Part I of this series focused on the impact of impending tax increases following the Presidential Election for corporate executives and salaried professionals. Part II of the series will focus on planning opportunities for business owners.
Part II will also provide a quick review on the so-called Hobby Loss rules in starting a new business. Aside from the obvious tax benefits of starting and having your own business, it makes a lot of sense for other reasons than tax planning.
First, there is a good chance that you lost a decent portion of your savings following the 2008 recession (depression). As it is said, a recession is when your neighbor loses his job. A depression is when you lose your job. Additionally, the real estate bubble probably evaporated the remaining equity in your home.
Second, you never know in Corporate America if this Friday is your last day on the job. Given the economic circumstances, it takes a long time to mount and execute a job campaign in order get a new job. It could take a year or longer. Under the theory it is never good to have all of your eggs in one basket; it makes sense to have a source of income outside of your regular employment. Just the same, if you are a business owner, it probably makes sense to have more than one business. Your Boss may not like it, but it is probably unlikely that your current employer has guaranteed lifetime employment either.
Third, corporate pension plans are far less generous than they were in the past. Better those corporate shareholders earn an extra two cents per share this quarter than to make a decent contribution into a defined benefit plan. It seems like that the only decent pension plans to be found are in employment with the federal or state and municipal government. If you have your own business, you can set up this type of pension plan and your spouse.
The Bush tax cuts are due to expire at the end of 2012. The President is on the record stating that he will oppose an extension of the Bush tax cuts for taxpayer’s earnings over $250,000 per year. Personally, I do not see the President budging much on this one regardless of the amount of revenue it raises.
The President also stated that he would favor an estate tax exemption of $3.5 million per taxpayer. The Republicans will have to save the elimination of the federal estate tax for another day.
Nevertheless, we still have a bipartisan Congress that can’t agree on anything including the date of the annual Congressional Picnic. However, the President holds the ‘Trump Card”, veto power.
This article is designed to outline a few tax planning ideas in light of the election. Part II focuses on some general tax planning ideas for business owners and would-be business owners..
B. How Far is the Fall of the Cliff?
The answer depends on whether you fall from the top (highest income earner) or somewhere in between. Aside from increases at the federal level, it is not beyond the realm of possibility to face tax increases at the state level where the fiscal woes are equal to or exceed the challenges at the federal level. Taxpayers in states like New York, New Jersey and California are looked at combined marginal brackets of 52-55 percent.
The implementation of ObamaCare adds another 3.8 percent of taxation on unearned income for joint filers with taxpayers with adjusted gross income (AGI) in excess of $250,000. Top bracket income earners are also exposed to the phase out of personal exemptions and itemized deductions.
The phase outs have the effect of adding an additional two percent to the marginal bracket. The long term capital gains rate increases to 20 percent. Dividends will return to being taxed as ordinary income once again.
What can you do? Believe or not, a lot!
C. Business Owners
The so-called hobby loss rules are covered in IRC Sec 183. The rules are designed to prevent taxpayers from operating a business strictly to manufacture tax deductions in a business that is really a personal hobby. There is a presumption that a business demonstrate a profit in three out of five years and two out of seven years for a horse breeding business.
Alternatively, Form 5213 provides the taxpayer with the ability to make an election which delays the determination until the end of the four year or sixth year for any breeding activity. Each different business activity would require its own election.
You need to consider doing a few things in order to support the “business versus hobby” argument. First, treat the business like a business with separate books and records and a bank account. Second, prepare a detailed and written business plan for the business. Third, try to minimize the personal and recreational aspects of the business. Fourth, acquire real expertise and the business and don’t be afraid to hire expertise. Lastly, the corollary rule to “If it ain’t broken, don’t fix it.” If it is broken, fix it. Try and try again.”
(1) Make an Election to be taxed as a C Corporation
Over the last 10-15 years, virtually every new business has been created as a pass-through entity such as a LLC or S Corporation. As a result, businesses have been taxed at the individual shareholder’s tax rate. With tax rates increasing in the near future, it may be time to rethink that strategy and create a new subsidiary of the company that is a regular corporation, i.e. C Corporation.
The tax arbitrage may be more favorable for a business owner in New York or California that may be taxed at a combined rate of 55 percent while the corporate tax rate on the first $50,000 is 15 percent. At the same time, a number of tax planning strategies exist to minimize corporate taxation.
From the standpoint of employee benefit participation, a regular corporation offers more flexibility for from the standpoint of the business owner. Participation in some benefit programs is limited for partners and more than two percent shareholders in S corporations. These limitations do not exist within a regular corporation.
Here is a brief outline of some of those deductions:
Home Office Deduction
IRC Sec 179 Deduction – Expense certain capital expenditures instead of amortizing them.
Group Life Insurance
Long Term Care Insurance
Business travel and entertainment
(2) Form a Captive Insurance Company
A captive insurance company is a closely held insurance company designed to insure the under-insured and uninsured property and casualty risks of your operating companies. The captive insurance company is owned by the business owner or a family trust for estate planning purposes. The business owner retains management control over the investment of the captive’s assets.
The business owner as the majority shareholder, CEO and Chairman of the board of directors, has full control over the management of the captive. From an income tax perspective, the premiums are a tax deductible expense to the operating company (the insured) and the captive insurance company pays little or no taxes.
From a gift tax perspective, the premiums paid by the company are not treated as a taxable gift to the family members who may be beneficiaries of a family trust owning the captive insurer.
The exit strategy for a captive may be a sale or liquidation at long-term capital gains rates.
(3) What if You do Business Internationally?
(a) Defer taxation on International Sales
If you do some business internationally, consider creating a foreign corporation to defer U.S. taxation while also avoiding taxation abroad. In order to accomplish this result, you need to navigate carefully through the tax minefield to avoid Controlled Foreign Corporation (CFC) treatment.
You may be able to achieve substantial tax reduction and deferral for your business overseas by creating an Interest Charge Domestic international Sales Companies (IC-DISC). This works for exporters as well as engineering and architectural firms. An Interest Charge Domestic International Sales Corporation ( IC-DISC) is a tax-exempt, domestic corporation set up to receive commissions on your company’s international sales.
The IC-DISC does not need to have an office, employees or tangible assets nor is it required to perform any services. The attractiveness of the IC-DISC is its ability to defer international taxation at a relatively low cost, the interest charge against any deferred income. The interest charge is based upon the yield on treasury bills.
(4) Family Pension Plan
One of the problems with traditional pension plans is a series of regulations that force a business owner to contribute a certain level for employees. The effect of this that the plan becomes expensive for the company. The regulations have complex rules known as the controlled group rules and affiliated service group rules that limit the ability of the business owner to set up subsidiary or related companies with fewer employees to maximize pension contributions for the business owner.
One noteworthy exception exists for the spouse of the business owner. If you have a business with large number of employees, and high taxable income making a defined benefit plan to expensive in the operating company, consider creating a company owned by your spouse that provides consulting services to the operating company. Your spouse can set up a pension plan in that company. The exemption provides that your spouse cannot be a shareholder, employee or officer or director of the operating company.
(5) Asset Protection A Hidden Tax
Most states offer minimal protection from the claims of potential creditors. Your personal and commercial umbrella liability coverage have important exclusions. The only reasonable certainty of protecting your assets from the claims of creditors is offshore asset protection planning. Nevada and South Dakota are good interim measures but do not offer the legal certainty of the offshore jurisdictions in my opinion.
If the federal government is a potential creditor, offshore is your only chance. If you have a potentially contention divorce and property settlement in your future, offshore is your only chance to protect your assets.
The future is now! You need to develop a multi-faceted approach to deal with the adversity of the changing environment. I have attempted to outline a few ideas that provide for tax reduction and deferral. If you don’t have a business, start one! If you have a business, start another one that is different from your current business. You never know……..!