Overview

Both of my parents were comfortably retired by my age after a thirty year career with the federal government. Currently, my retirement date is the lesser of age 95 or my passing. Like a lot of people in the early part of my career I looked for the quickest path up the corporate ladder moving from one job to another. As I progressed up the corporate ladder and arrived at a rung on the ladder that I was comfortable with, the company pushed me off of the ladder over and over again. These days it does not really matter whether you are a strong performer or a weak performer.  As a middle manager in Corporate America (aka “The Man”), you have a very significant chance of being “downsized”.

There is also a pretty decent chance that if downsizing happens after age 50, you may never get another job in Corporate America of a comparable scale. This dilemma has also carried over to federal, state and municipal workers who have heretofore enjoyed great employment stability and often times richer retirement and employee benefit programs than private industry. The economic reality is that there is no longer any security in the traditional sectors of employment.  Furthermore as a worker, you are lucky to have a pension plan in Corporate America. At this stage of the game, most companies have a 401k that is funded by the employee with a match from the employer, if you are lucky.

On that basis, it is my suggestion that everyone that works in Corporate American or who is self-employed live as if they two weeks away from receiving their Pink slip. Severance packages are not a constitutional right! As a result, salaried employees will find themselves (whether they like it or not) as accidental entrepreneurs. The time between jobs can seem to be infinite. You can either spend your time looking for a job, or plan for the unemployment contingency by creating your own business while you still have your job. The bestselling business writer Michael Masterson suggests to his readers that a person should have multiple sources of income. This philosophy should also apply to those that are self-employed. Your primary business today may be great today and obsolete tomorrow.

This article is the first in a series of articles discussing the virtues and financial power of creating your own business as a vehicle for ensuring your current and future financial stability. My thesis is that everyone among the salaried and self-employed will eventually find themselves as “The Accidental Entrepreneur”. Nevertheless, there is so much planning power in having your own business that it will be the remedy to ensure your financial security before age 95.

The Hobby Loss Rules  

The financial and tax benefits of owning your own business are applicable regardless of the size of your company. For example, your business can sponsor its own pension plan and offer plans that are far more attractive than Corporate America. Your company on your “day job” may not have a very good pension plan but that does not mean that you cannot sponsor a pension plan in your business.

Your business may operate at a tax loss which might allow you to offset your salaried income using that loss. However, the initial threshold obstacle to overcome is the application of the hobby loss rules in IRS Section 183 of the Internal Revenue Code. The Tax Code allows deductions for ordinary and necessary business expenses of carrying on a trade or business.

The hobby loss rules limit deductions for activities not engaged in for profit. IRS Sec 183 allows the deduction of expenses only to the extent that the taxpayer has gross income from the business activity during the tax year. Therefore, it is important and necessary to establish the profit motive to avoid the application of the hobby loss rules.

The treasury regulations of the hobby loss rules (Reg.1.183-2(b) list nine objective factors to aid in the determination of whether an activity was engaged for profit:

1. Extent to which the taxpayer carried on the activity in a businesslike manner
2. Taxpayer’s expertise or reliance on the advice of experts
3. Time and effort the taxpayer expends to carry on the activity
4. Expectation that the assets used in the business activity may appreciate in value
5. Taxpayer’s success in similar activities
6. Taxpayer’s history of income and loss from the activity
7. Amount of occasional profits, if any
8. Taxpayer’s financial status
9. Elements of personal pleasure or recreation

IRC Sec 183 has presumption that a taxpayer is engaged in a business activity if the activity was profitable for three of the last five years[1]. In the event the presumption is not met, the taxpayer must establish a profit motive using the nine factors to establish the profit motive.

In the event, the taxpayer engages in multiple activities, the facts and circumstances may be categorized as a single or multiple activities, the IRS will normally accept the taxpayer’s characterization of the activity as a single or multiple activity enterprise.

When the taxpayer fails to establish a profit motive in the activity, the Tax Code applies a three-tier system to allowable deductions. Tier One deductions include, qualified home interest expenses, tax-related expenses, medical expenses, charitable contributions, casualty losses and bad debts. Tier Two deductions are allowable to the extent of gross income from the activity after Tier One deductions. These include general operating expenses such as rent utilities, labor, supplies, insurance and advertising. Tier Three deductions are allowed to the extent of gross income reduced by Tier One and Tier Two deductions. Tier Three deductions include depreciation and partial losses for capital assets.

The passive loss rules of IRC Sec 469 generally defers passive activity losses and credits until the business owner disposes of the entire interest in the activity in a taxable transaction. The passive loss rules do not apply to the hobby loss rules. The two percent floor of adjusted gross income for miscellaneous itemized deductions applies to deductions for hobby losses.  

Strategy Example

Facts

Willy Wonka, age 50, is a human resources consultant for large companies. He sees the writing on the proverbial wall that his corporation may cut the company’s middle management workforce over the next several years.  Wonka has excellent consulting skills and realizes that many of the small businesses in his community can benefit from the same knowledge.

Strategy Example

Wonka creates a new business as a limited liability company and is immediately successful. The company has no employees. He and his wife each take a salary of $25,000. The LLC adopts a 401k/profit sharing plan and a cash balance defined benefit plan. Willy and his wife, being able to exercise catch-up contributions ($6,000 each) each defer $24,000 into their respective 401k accounts. The company makes an additional contribution of $1,500 for each participant as a profit sharing contribution. Lastly, the company makes contributions into the cash balance defined benefit plan of $35,000 each. As a result, the company profit is zeroed out. Willy and his wife have taxable income of $2,000 collectively while making pension contributions of approximately $100,000!

Summary

The current political and economic environment suggests people are tired of the status quo. Corporate America is loyal to Corporate America. If you want to have a retirement age that is earlier than age 95, you need to step it up! Create a business today on the internet using your existing skills. The legal and tax benefits of owing your own company are substantial. Future articles in this series will outline these benefits one-by-one.

I have outlined a strategy that has significant planning utility.  There are certain additional enhancements that can be employed to amplify the planning benefits.  I implore you to consult uniquely qualified and properly licensed professionals in this arena.  I stand ready to discuss the pros & cons with you, in light of your wealth planning objectives. All introductory calls from prospective clients and/or advisers are welcome and complimentary.