Tag: Income Taxes

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.

 

 

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The Rental Loss, another C.A.S.H. Lesson

Today’s lesson from C.A.S.H is on the risk of hobby loss on your rental property.  That’s right, your rental house follows a similar set of rules when it comes to acting as a rational investment.

See, the guiding principal behind every investment is the concept of making money.  Congress enshrined this ideal in IRC 183.  And taxpayers and the IRS have been fighting ever since.  The basic concept is that no one invests to lose money and real investors would not continue to pour money into an investment that can never recover.  Logical.

This same problem comes up with rentals.  John Caton and I were discussing this issue yesterday.  We were waxing nostalgic about some of the things we had seen over the years.  His story beats mine on this subject so I will use his.  Names, places and amounts have been changed to protect the innocent.

Hal, an executive with a decent sized construction company, was married with 2 children.  Hal came in for a tax interview.  He said Wilma, his wife, would arrive in about 15 minutes.  While they waited, Hal asked John what the requirements for claiming a dependent were because he was thinking he should add two more because he was providing over half of their support.

John explained that there had to be some relationship between the taxpayer, in this case, Hal and Wilma, and the person claimed as a dependent.  Plus, they had to provide over half of the support.  John pointed out that caring for their aged parents would qualify but if they had siblings then Hal would want to get a letter from them saying they all agreed Hal and Wilma provided the majority of support.

Hal was silent for a moment.  Would that include providing housing?  Hal inquired.  John, being a curious accountant – how he survived to middle age being curious is still a mystery – asked him to explain.  What if he rented a house for them?  Possible but it would depend.  (the profession’s get-out-of-jail-free card)

About that time, Wilma came in and John said he would get back to Hal about his thoughts.  Hal said to forget it.

On Hal’s and Wilma’s 1040 was a rental property.  Hal bought it for an investment 5 years earlier.  The property generated about $9,000 in rental income and generated total expenses of about $22,000.  This had gone on for all 5 years but year 1 had a loss of almost $40,000.

Fast forward about 6 months.  Wilma comes in for an appointment.  The IRS wrote wanting an explanation of the losses for years 1 and 2.  John was quite curious as Hal typically handled these types of things.  John assumed that Hal was off on some job site.

No, that wasn’t it.  Wilma starts crying in his office.  John thinks the worse, Hal passed away.

By the way, death is not the worse apparently.  Not even close in some instances.

Wilma goes on to explain.  The two dependents Hal inquired about?  His girlfriend and their 4 year old child.  Yes, it seems good old Hal bought the rental when he found out she was pregnant.

The rental, she told him, wasn’t one.  Hal confessed to her he actually made the income number up.  The expenses?  Well, the mortgage interest and the property taxes were real but the rest were all expenses paid to support the girlfriend and their child.  Furniture, clothes, food, you name it, he claimed it as a rental expense.

No income, no real expense but years of losses.  a husband with a love child and an IRS audit waiting in the wings.  Wilma was, to no ones surprise, not very happy.  But she said there was an upside.

After she kicked Hal to the curb, he apparently went to the girlfriend to tell her he was ready to commit to her.  When he arrived, the girlfriend was entertaining a guest for dinner.  Her new boyfriend.

Like I said, death would have been the easy thing for Hal.

Yes, I know, not really a story about rental losses.  True but frankly it had such an interesting message that I couldn’t pass up writing about it.   But the story did touch on the hobby loss implications.

Typically with rentals, losses are considered passive and have limitations as to their deductibility.  The preparer felt that Hal was a “real estate professional” and, instead of limiting the losses, took the full amount Hal and Wilma were entitled to.  This, by the way, was the reason for the initial IRS inquiry – to determine if they qualified.  John felt he could win that argument – everything else being equal.

John knew that the next argument was the risk of hobby loss.  John made Hal go out and do market research each year on fair rental amounts.  This is known as the business plan defense.  The $9,000 was on the low end of the range but would likely have passed – except for the minor little problem of it being fictitious.  Interestingly, the made-up rents less the mortgage interest, property tax and depreciation were almost at breakeven.

Hal wanted to be a hog.  The IRS slaughterhouse is full of ’em.

The preparer was totally blindsided by the, shall we say, aggressive approach to expenses.  Had Hal been fully honest, no one would have allowed baby clothes to be deducted.  Other than the possible tax fraud, it sure looked like an activity engaged in for profit and therefore the losses – the real ones – should have been allowed.

The C.A.S.H. moral of the story?  There are so many in this one but I think the key takeaway is pigs get fat and hogs get slaughtered.  Don’t get branded a hog.

Oh, and multiple years of rental losses don’t necessarily mean that the activity is a hobby.  Make sure rents are reasonable for your area, that amenities are fair and can be priced into the rent or are expected in the marketplace.  And for crying out loud, don’t try to fool your spouse by sticking the second family in the rental house!

My thanks to John for the amusing story.  As always, if you have any questions or would like more information on hobby losses or real estate, feel free to contact me.

Have a great day.

 

Committee Advising Superior Hobbies

Good morning.  Ginger is becoming more and more secure and is now switching between Kubae and me.  Yesterday she wouldn’t leave Kubae’s side and today she is constantly under foot – mine to be precise.  Fortunately I sit a lot.

There is an interesting tax court Case, Welch, that I discovered in my Monday research.  It is all about hobby losses.  I will provide a more detailed summary later this week but wanted to share my thoughts on the big thorny issue of small business losses I have faced in my years of public accounting.

Oh, and in case you would like to make a donation, make your check out to the Committee Advising Superior Hobbies (CASH for short).  Yes, this is from an old Beverly Hillbilly episode.  Ha and you didn’t think accountants had a sense of humor or ever watched bad TV (The Office anyone?).

I have reviewed thousands of individual, partnership and S Corporation returns over the years.  I have seen hundreds of potentially troubled hobbies.  This is because most had multiple years of losses and the Internal Revenue Code (IRC) provides a safe harbor of 3 years of profitability out of 5.

Most were of the garden variety small business type.  An individual had a full-time job and then had a sideline business.  Most generated some income but no where near the costs of keeping the business alive.  So, the owner plowed additional money into the operation.  Sounds familiar?

They never really had business plans and, typically tried to remedy the problem following Einstein’ oft-misquoted definition of insanity “Doing the same thing over and over again while expecting a different result”.  Classic madness – but ’tis the spice of life I suppose.

Your tax firm’s role is to guide your decision making, especially when it comes to potential audit-risk areas.  Schedule C and Schedule E losses are potentially easy targets for IRS audit – especially when you have 4,5 or 6 straight years of losses and are receiving a substantial W2.

So what is the advice from a mild-mannered, fiscally conservative accountant?

It depends.

Like you didn’t see that coming.  But, while each potential hobby-loss business is somewhat unique, each follows similar patterns.  The owner finds something they are good at and try to monetize it.  They generate a little revenue and then talk to the accountant.  The accountant, believing in the client’s dream and hearing the “I don’t want to pay taxes” grumble from the client, starts finding other supporting expenses to write-off.  The home office, the internet, driving to the mailbox down the country lane.

So, while your little business is huffing and puffing, chugging up the hill towards profitability, your tax guide is piling more and more weight on you to keep your inertia from getting out of control.  Yes, you guessed correctly, most of the expenses that drive the loss are actually not direct costs of being in business.

One Schedule C I reviewed is a great example.  Her little business generated $25,000 in revenue.  The direct costs were about $15,000, for a $10K gross profit.  She lived in Portland and drove to Cannon Beach every weekend to a little craft bazaar.  You guessed it, for 4 years straight, we dutifully recorded her mileage and the meals and entertainment (she owned a beach house in town) which generated about $20,000 in additional costs.  Voila!  Tax loss!

And the possible loss of the safe harbor.

I approached the client manager with a new plan.  Let’s cut these expenses in half and call them personal.  She ends up with a small profit.  Victory I cry!

Not so fast. The client wasn’t pleased with this amazing insight into protecting the losses. After all, no one saw fit to tell her this before.  Even after explaining the risk that the IRS can go back to year 1 and deny every year of losses (did you know that?) she wasn’t sold.  She was fixated on the $575 in taxes that were due.

Keep in mind that her 5 years of accumulated losses were over $120,000.  At her 25% tax bracket, she had sheltered over $30,000 over the years.  We were trying to save that $30,000, plus penalties, plus interest, plus plus plus.  And the cost was a mere $575.

I know, its hard sometimes to want to pay additional taxes.  I hate it as much as everyone else.  But, given the choice of paying a little tax or paying a lot of tax, I will choose a little tax every time.  Trust your tax advisor when we offer our kernels of tax wisdom.

And really, C.A.S.H. needs you: More importantly I need C.A.S.H. to continue to bring you these excellent little tidbits of hard won knowledge. So donate today!  Or you can simply become a client and we both win.  Feel free to contact me anytime with questions or if you would like to meet and discuss how ITS can help you and your company increase profitability while minimizing your taxes.

Have an awesome day.

Happy Thoughts

Good morning.

I write more about our newest family member on my other blog CORE Beliefs but Kubae and I are so excited to welcome Ginger into our home!  We picked her up Saturday from the Southwest Washington Humane Society.

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Here are my two wonderful young ladies.  Yes, Ginger has her own pink bed, pink walking harness, pink extending leash and collar and even a pink car seat.  She is a corgi-terrier mix, 6 months old and hates being separated from her “mommy”.

No, she does not sleep in her bed.  It is funny, when we put her little bed on top of the chest, I told Kubae that our little sweetheart was going to jump into our bed within 5 minutes.  No sooner did we turn out the lights than we heard her little paws on the foot rail and a soft plop as she hit the mattress.  She curled right up between us!  The good news is she sleeps through the night.

Moving on.

You have no doubt heard the various predictions about the tax reform bill that is currently in committee.  You have probably even formed an opinion as to the effectiveness of this effort at tax reform.  Sadly, your opinion is likely based upon your political disposition instead of really getting to understand what is being done.

When you hear that tax reform never pays for itself, be careful.  I think the evidence is there that within a short time span the tax law does not spur sufficient growth to “pay for itself”.  But I think there is a case that, over a generation, the tax cuts can be effectively stimulative.  The bigger issue is if the pain and suffering are worth the wait.

The 1986 tax act was a major rewrite of the tax code.  It did not really “pay for itself” in the first 5 or 10 years.  I believe, however, that when we look at today’s tax receipts, federal spending and redistribution, we notice that our tax receipts are substantially higher than what they were in 1985.

More importantly, it changed certain behaviors by changing the incentives.  Passive activities were no longer sought after for their generous tax breaks – unless one could find a passive investment that spun off income.  Requiring social security numbers and birthdates for dependents de-incentivized the deduction of, shall we say, dubious dependents.  Yes, I have heard that it created a far more complex tax code – I wouldn’t know for certain because in 1986 I was playing Marine – but I think overall it led to an economic improvement that has enhanced our lives and general prosperity.

As you measure the economic impact of the current tax reform measures, keep in mind that part of what we want to change is how certain behaviors are incentivized.  One code section that comes to mind is section 121.  IRC 121 is the home sale exclusion rules which state that if you own and live in your home 2 of 5 years, the gain can be excluded.  I believe it was enacted in 1999 (or thereabout).

This was a huge benefit to home owners over prior law.  The prior law required you to buy a home of equal or greater value than the home you sold.  Unless you were over 55.

With this change, you could now sell your home and rent until you found the right property.  If you moved from a high cost of living area to a much lower one, you would not have to fear being taxed because your new home was less in value, even if larger.  It provided opportunity – that is, an incentive, to consider moving every few years instead of every decade.

Yes, as with all changes like this, there were lots of attempts to structure transactions to get the benefit without technical compliance.  And there is a link between IRC 121 and the huge run-up in home values in the early 2000’s but I think, overall, that this “reform” served the economy better than under the old law.

Now, congress wants to update IRC 121 and incentivize people to live in their homes longer by requiring 5 years of 8 owning and living in the home.  It remains to be seen if this is a positive or negative incentive – especially with an economy that possibly is going to require citizens to relocate for new job opportunities.   But the point is, it might take more than 5 or 10 years to determine if a change helped or hurt the economy.  And if, after 10 years, congress sees that it is perhaps not working as intended, I would hope they would try to correct it by having a fair and open debate.  Ahh to be a dreamer.

As you read the opinions of your favorite pundits and listen to your talking tax heads, keep in mind that things change constantly.  So, have a happy thought and don’t get wrapped up in the minutia of their debate.  Updating the tax code is a good thing, although I do agree it could have been handled a little more maturely by everyone involved.