Tag: S Corporation

Update on Converting

Well, it appears I misread the tax law change.  Personal Service Corporations (PSC or professional corporations) are in fact subject to the new 21% tax rate.  Because they are no longer at 35%, the benefit for converting to an S Corporation may no longer be valid.

Now, this is not 100% certain by the way.  The problem is that the writers used the term “amend” versus “strike”.  And they amended the original paragraph which contained the tax brackets to state only the 21%.  The problem is the next subsection.

That next subsection says that certain qualified corporations pay tax at 35%.  Not the highest tax rate but codified at 35%.  But, one way to read the change is to strike-through all the language in code section 11(b) and replace it with the 21% tax rate.

I know.  YAWN.  Except that we are trying to get some planning into place and an S election has to be filed relatively quickly.  And the devil to planning is in the minor nuances of things like “amend” versus “strike”.

For want of a nail a horseshoe was lost and because of the loss of one little nail a certain general was executed.

If in fact this reading holds true, I am not convinced a C Corporation should convert to S Status.  I actually think that it may be better on net cash flow to be a C Corporation.  This is especially true where the pressure is on to pay out disparate compensation to the owner/operators.

Take a medical practice, for instance of 4 doctors, each owning 25% of the outstanding shares.  Lets say that each gets to take, in the form of wages, 50% of the net collections on their patients.  Then they would look at the profits at the end of the year and issue a bonus with 80% of that pool of money being paid to them.

Under old law, this was important because the medical practice was a PSC under 448(d)(2).  As such, any taxable income was taxed at a flat rate of 35%.  They didn’t want any amount of money taxed at that level unless it was coming to them.  And they sure as heck didn’t want it as a dividend as it would first be subject to 35% corporate tax and then the 15% qualified dividend tax – or 50% overall.

But if in fact the PSC is taxed at 21% then I am not sure that paying it all out in wages is the best approach.    That is because the total tax rate for most people on taxable profits in a C Corporation will be the:

  • Corporate rate of 21%
  • Qualified dividend rate of 15%
  • Total tax rate of 36% on corporate taxable income when paid as a dividend
  • And you eliminate 1.45% Medicare tax

Again, there are more caveats, conditions and restrictions but it should be close to this result because there is a preferential treatment of capital income.

Each business has to be analyzed for its unique interplay between shareholder and company but generally speaking it works out that paying about 80% of the pre-officer compensation profits as wages and then issuing a dividend on the remaining cash (after tax) generates a little more net cash flow to the shareholder/employees.  More net cash flow is what this is all about.

The only scenario where being an S Corporation delivers superior net cash flows is when the shareholder/employee doesn’t take a wage: But the difference isn’t so large that it is worth the risk of being audited for unreasonable compensation (and losing).

Lets take a doctor practicing in a PSC where she is the sole shareholder.  The Corporation nets $500K of taxable income before shareholder compensation.  Under old law, the net cash after all taxes (including payroll taxes) was about $290K if we made sure that all the income was treated as wages to her.

Under the new law, the net cash is about $360K if we treat the income as wages to her.  But, we see a slight savings by only paying her $400K in wages and then taking the dividend of the remaining cash after tax.

Why is this important?  Because it used to be we had to get PSC taxable income really close to zero – which was challenging at best because you can’t always predict collection patterns. But now, with the tax rate at 21%, the practice does not have to be as accurate, which will reduce the amount paid to accountants to calculate the bonus and we can leave a little more profit in the business to pay out as a dividend and no money is really thrown away.

So, if you are already going through the motions of converting to an S Corporation – wait, you were crazy enough to take tax advice from a blog???? STOP the madness.  Talk with your accountant about the right way to approach this.  Have your tax professional help you analyze the various options.  If you like, I can send you my clunky tax comparison workbook so you have something to play with to help you see the cash savings possible.  And if you are looking for a new tax professional to assist you, feel free to write and we will be happy to offer you our best advice.

Have a great day.

 

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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.

Consequences

Happy Wednesday.

Prior to my going to work in the private sector as first a business development and marketing director for a startup and then a controller, I worked with lots of small business owners.  Almost all were structured as S Corporations.  And they almost always got in trouble for unreasonable compensation issues.

Unreasonable compensation is an outlier issue.  What I mean is that, compensation is considered reasonable if it is likely someone would take that pay package in the real world.  With C Corporations, the unreasonableness comes when the owners receive W2 income that is not tied to their job performance and where it drives the Company’s profits to zero.  With S Corporations, the unreasonableness comes when owners don’t take wages and instead act as though the business earned all the profit.

An Example:

XYZ Corp. earns $1.0 Million before payroll to Owen, the 100% shareholder.  Owen wants to take all the money out of XYZ, and at the lowest possible tax cost.  This is a fair requirement and depending on C or S status, drives a particular approach and potential audit issue.

As a C Corporation, XYZ would not want to say that Owen didn’t earn a wage and issue a dividend.  First, XYZ would pay about $350,000 of tax on the $1.0 Million in profits (35%).  Then, Owen would receive the $650,000 and pay about $100,000 in personal tax on the distributions (roughly 15%, I rounded up for simplicity sake).  So, Owen would net only $550,000 out of $1.0 Million.

If XYZ paid Owen $900,000 in wages, the tax consequences are more involved but lower.  First would be the payroll taxes, which is equal to l.2% of the first $150,000 of wages for both Owen and XYZ, plus 1.45% each for medicare on all of the wage, roughly $25,000.  Total payroll taxes are $45,000.

Owen hates the idea of writing a check to the IRS in April so he has 35% withheld.  The total withholding is $315,000.

And XYZ earned a profit of about $50,000 (since the company’s payroll taxes and the wages paid are deductions) and owes about $7,500.

Total taxes when paid out in the form of wages and driving XYZ’s profits to near zero?  $370,000 and Owens net cash received is about $570,000 (rounded of course).  And if he took a dividend of the remaining $40,000 net cash in XYZ, he would net almost $600,000, or a total overall tax rate of 40%.

The IRS would prefer that XYZ have much higher profit and taxable dividends to Owen as the combined tax effect is higher.

But what if Owen elected XYZ to be an S Corporation?

Here the consequences are reversed.  If, as an S Corporation, Owen took the $900,000 in wages, the tax effect would be the same.  But, he personally would pay the tax on the $50,000 at his marginal tax rate – 35%.  The total tax bill would be closer to 45% which is not as good as being a C Corporation and paying wages.  But, what if he didn’t take a wage?

XYZ would pass the net income to Owen, $1.0 Million.  Owen would be taxed at 35%, or pay $350,000.  There would be no payroll taxes and there are no corporate taxes so that 35% is all there is.  Net cash to Owen is $650,000.

This is a far superior approach as it drives the lowest overall tax bill.  It is also fraught with serious consequences as it is likely even more “unreasonable” than the C Corporation paying everything out in wages.

Which brings me to a quick story.  A new client came to see us – a dentist.  Not surprisingly he was being audited for unreasonable compensation.  You see, the good doctor decided to pay himself $12,000 a year and claimed that his practice generated profits of almost $500,000.

His case wasn’t helped by the fact that 2 years earlier he was a sole proprietor and earned $300,000.  The year after that he was a C Corporation and paid himself $400,000.

He wanted to know what to do.  I gave him two choices.  Pay the firm $10,000 to fight with the IRS and most likely lose and have 100% of the profits taxed as wages or pay us $2,500 to negotiate a more realistic figure of about $200,000 for wages.

He wisely chose the later option.  We were actually able to make the case that a “reasonable profit” from the business was about $300,000 – taking into consideration the focus on non-dentist services offered and a return on his capital investment.  We also convinced the IRS to waive penalties and interest on the underpayment.

If (and possibly a big IF) the tax law changes for pass-through entities, this type of challenge will become even more prevalent.  So, if you own a pass-through entity, make sure your professional is looking out for your best interest, not just how much tax can be saved.  And if you would like to discuss your tax position with someone, feel free to send me a message.  Remember, pigs get fat and hogs get slaughtered.

Have a great day.

 

The tangled web of pass-throughs

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.