GREAT IDEAS FOR ENTREPRENEURS FROM THE THOUGHT LEADERS AT CASEY NEILON
Many of the strategies that allow you to maximize benefits from the new tax law require you to take action soon.
Three-Dimensional Tax Strategies
The complexity of the TCJA gives it a three-dimensional feel, especially when combined with the existing tax law and strategies that have not changed. The TCJA, coupled with the existing law, requires a comprehensive analysis of your situation to determine the best possible outcome for tax mitigation and long-term tax and financial planning.
I tend to think of the material we now have to work with like a Rubik’s Cube. Do you remember those? As you rotate the colored squares on the face of the cube, you change the entire cube, not just the color pattern you were trying to complete.
Here is a scenario of a common ownership structure for one of our clients:
- Entity A – 100% ownership interest in a limited liability company with no employees and material participation by the owner netting $100,000 in income
- Entity B – 20% ownership interest in a limited partnership with 50 employees and no participation by the owner netting $30,000 in income
- Entity C – 60% ownership interest in an S corporation with the owner as the only employee netting $80,000 in income and drawing a $20,000 salary
In this structure, the client realizes $230,000 in ordinary income from 3 different entities. This income varies in character; some will be treated as non-passive, some as passive. Some of the income will be subject to self-employment tax and some will not.
Some of the income can be considered in the calculation to determine the maximum retirement plan contribution allowable; some will not. Each of these issues requires consideration to maximize the tax benefit within the parameters of making good business decisions.
The new tax law adds another layer of complexity to the existing decision-making process for this client as they will now have to consider:
- Whether electing certain depreciation methods commonly utilized in the past makes sense given the new pass-through entity deduction
- Whether wages are an important factor in determining if they qualify for the pass-through deduction
- Whether adding a new entity which will employ staff, thereby increasing the potential pass-through deduction, will reduce the benefit derived from a maximum retirement plan contribution
- The list goes on and on; these are just a few examples
The point I’m making here is that if you change your tax strategy for one entity, it can impact your entire tax picture. More importantly, the TCJA has likely already made changes to your tax planning potential and you shouldn’t wait to discover what those changes will look like and how you should respond. Let me give you an example.
A Client Case Study
I have a client, let’s call him Mike, who has a complex structure of ownership interests in several businesses entities. He is a serial entrepreneur, like many of my clients. Mike has a lot of ideas and the courage to invest in them.
Mike is planning on forming a new company in addition to the complex set of entities he owns today (similar to what I described as Entities A, B & C above). This new entity is going to be paying approximately $100,000 in wages. He expects to realize $200,000 in net income in 2018 and this entity provides personal services.
When I first heard about the new entity formation, I was concerned about how it might impact Mike’s tax-deferred retirement strategy. I knew he did not initially realize that he may have to make contributions for the employees if he wanted to maximize the contribution he would benefit from individually.
Mike makes $50,000-$100,000 in retirement plan contributions annually. He benefits from this personally through a complex strategy that includes a defined benefit plan and a 401(k) profit-sharing plan.
In addition to my concern about the retirement plan, I also quickly determined that there are many planning strategies that could impact his taxable income at the individual level as a result of the TCJA. I set up a meeting with Mike to discuss this situation.
I discovered that he planned to add significant employees in 2018. This could have directly impacted his retirement funding strategy, depending on a number of factors. He also stated that he was planning to purchase a substantial amount of equipment. Just a few of the initial issues we considered were:
- When should he add employees, given the retirement plan’s eligibility period for new participants?
- Should he make contributions on behalf of the employees?
- Should he make non-deductible contributions?
The answers to these questions become even more complex, given the new tax law. Here are just a few of the factors we have begun taking into consideration:
- If he has flexibility in the formation and ownership structure of the new entity, is he going to be a minority, passive owner, which may allow him to continue funding his retirement strategy without changes but would limit his ability to take the 20% pass-through deduction?
- Although he is eligible for substantial depreciation deductions, should he elect out, resulting in higher net income in order to maximize the 20% pass-through deduction or take the largest depreciation deduction available in order to get below the income thresholds that would preclude a 20% deduction for service companies?
- Does he have the ability to influence his taxable income in order to fall below the threshold that requires analysis of other variables, such as wages and whether a company primarily provides services, in order to maximize the 20% pass-through deduction?
- Do the new or existing companies have the need to retain profits, in which case a C corporation structure may make sense to defer some taxes and reduce personal income, which may result in falling below the threshold that would preclude a 20% pass-through deduction for service companies?
- If none of these strategies result in reducing income below the threshold, are there significant investments in real estate that might increase availability of the 20% pass-through deduction?
- If one of the entities has components of service and non-service activities, does it make sense to separate them out into separate entities to capitalize on the 20% pass-through deduction?
As you can see, there are a lot of factors to consider to ensure Mike receives the greatest benefit possible from the new law. Even if your situation is not as complex as Mike’s, you’ll probably still be impacted by the new tax law in ways you might not realize right now. Because there are so many variables to consider in our new tax environment, I recommend you seek professional assistance right away.
What You Should Do Now
Given the three-dimensional nature of the new tax environment, my counsel to entrepreneurs is to set up a consultation with your tax advisor sooner rather than later to impact your 2018 tax planning and beyond. There are too many variables to go it alone. Please bear in mind that your tax and financial planning timelines might be much more involved now than in the past. So get started early.
I would also counsel you to plan several check-ins over the course of the next 18 to 24 months with your tax advisor. The IRS will begin to release regulations and revenue procedures and rulings to define the tax code based on the new law. In addition, court cases will eventually follow, which will establish precedence.
In other words, you should be prepared to make changes to your tax strategies as regulations, litigation and revenue rulings clarify the new law. Please do not assume that this is a “one-and-done” tax era. I don’t believe that to be true. I cannot predict how things will change, but I can predict that things will change.
It’s important to me to give my clients every possible advantage when it comes to mitigating taxes and building net-worth. The new tax law holds great promise for business owners. But determining how to realize that promise may be more complex than you realize. I believe a close analysis of your situation is the best strategy. Let’s have that conversation soon.
Darsi Casey – CPA, MST, MANAGING SHAREHOLDER
They call me the Managing Shareholder at Casey Neilon. I see myself as the chief problem solver. I get the privilege of working with fascinating people with a wide variety of backgrounds and problems… this is what fires me up! I have been managing our firm and serving clients in this capacity since founding the firm in 2006 and have been practicing in public accounting since 1989. As an experienced entrepreneur myself, i have learned that the best way to predict the future is to create it (I borrowed that quote from Abe Lincoln).