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.
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.
3. Set up a DB-DC plan