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Archive for November 2019

It Might be Time to Give up on the S Corporation

On a sunny spring weekend in Seattle nearly five years ago I attended a conference. In the audience was Pete Adeney, aka, Mr. Money Mustache (MMM). 

MMM took to my message immediately, interrupting my presentation to inform me I was his new accountant. I took it in stride. My gift to gab exceeded my surprise.

What caught the ear of MMM was a strategy I have used for decades to save business clients money: the S corporation.

The beauty of the S corporation is that some of the profits flow through to the owner outside self employment or FICA taxes. At 15.3% for many, it is a meaningful savings.

Not everyone should use an S corporation (or LLC electing to be treated as such).  Side hustles frequently do not have enough profit to make it work. Profits under $30,000 are best left as a sole proprietorship or partnership, without consideration for legal and other matters. Between $30,000 and $50,000 it is time to start running the numbers and once profits exceed $50,000, and are likely to continue to do so, you need to get serious about an S corporation.

Many factors come into play. The previous paragraph is only a suggestion and not hard and fast tax advice. I have S corporations in my office with less than $30,000 in profits and businesses with over $50,000 in profits still waiting for the S corporation to benefit them.

That presentation in Seattle five years ago was the spur for me to start this blog and is one of my first posts. It also prompted MMM to publish on the topic as well

And now the advice is all wrong.

 

More than One Flavor of Corporation

Corporations come in two flavors: the regular, or C, corporation and the S corporation. Small businesses are familiar with the S corporation because it was designed for them. Profits flow to the owners because the S corporation rarely pays income taxes. 

Regular corporations are generally larger due to tax issues. Most stocks listed on U.S. exchanges are C corporations. 

Small business owners: deduct all your child care expenses. New tax laws have made it easier for owners to deduct personal tax-free benefits. #ICHRA #HRA #QSEHRA #Fringebenefits #employeebenefits #childcare #deductionsBoth flavors of corporation can be organized in one of two ways. The first is to organize as a corporation and the other is to organize an LLC and elect to be treated as a corporation for tax purposes. You can then elect S status, if desired.

The S corporation avoids double taxation on dividends paid out of profits. The drawback is that C corporations can provide more benefits to owners without restrictions. The dreaded “except for 2% shareholders” phrase in the tax code limits the advantages of the S corporation. In the past C corporations faced a higher income tax rate compared to tax rates for individuals. 

The Tax Cuts and Jobs Act of 2017 (TCJA) changed all that.

Regular corporations prior to the TCJA had a graduated tax rate on profits that started at 15% and climbed to 35%. C corporations now pay a flat 21% income tax rate. Individual tax rates (the rate profits from an S corporation are taxed at as they flow to the owners) top out at 37%.

Instead of profits flowing to the owners on a K-1 annually, a regular corporation pays taxes on its income and pays dividends from the remaining profits. The dividend can be qualified, but multiple additional issues abound with dividends paid from a closely held C corporation we will not be able to address in this post. (The link is to an old article from the AICPA which is still relevant today.)

C corporation dividends are NOT deductible by the corporation, but are taxable to the recipient, hence the double taxation since the corporation already paid income tax on the profits. The corporation paid income tax on the profits at 21% and the owners pay tax again at the rate for dividends (qualified or non-qualified). 

Up to this point it still looks like the S corporation is the way to go for virtually all small businesses and you would be right. However, for fringe benefit purposes, an S corporation is treated as a partnership, and a greater than 2% shareholder is treated as a partner rather than as an employee. To reiterate, this is for fringe benefit purposes only. And it makes all the difference.

 

No Simple Choices

S corporation owners still enjoys access to all the retirement plans of a regular corporation with some modifications. Health insurance premiums (IRC Secs. 105 and 106) are generally added to wages and then deducted on the personal return (Rev. Rul. 91-26). The same applies to group life insurance up to $50,000 (IRC Sec. 79) and meals and lodging for the employer’s convenience (IRC Sec. 119).

Get the most out of your tax-free fringe benefits as a small business owner. #fringebenefits #businessowner #smallbusiness #employeeawards #watch #ICHRA #QSEHRAThis is where the choice is less clear than in the past. The above fringe benefits still have value to the owner of an S corporation as long as a few hoops are jumped through. The benefits are available to C corporation owners as well, just with fewer hoops to jump through.

Numerous benefits available tax-free to employees do not apply to 2% shareholders of an S corporation. With the C corporation tax rate at a low 21% and dividends likely qualified (taxed on the personal return at the long-term capital gains (LTCG) rate), double taxes may no longer be the issue it once was. 

For some individuals, the LTCG tax rate can be 0%. This stops double taxation of dividends in its tracks. Even if dividends are taxed it is at the lower LTCG rate rather than at ordinary income rates. The top LTCG rate is currently 20%, however, there is a small (on percentage terms) additional tax on higher incomes that could push the effective LTCG rate to 23.9%.

But the benefits are the real prize. How many fringe benefits you give the owners will determine if the C corporation is better for you. Some of these benefits are massive, allowing for 5-figure deductions. Something you can’t do with an S corporation.

 

Deducting Fringe Benefits

We will touch on the most common and valuable fringe benefits you can deduct with a C corporation as an owner where it isn’t allowed as a 2% or greater shareholder in an S corporation in most cases.

 

Flexible Spending Account (FSA): This is the “use-it-or-lose-it” account you might be familiar with. Employees are allowed to withhold from their wages or salary up to $2,700 (for 2019) per year for medical expenses. If married, a spouse can do the same. 

The FSA does take planning. If the employer plan allows, up to $500 can be carried over to the next year OR up to a 2 1/2 month grace period allowed to use the money in the HSA. 

The FSA is a salary deferral; a deduction is not allowed since it is already excluded from income.

You can use FSA funds for uninsured health costs, such as: eyeglasses and exams or a gym membership or message therapy with a doctor’s prescription.

You can read more about the FSA here.

There is also a Dependent Care Flexible Spending Account (DCFSA) where employees can elect to exclude up to $5,000 from income for dependent care expenses. The employer can also provide some or all of this amount as a tax-free fringe benefit. FICA and FUTA are also avoided. 

There are several opportunities with a Dependent Care Assistance program (IRC Sec. 129) and a credit for employers covering qualified child care expenses (IRC Sec. 45F). You can read details here.

 

Deduct all your health insurance premiums and medical care costs tax-free. #healthinsurance #benefits #employee benefits #healthinsurancepremiums #medicalcosts #deductiblemedicalcosts Deductibleinsurance #HRA #QSEHRA #ICHRAHealth Reimbursement Accounts (HRA): This might be the number one reason a small business owner may choose the C over the S corporation. 

Once again we have two choices. The Qualified Small Employer Health Reimbursement Arrangement (QSEHRA) and the Individual Coverage Health Reimbursement Arrangement (ICHRA). The ICHRA is available starting January 1, 2020; the QSEHRA is currently available.

The QSEHRA allows a tax-free benefit to individuals of $5,150 and $10,450 for families in 2019 for medical expenses, including insurance premiums (though the Premium Tax Credit (PTC) is reduced by the amount of the benefit, if claimed). The employer pays this benefit. The employee has nothing to report on her return with the exception of the adjustment to the PTC.

The new ICHRA has no annual cap. Yes, you can deduct a lot under the ICHRA! There are some differences, however. If you receive any benefit under an ICHRA you cannot get any Premium Tax Credit. 

It should be noted that the QSEHRA and ICHRA are for employers without group health insurance. Employees with individual insurance is allowed and what these plans are designed for.

There are several considerations with HRAs. Here is a good chart comparing the two.

 

Employer Provided Vehicle: An S corporation can provide the same benefit, but it is cleaner and easier with a C corporation. The vehicle can be used by the employee for business or personal purposes and, depending on the facts and circumstances, may be tax-free to the employee.

There are a lot of moving parts to the employer provided vehicle. Discuss this option with your tax professional to determine if it is of value for you.

 

Employee Achievement Awards (EAA) (IRC Sec. 274(j): If you have a written plan it is a qualified plan. The qualified plan can offer awards up to $1,600; $400 if not a qualified plan.

The TCJA changed the rules a bit for the EAA. Cash and equivalents are not allowed: cash, gift cards, gift coupons, gift certificates, vacations, meals, lodging, event tickets, stocks, bonds or securities. Only arrangements that confer the right to select and receive tangible personal property (a watch or plaque, for example) from a limited assortment of items preselected or preapproved by the employer are allowed. (IRC Sec. 274(j)(3). The award must not appear as disguised compensation. There are additional limitations.

 

The Best Route

There are many more fringe benefits to consider. To keep this post brief I will punt on the other tax-free fringe benefits. It is recommended you review these issues with your tax professional as there are significant opportunities to reduce taxes with these strategies.

Now you need to determine if the S corporation is best for you. It boils down to the fringe benefits. The lower flat tax rate for C corporations are a consideration and your personal tax rate on dividends from your corporation will play a role, too.

However, the biggest determinant will be tax-free fringe benefits. And when it comes to benefits the HRA will top the list. Large deductions allowed with a C corporation can remove enough income from the taxable column to create an overall tax for the C corporation lower than the S corporation. It does take planning to determine this.

The QSEHRA is a powerful tool under the TCJA personal and corporate tax rates. The new ICHRA is something you must examine. With virtually unlimited deductions for health related expenses and insurance premiums, the ICHRA will make the C corporation more valuable to small business owners than ever before.

There is no shortcut. You have to put pencil to paper or have a tax professional do it for you. It might be worth paying a seasoned tax pro to help you determine the best route. Every step inserts additional tax considerations tax professional should be familiar with that a novice may not. Investing in your business can pay hansom rewards.

 

Caveats

Tax are never easy. All the good ideas in this post still need a warning label.

If you are an LLC electing to be treated as an S corporation you can elect at any time to become a regular corporation (terminate the S election). However, you cannot elect to be an S corporation for at least five years, even if circumstances (or the tax code) change.

Also, if you are a C corporation with accumulated earnings that elects S status your tax return becomes much more complicated and probably more expensive to prepare. There are additional risks for an S corporation that spent any time as a C corporation; you should discuss these potential issues with a tax professional. The risks could subject the S corporation to additional taxes. Get all the facts before jumping.

Finally, in 2025 the tax code reverts back to 2017 rules for individuals if Congress doesn’t act. Corporate changes were permanent. One more thing to consider before you make a decision.

 

A small business should hire a competent tax professional to deal with the considerations put forth in this post. Too many variables can intercede.

This post allows you to ask good questions of your tax professional. A small investment with the taxguy should pay you back in multitudes of order compared to the fee invoiced. 

Don’t accept the S corporation as the default for small businesses anymore. The C corporation might save you more money.

Print this post out and/or send a copy to your tax professional and ask if this is something that could benefit you. Pay the nice tax professional. She will earn her keep on this one and it is well worth it to you. 

 

 

More Wealth Building Resources

Personal Capital is an incredible tool to manage all your investments in one place. You can watch your net worth grow as you reach toward financial independence and beyond. Did I mention Personal Capital is free?

Side Hustle Selling tradelines yields a high return compared to time invested, as much as $1,000 per hour. The tradeline company I use is Tradeline Supply Company. Let Darren know you are from The Wealthy Accountant. Call 888-844-8910, email Darren@TradelineSupply.com or read my review.

Medi-Share is a low cost way to manage health care costs. As health insurance premiums continue to sky rocket, there is an alternative preserving the wealth of families all over America. Here is my review of Medi-Share and additional resources to bring health care under control in your household.

QuickBooks is a daily part of life in my office. Managing a business requires accurate books without wasting time. QuickBooks is an excellent tool for managing your business, rental properties, side hustle and personal finances.

cost segregation study can reduce taxes $100,000 for income property owners. Here is my review of how cost segregation studies work and how to get one yourself.

Worthy Financial offers a flat 5% on their investment. You can read my review here. 

Redefining Frugality

Are rewards programs destroying your finances? All those points might be killing your budget and making you poorer. There is a better way. #rewards #miles #points #budget #travel #bonusesFrugality has changed from a few decades ago.

Growing up in the backwoods of Nowhere, Wisconsin frugality was a necessity of life. Rural communities once had strong emotions started during the Great Depression. My grandmother spoke of having one egg per week (and we were farmers—the rest were sold) which the man of the house ate because he did more physical work and needed the strength. 

We also heard stories of eating lard sandwiches and “learning to like it, too”, as Grandma Accountant used to put it. Things were hard in those days; harder than anything experienced in these parts by anyone under 100 years of age.

Frugality was an ingrained part of life. Debt was to be avoided like rabies. Old-timers knew it was impossible to survive either. A lot of good men met their end back in those days when things turned sour and the lessons were never forgotten.

Frugality was more than just not spending or bragging rights for a blogger. Spending on anything not an absolute necessity was akin to sin. And it was hard to look up at the cross on Sunday morning if you committed such an egregious sin. 

Those days are long gone. Only a few with a long memory remember grandparents warning of the perils of frivolous spending. 

It was easy to define frugality in those days. Frugality meant saving a very large percentage of your income and sacrificing at least some necessities. Frugality also meant industriousness. Flaunting of wealth was as bad or worse than foolish spending and nobody wants to be the fool.

The lines have blurred in the last decade. Frugality is easier because it is easier to game the system. We even brag about it—a social crime in the not so distant past. 

Now we can travel the world on someone else’s dime and still claim the trophy of frugalism. Websites and blogs abound in strategies to shift your spending to another’s financial statement. Gaming credit cards is all the rage. And credit cards are not the only game. There are so many moving parts in the financial system now you can drive a truck through it without hitting a frugality checkpoint.

But is this really frugal? Not by any definition from the past. Our grandparents would not consider the current state of affairs frugal. They would actually be appalled at modern behavior passing as financially responsible behavior. 

With new rules and a new world order it is time for a better definition of frugality. It is unacceptable to claim current spendthrifty behavior as actually frugal behavior. This has always led to disaster in the past and there are no indications the laws of economics have changed.

So today we will attempt to redefine frugality for a modern world with options to game true frugal living. 

 

Measuring Frugality

The problem stems from what we measure. In the past we measured frugality by spending levels, or better yet, by the savings rate. In the backwoods it was common to see 50% savings rates and higher, emphasis on “was”. People just did not spend what they earned. 

Money is no longer an accurate gauge of frugal behavior. A few quick financial maneuvers can provide points from whatever source good for cash, prizes and/or travel. The tax-free cash doesn’t count as spending in most people’s minds. That is an unfortunate belief to have. 

Travel is the worst offender. Free and semi-free travel is all the rage. It has even affected business and first-class travel as so many can now achieve such levels at very low cost. First-class isn’t what it used to be according to what I have read.

The damage to the environment is all the same. The climate doesn’t care if you think you are frugal as you dump a few more tons (or tonnes for my non-American readers) of carbon into the atmosphere without personal financial cost because you cashed in some points. Earth thinks you still did the spending; Earth thinks you are less than frugal regardless what you exclude from your budget.

Redefining frugality in a world or rewards points, bonuses and free handouts. All that unrecorded consumption affects the planet and environment while exposing your finances to new risks. #risks #finances# #frugal #frugality #spending #rewards #rewardsprograms Measuring “earned income spending” is not the truth. Your impact on the planet is still very high if you engage in off-balance sheet spending. (Yes, this is a twist of words. I know spending goes on the P&L. I used this analogy as a twist on the questionable behavior of public corporations that use off-balance sheet debt to mask their true financial condition.)

All spending counts. Better yet, all consumption counts!

Because the claims of frugality are so easy to fraudulently (an ethical crime only) acquire today a better way to assess frugal behavior is by measuring consumption. 

I’m guilty of the same crime. I avoid travel as much as possible, but have no problem if people travel to me. How is that different from a blogger taking a free trip to a conference just because they are a blogger? The environmental damage is all the same; the resources still consumed.

I’ve gone a step further (and hence have committed a higher crime). My home (and water) is heated and cooled by a geothermal heat pump. Very energy efficient. Then I plow said savings into a 3,000 square foot home with a hot tub, Jacuzzi and a two acre pond. (Save the “hypocrite” catcalls for later.)

Odds are my next vehicle will be electric or some hybrid of such. The miles will be driven with a lower environmental impact. Yet, the massive consumption of an auto purchase is present.

My carbon contribution to the atmosphere is smaller than most Americans and probably on par with a typical European. This puts me well above levels of African nations and most nations, for that matter, outside Western Europe and North America. I have to be careful how loudly I proclaim my innocence.

And the free gifts keep coming. Over my adult life I received plenty of free promotional items as enticements. Blogging is no different. They even have laws now where bloggers have to disclose if they received compensation or free use of the item or service they blog about.

On The Wealthy Accountant Facebook group I have asked people what they consider spending. The vast majority confess they don’t consider credit card rewards as spending. Well, it is tax-free income so it shouldn’t count as spending then either, should it? 

But it is spending! Consumption, too! 

Measuring frugality is extremely difficult due to all the changes in modern society. Spending has been distorted and even CO2 emissions are an inaccurate way to measure frugal behavior. Each method can be gamed. A good start might be to track your CO2 emissions or equivalents with a basic calculator from the EPA. It isn’t a perfect solution, but better than mere spending as a frugality gauge.

Greenhouse gas emissions are also a problematic measuring tool. That electric vehicle might spill less pollutants into the air as you drive, but the contribution from production might be tremendously high. At best it is hard to measure.

And not all costs are included in the environmental equation. The polluting of the land, water and air extracting oil is not included in the price of a gallon of gasoline. We act as if dumping pollution into the environment is a free ride. The tragedy of the commons is in full swing. 

 

Building a Better Frugal Human

If spending and CO2 emissions do not accurately reflect frugal behavior, what does? It all circles back to consumption.

Asking you, kind readers, to track your greenhouse gas emissions would be too much. Even the accountant in me would not stay true to that course for very long.

A better way to determine your level of frugality is to measure consumption and its equivalents. If you get a better price you are considered more frugal. An electric vehicle is still better for the environment than an internal combustion engine (ICE). If you reduce costs by utilizing technology you are still frugal. 

But you also must include all the free rides from gaming the system. Using points to fly around the world first-class is still something like $30,000 or more in consumption equivalents. 

This is different from taxes, by the way. Business owners can shift personal spending to the business ledger legally. It doesn’t mean you (or I) were frugal. Deducting my travel expenses to FinCon or other financial or tax conferences, while a deductible business expense, is really a personal expenditure to be added to the frugality thermometer since their is an element of personal pleasure. 

If you are not brutal in your assessment of consumption you will inevitably game the system to your favor, skewing the results and fooling yourself into believing you are really frugal when you are actually not. 

I have been known to brag about spending only about $20,000 per year to live. This is true. But. . . 

But that is not a true picture. What is the cost—and continuing costs—of maintaining 3,000 square feet of home? The pond? Hot tub? And what about the stuff from the business? Do I acknowledge business meals as also a part of personal consumption? I had better if I want a true picture. Thousands in annual credit card cash rewards used for books for my personal library are personal consumption, even if they are business related! I would buy and read them even if not in business because I enjoy my work.

I see bloggers all the time claim serious levels of frugality. It does not take a deep dive to determine this is smoke and mirrors. Their social media feeds are filled with travel tales that paint anything but frugality. Add the actual cost of the free airline tickets as real consumption to the expenditure column and the consumption level starts to look quite hedonistic. 

 

Why Does It Matter

Why do I or should you care about frugality? Does it really matter if we don’t count the freebies of life in our frugal measurements?

Actually it does if you consider your impact on the climate and the world at large. The impact on the environment is your concern as it does affect quality of life. If you dump pollutants into the air with reckless abandon you by default give permission to others to do the same. When the herd of lemmings run off the cliff in synchronized fashion it makes a splatter spot at the foot of the cliff noticeable to all. 

Keeping spending low by pushing the cost on somebody else is a bit rude, but acceptable in our modern world. The spending shift is sometimes by design of those doing the paying; those without any real frugality concerns. These gifts are nothing more than inducements to get you—or others in your sphere of influence—to take up the additional consumption.

Overcome spending, consumption, debt and financial problems. Rewards programs are designed to get you to spend more and keep you in debt. Break the cycle with these secret tips. #secret #tips #spending #consumption #rewards #debt #financialproblemsYou are better than that. Gaming the system is not a bad thing and no worse than gaming the Tax Code to reduce your tax liability (a really good thing). I am 100% for using credit card rewards and still accept the benefits of business ownership. If my meal or travel is paid by someone else it is still an acceptable behavior as long as I acknowledge I engaged a level of consumption.

But when it comes to consumption I have to admit I am less frugal than I pretend. As I grow this blog and other business projects I find I am on the road more often. I can call it whatever I want as long as I am honest in admitting my personal consumption is really personal consumption. It is hard to be truly frugal as a business owner of any size. Businesses spend to survive.

My personal spending is low. When I bow out of the business life a few business expenses will end up on the personal financial statement it was really on all along and some expenditures will cease. Travel and other consumption will stop or be severely curtailed. Then I may regain my badge of frugality. True frugality

Until then I need a serious reality check and so do you. You are consuming more than you admit and if you want to really be frugal that has to stop because the planet can’t take anymore. And shady personal accounting will not lower environmental pollutants anymore than shady accounting made Enron a profitable company.

 

 

More Wealth Building Resources

Personal Capital is an incredible tool to manage all your investments in one place. You can watch your net worth grow as you reach toward financial independence and beyond. Did I mention Personal Capital is free?

Side Hustle Selling tradelines yields a high return compared to time invested, as much as $1,000 per hour. The tradeline company I use is Tradeline Supply Company. Let Darren know you are from The Wealthy Accountant. Call 888-844-8910, email Darren@TradelineSupply.com or read my review.

Medi-Share is a low cost way to manage health care costs. As health insurance premiums continue to sky rocket, there is an alternative preserving the wealth of families all over America. Here is my review of Medi-Share and additional resources to bring health care under control in your household.

QuickBooks is a daily part of life in my office. Managing a business requires accurate books without wasting time. QuickBooks is an excellent tool for managing your business, rental properties, side hustle and personal finances.

cost segregation study can reduce taxes $100,000 for income property owners. Here is my review of how cost segregation studies work and how to get one yourself.

Worthy Financial offers a flat 5% on their investment. You can read my review here.