Tag: pass-through

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.

The tangled web of pass-throughs

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

No doubt like many a tax-nerd, I spent part of the weekend trying to understand the senate and house tax bills and their impact on clients.  Obviously, it is a waste of time as there is no guarantee that either will become law as the tax acts are going to conference but, it is educational none-the-less.

I wrote the other day about how it works for individuals but now, what about someone who owns rental properties or other pass-through business?

Nothing I have read so far indicates that they are doing much in the way of changing the Passive Activity Loss (PAL) rules, so your investment in a rental property while probably still follow current law which means that you will likely not be able to take rental losses if you make more than $125K.  On the other hand, if your rental is a Passive Income Generator (PIG), you could see some tax savings… maybe.

What you should realize is that the very generous immediate write-off for business purchases does not include buildings.  You will still need to capitalize the purchase of rental property.  And it appears that the tax life will likely remain as it is today – 27.5 for residential and 39 for commercial.

If your rental is a PIG and throws off $10,000 of income, your tax liability would be no more $2,500 under the House’s version as this one taxes pass-through income at 25% maximum.  Obviously, if your total income puts you in a lower tax bracket, you would be taxed at that rate.  The senate version, on the other hand, provides a deduction of 23% of taxable income.  But as will all things tax-related, it isn’t quite that simple.  It limits the deduction to 50% of wages paid.

Since this is a rental property, you will likely not have employees.  Therefore 50% of zero is, of course, zero.  Since this is zero, you would pay tax at your regular tax rate.  Again, if you are in a lower tax bracket, it doesn’t really matter but, if you make more than $200,000, then you are in the 32% bracket and there really isn’t any savings.

The senate version is aimed at S Corporations and attempts to exert pressure on shareholder/employees to take “reasonable compensation”.  But take the following fact patterns.  Z Company has $1.0 Million of profits before taking into consideration officer wages.  Z Company employs 50 employees and has $2.0 Million in payroll.

50% of $2.0Million is $1.0 Million.  23% of $1.0 Million is $230,000.  Without the owner/officer taking payroll, they will get the full 23% deduction.  It doesn’t matter that the owner did not take wages.  For what it is worth, W2 wages could be as low as $560,000 in this example, with or without officer compensation, before the shareholder starts to lose the deduction.

Another problem is that both versions limit the types of businesses that can qualify.  Professional services businesses will not get to take advantage of the lower rates since it is assumed that professionals do not employ others.  So, take a doctors office: the doctor has a front desk person, an office manager, four nurses and the doctor.  Six employees.  Compared to a small contractor with a bookkeeper, a foreman and 4 laborers.  Also six employees.  If they both make the $1.0Million of profit and pay $600,000 in wages, the contractor gets the deduction of $230,000 and the doctor doesn’t.  This is true even if the contractor works more hours than the doctor.

It will be interesting to see how the pass-through entity issue plays out in conference.

Have a great day.