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.

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.

 

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.

 

 

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.