The IRS has a complex formula in determining who to audit so secret even the government doesn’t know what it is. This secret is the subject of much debate and some even claim to know the formula. (They also have the secret formula to Coca Cola.)
In my neighborhood if you have an S corporation and get audited, I apologize. The lady who handles S corporation audits at the IRS around here was once an employee of mine. I take full responsibility for my limited role in training her. I am ashamed of my behavior.
But an IRS audit is not really an issue for most people. IRS audits are at all-time lows and do not look to be expanded much in the future. Most audits are not the dreaded visit to the IRS office or the auditor showing up at your place. Most audits are of the correspondence type, where they send you a letter. Correspondence audits are generally narrow in focus and are the result of a misplaced number or a mismatch on the tax return with information the IRS has.
Since so few people get audited nowadays, there should be no worry among taxpayers of a visit from your friendly government revenue agent. Still, I audit proof every tax return I prepare and train my employees to do the same. This isn’t cheating either. I am talking about preparing a tax return in a manner that doesn’t encourage scrutiny.
Who I Would Audit
The IRS seems to take an erratic course when choosing who to audit. Areas I would consider fertile ground for audit are ignored and areas where the ground has more stones is gleaned for any additional revenue. It seems counterproductive to take such an approach.
Since so much income is now reported to the IRS, most returns are easy to eliminate from audit consideration, or so you would think. Business owners and landlords are prime audit candidates since they receive income not always reported to the IRS. But there are millions of small businesses and landlords. You can’t audit them all.
The IRS selects tax returns for audit using their DIF System (Discriminant Inventory Function System). Other methods are used to uncover unreported income (UI DIF: Unreported Income Discriminant Index Formula). Only a government could come up with such names and acronyms.
The higher your DIF score the greater the chance of audit. The system works pretty well and is constantly tweaked and updated to improve efficiency. It also misses by a mile more often than not.
When you have 30 plus years in the tax industry you start to get a feel for who is pulling a fast one on their tax return. I am wrong periodically, but usually I can sniff out malfeasance.
There are two types of tax returns I would focus on auditing if I were an IRS auditor. The first is S corporations showing a loss and the other is people deep in debt and still spending.
The S corporation seems a strange choice. It isn’t. Since debt by an S corporation does not increase basis unless the debt is from the shareholder, all kinds of nasty surprises show up if the corporation shows a loss above basis. This is a complex area of tax law we will not delve into today. All I will say is please, if you have an S corporation, never have the company borrow from anyone but you, the owner. Guaranteeing a loan doesn’t help. Talk to a tax professional if you have this issue.
What I do want to focus on today is the type of person incentivized to cheat on their taxes: those deep in debt and spenders. A better way to look at who I would audit is to look at who I would not audit.
Who I Would Not Audit
If I worked for the IRS there is a group of people I would avoid auditing except for the most extreme cases. People reading this blog are awful candidates for audit! Why? Because savers don’t have a reason to cheat on their taxes. The people reading this blog are more interested in investing every penny they can. Instead of cheating on their taxes so they can spend more or to fund a heavy burden of debt, they cut spending on stupid stuff to free capital for investments in index funds and real estate.
People with a lot of toys are perfect candidates for audit. Decades in the business has proven my theory correct. When I see a client with a lot of big-boy toys they always perform poorly in audit. It is so bad I am nervous just preparing their returns. You know they have some serious preparer penalties out there. Never paid one; don’t want to start now.
A couple of things always concern me. When a client drives up in Hummer I am certain they don’t want to pay my fee (or they can’t). In the interview process I may learn of a lifestyle filled with lots of stuff coupled with debt. The risks these clients present my firm and me is higher. If I know of income and/or expenses, they must go on the return. It’s the stuff I don’t know about that keeps me thinking. The IRS may not believe I didn’t know. And then those preparer penalties show up again.
Avoiding Audit and Winning if You Are Audited
There is no fool-proof, 100% guaranteed way to prevent an audit. There are things you can do to significantly reduce your chances of getting that letter from your uncle in Washington.
- Report all income as it appears on tax documents.
- Make adjustments on the tax return for incorrect tax documents.
- Disclose positions you are taking on the tax return if you are adjusting for a tax document and for issues that make the return look like it has an issue (large charitable contributions, large business expenses, et cetera).
Where tax documents do not report the transaction to the IRS you need to consider how the return looks. Cost of goods sold higher than normal or other business or rental expenses should be covered in a disclosure included with the return. Better yet, change the mechanics of the tax return without changing the final result.
To prevent the IRS computer from throwing a fit, I will change how I handle certain numbers. This usually applies to small business owners, side gigs, hobbies, and landlords. For example, let’s say you have a really large advertising expense for a program in your business that failed to generate expected revenue. First, I would add a disclosure to the return. I would also break it up if possible. I might list the Yellow Pages ad separately to bring down the out of place advertising number.
Before you ever file your tax return you should review the return with the eyes of an auditor. What would you question if you worked for the IRS? Be brutally honest. Many returns selected for audit never get called because the auditor reviews the return and knows there is not much to gain if they open the file. As long as her supervisor doesn’t demand the audit take place, the thing will eventually run out of stat. The best audit is the one you never have to fight. Even if you win on all counts in an audit you still have time and money invested defending yourself.
When you review your tax return for things that look off, consider changing how you report the item. Again, I am not talking cheating. What I suggest is breaking big number up so they don’t look so out of place. When in doubt, disclose. Too many tax professionals are afraid to disclose a position they are taking with the IRS. They think it alerts the IRS to something they should audit. I disagree.
When the IRS sees a disclosure attached to a tax return it means you took the time to research the issue. You already self-audited. The IRS might disagree, but collecting more tax revenue is more difficult when the taxpayer already went out of her way to prepare an accurate return. My experience shows the same. I have never had a client audited when there was a disclosure attached to the return. Ever! That doesn’t mean I will not have one waiting for me when I get to the office. Even if there is one waiting for me, the number of audits of returns with a disclosure is very small.
The IRS is Reading this Blog
IRS auditors probably read this blog. It doesn’t bother me. They want to know how I conduct business, fine. One of the local auditors worked for me for a short time and knows how I conduct business. Like any tax professional, I sometimes get things wrong. Shit happens. What I don’t allow is willful errors. Judgment calls are part of the trade. Some returns we are happier with than others.
Since this is a public blog written by the owner of an accounting firm and we can assume the IRS is watching, let me share a few additional tips. I cannot remember the last time I saw a tax return audited from someone who maxes out their retirement account. I can’t remember ever seeing one. I think the IRS knows what I know; savers rarely cheat on their taxes. What would their incentive be? These people think along the lines of spending less. Their attitude is: my taxes are what they are. I’ve done everything I can to reduce them.
And reduce them they have. How much cheating do you have to do to get the same benefit as filling every retirement account you can? If you sock away $20,000 into your 401(k) and IRAs, the IRS can easily see what you did. Drop an extra 20k into the contributions to charity line on Schedule A and the revenuers might just want to verify that.
So how do you reduce your risk of audit to near zero? Simple! Spend less, pay off debt and save/invest more. The IRS is defenseless against such intelligent financial planning. It’s all legal. Pay off a credit card and you now have tax-free income! All that interest was not deductible and is now free for you to use elsewhere. In effect, tax-free income.
You can double down on the benefits by pushing the interest saved on consumer debt into a retirement account to get additional tax advantages. And the IRS has nothing to talk to you about. Your life is simpler. The government has less interest in your money. And you can finally start living the life you dreamed.
That is something everyone should be happy doing. Even an IRS auditor.
Starting 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.
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.
Too 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.
I 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.
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.
Before you fire up your email to insult my mother’s choice to have children (or congratulate my good taste), here me out. This blog is devoid of politics, trust me. What I share in this post is in no way indicative of who I support for POTUS. This blog is about personal finance, financial independence, lifestyle, and TAXES. Check the top of the page; it is clear as day.
The latest news comes from Trump’s 1995 tax return. I could care less that some people think he is a good businessman who lost $916 million in one year. What bothers me is the mental morons calling Trump’s actions “genius”. Wrong! Or Trump calling his actions “brilliant”. Wrong! By the end of this post I will show you how The Donald threw away $300 million in cash. His accountant should be flayed, quartered, and beheaded for his incompetence. If Donald Trump knew how badly he screwed up on his tax return he would be spitting nails.
I did not see the tax return published in the New York Times. My only information is third party comments in the news. Using such information calls my intelligence into question. But it will provide an awesome example of how we can use the tax code to really save and make money.
This is what looks like happened. Trump started several companies that filed for bankruptcy. He structured these companies as sub chapter S corporations so all the gains and losses flowed to his personal tax return. That is the first problem.
The structure of these businesses are probably why the IRS is auditing him. Deductions exceeded his revenue causes a net operating loss (NOL). This is not unusual. In a simplified way, it means his taxable income dropped below zero due to the business loss on his personal tax return.
NOLs currently are carried back two years and forward twenty. Back in 1995 it was slightly different. (If memory serves, back in 1995, NOLs had to be used in 18 years; three years carried back and 15 forward after the NOL was created. Don’t quote me on that. I’m writing at home without the help of tax guides from 1995.) (I verified the info.) Under current tax law, Trump needed almost a billion dollars in income from 1996 to 2015 or the NOL would expire unused.
The IRS is probably looking at the NOL because the NOL must be reduced by the amount discharged in bankruptcy court. You don’t get to double dip. If Trump tried to ram certain gains through on his tax return prior to the NOL expiring and if he did not reduce the NOL by the amount of debt discharged the IRS has solid footing to audit.
Let’s not belabor the point. We will assume Trump had a real $916 million NOL back in 1995. Because he set the companies up as S corporations, the gains and losses ended up on his personal tax return (pass-through on Schedule K-1 from the company to Page 2 of Schedule E on his personal tax return). This is really bad. On his personal tax return, the NOL must be used by year 18 or it is cancelled and is worthless.
The problem starts with the structure. If Trump organized his businesses as regular corporations, also known as a C corporation, the NOLs would have remained with those corporations. We talked about the tax benefits of S corporations on this blog in the past. My recommendations remain correct for small business owners. For large businesses, like Trump Airlines where I suspect a large part of the NOL originated, the regular corporation is better. There are a lot of reasons why, but we will only focus on the NOL.
C corporations with a NOL have a valuable asset. If another corporation buys the company with a NOL, the acquiring company can use the NOL to offset their taxable income. Since Trump is in New York I will use an estimate of 40% combined federal and state tax rate for C corporations for easy figuring. A $916 million NOL could save an acquiring corporation over $350 million in taxes! If Trump had structured the deal correctly he would have recouped $250 – $300 million from a company willing to buy solely on the value of the NOL, without consideration for any remaining assets, goodwill, or client base.
Time value of money says selling the NOL for cash now beats tax breaks spread over 18 years. The tax breaks will only help if he has income. An acquiring corporation with plenty of profits are sure to benefit sooner than Trump could himself without risk of a partially cancelled NOL. Also, cash in hand is worth more than a possible tax benefit. The risk is shifted to the buyer when the business with the NOL is sold.
Of course, the IRS is fully aware people like the Wealthy Accountant know how this stuff works, even if Trump and his accountants don’t. Section 382 of the Internal Revenue Code (IRC) limits this little trick if 50% or more of a company with a NOL changes ownership. Since the buyer will acquire 100% of Trump’s company with a NOL, the acquiring company will use a formula to determine the amount of NOL they can use each year.
The bottom line is if Trump structured the deal properly he could have cashed in big-time due to the NOL. Big NOLs have value which can increase the amount of money the acquired company’s shareholders get. The best possible outcome would have been $300 million to Trump back in 1995. It is more accurate to say Trump would likely have received closer to $150 million. I guess if you are really rich, $150 million isn’t enough to worry about. It would make a difference for me if anyone cares.
But WA, you said in the past we should have an S corporation for our business. I did and I am correct. I never thought Trump would read my blog and think he is a small business.
Donald worried if he had a profit as a C corporation he would pay more tax. Wrong! General Electric generates billions in profits annually and frequently pays few to no income taxes in the U.S. Trump is so small compared to GE I could handle his whole tax situation myself with one helper. (No kidding! I’d have to quit everything else I do to get the work done, but it is possible.)
Here are a few things Trump could have done if he did it my way. When he had a profit in his C corporation he could use a tax inversion to funnel U.S. profits to a low tax country for usage of the Trump brand. Another neat trick is using the foreign tax credit with the partially tax-free nature of dividends received by a regular corporation. For example: A U.S. C corporation excludes 70% of dividends received from another corporation if they own less than 20% of the stock, a common occurrence. If the C corporation owns British Petroleum it gets the foreign tax credit and the dividend exclusion, a legal form of double dipping. Several years ago a public company used this strategy to reduce its federal taxes to zero and was taken to Tax Court by the IRS. The IRS lost.
A Lesson in Business
Trump is not a good businessman in my opinion; he threw away a couple hundred million due to stupidity. He inherited a sizable amount of wealth and left the bank holding the bag when things soured on business deals; that is where he got his wealth. Trump is good at protecting himself. When it comes to taxes he screws himself more than the IRS ever will. If he played it fast and lose, the IRS will tear him a new one in audit when it never should have been an issue. If he paid me to advise him he wouldn’t have to worry about the NOL; he would have cashed his check twenty years ago.
And no, Donald, I am not accepting new clients.
The 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:
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.
The 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.
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.
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.
There 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.
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.
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.
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.
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 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:
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:
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:
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.
Self-employment tax: $7,650
Income tax federal and state at 20% combined: $10,000
Total tax: $7,650 + $10,000 = $17,650
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
Self-employment tax: $15,300
Income tax federal and state at 25% combined: $25,000
Total tax: $15,300 + $25,000 = $40,300
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).
Self-employment tax: $19,044
Income tax federal and state at 30% combined: $45,000
Total tax: $19,044 + $45,000 = $64,044
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
Self-employment tax: $21,944
Income tax federal and state at 40% combined: $100,000
Total tax: $21,944 + $100,000 = $121,944
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.
Self-employment tax: $29,194
Income tax federal and state at 40% combined: $200,000
Total tax: $29,194 + $200,000 = $229,194
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
A 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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