News & Articles

It's Not Too Late for Some Business Owners to Lower Their 2018 Taxes

Posted on Mon, Mar 25, 2019

Most businesses will owe less tax for the 2018 tax year than they would have under prior law, thanks to changes brought by the Tax Cuts and Jobs Act (TCJA). But have you done everything possible to lower your business tax bill for last year? Even though 2018 is in your review mirror, there are some possibilities for business owners to consider if your return for the last tax year hasn't been prepared yet.

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Tags: Deductions, C corporation, LLC, Sole Propietorship, Tax Cuts and Jobs Act (TCJA), Qualified Business Income (QBI)

Converting an Unincorporated Business into an S Corp

Posted on Fri, Jun 30, 2017

The federal self-employment (SE) tax just keeps going higher and higher. If you've reached the breaking point, there may be a way to tame the SE tax beast by converting your existing unincorporated small business into an S corporation.

Of Course, There Are Caveats

Potential audit target. The IRS is aware of the strategy of converting an unincorporated business into an S corp to save on taxes. The government is trying to audit more S corps to see if they are paying unreasonably low salaries to shareholder-employees. However, S corp audit rates are still low. The tax-saving advantage of converting is lost if the IRS successfully asserts that S corp distributions to shareholder-employees are actually disguised salary payments. If that happens, the IRS will assess unpaid FICA taxes, interest and penalties. Your tax advisor can help you build a case so that in the event of an IRS audit, you have well-documented support that salaries are not unreasonably low.

Impact on retirement contributions. When considering an S corp, keep in mind that paying a modest salary can reduce the amount you can contribute to a tax-favored retirement program (such as a profit sharing or SEP plan). However, you may be able to mitigate this concern by setting up a 401(k) or defined benefit pension plan.

Other complexities. An S corporation conversion creates some paperwork and other issues.

That is because transactions between an S corp and its shareholders, including asset and liability transfers upon incorporation, must be carefully planned to avoid adverse federal (and possibly state) income tax consequences. You also have to meet state-law corporation requirements such as conducting annual meetings and keeping minutes.

Plus, a number of tax law hurdles must be cleared for S corp status to be available. For example, shareholders must be individuals or specified types of trusts. The Social Security and Medicare tax savings must be big enough justify the extra effort of operating as an S corp.


Partnerships and Multi-Member LLCs

A business operated as a partnership or a multi-member LLC also faces high SE tax bills. Partners and LLC members are considered self-employed individuals for federal tax purposes. Therefore, they generally must pay SE tax on their shares of net SE income from the partnership or LLC.

In this scenario, the same tax strategy is available. The co-owners can consider converting an existing partnership or LLC into an S corporation. Then, they can pay themselves relatively modest, yet reasonable, salaries while paying out the remaining profits as cash distributions. The salaries will be subject to Social Security and Medicare taxes, but the cash distributions will be exempt from those taxes. The tax savings will recur year after year, as long as the business maintains or exceeds its current profits.

How to Evaluate the Option

If you're a self-employed individual — meaning a sole proprietor, partner, or LLC member — you have to pay the SE tax on your net SE income. The SE tax has two parts:

1. The 12.4% Social Security tax. Social Security tax is due on net SE income up to a certain amount. Unfortunately, the ceiling goes up every year because of inflation adjustments. For 2017, the Social Security tax ceiling is $127,200 (up from $118,500 for 2016).

2. The 2.9% or 3.8% Medicare tax. The Medicare part of the tax is due on an unlimited amount of net SE income. In other words, there's no ceiling.

So until your net SE income exceeds the Social Security tax ceiling of $127,200 in 2017 (up from $118,500 for 2016), you owe the SE tax at the painfully high rate of 15.3% consisting of 12.4% Social Security plus 2.9% Medicare.

After the ceiling is exceeded, the Social Security tax portion drops away, and the SE tax rate falls to 2.9% to cover the Medicare tax. However, the Medicare tax jumps to 3.8% once your self-employment income exceeds the applicable threshold ($200,000 for unmarried individuals or $250,000 for married couples filing jointly).

Note: The tax results are the same if you operate your business as a single-member LLC, which is treated as a sole proprietorship for federal tax purposes.

While the SE tax is painful now, it's could get worse in the future.

So it may be time to consider an S corporation conversion. Reason: The SE tax doesn't apply to earnings from an S corporation business.

However, the FICA tax applies to salary compensation paid to an S corp shareholder-employee. In 2017, the FICA tax rate is 15.3% on salary up to the $127,200 Social Security tax ceiling. Salary above the Social Security tax ceiling is subject to a 2.9% or 3.8% FICA tax rate to cover the Medicare tax.

The employee share of the FICA tax is withheld from an S corporation shareholder-employee's salary; the other portion is paid by the corporation directly to the U.S. Treasury.

The Tax Savings

The FICA tax is only due on an S corporation shareholder-employee's salary. So when the company pays only a portion of its profits to the owner, or owners, in the form of a reasonable salary, with the remaining portion paid out in the form of cash distributions, only the salary portion is hit with Social Security and Medicare taxes (in the form of the FICA tax). The profits paid out as cash distributions are exempt from the FICA tax (and exempt from the SE tax too).

Key Point

These tax-saving results are not a one-time phenomenon. You can collect similar Social Security and Medicare tax savings, or better, in future years if the business maintains or exceeds its current level of profitability.

Converting an unincorporated small business into an S corporation is not a great idea in all situations but it works for some businesses. Consult with your EHTC Tax Advisor for more information.

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Tags: Business, LLC, Taxes, Sole Propietorship, S Corporation

The Joint Committee on Taxation Report Summary

Posted on Wed, Dec 07, 2016

The Joint Committee on Taxation (JCT) is a nonpartisan Congressional committee that, among other things, assists in the analysis and drafting of proposed federal tax legislation and prepares reports that interpret newly enacted federal tax legislation. The JCT recently issued the Overview of the Federal Tax System as in Effect for 2016. Here are the details of that report, including some interesting trends about business taxes.

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Tags: C corporation, LLC, Partnership, Sole Propietorship, S Corporation

New IRS Regs on Disguised Sales Affect Partnerships and LLCs

Posted on Mon, Oct 31, 2016

In October, the IRS issued new guidance targeting strategies that are used to exploit the tax benefits associated with partnerships and limited liability companies (LLCs) that are treated as partnerships for tax purposes. In a nutshell, under the new guidance, property transactions between partners and partnerships are more likely to be classified as disguised sales and, therefore, subject to taxes. Here's a summary of the most important aspects of the new temporary and final regulations on disguised sales that apply to these entities.

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Tags: IRS, LLC, Taxes, Partnership, Section 752

IRS Issues New Regs on Allocating Debt to Partners and LLC Members

Posted on Wed, Oct 26, 2016

On October 5, 2016, the IRS released new temporary and final Section 752 regulations. Sec. 752 of the Internal Revenue Code and related regulations explain how to allocate partnership debt among partners for purposes of calculating the basis of their partnership interests. This calculation determines what's often referred to as the partners' "outside basis" in the partnership (their basis for deducting losses and receiving tax-free distributions). In some situations, the new regulations make it more difficult for partnerships to manipulate the rules to increase the outside basis of certain partners for tax planning purposes. In most situations, however, the effects of the new regulations are neutral.

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Tags: IRC, IRS, LLC, Partnership, Section 752

Watch Out for Potential Tax Bill When Converting Corporation

Posted on Thu, Dec 11, 2014

Your medical practice, currently running as a C or S corporation, may be considering the idea of converting to a limited liability company (LLC) or limited liability partnership (LLP). Under the right circumstances, that could be a good idea from a tax perspective. Here's why: Both LLCs and LLPs can be treated as partnerships for federal tax purposes. The tax rules for partnerships are far more flexible than the corporate rules.

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Tags: EHTC Article, Assets, IRS, Newsletter, Articles, LLC, LLP, Corporation, intangibles, Taxes, Goodwill

Court Decisions Make It Easier to Deduct LLC Losses

Posted on Fri, Oct 31, 2014

What happens if you're the owner of a limited liability company (LLC) that generates tax losses, and you don't spend a lot of time in the activities of the business? The losses might be classified as passive, and your ability to currently deduct them might be severely restricted by the passive activity loss (PAL) rules.

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Tags: Tax, EHTC Article, Business, Tax Court, loss, IRS, Newsletter, Articles, LLC, PAL, passive activity loss, Taxes