss of those deductions is going to sting.  Unless you can make it work as an independent distributor of the companies products – in which case, yes, you may want to work with a tax preparer.

You will adapt to the new tax law just like tax preparers will adapt.  I doubt that 2019 will see a dramatic reduction in the number of returns filed by paid tax preparers; perhaps by 2021.  Of course, that assumes we are not whipsawed by a change in congress which decides to change the tax code again.

In the meantime, use your resources to engage the best professionals available.  If you are interested in starting a business then I suggest talking with a professional who can help you plan and grow your business profitably.  Too much of an emphasis on taxes minimizes your potential.  Trust me, there are lots of ways to use profits to improve your business but you have to make the money first.  The easiest tax planning is based on zero.  It is the absolute worst for planning your life though.

Time for the plug.  If you are looking for some solid planning feel free to contact me.  I enjoy working with small business owners who have dreams of making a ton of money and who want great advice for getting their business to the next level.  I am here to be of service to you.  Feel free to contact me anytime.

Have an awesome Tuesday.

The New Bonus Depreciation Deduction

Continuing on with my examination of the new tax act, I am going to examine the purported meat of the “jobs” portion of this act.  Beginning 9/27/17 (that’s right, assets purchased as of a very odd date at the 3nd of the third quarter) you can deduct 100% of the purchase price for certain qualifying assets.

But, this is one of those temporary tax deals.

Placed in Service before % Deductible
1/1/2023 100
1/1/2024 80
1/1/2025 60
1/1/2026 40
1/1/2027 20

It get better, I think.  the new code appears to also allow for the purchase of used property.  The code section they added says, ”

c) APPLICATION TO USED PROPERTY.—
(1) IN GENERAL.—Section 168(k)(2)(A)(ii) is amended to read
as follows:
‘‘(ii) the original use of which begins with the
taxpayer or the acquisition of which by the taxpayer
meets the requirements of clause (ii) of subparagraph
(E), and’’.
(2) ACQUISITION REQUIREMENTS.—Section 168(k)(2)(E)(ii) is
amended to read as follows:
‘‘(ii) ACQUISITION REQUIREMENTS.—An acquisition
of property meets the requirements of this clause if—
‘‘(I) such property was not used by the taxpayer
at any time prior to such acquisition, and
‘‘(II) the acquisition of such property meets
the requirements of paragraphs (2)(A), (2)(B),
(2)(C), and (3) of section 179(d).’’

To interpret legaleze, the “original use” means new property.  Under the old code, what you had to buy in order to qualify was new, under the premise that new stuff creates jobs.

The new tax law adds a new clause, “such property was not USED by the taxpayer at any time prior to such acquisition…”  Again, to interpret, whatever you buy will qualify as long as you didn’t already use it before buying it.  Think converting a leased car.  You were using it and then decide to “buy” the car.  This would not qualify as you already used it.  It doesn’t stop you, however, from buying someone else’s leased vehicle and then claiming the bonus depreciation.

Ok, I am with you, used equipment doesn’t generate jobs.  But it does allow a business the option now of spending 30-40% less by buying pre-owned and still getting the 100% write off.

What is interesting is the new tax law provides taxpayers the option to elect out of the bonus depreciation.  I will admit that under the old rules, where we had graduated corporate tax rates, I often suggested that C Corporations elect out because the item was taxed at less than 25% and we were pretty certain that the next years tax rate was going to be 35%.  But now, it is a flat 21% so there are no brackets to maximize.

The election is no doubt for Schedule C businesses and possibly pass-through entities since they are still subject to the graduated tax brackets.  I have to analyze a few scenarios to see if the election is worthwhile though.

And try to find the hidden gem that is no doubt lurking in one of the “by extension” paragraphs.  These call to the other code sections to ensure their references are updated and possibly one of these has another limit I haven’t caught yet.  Stranger things have happened.

Naturally, please don’t take this as tax planning advice and whatever you do, don’t rush out and buy stuff without talking with your tax professional.  If you like, I am happy to discuss your situation and help you decide if taking the 100% bonus depreciation is worthwhile if you are not currently working with a professional.  Feel free to contact me if you have any questions about this or any other aspect of the new tax law.

Have a great day.

 

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.