In this Wealth Planning Update:
A common goal among business owners is to maximize the positive impact their businesses have on their families, employees, and communities. With that in mind, a business owner may make specific strategic decisions about his or her entity structure, operational tactics, timing of income and expenses, employee benefits, and a multitude of other issues. An important consideration that affects all of these strategic decisions is tax exposure.
As the old adage goes, “you have to pay taxes, but you don’t have to leave a tip!” The following is a sampling of seven considerations for business owners as they develop their overall tax and wealth management plan.
Source: Wells Fargo Wealth Planning Center, July 2016
1. Entity Selection: It is important for business owners to understand the income tax differences when they select the ideal entity type for their business. For example, C corporation shareholders can face marginal federal tax rates that are as much as 10 percent higher than S corporation shareholders. Further, if a business is located in a state with a large disparity between the corporate and individual income tax rates, a C corporation shareholder may face marginal tax rates that are more than 15 percent higher than S corporation shareholders. On the other hand, C corporations have a number of benefits that S corporations do not have (e.g., ability to accumulate earnings, deducting fringe benefits, etc.). Even if a company is well established, it may be a worthwhile practice to review whether or not the current entity selection is still appropriate.
2. Adding New Entities: Looking beyond simply changing the existing entity type, many business owners find it advantageous to add new entities to their existing structure. For example, a law firm partner may receive a K-1 from their firm each year. The partner pays income and self-employment taxes based on the income and deductions reflected on the K-1. If the partner were to own their interest in the partnership through a professional corporation—treated for tax purposes as an S corporation—they may be able to restrict the amount of taxable income that is subject to self-employment tax (15.3%; 7.15% for the individual and 7.15% for the employer). By paying him or herself a reasonable salary from the new entity and distributing the remaining taxable income, the partner may only be subject to self-employment tax on the portion of income paid to them classified as salary.
3. Forming a Captive Insurance Company: Business planning also involves evaluating whether or not to pursue new enterprises. The goal of such a pursuit could be to enhance profitability, mitigate risk exposure, or gain a competitive advantage. One example of such a venture is a captive insurance company.
A captive is an insurance company created and owned by one or more business owners to insure the risks of its owner (or owners). Captives are essentially a form of self-insurance whereby the insurer is owned wholly by the insured.
*Current Company may deduct the premiums paid to the Captive. The Captive does not pay income taxes on the premiums they collect, nor on the earned underwriting profits, provided that the net or direct premiums do not exceed certain thresholds (i.e., $1.2 million in 2016).
Source: Wells Fargo Wealth Planning Center, July 2016
In addition to shielding as much as $1.2 million (increases to $2.2 million in 2017) from income taxes each year, if these companies are structured and maintained correctly, they may provide the business owner with a number of benefits, including:
4. Performing a Cost Segregation Study: A foundational principle of income tax planning is to accelerate deductions and defer income in order to delay the payment of income taxes until future years. This additional liquidity can then be invested until the tax payments are due. For example, business owners often use cost segregation studies to classify their new and existing assets into certain categories. The proper classification of these assets allows them to depreciate certain property at a more accelerated rate. Although accelerated depreciation is just a favorable timing difference, the tax savings and enhanced cash flow can often be significant.
5. Integrating/Upgrading Retirement Benefits Plans: A qualified retirement plan is a tax-advantaged retirement plan that allows an employer and/or employee to make contributions to the employee’s retirement account. Key characteristics of such plans include the following:
Even if a business owner has a current retirement plan in place, a review of alternate plan offerings may be beneficial. For example, many business owners have defined contribution plans in place for employees (e.g., a 401(k) plan). Under certain circumstances, a defined benefit plan may be a suitable addition. Adding such a plan may have a significant positive impact on the business owner’s ability to save tax deferred funds, attract and retain key employees, and even maximize the value of the company.
6. Utilizing State Specific Tax Opportunities: Many states provide credits, tax breaks, and other pro-business policies to lure corporations to incorporate and do business within their state. It is crucial for a business owner to understand the tax and regulatory environment in their state of domicile and whether other states may have more favorable offerings for their type of business. For example, Delaware does not tax corporate income generated in other states and does not tax royalty receipts on certain intangible assets. According to a study conducted by Jacob Thornock, Assistant Professor of Accounting at the University of Washington’s Foster School of Business, incorporating subsidiaries in Delaware may cut a firm’s state tax burden by an average of 40 percent.
7. Taking Advantage of the 14 Day Rental Exclusion: There is a multitude of lesser known tax benefits that are available to taxpayers. For example, a taxpayer may rent out their home for up to 14 days per year without owing taxes on the income received. A business owner could take advantage of this provision by renting out their home to their business for team-building activities, holiday parties, etc. The rental expenses should be deductible for the business and the business owner would not be required to report any of the taxable income. Additionally, the tax deductible expenses associated with the property (e.g., mortgage interest, real estate taxes, etc.) are not required to be pro-rated and would likely continue to be deducted on Form 1040, Schedule A.
It is clear that tax exposure affects business owners’ ability to have a positive impact on their families, employees, and communities. Ongoing changes in the tax and legal environment, the economic landscape, and the lives of business owners and their families warrants regular review of the existing tax situation. It is important to work with a qualified wealth management team in coordination with tax and legal advisors to identify opportunities to minimize the impact of taxes. Please work with your Wells Fargo relationship manager, the Regional Wealth Planning Group, and your other advisors to coordinate a tax and wealth plan that suits your needs.
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The information and opinions in this report were prepared by Wells Fargo Wealth Management. Information and opinions have been obtained or derived from sources we consider reliable, but we cannot guarantee their accuracy or completeness. Opinions represent Wells Fargo Wealth Management’s opinion as of the date of this report and are for general information purposes only. Wells Fargo Wealth Management does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.
Wells Fargo and Company and its affiliates do not provide legal advice. Please consult your legal advisors to determine how this information may apply to your own situation. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared.
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