C-corp income splitting

[Axecleaver]

Hi Mustachians,

Due to a big business win six months ago, my income has gone up unexpectedly. I currently have my corporation structured as a single member LLC, which is a passthrough entity for tax purposes. Revenue for this year is projected at 574k, expenses of 274k, leaving an estimated net of 300k.

At this income level, even with maxing out 401k's, my wife and I miss out on a lot of tax deductions: tuition deductions, personal exemption phase outs, no IRA's, student loan interest to name just a few. If my income goes up another 4k, I'll hit the AMT limits, and then things get really expensive. The effective tax rate on new income at that point is over 50%, due to exemption phase-outs and state tax disregard (AMT ignores those, and I'm in NY, where property taxes and state taxes are the highest in the nation). 

I'm considering incorporating as a C-corp, which gives me the advantage of adding another taxable entity to the mix. This way instead of my wife and I making 300k this year, the corporation could make 150k and pay me 150k. We would both be taxed at a lower effective rate. My questions:

1. Anybody with experience doing this?
2. Best way to structure the net income to minimize taxes.
3. Can I structure part of the distributions as qualified dividends? Normally dividends are taxed twice, once for the corp and once when they're received, but I think qualified dividends can be tax-free under a certain limit. This would let me reduce our income further and avoid payroll taxes on it.
4. Can I put the company into a Roth IRA and have it hang on to its money until I need it?
5. Can I have the company hang on to its money until my gravy train runs out, and then have the corp pay me qualified dividends in retirement at a much lower or even tax free rate? The company would pay income on money it earns now, and then distribute it in retirement later.

Any other ideas for restructuring things that I haven't considered, deeply appreciated!

[protostache]

I'm not an accountant so ignore this at will, but I think it is well worth your time and money to contact a CPA or two and get some qualified opinions on your options. My business will be making roughly a third of what yours will this year so it made sense to elect S-corp taxation, which may be something to consider. Your business would still be a state-level LLC with all of the advantages that has, but the IRS can tax it as a corporation (either C or S). You don't have to reform the business, nor do you have to go through the yearly rigamarole that being a corp implies. Once you pick this option you have to stick with it for five years.

The main advantage of an S-corp is being able to split your income between W2 and distributions, since that way you avoid medicare and social security taxes for any income above your W2. You still pay federal and state on all of your income (S-corp income gets taxed on your 1040 using form K1), so I don't think this arrangement will get you out of AMT.

C-corp taxation sounds like it would work better. Your business would only pay taxes on profits at the corporate tax rate, and more importantly I believe that that will be completely separate and not listed on your personal 1040 at all, getting you out of AMT territory. That said, you still have to pay 40% on "profit" and there are penalties related to keeping unreasonable amounts of retained earnings, but I don't know how all that works (this is where actual accountants come in handy).

[Cheddar Stacker]

CPA here.

It's an interesting thought experiment. A few questions:

1) You mentioned maxing out 401k's. What exactly do you mean by this? $18K each? Because that is the 401k limit but...
2) SEP IRAs, SIMPLE IRAs, KEOUGH, etc. can have a limit of up to $53K/person and you seriously need to figure that out quickly if you haven't opened these type of accounts. Some of them must be opened before 12/31 of the tax year.
3) How can I get in on this action? : )

So the C-Corp tax rates, in case you haven't looked them up yet, are quite high. $0-$50k=15%, 50-75k=25%, 75-100k=34%, 100-335k=39% and it stays in the 3x% range beyond that. So at 150K your C-Corp would pay $41,750 in federal taxes (28%).

As long as you are holding the C-Corp stock long-term, the dividends should be considered qualified. You have no requirement to pay them as the net income is earned by the C-Corp, you can leave them for years and pay them later. The IRS doesn't like C-Corps hoarding Retained Earnings either though, so read up on that because they may encourage dividends. I've never dealt with this directly, but I've heard my partners discuss it. Anyway, that's a great way to avoid the double taxation that comes from C-Corps paying tax on net income, then shareholders paying 15% tax on Dividends. If you wait until FIRE you would likely pay 0% tax on them.

Best way to structure the net income to minimize taxes: Maybe go C-Corp, pay a wage/retirement contribution to get C-Corp income down to an effective tax rate in the 25% range. $125K = 32K tax, which is 25.6%. $100K = 22,250 tax which is 22.3%.

So $300K total net income.
Pay a wage of $138K, grossed up for ER payroll taxes would equal $147K in corporate deductions.
Pay a SEP/SIMPLE contribution of $53K.
Leave $100K bottom line in C-Corp which would net $77,750 after tax.

Now your personal taxable income from all of this is only about $138K ($147,255 - 9,255 ER Payroll tax). If this is your only income this puts you right back down into the area where you will get some SL interest deductions, all personal exemptions, Roth IRA's, unfortunately no tuition deductions though as that is around $100K AGI. If you want to get your personal income down even more, make it $150K C-Corp bottom line and your wage goes down $50K.

Can you put the company in a Roth IRA? No, not if you are running it, drawing a wage from it, etc. You can't be involved in actively running a business when it's in a Self-Directed IRA. There was a thread on these back in January, and it was discussed a bit in my journal if you want to dig deeper on those rules.

I would think this would all have an annual cost (legal, accounting, licensing, etc.) of about $1,000-4,000 depending on how much you are willing to do yourself. But all of that would be deductible by the C-Corp.

[GeorgiaCPA]

Your tax avoidance strategies are not very sound.  You are at the point where you need a good tax advisor to guide you through a tax minimization strategy.  This is not my specialty, but I will offer a couple of points below. 

1 - Do to double taxation on C-corps (once on the earnings and again on the dividends) we don't see many C-corp conversions unless they are in the process of a liquidity event.
2 - Not sure what business you are in, but assuming you are a cash basis tax payer, pay upfront as much of your expenses as possible prior to 12.31, and collect your receivables after 12.31.  There may be other strategies, but it really depends on the type of business.
3 - You need to be in the 15% tax bracket for qualified dividends - you're not even close.
4 - Based on the initial facts - you would not qualify to place the Company into a Roth account - first - these arrangements prohibit self dealing (as you are an owner/employee that disqualifies you) and second - how are you planning to make such a large transaction into a Roth in a single year without violating the self dealing rules.
5 - If you plan to hold onto the cash you will need to prepare a defense for the "Accumulated Earnings Tax" - The IRS wants to get their taste sooner, rather than later. Holding onto excessive earnings can become a taxable event.

SEP IRA contributions are limited to 25% of your compensation - so you would need to maximize your earnings in order to make a full contribution

Once you have met with a tax professional and have maximized deductions - take more vacations and work less to minimize excessive earnings that are taxed at greater than 50%.

[Cheddar Stacker]

Your tax avoidance strategies are not very sound.  You are at the point where you need a good tax advisor to guide you through a tax minimization strategy.  This is not my specialty, but I will offer a couple of points below. 

1 - Do to double taxation on C-corps (once on the earnings and again on the dividends) we don't see many C-corp conversions unless they are in the process of a liquidity event.
2 - Not sure what business you are in, but assuming you are a cash basis tax payer, pay upfront as much of your expenses as possible prior to 12.31, and collect your receivables after 12.31.  There may be other strategies, but it really depends on the type of business.
3 - You need to be in the 15% tax bracket for qualified dividends - you're not even close.
4 - Based on the initial facts - you would not qualify to place the Company into a Roth account - first - these arrangements prohibit self dealing (as you are an owner/employee that disqualifies you) and second - how are you planning to make such a large transaction into a Roth in a single year without violating the self dealing rules.
5 - If you plan to hold onto the cash you will need to prepare a defense for the "Accumulated Earnings Tax" - The IRS wants to get their taste sooner, rather than later. Holding onto excessive earnings can become a taxable event.

SEP IRA contributions are limited to 25% of your compensation - so you would need to maximize your earnings in order to make a full contribution

Once you have met with a tax professional and have maximized deductions - take more vacations and work less to minimize excessive earnings that are taxed at greater than 50%.

Hey GeorgiaCPA, it took me quite a long time to see the forest through the trees, but you need to think more like an MMM CPA and less like a regular CPA around these parts. We spend the majority of our time working professionally with business owners who maximize profit, earn 7 figures, and plan to work until 70. This crowd is more about reducing tax burden by spreading it out over multiple years. Given that context, in response to your points #1 and #3:

1) This will disappear if he works hard for 5 years, then stops. Hold the earnings, sell off any business assets after 5 years and slow down, begin paying Qualified Dividends of $50K/year which are taxed at 0% since he will be in the 15% bracket at this point.

3) Not now, but he may be soon.

I don't know enough about the accumulated earnings tax to comment, just that it exists. I know we have plenty of clients with $3-50M in Retained Earnings and we've never had a problem with this to my knowledge.

On the SEP IRA, you can use a combination of things to get to the $53K. I think a SEP and SIMPLE combo would get him there, or close based on the example I laid out.

[bacchi]

Can your company create a defined benefit plan? The fees are a lot but it's probably worth it if the income continues for at least 5 years.

[BlueHouse]

congratulations on your business success! 
I'm not a CPA, but I am incorporated as an S-Corp. 

I take about half income as W-2 and the other half through dividends, which saves me the medicare tax amount on employee and employer side.  As an expense, the business matches my 401k about 35K.   You may be able to add your wife as an employee and do the same for her. 

That's about it for the tax advantage side of it, but if it's possible to add your wife as an employee, you could defer taxes on 70K (yours and hers) of business income just with the 401k setup.

I use Paychex for payroll processing and 401k administration.  they have a fund lineup with most Vanguard funds for $240/year.  I'm thinking of switching mine to a solo 401k, since it's just me in the plan. 

[Midwest]

1) Any plans to sell the business?  Have you considered the implications of a C-Corp to that?
2) How many employees?  I see mention of a 401k, but a solo 401k if you and the wife both work for the company (and are the only employees) allows significant contributions after considering the employor match.

Midwest

[Axecleaver]

Thanks for all your awesome advice. Clarifications to questions below.

You are at the point where you need a good tax advisor to guide you through a tax minimization strategy.

Roger that, I have a CPA I have worked with for 20 years, we plan to meet on these issues. Now I can go to that meeting reasonably prepared.

1) You mentioned maxing out 401k's. What exactly do you mean by this? $18K each? Because that is the 401k limit but...
2) SEP IRAs, SIMPLE IRAs, KEOUGH, etc. can have a limit of up to $53K/person and you seriously need to figure that out quickly if you haven't opened these type of accounts. Some of them must be opened before 12/31 of the tax year.

I made the max $52k contribution last year from my LLC earnings, and I had planned to make the $53k contribution this year. Last year it was a SEP IRA that I had set up when I was 22, and I rolled it over into a solo 401k this year and changed from Fidelity to Vanguard. I had made some poor investment decisions early in my life and have started to fix those.

My wife currently has a SIMPLE IRA at a nonprofit where she works, which screws some things up for us. The SIMPLE IRA isn't tax deferred (over the income limit), and we couldn't contribute to a separate 401k for her because of it. She may leave that job and become a majority owner of the C corp, take a salary, and let us put money away for her, too. We are still working this out, also see below on the 25% contribution limit which Georgia noted.

3) How can I get in on this action? : )

Same thing as any Mustachian endeavor, work hard, get lucky, stay focused intensely for a few years and retire :). I'm in public sector consulting, I partnered with a few different companies last year to write proposal responses at-risk. I worked for free in exchange for a piece of the action if we won. So I ended up spending about 600 hours last year writing proposals while working full-time on some other 100% travel hourly deals, and a big one came in. It was about a year between writing the proposal and starting the project. Then I executed the "land and expand" strategy to expand my scope by adding employees with the prime contractor and taking a conservative margin, which is a win-win. There are some other details but the takeaway is I was in the right place at the right time, saw an opportunity, exploited it, and got lucky.

[/quote]
So the C-Corp tax rates, in case you haven't looked them up yet, are quite high. $0-$50k=15%, 50-75k=25%, 75-100k=34%, 100-335k=39% and it stays in the 3x% range beyond that. So at 150K your C-Corp would pay $41,750 in federal taxes (28%).
[/quote]
Well, crap! That definitely changes the split, but maybe not the strategy. Thanks for the advice on retained earnings, added to my list.

2 - Not sure what business you are in, but assuming you are a cash basis tax payer, pay upfront as much of your expenses as possible prior to 12.31, and collect your receivables after 12.31.  There may be other strategies, but it really depends on the type of business.

Roger that, I have this locked down. My accounting is cash basis. I'm a consultant and make margin on services from employees that are bought from a staffing company. So I typically pay the November bill for their services in December, and I don't get November receivables until 1/7. This lets me push about 50k in revenue to the following year and realize about 30k in expenses in the current year. Net effect will be to push 50k into a final, retirement tax year. If I add more employees the effect of this gets progressively larger, which is exciting.

3 - You need to be in the 15% tax bracket for qualified dividends - you're not even close

I need some help on this. My understanding is that qualified dividends are taxed at either 0% (for people in the 15% tax bracket) or at the capital gains rate of 15% plus a 3.8% Net Investment Income Tax for a final rate of 18.8% for people above that. The dividends would have to be taxed at the corporate level first, and then they'd get the double taxation hit at 18.8%. Or, I could keep the money in the corporation until I retire, then distribute it as dividends at an amount that keeps me in the 15% bracket. In this case, I'd still have had to pay the corporate tax rate on it in the year it was earned.

So $300K total net income.
Pay a wage of $138K, grossed up for ER payroll taxes would equal $147K in corporate deductions.
Pay a SEP/SIMPLE contribution of $53K.
Leave $100K bottom line in C-Corp which would net $77,750 after tax.

if it's possible to add your wife as an employee, you could defer taxes on 70K (yours and hers) of business income just with the 401k setup.

This mix looks about right, but with a gross salary of 147k, how do I get around the 25% contribution limit to get to the 53k? I could also pay my wife, but I think this ends up costing us money because above 117k on one wage, we don't pay the SS tax. This gives me some numbers to play around with though.

take more vacations and work less to minimize excessive earnings that are taxed at greater than 50%

Yeah, you're not kidding! I first became aware of this issue earlier this week when I started running some projections on earnings  to ensure my estimated tax payments were adequate, and realized how much awful stuff would happen if I hit the AMT. Once I saw how heavy the taxes were on additional earnings, I realized what a waste of time it would be to add more income.

Can your company create a defined benefit plan?

Thanks, adding that to my research list. That could be one way to siphon off earnings now that I wouldn't use until later, when my tax bracket would be a lot lower. I think this works kind of like an annuity, but I definitely need to look into this.

1) Any plans to sell the business?  Have you considered the implications of a C-Corp to that?

I haven't, good point. I don't have any plans to sell, but I never say never. Will need to look into this. As a consulting business, the value of the corporation is in the employees (primarily myself) and our contracts, where I'm a named resource. So buying the business probably doesn't make much sense. Regardless, adding this to my things to consider.

2) How many employees?  I see mention of a 401k, but a solo 401k if you and the wife both work for the company (and are the only employees) allows significant contributions after considering the employor match

No "official" employees, but we have three people generating revenue for the company on a regular basis. Me, plus two other full time guys that I have working W-2 for a staffing company that bills me.

[GeorgiaCPA]

Hey GeorgiaCPA, it took me quite a long time to see the forest through the trees, but you need to think more like an MMM CPA and less like a regular CPA around these parts. We spend the majority of our time working professionally with business owners who maximize profit, earn 7 figures, and plan to work until 70. This crowd is more about reducing tax burden by spreading it out over multiple years. Given that context, in response to your points #1 and #3:

I hear you Cheddar, but with $300K in profits and a multiple of 3 he'd be at $900K for a sale of the business.  In a true MMM scenario he'd sell and be retired (if possible) this year or next.  My suggestions took a longer term vision as it appears the OP may be for a longer term.

3 - You need to be in the 15% tax bracket for qualified dividends - you're not even close

I need some help on this. My understanding is that qualified dividends are taxed at either 0% (for people in the 15% tax bracket) or at the capital gains rate of 15% plus a 3.8% Net Investment Income Tax for a final rate of 18.8% for people above that. The dividends would have to be taxed at the corporate level first, and then they'd get the double taxation hit at 18.8%. Or, I could keep the money in the corporation until I retire, then distribute it as dividends at an amount that keeps me in the 15% bracket. In this case, I'd still have had to pay the corporate tax rate on it in the year it was earned.

Axe - look at Cheddar's response as he is correct.  If you pay out dividends post retirement and you Ordinary Income is in the 15% bracket there would be zero taxes (assuming no changes in tax laws).  As for keeping your earnings in the business and the "Accumulated Earnings Tax" you need to consider your time horizon.  At your current rate you will have a very healthy stache in just a couple of years.  If you plan to do this for a decade or more (at which point you would have more retained earnings in the company than annual revenues) you will need to do some additional planning.

Determine your future plans (retirement, spending needs, etc), then tailor an exit strategy.

[Cheddar Stacker]

Agreed with everything in Georgia's last post. One other slight clarification on what Axe said in the quoted part - the 3.8% is only on investment income when your AGI is > $250K. So with proper tax planning if your AGI stays under that amount, even if you have to pay dividends now it would only be a 15% tax on top of the corporate tax you pay.

Even with double taxation, you could still possibly pay less total tax than you might pay though with no tax planning moves at all and leaving it all as an LLC.

[Midwest]

Axe:

I don't follow your comment on the SIMPLE IRA.  Not aware of an AGI limit on a simple

With regard to the wife, why don't you pay her via w-2 in the current biz and max her solo 401k as well?  Depending on the interaction with the simple, she could shelter another 40 or 50k that way.  If you elect S-status and she owned 1/2, she gets a salary high enough to max the 401k + the 25% contribution.  That minimizes self employment tax.  I can't recall the SIMPLE intereactoin with 401k off the top of my head, but she could always choose not to participate in SIMPLE if it's messing up the 401k.

Once you factor that in, I think the C-corp gets a lot less attractive.

Midwest

[Axecleaver]

I don't follow your comment on the SIMPLE IRA.  Not aware of an AGI limit on a simple
Once you factor that in, I think the C-corp gets a lot less attractive.

You're right, I think I mixed up the AGI limits on traditional IRA's with the SIMPLE IRA. The max is (25% employer contribution) + (5500 employee contribution for an IRA | 17000 for 401k). It's not 25% total which is how I was thinking of it. So, I think I can get there with these limits.

The decision point on S corp vs C corp is probably going to hinge on how much to keep in corporate reserve waiting for retirement. Need to look at this more closely, but theoretically I could do S corp with $50k in profits, pay the 15% corp tax, and the passthrough on dividends we pay 15% on the remainder, for an effective rate of 27.7%. A C corp could pay the 15%, hold on to it for a while (assuming a retained earnings strategy) and pay it out in retirement in amounts that keep us in the 15% bracket, tax-free.

with $300K in profits and a multiple of 3 he'd be at $900K for a sale of the business.  In a true MMM scenario he'd sell and be retired (if possible) this year or next.  My suggestions took a longer term vision as it appears the OP may be for a longer term.

You're right Georgia, this is a six-year contract, my plan is to complete this in 2020 and retire then. The big barrier to selling the business sooner would be that I'm named staff on the big contract and delivering about 40% of the revenue; I'd have to keep working for the company to retain that value. But, it has given me something to think about, because the odds of growing the business over the next five years are pretty good. That's another mark against the C corp and a component of the exit strategy.

I have a meeting scheduled for Mid-may with my CPA, I'll post a followup with the final outcome. Thanks for all the great advice!

[Midwest]

I don't follow your comment on the SIMPLE IRA.  Not aware of an AGI limit on a simple
Once you factor that in, I think the C-corp gets a lot less attractive.

You're right, I think I mixed up the AGI limits on traditional IRA's with the SIMPLE IRA. The max is (25% employer contribution) + (5500 employee contribution for an IRA | 17000 for 401k). It's not 25% total which is how I was thinking of it. So, I think I can get there with these limits.

The decision point on S corp vs C corp is probably going to hinge on how much to keep in corporate reserve waiting for retirement. Need to look at this more closely, but theoretically I could do S corp with $50k in profits, pay the 15% corp tax, and the passthrough on dividends we pay 15% on the remainder, for an effective rate of 27.7%. A C corp could pay the 15%, hold on to it for a while (assuming a retained earnings strategy) and pay it out in retirement in amounts that keep us in the 15% bracket, tax-free.

You have 300k in income before wages/retirement - correct?  In order to keep the C-Corp down to $50k (and the 15% bracket), you'll need to pay $150k in wages/payroll taxes and $100k in retirement (or something along those lines).  If that's what you are thinking, I suspect you'd be better off with an S-Corp.  Minimize wages and associated payroll taxes.  Once you pay the taxes inside the S-Corp, future distributions are tax free up to basis.  There is no 15% tax on dividends from an S-Corp.

Note - My thought process assumes NY doesn't tax S-Corps at the corporate level.

[Axecleaver]

After meeting with my accountant, I wanted to post a followup.

One piece of (critical) information my accountant knew but I failed to mention, is that we have a 16 yo daughter who will be going to college in September. By paying her a wage, we reduce our basis below the AMT and phase-out amounts, and she gets access to an IRA. She is also able to take advantage of the $2500 tuition tax credit (a huge savings). This is offset by the increased payroll taxes (15.3% - 2.9% = net 12.4%). When all is said and done, we're paying her $56k this year, paying about $11k in state and federal taxes, instead of about $30k. Net savings ~19k in taxes. The goal is to stay under the 15% rate cap, and take advantage of as many tax credits as possible. Her age makes this problematic for a few of the credits (saver's credit for example), will get better once she turns 18 and then the strategy may shift again.

Using this strategy, the S corp results in the most savings, although I missed the election cutoff for that and will not have it take effect until next year.  We will likely have her start paying her own health insurance in 2016 and take advantage of the split income in ways we weren't able to this year.

With access to a second person, we can tune our income mix as income increases, without having to worry about those nasty marginal rates until much later. If income goes up further, we'll add my wife to the roster, pay the payroll taxes, and get access to $53k 401k contributions per year to stay under the phase-outs.

It's also been a good opportunity to educate her about the business and how our tax system works.