How Pass-Through Income Will Be Taxed For Small Business Owners

While one of the most significant changes incorporated in the new legislation was reducing the corporate tax rate from the current 35% rate to a 21% rate in 2018, the tax bill also contains a big tax break for small business owners. Unlike large corporations that are taxed at a flat rate, most small businesses, are "pass-through" entities, meaning that the profits from the business flow through to the business owner's personal tax return and then are taxed at ordinary income tax rates.While pass-through income will continue to be taxed at ordinary income tax rates, many small business owners will be eligible to deduct 20% of their "qualified business income" (QBI) starting in 2018. In other words, some pass-through entities will only be taxes on 80% of their pass-through income.

Pass-through entities include

Sole proprietorships

Partnerships

LLCs

S-Corps

Unanswered Questions

I wanted to write this article to give our readers the framework of what we know at this point about the treatment of the pass-through income in 2018. However, as many accountants will acknowledge, there seems to be more questions at this point then there are answers. The IRS will need to begin issuing guidance at the beginning of 2018 to clear up many of the unanswered questions as to who will be eligible and not eligible for the new 20% deduction.

Above or Below "The Line"

This 20% deduction will be a below-the-line deduction which is an important piece to understand. Tax lingo makes my head spin as well, so let's pause for a second to understand the difference between an "above-the-line deduction" and a "below-the-line deduction".The "line" refers to the AGI line on your tax return which is the bottom line on the first page of your Form 1040. While both above-the-line and below-the-line deductions reduce your taxable income, it's important to understand the difference between the two.

Above-The-Line Deductions

Above-the-line deductions happen on the first page of your tax return. These deductions reduce your gross income to eventually reach your AGI (adjusted gross income) for the year. Above-the-line deductions include:

• Contributions to health savings accounts

• Contributions to retirement plans

• Deduction for one-half of the self-employment taxes

• Health insurance premiums paid

• Alimony paid, student loan interest, and a few others

The AGI is important because the AGI is used to determine your eligibility for certain tax credits and it will also have an impact on which below-the-line deductions you are eligible for. In general, the lower your AGI is, the more deductions and credits you are eligible to receive.

Below-The-Line Deductions

Below-the-line deductions are reported on lines that come after the AGI calculation. They are comprised mainly of your “standard deduction” or “itemized deductions” and “personal exemptions” (most of which will be gone starting in 2018). The 20% deduction for qualified business income will fall into this below-the-line category. It will lower the income of small business owners but it will not lower their AGI.

However, it was stated in the tax legislation that even though the 20% qualified business deduction will be a below –the-line deduction it will not be considered an “itemized deduction”. This is a huge win!!! Why? If it’s not an itemized deduction, then small business owners can claim the 20% qualified business income deduction and still claim the standard deduction. This is an important note because many small business owners may end up taking the standard deduction for the first time in 2018 due to all of the deductions and tax exemptions that were eliminated in the new tax bill. The tax bill took away a lot of big deductions:

• Capped state and local taxes at $10,000 (this includes state income taxes and property taxes)

• Eliminated personal exemptions ($4,050 for each individual) (Eliminated in 2018)

  • Family of 4 = $4,050 x 4 = $16,200 (Eliminated in 2018)

• Miscellaneous itemized deductions subject to 2% of AGI floor (Eliminated in 2018)

Restrictions On The 20% Deduction

If life were easy, you could just assume that I'm a sole proprietor, I make $100,000 all in pass-through income, so I will get a $20,000 deduction and only have to pay tax on $80,000 of my income. For many small business owners it may be that easy but what's a tax law without a list of restrictions.The restriction were put in place to prevent business owners from reclassifying their W2 wages into 100% pass-through income to take advantage of the 20% deduction . They also wanted to restrict employees from leaving their company as a W2 employee, starting a sole proprietorship, and entering into a sub-contractor relationship with their old employer just to reclassify their W2 wages into 100% pass-through income.

S-Corps

Qualified business income will specifically exclude "reasonable compensation" paid to the owner-employee of an S-corp. While it would seem like an obvious reaction by S-corp owners to reduce their W2 wages in 2018 to create more pass through income, they will still have to adhere to the "reasonable compensation" restriction that exists today.

Partnerships & LLCs

Qualified business income will specifically exclude guaranteed payments associated with partnerships and LLCs. This creates a grey area for these entities. Partnerships do not have a “reasonable compensation” requirement like S-corps since companies taxed as partnerships are not allowed to pay W2 wages to the owners. Also the owners of partnerships are not required to take guaranteed payments. My guess is, and this is only a guess, that as we get further into 2018, the IRS may require partnerships to classify a percentage of a owners total compensation as a “guaranteed payment” similar to the “reasonable compensation” restriction that S-corps currently adhere too. Otherwise, partnerships can voluntarily eliminate guaranteed payments and take the 20% deduction on 100% of the pass-through income.

This may also prompt some S-corps to look at changing their structure to a partnership or LLC. For high income earners, S-corps have an advantage over the partnership structure in that the owners do not pay self-employment tax on the pass-through income that is distribution to the owner over and above their W2 wages. However, S-corp owners will have to weigh the self-employment tax benefit against the option of changing their corporate structure to a partnership and potentially receiving a 20% deduction on 100% of their income.

Sole Proprietors

Sole proprietors do not have "reasonable compensation" requirement or "guaranteed payments" so it would seem that 100% of the income generated by sole proprietors will count as qualified business income. Unless the IRS decides to enact a "reasonable compensation" requirement for sole proprietors in 2018, similar to S-corps. Before everyone runs from a single member LLC to a sole proprietorship, remember, a sole proprietorship offers no liability barrier between the owner and liabilities that could arise from the business.

Income Restrictions

There are limits that are imposed on the 20% deduction based on how much the owner makes in “taxable income”. The thresholds are set at the following amounts:

Individual: $157,500

Married: $315,000

The thresholds are based on each business owner’s income level, not on the total taxable income of the business. We need help from the IRS to better define what is considered “taxable income” for purposes of this phase out threshold. As of right now, it seems that “taxable income” will be defined as the taxpayer’s own taxable income (not AGI) less deductions.

If the owner’s taxable income is below this threshold, then the calculation is a simple 20% deduction of the pass-through income. If the owner’s taxable income exceeds the threshold, the qualified business deduction is calculated as follows:

The LESSER of:

20% of its business income OR 50% of the total wages paid by the business to its employees

Let’s look at this in a real life situation. A manufacturing company has a net profit of $2M in 2018 and pays $500,000 in wages to its employees during the year. That company would only be able to take the qualified business income deduction for $250,000 since 50% of the total employee wages ($500,000 x 50% = $250,000) are less than 20% of the net income of the business ($2M x 20% = $400,000).

This creates another grey area because it seems that the additional calculation is triggered by the taxable income of each individual owner but the calculation is based on the total profitability and wages paid by the company. For the owners that required this special calculation for exceeding the threshold, how is their portion of the lower deduction amount allocated? Multiplying the lower total deduction amount by the percent of their ownership? Just more unanswered questions.:

Restrictions For "Service Business"

There will be restrictions on the 20% deduction for pass-through entities that are considered a "service business" under IRC Section 1202(e)(3)(A). The businesses specifically included in this definition as a services business are:

• Health

• Law

• Accounting

• Actuarial Sciences

• Performing Arts

• Consulting

• Athletics

• Financial Services

• Any other trade or business where the principal asset of the business is the reputation or skill of 1 or more of its employees

In a last minute change to the regulations, to their favor, engineers and architects were excluded from the definition of “service businesses”.

This is another grey area. Many small businesses that fall outside of the categories listed above will undoubtedly be asking the question: “Am I considered a service business or not?” Outside of the industries specifically listed in the tax bill, we really need more guidance from the IRS.

If you are a “services business”, when the tax reform was being negotiated it looked like service businesses were going to be completely excluded from the 20% deduction. However, the final regulations were more kind and instead implemented a phase out of the 20% deduction for owners of service businesses over a specified income threshold. The restriction will only apply to those whose “taxable income” exceeds the following thresholds:

Individual: $157,500

Married: $315,000

If you are a consultant or owner of a services business and your taxable income is below these thresholds, it would seem at this point that you will be able to capture the 20% deduction for your pass-through income. As mentioned above, we need help from the IRS to clarify the definition of “taxable income”.

Phase Out For Service Businesses

The amounts listed above: $157,500 for individual and $315,000 for a married couple filing joint, are where the thresholds for the phase out begins. The service business owners whose income rises above those thresholds will phase out of the 20% deduction over the next $50,000 of taxable income for individual filers and $100,000 of taxable income for married filing joint. This means that the 20% pass-through deduction is completely gone by the following income levels:

Individual: $207,500

Married: $415,000

Any taxpayer’s falling in between the threshold and the phase out limit will receive a portion of the 20% deduction.

Since the thresholds are assessed based on the taxpayer’s own taxable income and not the total income of the business, a service business could be in a situation, like in an accounting firm, where the partners with the largest ownership percentage may not qualify for 20% deduction but the younger partners may qualify for the deduction because their income is lower.

Tax Planning For 2018

It's an understatement to say that most small business owners will need to spend a lot of time with their accountant in the first quarter of 2018 to determine the best of course of action for their company and their personal tax situation.While we are still waiting for clarification on a number of very important items associated with the 20% deduction for qualified business income, hopefully this article has provided our small business owners with a preview of things to come in 2018.

Disclosure: I'm a Certified Financial Planner® but not an accountant. The information contained in this article was generated from hours and hours of personal research on the topic. I advise each of our readers to consult with your personal tax advisor for tax advice.

About Michael.........

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Tax Reform: Summary Of The Changes

The conference version of the tax bill was released on Friday. The House and the Senate will be voting to approve the updated tax bill this week with what seems to be wide spread support from the Republican party which is all they need to sign the bill into law before Christmas. Most of the changes will not take effect until 2018 with new tax rates for individuals set to expire in 2025. At which time the tax rates and brackets will return to their current state. Here is a run down of some of the main changes baked into the updated tax bill:

Individual Tax Rates

They are keeping 7 tax brackets with only minor changes to percentages in each bracket. The top tax bracket was reduced from 39.6% to 37%.

Capital Gains Rates

There were no changes to the capital gains rates and they threw out the controversial mandatory FIFO rule for calculating capital gains tax when selling securities.

Standard Deduction and Personal Exemptions

They did double the standard deduction limits. Single tax payers will receive a $12,000 standard deduction and married couples filing joint will receive a $24,000 standard deduction.The personal exemptions are eliminated.

Mortgage Interest Deduction

New mortgages would be capped at $750,000 for purposes of the home mortgage interest deduction.

State and Local Tax Deductions

State and local tax deduction will remain but will be capped at $10,000. An ouch for New York State. That $10,000 can be a combination of your property tax and either sales or income tax (whichever is larger or will get you to the cap of $10,000).Oh and you cannot prepay your 2018 state income taxes in 2017 to avoid the cap. They made it clear that if you prepay your 2018 state income taxes in 2017, you will not be able to deduct them in 2017.

Medical Expense Deductions

Medical expense deductions will remain for 2017 and 2018 and they lowered the AGI threshold to 7.5%. Beginning in 2019, the threshold will change back to the 10% threshold.

Miscellaneous Expense Deductions

Under the current rules, you are able to deduct miscellaneous expenses that exceed 2% of your AGI. That was eliminated. This includes unreimbursed business expenses and home office expenses.

A Few Quick Ones

Student Loan Interest: Still deductible

Teacher Out-of-Pocket Expenses: Still deductible

Tuition Waivers: Still not taxable

Fringe Benefits (including moving expenses): Will be taxable starting in 2018 (except for military)

Child Tax Credit: Doubled to $2,000 per child

Gain Exclusion On Sale Of Primary Residence: No Change

Obamacare Individual Mandate: Eliminated

Corporate AMT: Eliminated

Individual AMT: Remains but exemption is increased: Individuals: $70,300 Married: $109,400

Corporate Tax Rate: Drops to 21% in 2018

Federal Estate Tax: Remains but exemption limit doubles

Alimony

For divorce agreements signed after December 31, 2018, alimony will no longer be deducible. This only applies to divorce agreements executed or modified after December 31, 2018.

529 Plans

Under current tax law, you do not pay taxes on the earnings for distributions from 529 accounts for qualified college expenses. The new tax reform allows 529 account owners to distribute up to $10,000 per student for public, private and religious elementary and secondary schools, as well as home school students.

Pass-Through Income For Business

This is still a little cloudy but in general under the conference bill, owners of pass-through companies and sole proprietors will be taxed at their individual tax rates less a 20% deduction for business-related income, subject to certain wage limits and exceptions. The deduction would be disallowed for businesses offering "professional services" above a threshold amount; phase-ins begin at $157,500 for individual taxpayers and $315,000 for married taxpayers filing jointly.

About Michael.........

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

M&A Activity: Make Sure You Address The Seller’s 401(k) Plan

Buying a company is an exciting experience.  However, many companies during a merger or acquisition fail to address the issues surrounding the seller’s retirement plan which can come back to haunt the buyer in a big way.   I completely understand why this happens.  Purchase price, valuations, tax issues, terms, holdbacks, and new employment agreements tend to dominate the conversations throughout the business transaction.   But lurking in the dark, below these main areas of focus, lives the seller’s 401(k) plan.  Welcome to the land of unintended consequences where unexpected liabilities, big dollar outlays, and transition issues live.

Asset Sale or Stock Sale

Whether the transaction is a stock sale or asset sale will greatly influence the series of decisions that the buyer will need to make regarding the seller’s 401(k) plan.  In an asset sale, it is common that employees of the seller’s company are terminated from employment and subsequently “rehired” by the buyer’s company.  With asset sales, as part of the purchase agreement, the seller will often times be required to terminate their retirement plan prior to the closing date.

Terminating the seller’s plan prior to the closing date has a few advantages from both the buyer’s standpoint and from the standpoint of the seller’s employees. Here are the advantages for the buyer:

Advantage 1:  The Seller Is Responsible For Terminating Their Plan

From the buyer’s standpoint, it’s much easier and cost effective to have the seller terminate their own plan.  The seller is the point of contact at the third party administration firm, they are listed as the trustee, they are the signer for the final 5500, and they typically have a good personal relationship with their service providers.  Once the transaction is complete, it can be a headache for the buyer to track down the authorized signers on the seller’s plan to get all of the contact information changed over and allows the buyer’s firm to file the final 5500.

The seller’s “good relationship” with their service providers is key. The seller has to call these companies and let them know that they are losing the plan since the plan is terminating.  There are a lot of steps that need to be completed by those 401(k) service providers after the closing date of the transaction.  If they are dealing with the seller, their “client”, they may be more helpful and accommodating in working through the termination process even though they losing the business. If they get a random call for the “new contact” for the plan, you risk getting put at the bottom of the pile

Part of the termination process involves getting all of the participant balances out of the plan. This includes terminated employees of the seller’s company that may be difficult for the buyer to get in contact with.   It’s typically easier for the seller to coordinate the distribution efforts for the terminated plan.

Advantage 2:  The Buyer Does Not Inherit Liability Issues From The Seller’s Plan

This is typically the main reason why the buyer will require the seller to terminate their plan prior to the closing date.  Employer sponsored retirement plans have a lot of moving parts.  If you take over a seller’s 401(k) plan to make the transition “easier”, you run the risk of inheriting all of the compliance issues associated with their plan. Maybe they forgot to file a 5500 a few years ago, maybe their TPA made a mistake on their year-end testing last year, or maybe they neglected to issues a required notice to their employees knowing that they were going to be selling the company that year.  By having the seller terminate their plan prior to the closing date, the buyer can better protect themselves from unexpected liabilities that could arise down the road from the seller’s 401(k) plan.

Now, let’s transition the conversation over to the advantages for the seller’s employees.

Advantage 1: Distribution Options

A common goal of the successor company is to make the transition for the seller’s employees as positive as possible right out of the gate.  Remember this rule:  “People like options”.  Having the seller terminate their retirement plan prior to the closing date of the transactions gives their employees some options. A plan termination is a “distributable event” meaning the employees have control over what they would like to do with their balance in the seller’s 401(k) plan.  This is also true for the employees that are “rehired” by the buyer.  The employees have the option to:

• Rollover their 401(k) balance in the buyer’s plan (if eligible)

• Rollover their 401(k) balance into a rollover IRA

• Take a cash distribution

• Some combination of options 1, 2, and 3

The employees retain the power of choice.

If instead of terminating the seller’s plan,  what happens if the buyer decides to “merge” the seller’s plan in their 401(k) plan?  With plan mergers, the employees lose all of the distribution options listed above. Since there was not a plan termination, the employees are forced to move their balances into the buyer’s plan.

Advantage 2:  Credit For Service With The Seller’s Company

In many acquisitions, again to keep the new employees happy, the buyer will allow the incoming employee to use their years of service with the seller’s company toward the eligibility requirements in the buyer’s plan.  This prevents the seller’s employees from coming in and having to satisfy the plan’s eligibility requirements as if they were a new employee without any prior service.  If the plan is terminated prior to the closing date of the transaction, the buyer can allow this by making an amendment to their 401(k) plan.

If the plan terminates after the closing date of the transaction, the plan technically belonged to the buyer when the plan terminated.  There is an ERISA rule, called the “successor plan rule”, that states when an employee is covered by a 401(k) plan and the plan terminates, that employee cannot be covered by another 401(k) plan sponsored by the same employer for a period of 12 months following the date of the plan termination.  If it was the buyer’s intent to allow the seller’s employees to use their years of service with the selling company for purposes of satisfy the eligibility requirement in the buyer’s plan, you now have a big issue. Those employees are excluded from participating in the buyer’s plan for a year.  This situation can be a speed bump for building rapport with the seller’s employees.

Loan Issue

If a company allows 401(k) loans and the plan terminates, it puts the employee in a very bad situation. If the employee is unable to come up with the cash to payoff their outstanding loan balance in full, they get taxed and possibly penalized on their outstanding loan balance in the plan.

Example: Jill takes a $30,000 loan from her 401(k) plan in May 2017.  In August 2017, her company Tough Love Inc., announces that it has sold the company to a private equity firm and it will be immediately terminating the plan.  Jill is 40 years old and has a $28,000 outstanding loan balance in the plan.  When the plan terminates, the loan will be processed as an early distribution, not eligible for rollover, and she will have to pay income tax and the 10% early withdrawal penalty on the $28,000 outstanding loan balance. Ouch!!!

From the seller’s standpoint, to soften the tax hit, we have seen companies provide employees with a severance package or final bonus to offset some of the tax hit from the loan distribution.

From the buyer’s standpoint, you can amend the plan to allow employees of the seller’s company to rollover their outstanding 401(k) loan balance into your plan.  While this seems like a great option, proceed with extreme caution.  These “loan rollovers” get complicated very quickly.  There is usually a window of time where the employee’s money is moving over from seller’s 401(k) plan over to the buyer’s 401(k) plan, and during that time period a loan payment may be missed.  This now becomes a compliance issue for the buyer’s plan because you have to work with the employee to make up those missed loan payments.  Otherwise the loan could go into default.

Example, Jill has her outstanding loan and the buyer amends the plan to allow the direct rollover of outstanding loan balances in the seller’s plan.  Payroll stopped from the seller’s company in August, so no loan payments have been made, but the seller’s 401(k) provider did not process the direct rollover until December.  When the loan balance rolls over, if the loan is not “current” as of the quarter end, the buyer’s plan will need to default her loan.

Our advice, handle this outstanding 401(k) loan issue with care.  It can have a large negative impact on the employees. If an employee owes $10,000 to the IRS in taxes and penalties due to a forced loan distribution, they may bring that stress to work with them.

Stock Sale

In a stock sale, the employees do not terminate and then get rehired like in an asset sale.  It’s a “transfer of ownership” as opposed to “a sale followed by a purchase”.  In an asset sale, employees go to sleep one night employed by Company A and then wake up the next morning employed by Company B.  In a stock sale, employees go to sleep employed by Company A, they wake up in the morning still employed by Company A, but ownership of Company A has been transferred to someone else.

With a stock sale, the seller’s plan typically merges into the buyer’s plan, assuming there is enough ownership to make them a “controlled group”.  If there are multiple buyers, the buyers should consult with the TPA of their retirement plans or an ERISA attorney to determine if a controlled group will exist after the transaction is completed.   If there is not enough common ownership to constitute a “controlled group”, the buyer can decide whether to continue to maintain the seller’s 401(k) plan as a standalone plan or create a multiple employer plan.    The basic definition of a “controlled group” is an entity or group of individuals that own 80% or more of another company.

Stock Sales: Do Your Due Diligence!!!

In a stock sale, since the buyer will either be merging the seller’s plan into their own or continuing to maintain the seller’s plan as a standalone, you are inheriting any and all compliance issues associated with that plan.  The seller’s issues become the buyer’s issues the day of the closing.   The buyer should have an ERISA attorney that performs a detailed information request and due diligence on the seller’s 401(k) plan prior the closing date.

Seller Uses A PEO

Last issue.  If the selling company uses a Professional Employer Organization (PEO) for their 401(k) services and the transaction is going to be a stock sale, make sure you get all of the information that you need to complete a mid-year valuation or the merged 5500 for the year PRIOR to the closing date.  We have found that it’s very difficult to get information from PEO firms after the acquisition has been completed.

The Transition Rule

There is some relief provided by ERISA for mergers and acquisitions.  If a control group exists, you have until the end of the year following the year of the acquisition to test the plans together.  This is called the “transition rule”.   However, if the buyer makes “significant” changes to the seller’s plan during the transition period, that may void the ability to delay combined testing.  Unfortunately, there is not clear guidance as to what is considered a “significant change” so the buyer should consult with their TPA firm or ERISA  attorney before making any changes to their own plan or the seller’s plan that could impact the rights, benefits, or features available to the plan participants.

Horror Stories

There are so many real life horror stories out there involving companies that go through the acquisition process without conducting the proper due diligence and transition planning with regard to the seller’s retirement plan.  It never ends well!!  As the buyer, it’s worth the time and the money to make sure your team of advisors have adequately addressed any issues surrounding the seller’s retirement plan prior to the closing date. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Tax Reform: At What Cost?

The Republicans are in a tough situation.  There is a tremendous amount of pressure on them to get tax reform done by the end of the year.  This type of pressure can have ugly side effects.  It’s similar to the Hail Mary play at the end of a football game.  Everyone, including the quarterback, has their eyes fixed on the end zone but nobody realizes that no one is covering one of the defensive lineman and he’s just waiting for the ball to be hiked.   The game ends without the ball leaving the quarterback’s hands.

The Big Play

Tax reform is the big play.  If it works, it could lead to an extension of the current economic rally and more.  I’m a supporter of tax reform for the purpose of accelerating job growth both now and in the future.  It’s not just about U.S. companies keeping jobs in the U.S. That has been the game for the past two decades.  The new game is about attracting foreign companies to set up shop in the U.S. and then hire U.S. workers to run their plants, companies, subsidiaries, etc.  Right now we have the highest corporate tax rate in the world which has not only prevented foreign companies from coming here but it has also caused U.S. companies to move jobs outside of the United States.  If everyone wants more pie, you have to focus on making the pie bigger, otherwise we are all just going to sit around and fight over who’s piece is bigger.

Easier Said Than Done

How do we make the pie bigger?  We have to lower the corporate tax rate which will entice foreign companies to come here to produce the goods and services that they are already selling in the U.S.   Which is easy to do if the government has a big piggy bank of money to help offset the tax revenue that will be lost in the short term from these tax cuts. But we don’t.

$1.5 Trillion In Debt Approved

Tax reform made some headway in mid-October when the Senate passed the budget. Within that budget was a provision that would allow the national debt to increase by approximately $1.5 trillion dollars to help offset the short-term revenue loss cause by tax reform.  While $1.5 trillion sounds like a lot of money, and don’t get me wrong, it is, let’s put that number in context with some of the proposals that are baked into the proposed tax reform.

Pass-Through Entities

One of the provisions in the proposed tax reform is that income from “pass-through” businesses would be taxed at a flat rate of 25%. 

A little background on pass-through business income: sole proprietorships, S corporations, limited liability companies (LLCs), and partnerships are known as pass-through businesses. These entities are called pass-throughs, because the profits of these firms are passed directly through the business to the owners and are taxed on the owners’ individual income tax returns. 

How many businesses in the U.S. are pass-through entities?  The Tax Foundation states on its website that pass-through entities “make up the vast majority of businesses and more than 60 percent of net business income in America. In addition, pass-through businesses account for more than half of the private sector workforce and 37 percent of total private sector payroll.” 

At a conference in D.C., the American Society of Pension Professionals and Actuaries (ASPPA), estimated that the “pass through 25% flat tax rate” will cost the government $6 trillion - $7 trillion in tax revenue. That is a far cry from the $1.5 trillion that was approved in the budget and remember that is just one of the many proposed tax cuts in the tax reform package.

Are Democrats Needed To Pass Tax Reform?

Since $1.5 trillion was approved in the budget by the senate, if the proposed tax reform is able to prove that it will add $1.5 trillion or less to the national debt, the Republicans can get tax reform passed through a “reconciliation package” which does not require any Democrats to step across the aisle.  If the tax reform forecasts exceed that $1.5 trillion threshold, then they would need support from a handful of Democrats to get the tax reformed passed which is unlikely.

Revenue Hunting

To stay below that $1.5 trillion threshold, the Republicans are “revenue hunting”.  For example, if the proposed tax reform package is expected to cost $5 trillion, they would need to find $3.5 trillion in new sources of tax revenue to get the net cost below the $1.5 trillion debt limit.

State & Local Tax Deductions – Gone?

One for those new revenue sources that is included in the tax reform is taking away the ability to deduct state and local income taxes.   This provision has created a divide among Republicans. Since many southern states do not have state income tax, many Republicans representing southern states support this provision.   Visa versa, Republicans representing states from the northeast are generally opposed to this provision since many of their states have high state and local incomes taxes.   There are other provisions within the proposed tax reform that create the same “it depends on where you live” battle ground within the Republican party.

Obamacare

One of the main reasons why the Trump administration pushed so hard for the Repeal and Replace of Obamacare was “revenue hunting”.  They needed the tax savings from the repeal and replace of Obamacare to carrry over to fill the hole that will be created by the proposed tax reform.  Since that did not happen, they are now looking high and low for other revenue sources.

Retirement Accounts At Risk?

If the Republicans fail to get tax reform through they run the risk of losing face with their supporters since they have yet to get any of the major reforms through that they campaigned on.  Tax reform was supposed to be a layup, not a Hail Mary and this is where the hazard lies.  Republicans, out of the desperation to get tax reform through, may start making cuts where they shouldn’t.  There are rumors that the Republican Party may consider making cuts to the 401(k) contribution limits and employers sponsored retirement plan.  Even though Trump tweeted on October 23, 2017 that he would not touch 401(k)’s as part of tax reform, they are running out of the options for other places that they can find new sources of tax revenue.  If it comes down to the 1 yard line and they have the make the decision between making deep cuts to 401(k) plans or passing the tax reform, retirement plans may end up being the sacrificial lamb.  There are other consequences that retirement plans may face if the proposed tax reform is passed but it’s too broad to get into in this article. We will write a separate article on that topic.

Tax Reform May Be Delayed

Given all the variables in the mix, passing tax reform before December 31st is starting to look like a tall order to fill.  If the Republicans are looking for new sources of revenue, they should probably look for sources that are uniform across state lines otherwise they risk splintering the Republican Party like we saw during the attempt to Repeal and Replace Obamacare.  We are encouraging everyone to pay attention to the details buried in the tax reform.  While I support tax reform to secure the country’s place in the world both now and in the future, if provisions that make up the tax reform are rushed just to get something done, we run the risk of repeating the short lived glory that tax reform saw during the Reagan Era.   They passed sweeping tax cuts, the deficits spiked, and they were forced to raise tax rates a few years later. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

How Do Single(k) Plans Work?

What is a Single(k) Plan?

A Single(k) plan is an employer sponsored retirement plan for owner only entities, meaning you have no full-time employees. These owner only entities get the benefits of having a full fledge 401(k) plan without the large administrative costs associated with traditional 401(k) plans.

What is the definition of a “full-time” employee?

Often times a small company will have some part-time staff. It does not matter whether you consider them “part-time”, the definition of full-time employee is defined by the IRS as working 1000 hours in a 12 month period. If you have a “full-time” employee you would not be eligible to sponsor a Single(k) plan.

Types of Contributions

There are two types of contributions to these plans. Employee deferral contributions and employer profit sharing contributions. The employee deferral piece works like a 401(k) plan. If you are under the age of 50 you can contribute $19,500, in 2021, in employee deferrals. If you are 50 or older, you get the $6,500 catch up contribution so you can contribute $24,000 in employee deferrals.

The reason why these plans are a little different than other employer sponsored plans is the employee deferral piece allows you to put 100% of your compensation into these plans up to those dollar thresholds.

In addition to the employee deferrals, you can also contribute 20% of your net earned income in the form of a profit-sharing contribution. For example, if you make $100,000 in net earned income from self-employment and you are over 50, you could contribute $24,000 in employee deferrals and then you could contribute an additional $20,000 in form of a profit sharing contribution. Making your total pre-tax contribution $44,000.

Establishment Deadline

You have to establish these plans by December 31st. In most cases that plan does not have to be funded by 12/31 but you have to have the plan document signed by 12/31. You normally have until tax filing deadline plus extension to fund the plan.

Loans & Roth Deferrals

Single(k) plans provide all of the benefits to the owner of a full 401(k) plan at a fraction of the cost. You can set up the plan to allow 401(k) loan and Roth deferral contributions.

SEP IRA vs Single(k) Plans

A lot of small business owners find themselves in a position where they are trying to decide between setting up a SEP IRA or a Single(k) plan. One of the big factors, that is often times the deciding factor, is how much the owner intends to contribute to the plan. The SEP IRA limits the business owner to just the 20% of net earned income. Whereas the Single(k) plan allows the 20% of net earned income plus the employee deferral contribution amount. However, if 20% of your net earned income would satisfy your target amount then the SEP IRA may be the right choice.

Advanced Strategy Using A Single(k) Plan

Here is a great tax strategy if you have one spouse that is the primary breadwinner bringing in most of the income and the other has self-employment income for a side business. If the spouse with the self-employment income is over the age of 50 and makes $20,000 in net earned income, they could set up a Single(k) Plan and defer the full $20,000 into their Single(k) plan as employee deferrals. If they had a SEP IRA, the max contribution would have been $4,000.

A huge tax savings for a married couple that is looking to lower their tax liability.

About Rob……...

Hi, I’m Rob Mangold. I’m the Chief Operating Officer at Greenbush Financial Group and a contributor to the Money Smart Board blog. We created the blog to provide strategies that will help our readers personally , professionally, and financially. Our blog is meant to be a resource. If there are questions that you need answered, pleas feel free to join in on the discussion or contact me directly.

How Do Phantom Stock Plans Work?

In the world of executive compensation, there are a number of ways that a company can reward key employees.  Although most companies are familiar with traditional deferred compensation plans, one of the lesser known options which is growing in popularity is called a “phantom stock plan”.   Especially in small to mid-size companies.

Here is the most common situation, a closely held business or family business has a key employee that they would like to reward but also further tie that employee to the company.  The current owners of the company do not want to give up equity but they want to tie this reward system to the actual performance of the company as if that key employee was an owner or shareholder.   This can be accomplished via a phantom stock plan.

These plans provide select employees with additional compensation equal to the appreciation of a percent of the company for a partnership, LLC, or PLLC, or in the case of an S-corp or C-corp a given number of shares in the company even though the ownership only exists in theory.  For example, I own a company that is incorporated as a partnership and I would like to reward a key employee by providing them with an annual cash reward equal to a 5% ownership stake in the company without formally making them a partner.  Once the books are closed at the end of year I will issue a cash bonus to that employee equal to 5% of the net profits for the year.  From the employee’s standpoint, they are receiving the monetary reward mimicking a 5% ownership share of the company so they have an incentive to continue to grow the company.  From the employer’s standpoint, they have taken further steps to retain a key employee, they can deduct the additional comp pay to the employee, and the current owners have retained full control of the company.

The features of these plans and how they are design are limitless because they are just another flavor of nonqualified executive compensation plan. A few plan design features are listed below:

• Companies have full discretion as to who is covered and not covered by the plan

• Instead of paying out the benefit each year as compensation, the company can attach a vesting schedule to essentially put “golden handcuffs” on the key employee. If they leave the company prior to a stated date they lose the benefit.

• When awarding the shares or ownership the company can limit the award to just the appreciation of their shares or ownership percentage and not award the full current value of the ownership percentage. These are called “appreciation only” plans. Appreciation only phantom stock plans can be viewed as a favorable option to key employees because it does not require them to make a cash outlay to purchase their ownership interest as would normally be required by an actual equity or share purchase.

How do these plans work from an operation standpoint?  The ownership percentage or shares are issued to the employee as hypothetical units or “phantom units” that are just tracked internally by the company.   The employee is taxed on the benefit and the company can take the deduction for the compensation paid when there is no longer a “risk of forfeiture”. In other words, when the employee vests in the benefit whether they decide to “sell their phantom shares” or not.  As soon as the employee has the ability to “sell” their phantom interest in exchange for compensation that triggers the taxable event.

When designed correctly, these plans can be a valuable tool for small to mid-size companies in their efforts to retain key employees. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Small Business Owners: How To Lower The Cost of Health Insurance

As an owner of a small business myself, I’ve had a front row seat to the painful rise of health insurance premiums for our employees over the past decade.   Like most of our clients, we evaluate our plan once a year and determine whether or not we should make a change.  Everyone knows the game.  After running on this hamster wheel for the past decade it led me on a campaign to consult with experts in the health insurance industry to find a better solution for both our firm and for our clients.

The Goal: Find a way to keep the employee health benefits at their current level while at the same time cutting the overall cost to the company.  For small business owners reducing the company’s outlay for health insurance costs is a challenge. In many situations, small businesses are the typical small fish in a big pond. As a small fish, they frequently receive less attention from the brokerage community which is more focused on obtaining and maintaining larger plans.

Through our research, we found that there are two key items that can lead to significant cost savings for small businesses.  First, understanding how the insurance market operates.  Second, understanding the plan design options that exist when restructuring the health insurance benefits for your employees.

Small Fish In A Big Pond

I guess it came as no surprise that there was a positive correlation between the size of the insurance brokerage firm and their focus on the large plan market.  Large plans are generally defined as 100+ employees.  Smaller employers we found were more likely to obtain insurance through their local chambers of commerce, via a “small business solution teams” within a larger insurance brokerage firm, or they sent their employees directly to the state insurance exchange.

Myth #1:  Since I’m a small business, if I get my health insurance plan through the Chamber of Commerce it will be cheaper.   I unfortunately discovered that this was not the case in most scenarios.  If you are an employer with between 1 – 100 employees you are a “community rated plan”. This means that the premium amount that you pay for a specific plan with a specific provider is the same regardless of whether you have 2 employees or 99 employee because they do not look at your “experience rating” (claims activity) to determine your premium.  This also means that it’s the same premium regardless of whether it’s through the Chamber, XYZ Health Insurance Brokers, or John Smith Broker.  Most of the brokers have access to the same plans sponsored by the same larger providers in a given geographic region.  This was not always the case but the Affordable Care Act really standardized the underwriting process.

The role of your insurance broker is to help you to not only shop the plan once a year but to evaluate the design of your overall health insurance solution.  Since small companies usually equal smaller premium dollars for brokers it was not uncommon for us to find that many small business owners just received an email each year from their broker with the new rates, a form to sign to renew, and a “call me with any questions”.   Small business owners are usually extremely busy and often times lack the HR staff to really look under the hood of their plan and drive the changes needed to improve the plan from a cost standpoint.  The way the insurance brokerage community gets paid is they typically receive a percentage of the annual premiums paid by your company.  From talking with individuals in the industry, it’s around 4%.  So if a company pays $100,000 per year in premiums for all of their employees, the insurance broker is getting paid $4,000 per year.  In return for this compensation the broker is supposed to be advocating for your company.  One would hope that for $4,000 per year the broker is at least scheduling a physical meeting with the owner or HR staff to review the plan each year and evaluate the plan design options.

Remember, you are paying your insurance broker to advocate for you and the company.  If you do not feel like they are meeting your needs, establishing a new relationship may be the start of your cost savings.   There also seemed to be a general theme that bigger is not always better in the insurance brokerage community. If you are a smaller company with under 50 employees, working with smaller brokerage firms may deliver a better overall result.

Plan Design Options

Since the legislation that governs the health insurance industry is in a constant state of flux we found through our research that it is very important to revisit the actual structure of the plan each year. Too many companies have had the same type of plan for 5 years, they have made some small tweaks here and there, but have never taken the time to really evaluate different design options.  In other words, you may need to demo the house and start from scratch to uncover true cost savings because the problem may be the actual foundation of the house.

High quality insurance brokers will consult with companies on the actual design of the plan to answer the key question like “what could the company be doing differently other than just comparing the current plan to a similar plan with other insurance providers?”   This is a key question that should be asked each year as part of the annual evaluation process.

HRA Accounts

The reason why plan design is so important is that health insurance is not a one size fits all.  As the owner of a small business you probably have a general idea as to how frequently and to what extent your employees are accessing their health insurance benefits.

For example, you may have a large concentration of younger employees that rarely utilize their health insurance benefits.  In cases like this, a company may choose to change the plan to a high deductible, fund a HRA account for each of the employees, and lower the annual premiums.

HRA stands for “Health Reimbursement Arrangement”.  These are IRS approved, 100% employer funded, tax advantage, accounts that reimburses employees for out of pocket medical expenses.  For example, let’s say I own a company that has a health insurance plan with no deductible and the company pays $1,000 per month toward the family premium ($12,000 per year).   I now replace the plan with a new plan that keeps the coverage the same for the employee, has a $3,000 deductible, and lowers the monthly premium that now only cost the company $800 per month ($9,600 per year).  As the employer, I can fund a HRA account for that employee with $3,000 at the beginning of the year which covers the full deductible.  If that employee only visits the doctors twice that year and incurs $500 in claims, at the end of the year there will be $2,500 in that HRA account for that employee that the employer can then take back and use for other purposes.  The flip side to this example is the employee has a medical event that uses the full $3,000 deductible and the company is now out of pocket $12,600 ($9,600 premiums + $3,000 HRA) instead of $12,000 under the old plan.  Think of it as a strategy to “self-insure” up to a given threshold with a stop loss that is covered by the insurance itself.  The cost savings with this “semi self-insured” approach could be significant but the company has to conduct a risk / return analysis based on their estimated employee claim rate to determine whether or not it’s a viable option.

This is just one example of the plan design options that are available to companies in an attempt to lower the overall cost of maintaining the plan.

Making The Switch

You are allowed to switch your health insurance provider prior to the plan’s renewal date.  However, note that if your current plan has a deductible and your replacement plan also carries a deductible, the employees will not get credit for the deductibles paid under the old plan and will start the new plan at zero.  Based on the number of months left in the year and the premium savings it may warrant a “band-aide solution” using HRA, HSA, or Flex Spending Accounts to execute the change prior to the renewal date. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Tax Secret: R&D Tax Credits…You May Qualify

When you think of Research and Development (R&D) many people envision a chemistry lab or a high tech robotics company.  It’s because of this thinking that millions of dollars of available tax credits for R&D go unused every year.   R&D exists in virtually every industry and business owners need to start thinking about R&D in a different light because there could be huge tax savings waiting for them.

Most companies don't realize that they qualify

Road paving companies, manufactures, a meatball company, software firms, and architecture firms are just a few examples of companies that have met the criteria to qualify for these lucrative tax credits.

Think of R&D as a unique process within your company that you may be using throughout the course of your everyday business that is specific to your competitive advantage.  The purpose of these credits is to encourage companies to be innovative with the end goal of keeping more jobs here in the U.S.   If you have an engineers on your staff, whether software engineers, design engineers, mechanical engineers there is a very good chance that these tax credits may be available to you.   The R&D tax credits also allow you to look back to all open tax years so for companies that discover this for the first time, the upside can be huge.  Tax years typically stay open for three years.

Accountants may not be aware of these credits

One of the main questions we get from business owners is “Shouldn’t my accountant have told me about this?”  Many accounting firms are unaware of these tax credits and the process for qualifying which is why there are specialty consulting firms that work with companies to determine whether or not they are eligible for the credit.  Some of our clients have worked with these firms and the company only pays the consulting firm if you qualify for the tax credits. Kind of a win-win situation.

We recently attended a seminar that was sponsored by Alliantgroup out of New York City and on their website it listed the following description of companies that qualify for these credits:“

Any company that designs, develops, or improves products, processes, techniques, formulas, inventions, or software may be eligible. In fact, if a company has simply invested time, money, and resources toward the advancement and improvement of its products and processes, it may qualify”.

We love helping our clients save taxes and in this case, like many others, we were looking at R&D in a different light. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Avoid These 1099 “Employee” Pitfalls

As financial planners we are seeing more and more individuals, especially in the software development and technology space, hired by companies as “1099 employees”.  “1099 employees” is an ironic statement because if a company is paying you via a 1099 technically you are not an “employee” you are a self-employed sub-contractor.   It’s like having your own separate company and the company that you work for is your “client”.

There are advantages to the employer to pay you as a 1099 sub-contractor as opposed to a W2 employee.  When you are a W2 employee they may have to provide you with health benefits, the company has to pay payroll taxes on your wages, there may be paid time off, you may qualify for unemployment benefits if you are fired, eligibility for retirement plans, they have to put you on payroll, pay works compensation insurance, and more.   Basically companies have a lot of expenses associated with you being a W2 employee that does not show up in your paycheck.

To avoid all of these added expenses the employer may decide to pay you as a 1099 “employee”.   Remember, if you are a 1099 employee you are “self-employed”.    Here are the most common mistakes that we see new 1099 employees make:

Making estimated tax payments throughout the year

This is the most common error. When you are a W2 employee, it’s the responsibility of the employer to withhold federal and state income tax from your paycheck.  When you are a 1099 sub-contractor, you are not an employee, so they do not withhold taxes from your compensation…………that is now YOUR RESPONSIBILITY.    Most 1099 individuals have to make what is called “estimated tax payments” four times a year which are based on either your estimated income for the year or 110% of the previous year’s income.  Best advice……..if 1099 income is new for you, setup a consultation with an accountant.  They will walk you through tax withholding requirements, tax deductions, tax filing forms, etc.  It’s very difficult to get everything right using Turbo Tax when you are a self-employed individual.

Tracking mileage and expenses throughout the year

Since you are self-employed you need to keep track of your expenses including mileage which can be used as deductions against your income when you file your tax return.  Again, we recommend that you meet with a tax professional to determine what you do and do not need to track throughout the year.

The tax return is prepared incorrectly

No one wants a love letter from the IRS.  Those letters usually come with taxes due, penalties, and a “guilty until proven innocent” approach.  There may be additional “schedules” that you need to file with your tax return now that you are self-employed.  The tax schedules detail your self-employment income, deductions, estimated tax payments, and other material items.

Important rule, do not cut corners by reducing the gross amount of your 1099 income.  This is a big red flag that is easy for the IRS to catch.  The company that issued the 1099 to you usually reports that 1099 payment to the IRS with your social security number or the Tax ID number of your self-employment entity.  The IRS through an automated system can run your social security number or tax ID to cross check the 1099 payment and 1099 income to make sure it was reported.

Legal protection

As a 1099 sub-contractor, you have to consider the liability that could arise from the services that you are providing to your “client” (your employer).  As a self-employed individual, the company that you “work for” could sue you for any number of reasons and if you are operating the business under your social security number (which most are) your personal assets could be at risk if a lawsuit arises.  Advice, talk to an attorney that is knowledgeable in business law to discuss whether or not setting up a corporate entity makes sense for your self-employment income to better protect yourself. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Tax Secret: Spousal IRAs

Spousal IRA’s are one of the top tax tricks used by financial planners to help married couples reduce their tax bill.  Here is how it works:

In most cases you need “earned income” to be eligible to make a contribution to an Individual Retirement Account (“IRA”).  The contribution limits for 2021 is the lesser of 100% of your AGI or $6,000 for individuals under the age of 50.  If you are age 50 or older, you are eligible for the $1,000 catch-up making your limit $7,000.

There is an exception for “Spousal IRAs” and there are two cases where this strategy works very well.

Case 1:  One spouse works and the other spouse does not.  The employed spouse is currently maxing out their contributions to their employer sponsored retirement plan and they are looking for other ways to reduce their income tax liability.

If the AGI (adjusted gross income) for that couple is below $198,000 in 2021, the employed spouse can make a contribution to a Spousal Traditional IRA up to the $6,000/$7,000 limit even though their spouse had no “earned income”.    It should also be noted that a contribution can be made to either a Traditional IRA or Roth IRA but the contributions to the Roth IRA do not reduce the tax liability because they are made with after tax dollars.

Case 2:  One spouse is over the age of 70 ½ and still working (part time or full time) while the other spouse is retired.  IRA rules state that once you are age 70½ or older you can no longer make contributions to a traditional IRA.  However, if you are age 70½ or older BUT your spouse is under the age of 70½, you still can make a pre-tax contribution to a traditional IRA for your spouse.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.