Please note:   This post will be a little long today.  But, I didn’t think it would make sense to split it into multiple entries.  I am pretty sure you will agree with me when you finish reading it.

 

It’s time.  Actually, we should have had this discussion a few months ago.

But, if you are like my clients, you have been unwilling to consider your 2019 tax strategy until your taxes are filed.  And, now that you’ve seen what the new tax law has done to you, you are far more receptive.

Let’s start those of you who are employees of a firm or the government.  You don’t have a lot of options.  You get paid via a W-2 and file your income taxes.  It’s not likely your employer will consider changing your status to an independent contractor (and many of you shudder at the thought of being your own boss, anyway).  The big question is whether or not you can itemize.   And, you now understand that the ‘benefits’ the new tax law provided you are anything but.  You no longer have personal exemptions, that deduction of a little more than $4K for each dependent; it’s been lumped in with the standard deduction (that used to be either around $ 6K or $ 12K) and is now either $ 12K or $ 24 K.  Which means it takes a lot more expenses to get to itemize your deductions (especially since TheDonald and his minions decided to screw the Democratic party states by disallowing all state/local/property tax totals above $ 10K).

The chart below shows that only two families got larger deductions from their income under the new tax law.  But, dependent upon one’s income, the tax rates may have changed, which could offset the change in taxable income.  Plus, a few of you can get a child tax credit, further lowering your tax burden.

But, what about if you have a business?  Were you a C Corporation?  An S?  A partnership or LLC?  A Solopreneur?  I’ll use three scenarios- your business income (after expenses and before taxes) is $ 25K, $ 250K, or $ 1 KK.

A soloprenuer is a business run by a single proprietor (or a husband and wife).  This taxpayer owes the government social security and Medicare taxes on his/her net income from the business.  That is regardless of whether one also owes income taxes.  The new tax law lets solopreneurs shield 20% of their net income from income tax (but not from employer taxes) .  (This 20% reduction is called QBI- qualified business income.)   So, the solopreneur deals with the following situations.

	Social Security/Medicaid (SS) Bill	Taxable Income
Scenario 1	$ 3825	$ 18,807 ($ 25K -20% QBI- 1/2 SS)
Scenario 2	$ 24,179.60 (including the Medicare surtax)	$ 188,135 ($ 250K -20% QBI- ½ SS)
Scenario 3	$  69159.20	$ 930841 (no QBI at this level)

Before we discuss the other cases, I probably should refresh your minds about the various structured business entities.

A C corporation is what comes to mind to most of us when we think of a structured business.  The C entity is owned by shareholders and run by an elected board of directors. As we already know, the government considers a corporation a “person”- it can sue, it can be sued, and it has legal and financial liabilities- separate and above from those of the stockholder/owners.  That last fact is why one often hears about double taxation- the corporation is taxed on its income and shareholders are taxed for any dividends they receive, even though the corporation paid tax on that money.   (Unless we are talking about employer taxes, the stockholders are shielded from personal liability for corporate taxes.  You know, the “corporate veil”.)

A partnership involves two or more folks starting a business.  The entity should be registered with the state and/or local governmental authorities.  Other than that, partnerships aren’t really much different from solopreneurships when it comes to the social security, Medicare, and taxable income.  Except, the net income is divided by 2 or more people that are members of the partnership.  So, in the $ 1 million scenario, if there are 3 partners, they are entitled to the 20% QBI; if there are only 2, the odds are that the QBI is no longer available.

An LLC (limited liability corporation) is a hybrid.  An LLC is like a partnership in that it’s less formal than a C or S corporation and that profits pass through to the partners.  Unlike a partnership, where profits and losses are allocated based upon the percentage ownership for each partner, the LLC can allocate profits and losses almost at will.

But, there’s another difference between an LLC and a partnership. It’s that an LLC can elect to operate as an S or C entity, by notifying the IRS that all the shareholders so agree.

An S corporation is a corporation that has elected pass-through tax treatment with the IRS.  Other than the taxation rules, it is identical to the C entity- it’s owned by shareholders and run by a board of directors.  And, even though it is a pass-through entity, it files its own tax forms (an 1120S).

But, there are other rules for S entities.  (These can be corporations that have agreed to pass-through regulations or LLC’s that agree to be taxed as pass-through corporations.)  These entities are required to pay their owners- if they work for the entity- salaries.  And, as long as they compensate their stockholders at “reasonable compensation” rates, the firm’s stockholders obtain both salary and pass-through income.  The salaries would be taxed as if they were regular employees of any firm; the pass-through income is a dividend that is only taxed at the rates for the stockholder’s income levels.  Which under the new tax law can as high as 37%.

Which is why some of our clients are now considering forming a C corporation for their business.  Before the tax law change, if you were a C corporation and marginally profitable, the total tax rate you paid was 10%.   Unless you were a professional (lawyer, doctor, engineer)- which meant the corporation was taxed at the statutory rate of 35%.  Now, both of these entities pay a straight 21%.  (We’ll talk about our process to minimize taxes below.)  That means marginal firms now pay twice the taxes they used to shell out and professional firms got a 1/3 reduction.

There are other special reasons to consider a C entity.

Let’s consider that the owners plan to operate this business for at least five more years and then sell the entity?  That scenario is extremely advantageous to being a C corporation.  That’s even more true if the corporation will be accumulating its profits within the business until cashing out.  Why?  Because the government provides special capital gains rates to small businesses that sell out after 5 years!  This rule was developed under President Obama and is part of IRC 1202.  This stipulates that 100% of capital gains up to $ 10 million or 10X the initial investment in the firm is sheltered from taxes after 5 years.  (Note that this stipulation is NOT allowed for the restricted business entities- lawyers, doctors, artists, etc.)

Another reason (which is one that applied to the firm we started back in 1976) comes into play.  The concept of keeping the business going “forever”? If the stockholders retire and hired a manager to keep the business going, they can withdraw the accumulated profits on an annual basis as dividends.  Yes, those dividends will be taxable, but they will be “qualified” dividends and the tax rates to the stock owners can be much lower.  And, if the stockholders die with the corporation intact, capital gains taxes are erased at death.

But, what if you need to use some of the business profits each year?  Or, that a reasonable salary doesn’t let you live in the style to which you are accustomed?  Well, then, a pass-through entity may be the best choice for a business structure.  Unless, you only need a portion of the profits to meet your lifestyle or familial needs.

Then, you can do what we did with our C entity.  We paid all staff reasonable compensation.  However, that compensation only covered the design, development, and creative work we were doing.   All the management of the firm was effected by a different firm- a pass-through entity (it was an S, but an LLC, which didn’t exist back in 1976, is a viable option now).  And, that pass-through still left some profits in the C entity (which we planned on taking as long-term capital gains when we sold the firm), just providing us with the funds we needed for our families.   The best of both worlds.

We also created another sort of entity.  But, that concept is only shared with our clients.

We are available for your needs, too…