Tag: small business

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.

 

 

Advertisements

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.

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 Traveling Salesman

I love telling stories about the good, and not-so-good, things clients have done over the years.  Actually, to be honest, I like the not-so-good stories as they are educational and hopefully stop others from going down a path they might regret.

Part of my role is technical compliance and final reviewer of tax work.  My responsibility is to make sure that any significant tax position taken was backed up by adequate documentation and research.  I couldn’t stop clients from taking risky positions, but I could stop the firm from agreeing to dumb things that we couldn’t defend.

One tax return comes to mind.  It was a new client and I was having trouble getting my head around his small business.  It was on Schedule C and reported a loss of about $100,000.  He had a W2 for about $150,000 so was getting about 30K back in refunds.

What stood out most were two items.  Negative gross profit of $60,000 and an RV on the books which generated about $25,000 of depreciation.

Negative gross profit, by the way, comes from when you sell your product for less than the total cost of those products.  In this case, he had revenues of $12,000 and Cost of Goods sold of $72,000.

I wouldn’t sign off and the partner wanted to know what my concerns were.  I asked him if he talked to the client about his “business” and the answer was, “Not really.”

So, I was indulged and the client came in for a meeting.  I asked him to explain how his business worked.  He bought product, he told us and traveled up and down I-5 stopping at county fairs to sell his product.

Interesting.  We didn’t notice any fees for space rental at any events, though.

That’s because he parked his RV in the lot and sold on the outside.  Ok.

How many customers did the $12,000 represent?  We inquired.

One, he replied.  One client.  So what was the $4,000 of meals and entertainment?

He took this client out to dinner and to various ball games and other events because of their loyalty.

Who is this client? we asked dreading the answer.

His wife.

Yeah.  He and his wife took the summer off to travel and he bought stuff and he “sold” it to her.  Because she was such a loyal customer, he gave her a substantial discount on buying the stuff she “wanted”.  And he rewarded her loyalty with dinners and events.

Now, I know you are thinking BS, I am making this up.  I swear I am not.  Public accountants get some of the most entertaining and too-good-to-be-true stories out there.

Our main problem was that his prior accountant let him get away with it.  We suggested that he face the fact that on audit, the IRS would probably say this was a hobby (we didn’t bother to let him know it was probably outright tax fraud) and to protect the prior losses, he should shut down his business and maybe consider starting it up in 2 or more years after a cooling-down period.

He said no thank you but appreciated our advice.  He paid us for the work we did, took his “records” and went to find another tax preparer who wouldn’t be so nosey.

The moral of the story?  You may have heard the old saying that “Pigs get fat and hogs get slaughtered”.  Sometimes, it doesn’t pay to push the boundaries of acceptability.  He may never have been audited – hell he might have even been turned down by the next dozen tax preparers and decided he wasn’t going to win and dropped it – but it was still an extremely risky position to take and there was no real defense.

There are ways to make a business work while you travel.  But the odds are, the bigger the loss, the greater the risk, so documentation is vital to winning.  So, as you prepare for the end of the year and are looking to work with someone who wants to help you be successful, consider an accountant with integrity and who is willing to help you get everything right to protect you from major risks.  If you need the name of one, feel free to write me and I will send back the contact information for one or two to help you.

Have a great Tuesday.