Quantifying Entity Elections

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

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

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.