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Financial Planning > Tax Planning

5 tax plans every financial advisor should know

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Here are five tax plans every financial advisor, CPA and attorney must know: 

5. Set up an S-Corporation 

This plan is simple. Set up an S-Corporation and distribute profits using a K-1 as opposed to salary. The taxpayer will save the payroll taxes, which may be as high as 15.3 percent each year. One case, Watson v. Commissioner 668 f.3d 1008 (8th Cir. 2012), involved a sophisticated CPA who understood that a lower income would mean lower payroll taxes. However, a shareholder-employee’s compensation from an S-Corporation is often subject to IRS scrutiny, because S-Corporation flow-through income enjoys an employment tax advantage over that of sole proprietorships, partnerships and LLCs. 

This advantage is mentioned in Revenue Ruling 59-221, which held that a shareholder’s undistributed share of S-Corporation income is not treated as self-employment income. In contrast, earnings attributed to a sole proprietor, general partner or many LLC members are subject to self-employment taxes. Watson paid himself $24,000 in salary during 2002 and 2003 while withdrawing over $375,000 in distributions. The court determined a reasonable compensation amount of $93,000, requiring Watson to re-characterize $69,000 of distributions in each year as salary. Even if this was the case, Watson would still save the additional payroll taxes between his salary and the taxable wage base. 

Unfortunately, a radio advisor did not understand this basic plan. Dave Ramsey, who often gives advice on his radio show to individuals, recently stated the following to one of his callers. 

April 29th 2014 Dave Ramsey Show 1:43:53 
Facts of the case:

    1. Martin from Atlanta  2. 1099 self-employed sub-contractor doing outside sales for construction company  3. Caller is trying to figure out from a tax perspective if he should incorporate as an S-Corp

Martin: “Trying to figure out if I should incorporate?”

Dave: “No. There is no tax savings in incorporating or turning an LLC. The only reason you would do those two things is if you have a potential liability or you’re afraid you’re going to get sued over something and you needed a corporate veil … I don’t recommend incorporating something like you’re talking about … It adds to your cost because you have to have that corporate return prepared every year … I can’t address Georgia because I don’t know, but on a federal level you don’t save any money by having a sub-S … I wouldn’t do it … It’s just too much hassle.” 

Of course the advice was free and the caller received what he paid for: nothing.

Simplified employee pension

4. Set up a SEP 

The IRS publishes the form; the IRS makes available the rules; and the plan can be established as late as the due date of filing your tax return. The SEP is a simplified employee pension, but is not a pension; it is an IRA under the defined contribution rules. 

Like any tax plan, it is complicated and built to stay that way. 

The taxpayer adopts the model form and can place up to 25 percent of their compensation — to a maximum of $52,000 in 2014 — into a SEP and deduct the compensation from federal income taxes, state income taxes, Social Security taxes, Medicare taxes and Obamacare taxes. 

What’s the problem? The same formula must be used for all the employees and companies do not want to “give” their employees 25 percent of pay. The problem of employee cost and the $52,000 limit is solved with the next plan.

Defined benefit defined contribution plan

3. Set up a DB-DC plan 

The plan is a defined-benefit plan (DB plan) “cross tested” with a defined-contribution plan. The old rule 401(a) (26) placed into ERISA in1974 states the defined benefit plan must include 40 percent of the eligible employees to pass the “minimum participation” test. This means you can “exclude” 60 percent from the defined-benefit plan. 

Example: Company A has two doctors, two spouses and six employees. The two doctors and two spouses are in the DB plan and the six employees are “excluded” from the DB plan. However, “excluding” does not mean you can “ignore” these employees for “testing” other sections of the internal revenue code. The plan must pass the “minimum aggregation allocation gateway” test, which in English means the employees must receive 7.5 percent of pay, generally in a profit-sharing plan. The plan must also pass 401(a) (4) independently, which means that EBARS and rate groups need to be established. This is a plan you should not try at home and engage an “enrolled actuary” to perform these tests. (That is, if you can find one. According to Google there are 4,700 in the U.S.) 

However, the results can be favorable for a client who is interested in a tax deduction of up to $350,000 (in some cases). The DB plan allows tax-deductible contributions, which are not subject to the $52,000 limit but are actuarially calculated.

Bermuda captive insurance company

2. Set up a captive insurance company 

Captive insurance companies have been around for a long time. In fact, most of the Fortune 500 companies have established captive insurance companies. However, Rent-A-Center 142 T.C. No. 1 United States Tax Court 2014, is recent. Below is the holding from the case. 

Rent-A-center corporation is the parent of numerous wholly owned subsidiaries, including L, a Bermudian corporation. P conducted its business through stores owned and operated by its subsidiaries. The other subsidiaries and L entered into contracts pursuant to which each subsidiary paid L an amount determined by actuarial calculations and an allocation formula, relating to workers’ compensation, automobile, and general liability risks, and, in turn, L reimbursed a portion of each subsidiary’s claims relating to these risks. P’s subsidiaries deducted, as insurance expenses, the payments to L. In notices of deficiency issued to P, R determined that the payments were not deductible. 

Held: P’s subsidiaries’ payments to L are deductible, pursuant to I.R.C. sec. 162, as insurance expenses. 

What does this mean for tax planning? In a captive that maintains the 831(b) election, the first $1,200,000 in premium is not included in income. These “micro-captives” allow company A to transfer risk to company B, which they control, and receive a $1.2 million deduction. Employees do not have to be included in this plan. Of course the company has to “insure” risk of the parent and operate as an insurance company. Today, the captives may be incorporated in the U.S. with Vermont being the leader and Florida updating their 1982 statute in 2012 to compete for the “captive” formations.

Ha'penny bridge in Dublin, Ireland

1. Set up a “Double Irish Dutch” company 

Tax planning cannot get better than this corporate tax shelter. While the “boss” and “son of boss” both have been blasted, this shelter has held its own better than the US 20th Maine did at Gettysburg. 

This plan has been called the “Google” tax shelter or “Apple Inc.” tax shelter. According to some commentators, Microsoft, Facebook and other companies have already engaged in this type of planning. 

Imagine that the country of Ireland has a treaty with the United States, and the tax rate in Ireland is 12.4 percent as opposed to 35 percent in the U.S. It would benefit any company to have income flow to Ireland as opposed to the U.S. Imagine if you had technology (such as a search engine) which could be easily transported and owned by your Irish company. Set up Irish holdings, sell the search engine to them and pay rent for its use. Now the income flows to Ireland and your tax is at 12.4 percent. 

Imagine the Netherlands does not have a treaty with the U.S. like Ireland but does allow the Irish company to transport their earnings tax-deductible to them and then on to Bermuda where the assets can accumulate tax-free. Now the tax on the search engine earnings virtually disappears in the quagmire of international entities. For more on this, see “Stateless Income” by University of Southern California Professor Edward Klienbard, Florida Tax Review, Vol. 11 p.699 (2011).


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