Posts Tagged ‘LLC’

Why You Should Rent to Your Business

One of the most powerful tax strategies a small business owner has is the S corporation. Under most circumstances when a small business has grown beyond $30,000 to $50,000 of annual profits it is time to consider organizing as an S corporation or LLC electing to be treated as an S corporation for tax purposes. 

The tax savings can be significant. A sole proprietorship is taxed at ordinary rates, plus self-employment tax. For 2019 the SE tax is 15.3% of the first $132,900 of partnership and/or sole proprietorship profits. (If you have wages from other sources this is included in the $132,900. Once you exceed that limit from all these sources combined the SE tax declines to 2.9%.) Partnerships pass profits to the owners where they pay the SE tax along with income tax. For partnerships, guaranteed payments to partners and profits are both subject to the SE tax. 

An S corporation does not pay income tax. Instead, all the profits are passed-through to the owners of the entity and taxed as ordinary income only; SE tax does not apply to profits passed to owners of an S corporation. Owners of an S corporation are required to be paid reasonable compensation. The remaining profits avoid payroll taxes (FICA and FUTA) and SE tax. 

Small business owners usually want some legal protections as well. The corporate or LLC structure is available to accomplish these goals. The LLC is more flexible with additional legal advantages than straight corporate entities.

Once organized, the LLC can then elect to take on the characteristics of other types of entities for tax purposes. The LLC does NOT have a tax form at the IRS. The LLC either defaults to a disregarded entity (sole proprietorship or partnership if more than one owner) or elects to be treated as a corporation. The LLC can elect S status if they inform the IRS they want to be treated as a corporation. These are two separate elections: electing to be treated as a corporation (Form 8832) and then electing to be treated as an S corporation (Form 2553).

I discussed these advantages in greater detail in the past.

 

Proper Allocation of Assets

If you had an attorney handle your LLC set-up and a qualified tax professional handle the structuring of assets inside and outside of the business you already know the S corporation rarely, if ever, has real estate inside it. 

The proper structure of a business where the owners also control the real estate is to organize the business LLC, treated as an S corporation, to hold the business only and a separate LLC, defaulting to a disregarded entity, for the real estate. The business LLC then pays rent to the LLC holding the real estate. 

Recently a reader on this blog asked why this is important:

Comment from Hobo Millionaire:

Keith, would you mind explaining the benefit of you renting to your business vs your business buying the building and paying a note over time. Is there a tax issue with the depreciation? You can depreciate/offset your taxes and the business can’t? A specific post on this setup, showing actual numbers, would be great.

We will discuss why you never want to own real estate inside an S corporation or an LLC treated as such. 

Most of the time it is a mild inconvenience only. Then there are instances where the legal and tax problems are significant and serious.

Every issue surrounding separating the business entity from the real estate holding entity are easily remedied. 

 

Legal Problems

There is no law requiring you to separate the business from the real estate. However, the LLC is a legal structure designed to protect the LLC owners. If the real estate and business are held within one LLC, the real estate is at risk if the business gets sued. Depending on the industry, this can be a serious issue or a low-risk probability.

Separating business from real estate also makes it easier to sell fractional ownership of each easier. If the real estate is held inside the business LLC it is impossible to sell the real estate (or business) without selling the same fraction of the other at the same time. 

Example: If you sell 10% of the business LLC and the real estate is held within that LLC, you have sold 10% of the business and real estate. 

Held separately you can sell all or a fraction of either the business or real estate in any fraction you want. You can also add another member (or have fewer members) to the real estate investment without also including the individual in the business side of the equation. 

Once real estate is inside an S corporation there is no easy solution to removing it. Tax issues of holding real estate with a business inside the same LLC can be significant. 

Removing real estate from an LLC is deemed a sale of the real estate for tax purposes. This means all the gains and recapture of depreciation are currently reported and taxed accordingly. Even if you are a 100% owner of the LLC and remove the real estate from the LLC to your name only (ownership really hasn’t changed, now has it?) you will be taxed on the gains! 

Therefore, if you have real estate inside an S corporation it might be better to keep it there even though it isn’t an ideal situation. You should consult a qualified attorney and/or tax professional with experience in this area of practice to avoid making a bad situation worse.

 

Serious Tax Issues

S corporations are not taxed except in a few situations. In each situation where an S corporation does pay tax the S corporation was a C corporation first for a period of time. (Electing S status at the time the corporation is organized means there was no time when the company functioned as a regular (C) corporation.) 

Holding real estate inside an S corporation with accumulated earning and profits (AE&P) from when it was a C corporation has tax consequences. 

S corporations are subject to tax on Excess Net Passive Income (ENPI) when :

  1. The S corporation’s passive investment income is more than 25% of gross receipts, and
  2. At the end of the year the S corporation has AE&P from when it was a regular corporation.

The ENPI tax rate is 35%! Lets look at an example of where an S corporation might pay the ENPI tax.

XYZ Corp elects to be an S corporation with AE&P. XYZ has $100,000 of gross receipts this year. Of the $100,000 of gross receipts, $40,000 is passive investment income (dividends, interest, rents, royalties and annuities). Directly connected expenses to the production of the passive investment income  is $10,000.

The net passive income is: $40,000 – $10,000 = $30,000

25% of gross receipts are: $100,000 x 25% = $25,000

The amount by which passive investment income exceeds 25% of gross receipts is $15,000 ($40,000 net passive income – $25,000 25% of gross receipts).

ENPI calculation: $15,000 / $40,000 x $30,000 = $11,250.

XYZ as an S corporation with AE&P pays a passive investment income tax of $3,938 ($11,250 x 35%)

 

Easy Tax Problems to Fix

The good news is that all deductions related to real estate ownership remain intact even when you separate the business entity from the real estate entity. You can still borrow against the building and deduct the interest on the real estate holding LLC tax return, as well as, depreciation and other expenses paid and related to the property. 

You can still have a triple-net lease between the real estate LLC and the business LLC. This means the business LLC can still pay and deduct insurance costs, repairs and maintenance, property taxes, utilities and so forth. Only the interest and depreciation goes with the real estate LLC. Rent is paid by the business LLC and deducted; the rent is claimed as income by the real estate LLC. 

There are times where the real estate LLC might show a large loss due to a cost segregation study or some other tax strategy. This means your business might be earning a large profit while the real estate LLC gets a special tax benefit that allows a massive deduction which causes that LLC to show a loss.

Passive activity rules tell us we are limited in some instances, especially when our income climbs above $100,000. This is easily solved with a simple election on the individual’s tax return. (The LLCs don’t make the election. It is taken on the personal tax return level.) Having a large loss on the real estate LLC if you are a high earner would be a problem if there were no outs. 

The good news, again, is you can group the activities. By grouping the real estate LLC and business LLC activities you are allowed all the deductions as if they were one entity on the personal tax return. This resolved the passive activity rule issues.

 

Final Notes

There are no drawbacks to separating the real estate and business into separate LLCs that I’m aware of. Every attorney I’ve ever spoken with agrees with me on this. Real estate should never be held inside an S corporation or LLC treated as such. Any tax negatives are easily resolved with elections.

The issues involved with combining real estate and a business under a single S corporation are many. Legally you limit your options and put assets unnecessarily at risk. The tax problems are hard or impossible to resolve without inflicting additional tax pain.

Structured properly your business and assets can enjoy legal protections while basking in the light of lower taxes.

 

 

More Wealth Building Resources

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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. 

Should We Run Our Marriage Like a Business?

#marriage #shouldimarry #businessplanning #personalfinance #love #interpersonalrelationshipsTwo and a half years ago when I started this blog I had a vision for what it would become. The original primary goal was to encourage readers to slide a chair around behind my desk and view the world from my side of the desk. I’ve always found the world interesting from my perch. Things I would never know or experience were front and center due to my position in the world. It all fascinated me.

Before long I expanded my vision. I wanted this blog to be a sort of personal journal to my children. When I’m gone (and hopefully while I’m still here) my girls can reference the thoughts of their dad. Some things are modified to protect the guilty (as I like to say), but the flavor is all there. Who and what I am is on these pages. This is the most real me I’ve ever presented. It took decades of writing, learning and growing to reach the point where I was comfortable exposing myself to the world. (Please disregard the indecent exposure.)

Tax professionals don’t always see the world as I do. My practice is small so I serve a discreet clientele. I actually sit with my clients periodically when things get real. I know about marriages on the rocks before the world at large. I consult with clients with a medical death sentence before even their family knows. Sometimes I even know before their spouse does. While it is interesting, it is never easy advising in these situations. How do you tell a client their child needs to be institutionalized to protect parent and child? How do you tell a wife she should or shouldn’t divorce her husband? How do you explain to a client she must tell her husband about the massive gambling losses she suffered and that they are bankrupt?

If I refuse to help it only gets worse. The client came to me and closed the door before she sat down because it is serious. Problems raising the kids and marriage issues are common. Financial and tax issues are front and center because finances (and sometimes taxes) are affected by their situation and any response they consider. I’m always uncomfortable advising clients on how to deal with their children; I’m nervous when advising a woman she should divorce her husband and report the abuse to the police. It breaks my heart when the patrol car is out front of the office as I help a client deal with a criminal issue.

When my world was confined mostly to the local market is one thing. Now this blog has spread my reach to the entire world and certainly the entire U.S. One of these difficult questions has come as a call from the dark and I’m scared. I’m scared no matter what I do people will be hurt. Even ignoring the echo from the abyss has consequences.

Voice From Over the Transom

These types of questions cropped up in consulting sessions over the last few years. I’ve consulted (and/or prepared taxes for) people on every continent, except Antarctica. (Anyone at the Amundsen-Scott South Pole Station need to talk to a friendly accountant to break up the monotony of the endless night? I’ll donate a free hour just for the opportunity to say I served every continent on the planet.)  The level of personal questions generally is lower than from local clients because blog clients on the other side of the landmass are at a different place (metaphorically speaking). Until now.

About a dozen emails grace my inbox per day during the summer from readers (more around and during tax season). Some are congratulatory, showing appreciation and require little or no response. Some I can’t answer easily or right away so they linger in my inbox until I decide how to respond or it just gets too old and I let it pass. (I hate it when I do that and I do it too often.)

Then there are the emails I must answer and answer now. Sometimes readers contact me (clients, too) because it is a desperate situation. No response is a response and a bad one. The email I’m about to share approaches this level.

The email literally had a headline. I used it as the title of this post. I wanted to tweak it, but decided against it. Here is the email:

Dear Wealthy Accountant,
I found out about you listening to the ChooseFI series on YouTube. I had a question about my situation and was wondering if you had any advice. My partner and I are not married, but we live together, have a 5 year old and are expecting our second child. My SO (significant other) is self-employed as an artist and averages over 100k/annually and pays considerable taxes for it. My question is what is our best tactic for taxation, would we be better off getting married (even with me going back to school in the future) or should we keep our current situation and my SO “hire” me as an employee to help him with some administrative chores. I plan on staying home with our baby-on-the-way for 3-4 years. Thoughts?

At first I was going to send it to my assistant to recommend a consulting session where I get paid. The answers this woman was asking required more than a curt response and I felt there were serious personal risks to her if she got bad advice. Then I felt bad asking her for payment for such a personal issue.

I received her email in the early evening and decided to sleep on it before responding. The next morning I emailed back I wanted to write a blog post on her email, name excluded. She emailed agreement.

The reason for a full-blown post is because her question has similarities to many others I get. At first glance it seems she is asking tax questions. But the real question is revealed in her headline used as the title of this post. Her real question is: Should I marry the father of my children?

This is where I must weigh my words carefully. A living, breathing human being will listen to my words and take them seriously. This is the life of a man and woman. Two children are involved! No matter what I do will affect her decision.

I have no choice. The voice from the dark has become a plea. I cannot turn my back. I am honor and duty-bound to respond. There will be a price to an unnamed accountant as well.

The Easy Part

There is an easy and hard part to the request. I’ll do the easy part first because, well, it’s easier and this post is making me emotional. Besides, I tend to talk taxes when I’m avoiding the real issue.

The readers SO is an artist earning over $100,000 annually. I read that to mean somewhere between $100,000 and $150,000.

Our kind reader asks about taxes, but prefaces that with getting married. We’ll deal with marriage later.

According to the email, our reader’s SO is self-employed. YIKES! Of course he’s getting killed in taxes. As a sole proprietor, your SO is paying more tax than in any other part of the tax code. I can’t even cheat and trick my computer into getting his tax bill higher. Here is what I want you to do. (I’m talking to my email reader now. Please grab a chair, slide it behind my desk and observe.)

Without seeing the actual tax return, the probability is your SO should organize as an LLC and elect to be treated as an S corp. (Call my office if you want me to help you set this up.) This blog’s birth came about when I gave Mr. Money Mustache the same advice and I wrote about it here.

You never mentioned which state you come from. Each state has its own department handling LLCs and incorporations. There are fees involved. Some states (Texas, California, Delaware come to mind) have very high fees. Here is a little trick to save money. You don’t have to organize your LLC in your home state or where you live!

If the home state has reasonable fees you can have an attorney do the paperwork or set it up yourself. You act as your own registered agent. (LLCs and corporations need a registered agent to manage their filings. You must live in the state to manage the filings such as annual reports.)

If you reside in one of the high fee states, I have a solution. Wisconsin, where your favorite accountant resides, isn’t a high fee state! Since my practice is in Wisconsin I can act as your registered agent. After the initial organization setup costs, Wisconsin charges $25 annually, plus a $1 processing fee. If you use other online services to setup your LLC they automatically act as your registered agent. It’s where they make most of their money. They also charge $200 and up annually. Most are now over $300 per year, plus state fees. I’m such a nice man because my office charges $109 (at this time) and that includes the $26 Wisconsin wants.

There are two benefits if this appeals to you. First, you do NOT have to file a Wisconsin tax return; you’re not doing business here (unless you are from Wisconsin and I don’t know it). Second, a registered agent is where legal documents get delivered. If your SO gets sued, process service takes place at my office if the attorney follows the rules. This is important. If you are not available and the process server can’t deliver paperwork it is sent to the state. You could have a court date and miss it because you were unaware. You would lose by default and could be liable for the damages awarded in the suit. As registered agent, my office is open all normal business hours. My heart doesn’t flutter when the sheriff delivers paperwork, either. I only ask, “Who’s this one for?” Then I get my team on the horn and speed-dial you until we make contact. We also email and use other means to reach you. There are procedures to make sure the court is aware if you haven’t been made alerted to the suit.

You Are an Entity

Either my office or a local accountant can help you elect to treat your LLC as an S corp. This is important. As an S corp your SO gets a reasonable wage and the rest flows to his personal return without FICA/self-employment tax. This is a meaningful tax savings.

If he is not already doing so (and qualifies), an office in the home deduction is possible. Under new tax rules this can be more valuable than ever before with the standard deduction higher now. Your facts and circumstances will dictate.

Most important of all, he can super charge his retirement savings. The options are endless. This blog (and others) discuss a variety of retirement plan choices. If you tell me what your goals are and more details on your situation, I’ll tell you what you want. Once again, facts and circumstances prevail. And don’t believe what most blogs publish. You can pack away over $300,000 per year in a deductible retirement account in certain cases (it depends on your age (the older you are the more you can deduct) and profit level). You tell me how much you want socked away in a tax sheltered retirement plan and I’ll share the vehicle you’ll drive to the Vanguard index fund. Okay?

The New Employee

You can be an employee of your SO or the LLC he sets up. He can provide you health care benefits (usually) and deduct the premiums. However, if he is a sole proprietor, his premiums are deductible (usually) as an adjustment to income on his personal return. This means he still pays SE tax on the premiums. We used to use Section 105 to work around this issue for married people. I don’t see 105s much anymore as there are so many easier alternative options.

An LLC electing as an S corp avoids this issue, as the entity claims the deduction. (Tax professionals reading this: I’m keeping this simple for my kind reader’s sake. My statement is 98.27845363% accurate. We don’t have time in this post to discuss why my statement isn’t 100% true.)  If handled correctly, the health insurance premiums are reflected on the W-2. Technically there is a FICA tax issue, but mitigated by adjusting payroll to reflect a lower reasonable wage based on a lower level of profits due to the premium deduction by the entity.

This gets complicated; I understand. I’m glossing this over and tax pros are rolling their eyes because I’m telling a half truth. But from your viewpoint, it will look pretty much like I outline it. And my goal is to give non-tax professionals a reasonable way to view the options they can understand without years of tax experience.

In short, you can (and if you provide services for your SO’s business) and should be a W-2 employee. Even a token wage of say $15,000 allows you health benefits paid for and deductible by the business, plus the opportunity to start building your retirement account. Whether he remains a sole prop or decides to go the LLC route, there is a benefit to you and your SO (most likely) for doing so. Marriage also plays a role so we will address that next.

So, Should We Run Our Marriage Like a Business?

In short: NO!!!

What you and your SO have is not a business; you have an interpersonal relationship! You have a business relationship with a prostitute, not a loving SO. Can I be more blunt?

Mrs. Accountant and I have a nurturing 30+ year marriage. Mrs. A works part-time for my business. She is an employee of the entity! Yes. But my relationship with Mrs. A is not a business relationship!

Maybe I’m reading your email wrong. Tax issues do play a part in the decision-making process of living together, marriage and having children. Reading between the lines, I think your income is really low. As a result, there is probably a tax advantage to getting married.

But you don’t get married to save on taxes!

Even going back to school will probably be a better tax deal if you are married, not that that should be the reason to marry.

Please, come with me. (I’m putting my arm around your shoulder and guiding you to a chair where we can talk face-to-face without a desk between us. I lean in close and talk in a low, calm voice as a father does.) I have two young adult daughters. As their dad I tell them to think clearly when planning a life with someone. Living together is as serious a matter as marriage.

You have a child together and another on the way. (Congratulations!) You have a beautiful and awesome responsibility. If you are in love and have talked adequately about a life together as husband and wife, and worked out any issues and still find you want a life together, then have that life. It ends soon enough. Jordan Peterson says the meaning of life is to end needless suffering. Loneliness is a form of suffering. You have it in your grasp to end that. Your ships met in the night and both of you decided to sail together. With two children you already know the right thing to do.

Marriage has massive risks, especially for the male. But you already have children! And there are incredible benefits for both parties, as well. If you are ready, do what your heart tells you. Your mind should have ironed out all the issues by talking honestly together. If you are happy as you are, then don’t change anything. If marriage is both your callings, then do that.

Please, for the love of God, don’t get married (or refrain from getting married) due to taxes.

If you need anything else, you have my email. My door is always open to discuss this with all the personal details.

 

 

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.

A cost segregation study can save $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. 

 

Blogging and Taxes with the New Tax Bill

Bloggers often miss many opportunities when organizing their taxes. Writing on a regular schedule occupies a large part of the creative artist’s time. Taxes frequently become an afterthought.

Over the last two year several bloggers have approached me to review their tax situation. Some ended up as clients; other I only consulted.

A pattern has emerged. There are certain elements bloggers tend to forget. Non-cash deductions are almost always missed. Bloggers also frequently use the wrong entity structure to maximize benefits.

The Tax Cut and Jobs Act signed into law late last year has added numerous new elements to consider when planning your taxes. Bloggers need to consider these additional options or risk overpaying their taxes.

This is a good time as we head into tax season to review the tax rules affecting bloggers. We will cover the more common issues and expand into finding the best vehicle (entity) to use for your blog with a discussion on how the new tax rules affect your decision-making process as you operate your blog.

Income

Taxable income comes from several directions when running a blog. Google and similar advertising platforms provide a steady stream of income.

Amazon is a nice side niche getting worse every day as they reduce the fees paid on virtually every category.

Some bloggers have a specific advertiser lock in a location on their blog. All this income is reportable and subject to tax.

Serious money is earned from books and programs. Most bloggers understand these need to be reported on their return.

Other affiliate programs can turn a nice blog side gig into serious money. Good recordkeeping should assure you don’t miss any reportable income saving you angst should an audit letter arrive.

Before we leave income I want to point out one income source I bet everyone in the blogosphere is missing: awards swag. As a recent winner of the Plutus Awards for Best New Personal Finance Blog of 2017, I received some swag. There was some pretty cool stuff in there. The IRS also makes it very clear this is reportable income. It’s not my job to police you. My job is to inform. (Yeah, I know. Party pooper!)

Deductions

Bloggers have more business expenses than they realize. Even blogger clients think they have virtually no expenses! I have my hands full educating them. I also stalk my blogger clients as they tend to write what they are doing in their blogging business which gives me a good idea of what expenses will show up in their financials. When the financials lack the expected deductions I inform my client of my stalking tendencies and chisel the deductions out of them. Sometimes their blog post IS the deduction substantiation!

Bloggers who have a designated area in the home used on a regular and exclusive basis for their blog have several deductions coming their way. A proration of all home expenses are allowed as a deduction, plus all expenses directly related to the work space (repairs and maintenance, for example). Depreciation is also allowed.

If recordkeeping for a small office in the home is too much work you can always use the safe harbor of $5 per square foot of office space. The maximum home office deduction allowed with the safe harbor is $1,500 per year. Property taxes and mortgage interest are then fully reportable on Schedule A should you itemize.

There is a small issue between actual expense and the safe harbor of the home office. Sometimes the blog might not be profitable or only has a small profit. The home office deduction cannot cause a loss on Schedule C (for sole proprietors). Unused home office deductions are carried to the next year when actual expenses are used whereas the safe harbor deductions are permanently lost if you are unable to use them currently.

Office supplies, promotional expenses, postage and blog maintenance fees are all deductible. Most out-of-pocket blog related expenses are written off in the year paid (assuming most bloggers are cash basis taxpayers).

Travel is common in the industry. I find most bloggers are unsure of what travel they can deduct so they don’t take any deductions at all except for conferences they attend. More is deductible than you might expect.

If you always wanted to see Australia or retired and travel the world while writing a blog to fill time the expense is NOT deductible! A pure pleasure trip down under is not business related. But there might be several opportunities to deduct some expenses.

A blogger in this genre wanted to know if he could deduct some travel expenses where personal was intermixed. He was in the Philippines and was invited by another blogger to visit him is Taiwan (I think). He made the trip so he could discuss some business plans for his blog. I argue the air flight and all related expenses to travel from the Philippines to Taiwan are deductible, including, hotel and the meals and incidentals per diem (more on the per diem later). If he flew back to the Philippines or home I would argue this is deductible. If he flew on to a personal destination the last leg of travel might not be allowed. However, as long as the business portion of the travel is still in effect it should be an allowed deduction.

There are several non-cash deductions related to travel. Business miles are deductible. You can also deduct a per diem for meals and incidentals (M&IE) for each day on the road (technically, every overnight outside the metropolitan area of your residence). Lodging expenses also have a per diem for employees, but not owners or employee-owners; owners must use actual lodging expenses.

There are two ways to calculate your M&IE deduction: the high-low method or based on the rate for each city you conducted business in (involving overnight travel) and actual expense. The high-low method is easier. You get a flat M&IE rate of $57 for most areas within the continental U.S. (CONUS) and $68 for a few high cost areas.

DOT workers have a special rate of $63 within CONUS and $68 outside CONUS (OCONUS).

There are rates for OCUNUS as well for non-DOT workers.

You are allowed to switch methods during the year, BUT you must use the same method within a single business trip.

Meals and incidental expenses are 50% deductible for businesses; 80% for DOT workers (ie. truckers).

There is a modest amount of recordkeeping involved, but worth the effort. The per diems add up fast.

If your spouse travels with you and performs business related activities they may also qualify for a deduction of their travel expenses, including the M&IE per diem.

Business or Hobby

This question has taken on more meaning in 2018. For 2017 hobby expenses are still reported on Schedule A, subject to 2% (the first 2% of AGI of deductions in this category (safe deposit box, tax preparations fees, hobby expenses et cetera) reduce the actual deduction). In 2018 the “subject to 2%” part of Schedule A disappears. This means hobby expenses are never deductible in 2018 and after until they either change the Tax Code or the current provisions expire at the end of 2025.

I think most bloggers are a business even if they think they aren’t. Not making a profit doesn’t mean you are a hobby! If you have a profit motive and conduct your affairs in such a manner you are almost certainly a business.

If you make a profit more than 2 out of a five year period the IRS automatically assumes you are a business and not a hobby.

Business Structure and Entities

When you hang a shingle saying you are in business you are in business. You default to a sole proprietorship or partnership if there are two or more owners.

It’s a good idea to get some legal liability protection with an entity. Organizing as an LLC is the most common way to conduct business. You can also organize as a corporation and elect to be treated as an S corporation.

To kill the pain of tax planning.

LLCs have a huge advantage; they can take on the flavor of any tax treatment available. An LLC can be a disregarded entity and reports their taxes as a sole proprietor (Schedule A of the individual tax return) or a partnership if there are two or more owners.

Organizing your business as an LLC means you can elect to be treated as a corporation and therefore, can elect to be treated as an S corporation (a pass-through entity).

The biggest advantage an LLC has is the ability to change flavors (how they are taxed) without reorganizing the entity. You can start as a disregard entity taxed as a sole proprietor and later elect to be treated as an S corporation. The first election can be made at any time without question by the IRS. Any subsequent change must be after five or more years since the last election changing how the entity is taxed. Example: An LLC is treated as a disregarded entity starting in 2015. The business grew so the owner elected to be treated as an S corporation in 2017. Since the first election is automatic at any time the election is allowed. The LLC cannot again change how it is taxed until tax year 2023, the five-year required waiting period.

Which Entity is Best

The sole proprietorship (or disregarded entity) is the easiest to account for. The business income and expenses all are reported on the personal tax return on Schedule C. The one drawback of the sole proprietorship is the self-employment tax.

Most clients don’t make a lot of noise when I show them their income tax, but they squeal like a stuck pig when I show them the SE tax added on top. The SE tax is 15.3% on top of income taxes. There are some limits to the SE tax we will not cover here.

Once you have any significant blog income you will want to be an S corporation or LLC treated as such. As your income rises the taxes assessed a sole proprietor become increasingly painful.

S corporations (we will discuss regular corporations (C corps) in the next section on recent tax changes) are pass-through entities. Profits flow to the personal tax return. These profits are assessed income tax only, no SE tax.

S corporations are required to pay owners reasonable compensation. This is a wide road to travel and offers plenty of opportunities with serious pitfalls for the overaggressive. The owner’s wages are subject to FICA taxes (the twin sister of SE taxes). The remaining profits are taxed for income only.

Decision Tree Using Recent Tax Law Changes

For decades the entity decision was fairly straight forward. Once profits hit $30,000 – $50,000 it was time to think about an S corporation. Some businesses require higher profits before considering an S corporation, but anything under $30,000 is hard to justify considering the additional payroll accounting costs for owners and additional tax return preparation fees for the S corporation tax return.

The Tax Cut and Jobs Act changed all that. Regular corporations are now a consideration. Tax rates have dropped significantly for C corporations, except for those with profits less than $50,000.

C corporations always had one serious flaw small businesses couldn’t overlook: the double taxation of dividends. Now that the corporate tax rate is a flat 21% and all other business owners face a tax rate as high as 29.6% after considering the new 20% business income deduction, regular corporations are back in play.

For the first time in my career I have to seriously consider the regular corporation as an option. The choices are no longer so simple.

Also, reasonable compensation has more than one purpose. Most business owners want to keep their wage as low as possible to minimize FICA taxes. Now, S corporation owners may need to reconsider a HIGHER wage and FICA taxes to meet the cap on the business income deduction ($315,000 for joint returns and $157,500 for all others). An S corporation with one owner filing jointly on her personal return and $450,000 in profits will not qualify for the business income deduction. If the owner takes reasonable compensation of say $150,000, the S corporation will only have a $300,000 profit and the owner WILL qualify for the deduction if she files a joint return.

(Note: Don’t be confused about the reasonable compensation and guaranteed payments to partners issues. Wages can bring down the income and qualify the owner for the deduction for the cap. Reasonable compensation and guaranteed payments to partners do NOT count when using the formula for business owners above the cap. The formula above the cap is 50% of wages excluding those we mentioned OR 25% of wages excluding those we mentioned, plus 2.5% of the value of qualified property at purchase, generally unadjusted. (Think real estate.))

Time is on Your Side

Sweat is running down your forehead by now, I’m sure. Not to worry.

Review your books and make sure you didn’t miss any deductions for 2017. Things haven’t changed much this year. However, bonus depreciation on assets with a class life of 20 years or less is 100% if placed is service on or after September 27, 2017. For most businesses opting out of bonus depreciation this year is a bad idea. A bigger deduction this year coupled with a bigger profit next year when 20% of profits are a deduction is a powerful planning point.

We have plenty of time to review your situation before deciding which entity structure is right for you. Your favorite accountant will be busy this summer.

My office will review all business clients after tax season to determine if changes are appropriate.

For you, kind bloggers and readers, you are welcome to contact my office to review your situation. Most reviews will be after tax season. We will have time to facilitate any recommended changes to take full advantage of the new tax law. Don’t be surprised if you missed several deductions. Bloggers do that a lot.

I may ask one favor if you do contact my office. I might ask you to give me a plug on your blog because I’m a bit of a traffic whore. All you’ll be asked to say in an Irish accent is:

“Oh, that Wealthy Accountant fella is one swell guy.”

Now that wouldn’t hurt too much, would it?

Expand Your Business and Increase Margins with Outsourcing

outsourcingStarting a business is an act of love and courage. Enjoying a task soon becomes a business. You might start working out of the home or buy a small store front. The previous hobby now commands more of your precious time. A business is about more than making money. Small business owners love the work they do and get paid to do it. Awesome! Then reality sets in.

When I was a sophomore in high school I fell in love with the stock market crash of 1929. The teacher said economists don’t know what really caused the crash. The Smoot-Hawley Tariff was probably the trigger but many other events also played a role. I could not let it go. Every book in the school and public library in my small town was in my paw, devoured for any tidbit of information on why things went so wrong in 1929. I never found a definitive answer, but I did learn a lot about economics.

And the stock market. From that point on I wanted to be a stockbroker. When I was in college I took a business class, accounting, and macro and micro economics. Though I never earned a degree I learned a lot that has helped me in my career. It gave me a start on where and what to study to get good at finance.

Years later I saw an H&R Block tax course and took it. I was already preparing returns on the side and was ready to make the leap into a full-time seasonal business. I enjoyed preparing taxes and research. Tax Prep & Services was born. Later I would incorporate as Tax Prep & Accounting Services (TPAS). The name was intentionally generic. Schroder’s Tax Service or some other machination with my name was out. The day I started my business I already had an exit plan. There was a chance I would take that early retirement thing folks talk so much about, cutting short a practice I so enjoyed. The generic name made it easier to merge the company with another. In the back of my mind I was think General Motors, General Mills, and General Electric. I actually toyed with General Tax, but decided that would send the wrong message.

Growth

The business started as a tax practice, evolved into an accounting practice, and now is evolving into a personal finance communications company. By 2005 my office prepared north of 2,000 tax returns annually. It drove me insane! I spent my entire day managing people and the company. I prepared fewer tax returns than anyone else in the office, save the front desk staff. What I loved doing I was no longer doing! I had people for that. I was no longer happy.

That is when I decided to transform the company into an accounting firm. I added payroll and bookkeeping to the mix of services offered. We had few than 10 clients in this area and increased to over 100 in six months. At the same time I reduced head count in the preparation department. Unprofitable tax returns were gone and clients who required too much of my time was out. There is only one me and I have limited hours each day.

Fast forward to the last few years. TPAS was down to a comfortable size. I wanted to expand because I have a sickness. This time I had to be smarter. For several years I have had an online portal where you can prepare your own tax return using commercial grade tax software, the same software used in my office. This, I felt, was a vast improvement from other online programs. The issue was marketing. I could not figure out how to get it done.

Then it dawned on me I could offer the program to personal finance bloggers. If I shared revenue it would be a great way to promote that line of my business. The plan was in place until I met my first personal finance blogger, Pete, from Mr. Money Mustache. In less than thirty seconds my plan was in the ash heap. He was not interested in the DIY tax program, but wanted me to do his taxes. He was gracious, giving my brainchild a favorable mention.

img_20161113_163339Too Much Growth

There was no doubt such a visible client would bring a deluge of new clients, more clients than a small office can handle. I was happy with 700 clients and a handful of employees. I did not have to work much as my team did most of the work and I could prepare taxes for a few months of the year to my heart’s content. That is history now.

Giving up my practice was a consideration. If it was only about money it would have been an easy call. TPAS, presented to potential buyers with the new stream of clients, was worth a cool seven figures. Not bad for a country boy.  But it isn’t “only” about money. If it were I would never have met Pete because I would have cashed a check a long time ago.

The problem persisted. Readers of MMM wanted me to write a blog. I do write on some shitty blogger blogs and content farms, but it had been a few years since I focused my writing so heavy on finance. The Wealthy Accountant url was already owned by TPAS for 18 months. Now was the time for it to see the light of day. And still more people want to be clients.

I learned to say no a lot this year. A lot of people I could help were left to suffer because there was no room at the inn.

Automate Your Personal Life

Simplifying life with automation is easier than ever. Most spending can go on a credit card where they pay you a bit back and the credit card payment can also be on autopilot. A few minutes setting up the automation frees many hours over the years and saves on postage costs.

Amazon and other online retailers allow you to automate regular purchases. Coffee in the office never runs out; Amazon sends a new package on a regular basis so I don’t have to waste time reordering and Amazon gives me an additional discount for doing so.

Automating the Business

I had a choice: leave a lot of clients on the table (I have been) or find a way to manage the influx of new clients. I chose the latter. The stream of clients has slowed over the summer, but I am under no illusion tax season will be a quite time for me to relax.

This summer I have worked harder than any time of my life. As long as I can see the light at the end of the tunnel I was willing to do it. Bringing in thousands of new tax clients was possible if I engaged some of the grey matter between the ears. Enter: outsourcing.

Finding enough qualified employees is hard. Training employees on a different way to run an accounting office did not work. Time to get serious. Over the summer I worked on several outsourcing projects. I found several businesses I could train to handle my work flow. My employee count is actually lower (!) because a few employees left for greener pastures. I think they will regret not applying themselves later. The workload will drop, revenue will increase, and payroll for the staff I have will rise significantly.

agenda-outsourcingI inked the first of several outsourcing agreements this last week. All payroll clients in the office will be outsourced to this firm. I worked hard training them on my program. The best part is I got paid to turn my payroll over. The next best part is the clients are still working with my office and me to get the best tax deals. I now have more time to work with more clients and serve them better.

The best use of my time is to work with each client to get them setup and then turn the work over. Business management time is limited so outsourcing is a massive advantage. Most bookkeeping will be outsourced by the end of the year to local firms, once again trained by me. By working with a group of twenty payroll clerks and bookkeepers I leverage my time. I accomplish more in less time. Everybody wins. Profitability is up! Stress is down!!

Even some tax returns will be outsourced to firms I can personally train. This will be the hard part. I refuse to use outsourcing outside the country. My clients would have to give permission and I am uncomfortable sending personal information to a non-US source.

There are two massive benefits to me as a business owner. One, I get paid a very nice amount of money to technically sell this portion of my business. In reality I still have the clients. New payroll clients will also generate revenue for TPAS. Since I don’t have economies of scale in payroll, the sale/outsourcing of the payroll accounts brought in over 20 years of profits in that department all in one day and the partner company can do it cheaper, faster, and better. Two, I work less and get paid more. When a new client comes in, we handle tax setups and consultations. Then the payroll service pays me to get the payroll portion of the account. The client is served better with a dedicated staff and I keep my sanity

The same strategies apply to the bookkeeping and tax preparation end of the business. The best news is I stay in business doing what I love, get to talk with clients all day long about saving them money, and can serve thousands of people more than my small office could ever do on its own.

Letting Go

The hardest part for a small business owner is letting go of the reins. The business thrived due to hard work and an attention to detail. Business owners have a hard time trusting someone else will step in and do the job right. That is the number one reason a small business stays small. Your favorite accountant is guilty as changed. Nobody can do the job as good as me. Well, now I will leave thousands of clients in the dirt if I don’t step up my game. I found a solution which requires I let go. I trained these people. If I am so darn good then they should thrive too. What I have found is they do a better job and faster. When you get spread too thin it hurts quality. Time for the Wealthy Accountant to man up.

Instead of managing a dozen employees, I will manage workflow. A regular review of work performed by other firms will ensure quality. The client will be served better than ever! And that is why they emailed me for help.

It took a while to find an analogy to help me let go. Then I had it. Warren Buffett runs one of the largest companies on the planet with 24 people at the corporate office, plus himself. Berkshire Hathaway has over 300,000 additional employees. To me this means Buffett finds good people to run his companies and goes out and finds new businesses to buy. I am no Warren Buffett. Still, I can channel his talent and apply it. And so I am.

Even Non-clients Benefit

Never satisfied with mediocre, I am expanding these services to you, my dear readers, even if you are not a TPAS client. The final plans are in place. Once I am certain the outsourcing firm can handle the payroll properly with the additional influx of clients I will share the links in a future post. (I will also update this post to include the links.) All small business owners reading about the advantages of an LLC treated as an S-corp will now be able to hire the same outsourcing firms I use. Some of these firms are huge. I trained the people inside these firms necessary to get the job done right and maximize tax advantages.

Bookkeeping will be a bit slower setting up and you are already able to prepare your taxes online with TPAS. The number of clients served in 2017 should increase somewhere around 500%. By focusing my time on training outsourcing companies to get the work done rather than individual employees, I can focus on helping new clients get on the right track and set the process in motion so their personal finance plan is automatic.

Few accounting firms provide such a level of automation to their clients. My unique situation gave me an either/or choice. I choose or. (As in, I can either sell the business and retire (the real retire), or I can step up my game.)

What I am building is usable by other tax offices, too. The outsourcing strategies and resources I am developing are something anyone can use. Before the end of the year I will provide links to the contact person for payroll outsourcing. This person has a fully developed team well aware of the strategies I use with my clients to maximize tax savings. When it comes to LLCs treated as S-corps, I will tell you what you want to get paid to optimize taxes. My team of partner companies will understand what I am doing and execute with laser precision.

I am so excited! A summer of hard work is coming together. My expanded team allows me to help a massive number of people and businesses. One small tax office building, TPAS, will provide the tax/accounting/payroll services of a massive accounting firm at prices lower than any major firm charges. Bigger, better, faster.

Outsourcing is about focusing on tasks. The jack-of-all-trades never provides premium work. I tried it. It doesn’t work. I am a tax office. That is how I started; it is how I will end. All the other related services will still be available through TPAS. My outsourcing partners will keep work flowing smoothly as I work with larger and larger groups of people.

The results are already bearing fruit. In the last few weeks as payroll is slowly moving to the outsourcing company I have used the extra time to add 32 new clients. This would never have been possible without the new automated system. I have an excited group of businesses eager to serve the people I bring in. Keep your eyes open for more updates.

If you contacted me in the past, I am working through the list. When things came in too fast I had to skip large chunks of emails just to stay somewhat current. I will keep working back until I get to the people who emailed me months ago or even during tax season. Soon I will have staff helping me manage my email flow, sometimes over 300 per day. It takes a good plan to handle that volume. I finally have the first pieces in place to get the job done.

Business is like that. Your plans can change often and rapidly. Where you start is not where you end. My tax office is different than anything I imagined even a few short years ago. Business is exciting and addicting. The world changes and I am part of that change. I am inspired and humbled all at the same time. The accounting/tax industry needs radical changes to serve our communities. If I end up a leader in that transformation it will be the greatest thrill of my life. The accounting industry is uniquely positioned to transform our society from one that focuses on spending and long working hours into a society freed from the mundane tasks, freed to reach for the stars and dream dreams never dreamed before.

Why I Like Credit Card Debt in a Small S Corporation

downloadThe tax advantages of organizing as an S corporation or an LLC electing to be treated as an S corporation are significant. Self-employment taxes disappear with the corporate structure and with an S corporation there is no income tax either as all profit flows to the owners. As with all good things, there are pitfalls. The S corporation is no different.

Most small businesses in my office use the S corporation structure. There are a few rules that need to be followed, like the owners paying themselves a reasonable wage. The wage issue is easy to handle; I require S corporation clients to do their payroll in my office. Problem solved.

The other major issue with S corporations is basis. Before your eyes roll back in your head, hear me out. Basis is one of those animals many accountants screw up on or fail to track accurately. You need to have a fundamental understanding of basis if you are business owner. If your accountant messes it up the IRS still sends you the bill, not the accountant.

What is Basis?

Before we manage basis we need to know what it is. In this instance we are not talking about basis in a single asset. Our discussion focuses on your basis in your business. Basis in this instance is:

Initial investment

+Additional investments

+ Profits

– Distributions

– Losses.

It gets a bit more complicated, but we are a family blog so we will not talk dirty. There are two types of basis you need to understand in an S corporation: stock basis and debt basis.

Stock basis in its most basic form is the formula above. Debt basis comes from money you personally lend to the S corporation; loans by the S corporation guaranteed by an owner does not increase debt basis. Partnerships gain debt basis when the business takes out a loan and the owner is liable for the debt. It is common for businesses to get a bank loan where the bank demands a personal guarantee. With partnerships and sole proprietorships there are no issues doing this.

Example: Let’s say you are one of two partners in a partnership. Each partner owns 50% of the business with a stock basis of $10,000 for each partner. The partnership has an opportunity to promote the company with lots of potential, but it is expensive. By growing your firm the partnership will incur a loss of $25,000 in year one. To cover the loss the partnership gets a bank loan for $5,000 and each partner guarantees the loan.

Each partner will have a $12,500 loss to report on their personal return. Because each partner is liable for their portion of the debt, they can use the complete loss against other income on their personal return. If they don’t have other income to reduce they may have a net operating loss (NOL) which can be carried back two years and forward twenty years to offset other income.

Problems with S Corporations

S corporations suffer from the way debt basis is handled. The above example is simplified. Sole proprietors are indistinguishable from the owner and therefore there is technically no debt basis; debt acquired by the business is a debt of the owner. That is not always the case with S corporations or partnerships.

Non-dividend distributions from an S corporation are made from equity basis without regard to debt basis. At first glance it might be hard to see the problem. Time for an example:

The two partners above instead decide to organize as an S corporation (or are an LLC electing to be treated as an S corporation). The first year is the same as the above example for the S corporation with the exception of the debt being lent personally from the owners equally. The next year the company breaks even. (I’m keeping this simple for illustration.) Since the owners have personal bills they decide they will have the company borrow an extra $50,000 and distribute $25,000 to each owner. The owners guarantee the loan.

Each owner has no debt basis or stock basis! Distributions are made from equity basis only in an S corporation. After the company suffered a loss the prior year sending each owner’s equity basis to zero, all distributions are now taxed as a long-term capital gain (assuming they owned the company longer than one year)! In effect, you are taxed on borrowed money!

There are other issues (suspended losses, et cetera) we will not discuss today. My point is small business owners can save a lot of taxes with an S corporation, but handled incorrectly can create some nasty tax problems. Let me say it this way: Never, ever, ever have your S corporation borrow money from anyone other than you. It solves all the problems.

img_20160928_075441The Right Way to Fund an S Corporation

Okay, not all problems. Businesses need working capital or loans for capital equipment or improvements. Few companies, especially in the early year, are self funding. So how does an S corporation beat the problems of distributions and equity basis?

Simple. Well, simple in theory, difficult in practice. The easiest way around the basis issue in an S corporation is to borrow the money from the bank yourself and then turn around and borrow the S corporation the money. Now you have debt basis. After profits/gains are added to stock basis, distributions are subtracted, then losses. Since distributions are applied to stock basis before certain losses we don’t have long-term capital gain taxes to pay in most cases or other nasty tax surprises.

Then tax time comes around and you bring in your books with new bank debt. I explain the situation and with a million dollar smile you tell me it is okay, you guaranteed the loan. It’s not okay!

The lesson to learn up to this point is: Your S corporation should only borrow money from you, the owner. Each owner wanting to increase debt basis needs to borrow to the firm directly, not a loan guarantee. Bank loans to an S corporation guaranteed by owners does not increase debt basis so losses are suspended once stock basis is used up and further distributions are taxed as a capital gain.

Credit Cards

The problem described above seems to crop up every year. It has gotten to a point I need to find solutions clients will understand. Basis workshops for accountants usually extend for two or three days; the topic is that intense. I have to boil this complexity down into something digestible for my clients.

For my smallest S corporations I have stumbled onto a solution that helps a few clients stay on the straight and narrow. When the owner goes to the bank the bank wants to lend to the business with the owner’s guarantee by default. Credit cards are usually different. Most credit cards are in the name of the owner only. Since many credit cards now offer interest free loans with only a 2% fee, the cost of short-term borrowing is low. By using the credit card for working capital or as a line of credit, the owner gets funding for her S corporation by borrowing to her S corporation directly via the credit card, thereby increasing her debt basis and avoiding negative tax consequences.

Of course, the same goal is reached if the business owner takes out the loan and the S corporation guarantees the loan. This is a foreign concept to many bankers. It shouldn’t be. It protects their interests, too. (Reread the first sentence. Instead of the S corporation taking the bank loan guaranteed by the owner, turn it around. Have the owner take the loan and if the bank wants a guarantee from the business it is okay.)

Many business owners use credit cards for day-to-day expenses and bills. I am always relieved when the credit card is in the individual’s name and not the S corporation’s. It gives me an out when preparing their taxes. Bills paid on a personal credit card are really a de facto loan to the S corporation. I like that. Now we need to have some paperwork to account for the loan to the S corporation which we can prepare in-house.

Parting Shot

Basis calculations are extensive. I run basis worksheets on every business in my office. In some cases, money borrowed by the S corporation causes no problems. Sometimes it only causes suspended losses to be used later unless the stock is sold; then the losses are lost, never deductible. (There are ways to avoid that too.) If I were an IRS auditor I would pull every S corporation with a loss. It is low-hanging fruit for the IRS. Too many accountants and virtually no taxpayers understand the S corporation consequences of equity and debt basis.

There is one take-away from this post: Never let your S corporation borrow money from anyone other than owners. The owners borrow from the bank and in turn lend to the S corporation. It makes your accountant’s job much easier. And your life less taxing.

 

Note: If you are prone to insanity you can dig deeper into S corporation basis issues here. I focused on one issue today; basis is far more involved than one simple issue. Even the IRS link provided is a simplification. I have a book on my shelf at the office on S corporation basis; it is over two inches thick.

Reduce Your State Tax to Zero with an Inversion

Americans who read the news even poorly know large corporations use tax inversions to avoid massive amounts of taxes due the U.S. government legally. What most Americans don’t know is they can use the same strategies on a smaller scale to never pay state income tax again. My guess is fewer than ten accounting firms in the U.S. utilize these strategies to protect their clients from state taxes. Today I will show you how to use the tax inversion without the help of an accountant.

A tax inversion happens when a major corporation buys a smaller company in a low or lower tax country or municipality. The acquiring company then moves its headquarters to the acquired company’s country. We will not get into the minutia of corporate tax law as it is not the focus of this post. We will use techniques of large corporations where they are applicable to small businesses, landlords, and retired taxpayers living or working entirely within the U.S.

Individuals living and working in a single state will not find value in this discussion. Each state has its own set of tax laws to reduce income taxes a lot, but what we are interested in today is driving the state income tax to zero for business owners and landlords with a few simple moves. Your circumstances will determine how you structure your finances to avoid state income tax.

Small Business

High tax states like California, New York and Wisconsin place a massive burden on business owners of those states. Competing against rivals in low-tax or no-tax states is difficult to impossible.

To facilitate these strategies you will require a corporation (regular or S) or a LLC treated any way you want for tax purposes. Corporations and LLCs are entities and considered persons in the eyes of the law. This sets up some unusual opportunities.

In tax inversions by large public corporation the inversion is handled between divisions within the same company. For small business owners it would work better to have separate entities.

The best way to explain this is with an illustration. We will use my accounting practice, called TPAS here, as an example. Wisconsin is a high tax state and it is darn cold in the winter. We will use a simple example of a company with $1 million in profit for easy figuring.

Your friendly accountant is paying the dirty bastards, ah, I mean the state government, ~$75,000 per year in state taxes on his $1 million in profits. TPAS is located in Wisconsin. All clients are either in Wisconsin or send their stuff to Wisconsin for processing. Therefore, all work is being performed in Wisconsin, subjecting all profits to Wisconsin income tax. The goal: move those profits to a no income tax state.

The owner of TPAS prefers living in Texas. It is warmer and he gets to keep more of his income. The owner of TPAS-WI can’t move his business to Texas without losing most of his clients. As his advisor I tell him he should move to Texas (make Texas your domicile), but keep TPAS right where it is. His company’s profits will flow through to him personally, but because the business is in Wisconsin, Wisconsin income tax is still due.

Our friendly business owner has family back in Wisconsin and he is more than welcome to visit as often as he likes. But I recommend he start another business in Texas, an LLC: TPAS-TX. TPAS-WI will no longer e-file tax returns. Instead, they will farm out the e-filing to TPAS-TX for a fee. This is a high margin product that will in effect transfer a large amount of profit to TPAS-TX. For argument, we will assume TPAS-WI prepares 15,000 tax returns a year and pays TPAS-TX $50 each to e-file and process the acknowledgements from the IRS. TPAS-WI now has $750,000 less profit and TPAS-TX has the same amount of additional profit.

Now a process call “earnings stripping” is applied. TPAS-TX will loan TPAS-WI $3,125,000 for working capital at an 8% interest rate. The interest is $250,000 per annum and deductible by TPAS-WI and reported as income by TPAS-TX.

We have now successfully stripped 100% of the Wisconsin profit and applied it to TPAS-TX. I assume we have two LLCs treated as S-corporations here. The profits from both LLCs will flow to the federal tax return exactly as in the past; the tax will remain the same. However, there is no profit to report to Wisconsin, only Texas, therefore there is no tax owed Wisconsin. Since Texas has no income tax, state income taxes were eliminated.

Art by Tabatha Davis

Art by Tabatha Davis

It is a bit more complicated in real life, but you should now understand the basic mechanics of the structure. The biggest issue is the domicile of the owner/s. The state where the owner lives will be the state that is paid income tax on ALL profits; a credit is given for state taxes paid to other states.

My artistic talent is less than hoped for so I had Tabatha Davis draw the illustrations for me; she is an accountant in my office. There can be more moving parts (and probably will be) in a real life situation. Large companies already do this, but the little guy really needs to as well. The illustrations help visualize the process of getting money from a high-tax state to a low-tax state.

Landlords

I have several clients who would benefit from this so I hope they are reading. In this scenario we will assume the taxpayer lived in New York City once upon a time and now lives in a state with a lower tax rate. While living in NYC she purchased investment property.

You will only need one LLC for the income properties this time. The LLC can be and should be a disregarded entity. This means you will report your rent income and expenses on your personal tax return for the property as you always have. (You never put real estate inside an S-corporation or an LLC treated as an S-corporation for tax purposes.)

The process is simple. The LLC does NOT have a mortgage with the bank and you as guarantor as most people structure investment properties. Instead, you get the loan, secured by the property, and you lend the money to the LLC. The interest rate charged the LLC can be higher than the bank mortgage rate to you as long as a reasonable rate is used.

Here is what happens. We will assume you have a $1.5 million property with a $1 million mortgage. The interest rate from the bank is say 5%. You charge the LLC 8% on your loan to it. This is called a wrap-around mortgage and common in the real estate industry.

img_20160907_151910

Art by Tabatha Davis

Because real estate has unique tax laws to start with, your property has only $30,000 in profit after depreciation and other expenses. This is still enough profit for property held in NYC by someone living elsewhere to pay a hefty tax. Because the additional mortgage interest is $30,000, the LLC has no profit to report to NYC or NY. You still need to file a return, but that is the end of it.

The $30,000 additional interest to you over the bank mortgage interest is taxed at the tax rate where you live. You can keep the LLC perpetually in debt to you to maximize the ongoing deduction. The federal tax return will report interest income where there were rental profits before; the tax is the same for most taxpayers.

There is a tendency for people to want to charge a bookkeeping fee or management fee to the LLC with income properties. It is a bad idea since this turns rental profits into earned income subject to self-employment or payroll taxes. There is no need to get fancy with income properties. Mortgage interest should easily handle the shifting of income to your low-tax domicile taxing authority without any further need to reduce the tax at the property location.

Retired People

Ten or so years ago a retired wealthy client walked into my office who wanted to reduce his state income tax. He had a home in Wisconsin and was moving here from Illinois. I encouraged him to get a home in Texas and make Texas his domicile. He bought a small home in Texas as his primary residence, owned a second home in Wisconsin and Florida. By avoiding Wisconsin income taxes the Texas home was paid for with one year of tax savings.

Moral of the story: It is okay to visit or even own a home in a high tax state, but never make it your domicile.

 

Note: I added several additional options under the Share button, including Reddit. It will not hurt my feelings if you share. 

Lessons Learned: Investment Properties

IMG_20160721_081232When it comes to passive income, real estate is king. A small investment can be leveraged into a massive cash cow. This is the second in a series of posts on lessons learned. Some lessons in life come from clients or from watching clients deal with issues. With investment properties I pull from personal experience. Over the years I have owned over 100 single family homes, numerous duplexes, a few multi-unit buildings, a storage facility, commercial property, and farm land. The lessons I have learned buying, selling, and leasing real estate over the last 28 years should provide a few nuggets of wisdom you have not read before. This added wisdom hopefully flows to your bottom line.

Residential Real Estate

We will start with residential investment properties because I have more experience in this arena and most readers own/manage the same; I will address commercial property in a future post.  The issues I raise are only a sampling of the issues I find most relevant; a full review of investment property issues is beyond the scope of one blog post. The best approach is to start from the beginning and move through the lifecycle of an investment property, from purchase, to renting, to eventual sale.

Buy Right: The first step is the most important. Buying the right property at the right price will determine the profitability of your investment property. This is a good time to research rent rates in the neighborhood. Many landlords use the 1% rule to determine if a property is worth buying; I use a different method.

The 1% rent rule simply states rents should be 1% per month of the purchase price/value of the property. This is a good starting point. Low interest rates today turn more properties cash flow positive under this rule.

My rule is a bit more involved, but provides more assurance you have a good property. First, I only use the current rents of the building. Sellers always point out the ability to raise rents. If rents should be higher the seller should have raised them. I also check rents in the area to affirm the current rent rate is sustainable. Once I feel comfortable with the rental income situation I look at expenses. I always assume a no-money-down deal even if I pay cash for the property. By assuming the property is leveraged to the hilt I can determine if the rent minus expenses supports the property’s value. My calculations always include a 3% miscellaneous expense to cover deferred expenses such as a roof, furnace, siding, flooring, or improvements unless a higher percentage is warranted due to the condition of the property. The formula looks something like this:

  • Annual rent income, minus
    • Mortgage payment as if 100% leverage used,
    • Landlord paid utilities,
    • Insurance,
    • Taxes,
    • Management fees, if any,
    • 3% miscellaneous deferred maintenance
    • Other known expenses

Once all known expenses are deducted from the annual expected rent you get a number that must be positive. A negative number is a money loser before you even start. If the number is above water you have a decision to make. It is enough? Remember, a breakeven number means your cash investment portion is earning what a mortgage would earn. That is why I assume 100% leverage. If I pay 100% cash I expect my money should earn at least what the bank charges in interest. Of course a cash deal will cash flow if you do not consider your cash investment as worth anything?

The real trick here is determining any special events. Road construction or other city improvements can cause cash flow problems down the road. Research before you sign.

This VA repo made the partnership a generous return.

This VA repo made the partnership a generous return.

Finding the Right Property: Many communities have properties where the rent does not justify the property’s value. Still, deals can crop up here and there even in tight markets. Buying right takes time. It is easy to lower your standards when ideal properties are scarce. Bad idea! I would rather miss a deal than buy the wrong property. Remember, there will come a day when you want to sell. Issues when you buy frequently stick around and bite you when you sell.

Here are a few ways I found a large quantity of prime properties. My first rental property was a two-unit townhouse on 833 E. North Street in Appleton, Wisconsin. The owner was a man in his young 30s. He died of an aneurism. The family did not want the property so the bank got it back. I made the bank whole by paying $50,000. The rent was $485 per unit. I made money on the deal. Two years later I sold for exactly $75,000. I think we can agree I had a wonderful introduction to the investment real estate world.

I found the above deal because I introduced myself to half the bankers in town. I tend to be a bit obsessive-compulsive when it comes to numbers. I talked with bankers every day. The North Street property turned a $10,000 down payment into a $25,000 capital gain and over $400 of positive cash flow per month. Nice. The only reason I got the sweetheart deal instead of someone else is because I was in the right place at the right time. I was in the banker’s office when the property came in.

My biggest source of reasonably priced properties was Veteran’s Affairs. Back in those days landlords could only get adjustable mortgages on rental properties and interest rates were close to 10%.  The VA offered 7% fixed with only a small down payment. The buildings were also priced to move. The best news was I could buy the properties even though I was not a veteran. It was normal for us to buy 3-5 properties per month from the VA.

The only way to get the VA properties was through a real estate agent. My agent, in his infinite wisdom, bragged to the VA office in Milwaukee about my large profits. Within a few months the rules were changed. Now more money is needed down and only veterans need apply. The rules have probably changed again since those days, but it outlines how a great property source can be screwed away by an idiot.

There are many ways to find awesome properties. Always do the math. My own rule is: Never chase a property. It’s a rental; they will make more. No one property is worth chasing.

Saying No to Bad Deals: Pressure will be applied to convince you to buy. Real estate agents get paid when you open your wallet, not before. Sellers have a long line of BS to move their property. Learn to say no. Take your time in reviewing the property. A bad investment gets worse the longer you own it. A negative cash flow only increases your original investment in the inappropriate property. “No” is the most powerful work in the English language when it comes to investing in real estate. It is normal to review multiple properties before buying. As good as the VA repo deal was, we did not buy every property dangled before our eyes.

Sellers say a lot of things when it is not in writing. Get it in writing! And a property inspection is a must unless you are qualified to do the inspection yourself.

Determining Rent Rates:  Before purchase you should have a good idea of the range of rents in the neighborhood and how they match the target property. Craigslist, newspapers, “You’re Renting” and similar magazines are a good place to start your review of local rents. The real estate agent is also a resource with one caveat: the agent may pump you full of it to make a sale. You have to determine if the agent is honest; most are.

The rents for my buildings were always on my mind. A good tenant may face fewer and smaller rent increases. Tenants that pay on time and keep the place well maintained are a bonus for landlords. Bad tenants did not face larger rent increases; instead, I refused to renew their lease.

Multi-unit buildings have greater profit potential, but more risks (and costs) associated with them.

Multi-unit buildings have greater profit potential, but more risks (and costs) associated with them.

Finding the Right Tenants: I was picky when I rented my properties. I did a background check and verified income. Compared to the banks before the financial crisis in 2008, I was a tough nut. The alternative is more damages, unpaid rent, evictions, and court costs. My time was worth too much. An investment in time now paid off later a hundred fold.

Evictions: Late rent is never tolerated. Follow the laws of your state/city when involved in an eviction. Whatever the law allowed I used. The longer a bad tenant stays in your property the greater the damage. In some cases you may need an attorney. When you owned as many investment properties as I have there are eviction stories to tell. I will leave them for another day.

Regulations: Local governments have rules regarding landlords. Smoke alarms and lead paint in older building are all considerations. Your local apartment association is a great resource into the rules in your market.

Property Managers: Property managers should handle the regulation issues. Verify your manager is screening prospective tenants adequately without discriminating. Owning properties in outside markets requires a local manager. Income properties are considered passive income for tax purposes, but any landlord can tell you the work involved is anything but passive.

Hiring a property manager eliminates most time issues with your property. The manager should screen prospective tenants, collect rent, evict when necessary, pay the mortgage and other bills, and submit the remainder to you monthly. There are times when you will need to cover a major expense like a roof or furnace out of pocket.

I used several managers at a time. When you own over 100 properties across a metropolitan area you will need help. I screened and reviewed my managers on a regular basis. Most were good, but a few were not. Investing time up-front before you hire a manager cannot be understated. Property mangers usually have contracts locking you in for a period of time. It is a relationship. Make sure you want to be in the relationship before you make a commitment.

Maintenance: Money is saved when you handle maintenance on your own. To actually save money you need to know your limitations. Roofing was my favorite work; flooring was a disaster. I installed carpet once and realized it would be easier, faster and cheaper to hire a professional. I am okay at drywall and painting. A large portfolio of real estate will require an army of contractors. I spent as much time checking prospective contractors as I did researching a property prior to purchase. Every job was in writing.

Major maintenance issues are reduced when handled before they become large. A roof replaced when shingles were thin beat waiting a few more years and then replacing roof boards, too. Regular painting keeps properties looking nice and rents where they belong. My properties were always improved. Buyers of my properties received nicer looking buildings than what I originally bought. I also had better rents, better tenants, and a better sale price. Maintenance does pay for itself.

Selling Right: Selling is buying in reverse. Before listing or offering a property for sale you need to research your market. Pricing a property for maximum gain without a long duration on the market takes legwork prior to listing. Review other properties in the neighborhood. A real estate agent can help. Today, online resources are numerous. Realtor.com, MLS, Zillow, Homefinder, and Trulia are good research tools in determining a good selling price. These are the same tools used in your property purchase search.

A realtor is a valuable asset in selling your property; they also have a fee, normally a percentage of the sale price. Selling on your own is more work, but you save the fee. The choice is personal.

Debt Issues: Debt was a tool when I owned a pile of real estate. I rarely came to a purchase closing with money. The bank covered the entire amount, using equity in other properties, so closing went faster. Then we paid down the mortgages fast, building equity. I understand investors want to juice their percentage return with leverage, but leverage also brings risks. Investment property should have at least 20% equity from day one. Once you own the property for a few years equity should be larger than debt. Also, debt-free rentals really cash flow. A cushion shields you from unforeseen market forces and vacancies. Real estate is a great source of passive income as long as you are not mortgaged to the hilt non-stop. High debt is an accident waiting to happen. The winners of the housing crisis a decade ago were the people with cash ready to buy when opportunities presented.

Partnerships: Yikes! I owned income property in a partnership with my dad and brother. I knew going in I would do 99% of the work. The partnership worked, but that is the exception to the rule. Most partnerships are woefully lopsided. The one doing all the work get grumpy when the other partners want an equal share without doing the work. Partnerships can work, but remember you are married to your partners and divorce is messy.

Entity Selection: Real estate should never be held inside an S-corporation; only rarely inside a regular corporation. Liability protection, tax advantages, and ease of transfer are available with a LLC. Due to local laws and regulations a real estate attorney should be engaged. Real estate held in an LLC does not require preparation of an additional tax return; a box is checked in the tax software informing the IRS the property is held in a single-member LLC as a disregarded entity. In the future I will address entity issues in greater detail as they pertain to real estate.

Training Courses: The Wealthy Accountant is a lucky guy. He gets to see all the crazy stuff floating around. Expensive investment real estate courses are all the rage. Many of these programs sucker you, ahem, cost $25,000 or more to teach you how to make a killing flipping real estate. All I can say is “don’t.” There might be a good program out there, but the ones I have seen are junk. Worse, they turn you tax work into a nightmare. I’m busy enough. No more free seminars offering a free meal, guys. They cost too much.

Clean Up Crew: I did my best to stay brief, but investment properties have too many issues. I will break down the issues into small, more easily digestible bites, in future posts. Commercial property, farm land, and land held for development are different creatures from residential investment property. Most readers here are interested in residential property so I stayed on point.

Real estate investing has great opportunities for wealth creation and steady passive income if proper planning takes place prior to investment.

The LLC vs the S Corporation

Is an LLC or S corporation right for you? Your personal situation determines which entity you should use. The tax savings can be huge. #wealthyaccountant #llc #scorp #scorporation #business #smallbusiness #sidegig #entity #taxThere is a lot of confusion among small business owners when deciding on their entity classification and the tax savings involved. It is the first discussion I have with most business clients. It takes time to get pertinent information out so I decided it would be a good idea to write down.

There are five business entity choices, but it really is only three since two are default choices: sole proprietorship, partnership, limited liability company (and its close cousin, the limited liability partnership), regular corporation (also called a C corporation) and the S corporation. You default to a sole proprietorship if you are a one-person business or a partnership when two or more owners are involved.

Choices

Most attorneys feel every business ought to be an LLC. I agree with the attorneys on this and not only for legal reasons. I like to tell people LLCs are like tuna, it takes on the flavor of whatever you put it with. A single member LLC defaults to a sole proprietorship and joint owners to a partnership. There are no LLC tax forms (with the exception of the “check in the box” election form). A single member files a Schedule C on their personal return; a partnership files Form 1065 like any other partnership. Sole proprietor and partnership tax rules apply accordingly.

An LLC can also take on the flavor of a regular corporation or an S corporation by making a simple election. The “check in the box” election informs the IRS how you want to conduct your business. Most of you don’t want to follow regular corporation tax rules so you will file a second form electing to be treated as an S corporation.

Regular corporations pay their own taxes and dividends paid to the owners are not deductible by the corporation and are therefore double taxed. S corporation profits flow to the owner’s personal tax return and are only taxed on the personal level. Corporations must pay owners a reasonable wage. If you are wrapping your mind around this concept you will naturally want your wages from your LLC/S corporation as low as possible to avoid self-employment taxes on the pass-through profits. The IRS knows this and requires a reasonable wage, but reasonable is a wide road. The tax court is littered with cases on fair compensation. The IRS has provided a safe harbor (read note below) of 60% of profit as a reasonable wage.*

Example: You have an S corporation with $200,000 before owner’s payroll. Safe harbor for owner’s wages are $120,000.

51r-Q3dz1ML._SX388_BO1,204,203,200_Is it possible to have a lower wage and still be reasonable? Yes. A safe harbor is just that, a place where the IRS agrees not to challenge your position. Many owners will not use the safe harbor method. If you have employees (let’s say 20), a large portion of the profit is derived from said employees. Remember why S corporations exist. They allow small firms to conduct business without the negative tax rules of a large regular corporation while still maintaining the legal protection of the corporate structure. The concept of the S corporation is to allow profits from non-owner’s work (passive income) to flow through to the owners without the double taxation of regular corporation dividends or self-employment taxes on the profits derived from employees.

Small businesses frequently have several employees or subcontractors. A reasonable wage for owners may be higher or lower than 60%. Safe harbor is 60% so we can hang our hat on that nail as an owner’s wage ceiling. The higher the profits, the more likely the safe harbor will only be a guideline. There are several places online to find reasonable compensation numbers. Robert Half has a temp agency (Accountemps) that publishes reasonable compensation numbers for a large number of professionals; unemployment offices in most states do as well.

Legal Talk

Before we start this part of the discussion I want to remind you I am not an attorney. I encourage you to consult a competent attorney if you have any questions. I only provide my understanding of LLC versus S corporation law as it pertains to taxes.

What is the difference between an LLC and S corporation? Both provide legal protection. It is easier to understand LLCs when you understand why they were created. LLCs were created for legal, medical, and accounting firms. The reason LLCs were needed for these industries is because regular corporation tax laws are devastating to service corporations (you pay the top tax rate on every dollar of profit) and S corporations back then could only have 25 owners (100 owners allowed now). The other drawback of a corporation is the liability issue of all-acts versus own-acts.

An attorney can explain all the different rules between an LLC and corporation, both C and S. We will not dive into those details. There is only one legal area we will review. Remember, I am not an attorney. What I share here is how I understand the laws regarding LLCs and corporations.

The difference between LLCs and corporations involves something called own-acts and all-acts. As I understand it, LLC owners are only liable for own-acts while corporation owners are liable for all-acts. This is easiest to understand with an illustration.

41a3MMVh6EL._SX331_BO1,204,203,200_We will use a medical firm as our example. Suppose two groups of doctors get together to start a clinic. One group of doctors organizes as an S corporation, the other as an LLC. After some time in business both clinics suffer a malpractice lawsuit against one of their doctors. Unfortunately, both doctors lose their suit and own a huge settlement. In the S corporation, owners are liable for all-acts; therefore, all doctors are liable for the one doctor’s malpractice. The same situation happens in the LLC clinic. However, with an LLC, liability is only for own-acts; only the doctor sued is liable; the other doctors are protected from loss by the LLC.

Once again, review your situation with an attorney. Feel free to leave comments below. If I verify additional information, I will include it in a future edit.

Show me the Money

Now we get to the part I love the most, the money. How much money can you save in taxes with an LLC treated as an S corporation? To make it clearer for everyone I want to start with a really small company example and work up in size. We will assume our small business owner organized as a LLC from day one, but only elected to be treated as an S corporation at the appropriate time.

The strength of your business is partly determined by the entity selection: LLC vs the S corporation. Read the facts before deciding. Save taxes with an LLC or S corporation. #wealthyaccountant #llc #scorp #scorporation #company #business #entity #taxesThe micro business: We start our example with a small home-based business earning a modest $10,000 of profit per year. At this low level of profit electing to be treated as an S corporation is inadvisable. The cost of filing the extra tax return for the S corporation would eat up more than the tax savings. There is still one thing a business owner can do: rent out a portion of his home to his LLC.

Let me review the office in home rules. A single member LLC treated as a sole proprietor will follow office in home rules like a sole proprietor will with one additional option. The office in the home must be regular and exclusive. This means you can’t deduct a corner of the living room you use sometimes. The office in the home must be an exclusive area of the home (like a spare bedroom) and used only for the business.

The LLC is a person in the eyes of the law. (Remember Mitt Romney raising people’s ire when he said this on the campaign trail. He actually was right, even if his delivery could use some work.) Just because your business is reported with your personal tax return does not change the fact that the LLC is a person. Therefore, the LLC can rent space in your home from you. You must have a rent agreement between you and the LLC. You don’t need anything fancy. A simple commercial rental agreement will meet IRS requirements.

The LLC can deduct the full amount of the rent. With an office in the home it must be “regular and exclusive”. For a rent agreement between you and the LLC it only has to be for the benefit of the LLC, a much lower bar to hurdle.

Let me illustrate with some numbers:

Office in the home:

Profit: $10,000

Safe harbor deduction of spare bedroom office used “regular and exclusive”: $720 ($5 per square foot x 144 (a 12×12 room))

Business profit after office in the home deduction: $9,280

Self-employment tax: $1,420 (we round numbers when we prepare taxes.

Income tax (assume 15% federal; 5% state): $1,856

Total taxes attributed to the business: $1420 + 1856 = $3,276 total tax

LLC renting space in your home:

Profit: $10,000

Fair rental value of bedroom office, plus storage area of part of the garage and work area used in the basement: $500 per month; $6,000 per year

Business profit after office rent expense: $4000

Self-employment tax: $612

Rental income: $6,000 – rental portion of home expenses (mortgage interest, property tax, repairs and maintenance and depreciation) $720 (to keep consistent with the above example) = $5,280

Income tax: $4,000 (business profit) + $5,280 (rental profit) = $9,280 x 20% = $1856

Total taxes attributable to the business: $612 + $1,856 = $2,468

Total savings doing it the Wealthy Accountant way: $3,276 – $2,468 = $808

Not bad for a company only earning a $10,000 profit!

The next business we will review earns a $30,000 profit per year. I consider the $30,000 to $50,000 range a no-man’s zone. A $30,000 company can benefit from an LLC elected as an S corporation in some cases, depending on the industry. By the time you reach $50,000 it is easier to get enough tax benefits to offset the additional costs of an S corporation (payroll service expense and tax prep fee for the additional S corporation tax return). Our example will consider the LLC treated as an S corporation.

Our example will assume a small home-based business, but will not consider the LLC renting from you; I will incorporate that into the wage data which will give us nearly the exact same answer without getting to long here.

As a sole proprietor:

Profit: $30,000

Self-employment tax: $4,590

Income tax federal and state at 20% combined: $6,000

Total tax: $10,590

Ouch! Now you can see why you start thinking of tax alternatives when your business starts generating $30,000 or more in profit. It becomes painful really fast.

As an S corporation:

Profit: $30,000 – $18,000 (owner’s wage) = $12,000

No self-employment tax.

Payroll tax: $18,000 x .153 = $2,754 (We will not consider unemployment taxes either.)

Income tax at 20%: $30,000 (profit plus wage) = $6,000

Total tax: $2,754 + $6,000 = $8,754

Total savings doing it the Wealthy Accountant way: $10,590 – $8,754 = $1,846

Better, but it still hurts having a business. Still, you get to keep over 6% more of your money.

As we move to higher levels of income we can introduce other methods of tax reduction. To keep our illustrations simple, however, I will review these additional tax cutting ideas in future posts. Always consider these illustrations as non-inclusive; there are always variables that will change the results. By painting a narrow brush stroke I can show how a strategy works in a vacuum.

The remainder of this post will provide a quick illustration of the tax savings for a non-home based S corporation over a sole proprietor at $50,000, $100,000, $150,000, $250,000, and $500,000 profit levels. Once we reach over $100,000 the Social Security portion of the self-employment/FICA tax begins to reach its threshold and the tax savings change. I’ll point this out when we get there.

Sole proprietor:

Profit: $50,000

Self-employment tax: $7,650

Income tax federal and state at 20% combined: $10,000

Total tax: $7,650 + $10,000 = $17,650

S corporation:

Profit: $50,000 – $30,000 (owner’s wage) = $20,000

No self-employment tax.

Payroll tax: $30,000 x .153 = $4,590

Income tax at 20%: $50,000 (profit plus wage) = $10,000

Total tax: $4,590 + $10,000 = $14,590

Total savings doing it the Wealthy Accountant way: $17,650 – $14,590 = $3,060

Sole proprietor:

Profit: $100,000

Self-employment tax: $15,300

Income tax federal and state at 25% combined: $25,000

Total tax: $15,300 + $25,000 = $40,300

S corporation:

Profit: $100,000 – $60,000 (owner’s wage) = $40,000

No self-employment tax.

Payroll tax: $60,000 x .153 = $9,180

Income tax at 25%: $100,000 (profit plus wage) = $25,000

Total tax: $9,180 + $25,000 = $34,180

Total savings doing it the Wealthy Accountant way: $40,300 – $34,180 = $6,120

At this point I assume there are employees of the S corporation other than owners and reasonable owner’s wages are less than the 60% safe harbor. The Social Security limit is $118,500 for 2016. Wages or profits (for sole proprietors) above this level only pay the 2.9 % Medicare portion of the self-employment tax or FICA tax (both employee and employer share).

Sole proprietor:

Profit: $150,000

Self-employment tax: $19,044

Income tax federal and state at 30% combined: $45,000

Total tax: $19,044 + $45,000 = $64,044

S corporation:

Profit: $150,000 – $70,000 (owner’s wage) = $80,000

No self-employment tax.

Payroll tax: $70,000 x .153 = $10,710

Income tax at 30%: $50,000 (profit plus wage) = $45,000

Total tax: $10,170 + $45,000 = $55,170

Total savings doing it the Wealthy Accountant way: $64,044 – $55,170 = $8,874

Sole proprietor:

Profit: $250,000

Self-employment tax: $21,944

Income tax federal and state at 40% combined: $100,000

Total tax: $21,944 + $100,000 = $121,944

S corporation:

Profit: $250,000 – $100,000 (owner’s wage) = $150,000

No self-employment tax.

Payroll tax: $100,000 x .153 = $15,300

Income tax at 40%: $250,000 (profit plus wage) = $100,000

Total tax: $15,300 + $100,000 = $115,300

Total savings doing it the Wealthy Accountant way: $121,944 – $115,300 = $6,644

Note: There is a bubble effect once your income hits a certain level. Your tax savings may decline if you don’t apply other tax strategies. Working in a vacuum illustrates how the tax saving affect different income levels.

Our final example will not consider and Affordable Healthcare taxes.

Sole proprietor:

Profit: $500,000

Self-employment tax: $29,194

Income tax federal and state at 40% combined: $200,000

Total tax: $29,194 + $200,000 = $229,194

S corporation:

Profit: $500,000 – $100,000 (owner’s wage) = $400,000

No self-employment tax.

Payroll tax: $100,000 x .153 = $15,300

Income tax at 40%: $500,000 (profit plus wage) = $200,000

Total tax: $15,300 + $200,000 = $215,300

Total savings doing it the Wealthy Accountant way: $229,194 – $215,300 = $13,894

An LLC or S corporation? The choice is your and it makes a difference. You will live with your choice a long time so consider the tax and legal advantages before it is too late. #wealthyaccountant #legal #entity #entityformation #llc #scorporation #business #smallbusiness #successA final thought: This area of tax law covers a complex issue. It is not the only tax cutting strategy a business can use, but a very important one. It is of vital importance to business owners if they wish to survive. Several factors could slightly diminish the illustrated tax advantages shown while a significant number of other tax opportunities can reduce the tax liability. If you started as a partnership, the tax savings approximately double, especially for a husband/wife partnership. Knocking $25,000 off the tax bill is meaningful money.

Even if you prepare your own taxes, a tax professional should help you set up your business entity and help you determine reasonable wages. So many factors can change the results. Your situation will differ based on facts and circumstances.

Note: I received many questions on forming an LLC or corporation. In my office we used a company for years called The Company Corporation. You can check out their service by clicking the highlighted text.They handle all U.S states. 

 

* This isn’t exactly true. The IRS previously went through a laundry list of explanations over what “reasonable compensation” is. At one time they said any wage by the owner was acceptable, though there are many instances when they didn’t follow this, wanting a sizable owner’s wage. Then the IRS unofficially said $10,000 was a floor for the owner’s wage and to avoid “reasonable compensation” issues. 

At some point a large number of accountants felt 60% was a good starting point for reasonable compensation when the IRS became more vague in their explanation. The IRS kind of, unofficially, acknowledged this “might” work. 

As with everything, facts and circumstances prevail. An attorney with $100,000 in profit might be hard-pressed to argue $60,000 as reasonable compensation. A doctor could face the same issue. A plumber might argue 40% of profit as a reasonable owner’s wage and win.

It is my experience that the size of the company and number of employees matters. An S corp with 20 employees might only pay the owner 20% of profits as a salary and it could pass the reasonable compensation test. A one-man firm, on the other hand, might pay out nearly all profits as compensation to meet the “reasonable” requirement.

There are several salary guides available online. These guides provide an approximate wage or salary for the position in question. Salary guides are a good tool in determining a reasonable wage and winning an IRS audit should the IRS question your owner’s wage.

We use the 60% quasi safe harbor here and in our examples so we can more easily compare results.

 

 

 

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