Tag: Income Taxes

Taxes and Small Business

In our research for the upcoming Lunch and Learn, we discovered something quite interesting. I thought I would work through it here and try to figure out how to help small businesses plan effectively.

As part of the potential for tax reduction is an attempt to deal with flow-through entities; that is sole proprietorships, S Corporations and LLC’s. Currently, with flow-through entities, the tax on profits is paid by the owners. The problem becomes defining profits. Let’s look at 3 companies A, B and C.

Profits and Compensation

All 3 companies make $100,000 before owner compensation. A decides to pay herself $50,000 of wages, B decides not to pay any and C pays almost all in the form of wages. The tax consequences are remarkably different.

A B C
Taxable Income Before Owner Compensation      100,000      100,000      100,000
Owner Compensation        50,000              –        92,500
Company Payroll Taxes 8.0%          4,000              –          7,400
Taxable Income Passed Through        46,000      100,000            100
Income Tax for Owner
Wages        50,000              –        92,500
Taxable Income Passed Through        46,000      100,000            100
Taxable Income for Owner        96,000      100,000        92,600
Tax Liabilities 25.0%        24,000        25,000        23,150
Total Taxes Paid
Company Payroll Taxes          4,000              –          7,400
Owner Payroll Taxes          4,000              –          7,400
Income Taxes        24,000        25,000        23,150
Total Taxes        32,000        25,000        37,950
Taxes as a Percent of Income Before Comp 32.0% 25.0% 38.0%

The difference between the results is the payroll taxes which every employee pays and which every employer matches.  The problem is that the only statutory requirement is that “Compensation must be Reasonable”.   And this has been an audit headache as the term “Reasonable Compensation” is based upon the facts and circumstances of the particular taxpayer and Company.

This difference in the tax law has been around for decades and has been left to auditors and taxpayers to argue about the term “Reasonable Compensation”.    In this case, we have argued on all sides – that A’s and C’s compensation is reasonable and so is B’s.   Most professionals would worry about losing in B’s position but clearly any compensation less than the amount of taxable income before owner compensation is a win for the taxpayer by reducing employment taxes.

Given that there is already this disparity and given that Congress knows about it and has elected not to touch it yet should give us all pause for concern as Congress looks at passing a substantial rewrite of the tax law to both reduce rates as well as treat Business earnings with a different tax rate.

Deemed Wages

To address this issue Congress will need to figure out a way to address owner compensation. So far, in all the proposals they use a phrase “Deemed Wages” to account for owner compensation. Randy and I have debated this and we are of the opinion that what is likely to happen is that the IRS will publish a table of expected compensation for various businesses and the owner’s compensation should be close to that in order to be considered reasonable. If an owner wants to pay differently, there should be some written justification for the position, such as minutes to the board of directors or a memo from a meeting between the owners and their representatives.

Keep in mind though, that this is one areas where is almost no guidance as it hasn’t been touched before.

This change to how small business reflects taxable income will be major.  By addressing the disparity shown above, Congress will potentially eliminate an audit headache and improve compliance.  It may mean that some pay more and some pay less, but it could also help give taxpayers peace of mind by addressing the unknown of “Reasonable Compensation” and reducing the risk of money spent on litigating this issue.

 

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Taxes

Happy Wednesday.  It is an amazingly beautiful day in Vancouver and tonight Kubae and I are guests of Key Bank and Jeff Taylor at the Portland Thorns game.  We haven’t decided if we are eating in before we go or heading over to the Max station early and grabbing something to eat in Portland before the game?  Kubae and I are from different parts of the spectrum as I enjoy cooking and eating at home while she loves trying new restaurants every chance we get!  Does anyone have a suggest for a pre-game meal?

I was asked the other day why I never talk taxes.  This is not entirely true as I have older posts where I talked about it; and in this blog I haven’t gotten around to it yet!  But to dispel the concern about taxes, I will gladly write a few words.

There are two separate issues to address when writing about taxes: Filing and Planning.  Filing tax returns is an obligation.  Now, it can be easy or painful and it is your choice!  To make tax filing easy (and less costly) I strongly suggest you follow my guidelines in the various blog articles about how to structure and organize your accounting.  If you keep it simple and put transactions in the right place, your tax preparer will be able to easily complete your return for you to file.  No muss no fuss.

On the other hand, the small business owner who does not pay attention to his accounting generally makes tax filing a massive undertaking.  You are now paying someone with an advanced degree several hundreds of dollars an hour to fix your books.  I have seen year-end accounting services run to several thousands of dollars, all because the business owner had no idea what he was doing and the accounting firm (us as much as I hate to admit it) never took the time to properly teach the client how to keep a good set of records.

Planning for taxes is not an obligation, but is essential to the health of your business.  However, there are a few rules to tax planning you should be mindful of:

  1. Planning requires your business to be profitable before taxes
  2. Planning demands time
  3. Planning needs alternatives

Keeping these simple rules in mind, here is how to work with your accounting firm on tax planning:

  • Keep your books up-to-date and properly adjusted
  • Set an appointment no later than August 31 to review your books with the accountant
  • Be clear on your objectives for planning (new purchases, retirement, etc.)
  • Think about what you and your business might need over the next 12-18 months

There is nothing more frustrating, for you or your accountant, than waiting until February to discuss the fact you made $250,000 in profit for the prior year and then went out and bought vital business equipment which cost $250,000 in January.  The problem becomes, obviously, that you owe $75,000 in taxes on the prior year profits and you spent all your liquid cash on the equipment!

Yes, this happened more than once.

By coming in early and discussing your plans and objectives, you give your accountant the alternatives for you to review and approve.  In the situation above, for instance (and in hindsight), a planning meeting in August might have showed that profit was $175,000 and the owner might have addressed the fact that a new piece of equipment was needed early the next year.

Two things would have come out of that conversation – accelerate the purchase of the equipment and use some reasonable amount of debt to finance the purchase.  Due to the way the tax law works, taxes would have been reduced and the Company could have retained working capital – two objectives met for the price of one!

Since we are now approaching optimal tax planning time, consider making an appointment with your accounting firm to discuss and plan your tax situation.  And if you are currently not working with an accounting professional or would like a second opinion, feel free to contact me and have a free no obligation consultation on your business and plans.

Have a great day.