By Jason Watson, CPA
Posted Sunday, December 29, 2024

WCG CPAs & Advisors encourages short-term rentals to be owned by partnerships (ie, a multi-member LLC). Why? For three reasons-

First, the historical audit rate of partnerships (Form 1065) is 0.4%. Super low compared to individual tax returns (Form 1040) which might be 4% to 12% depending on your income levels. Why does this matter? When you have a big cost segregation depreciation plus your big startup expenses such as furniture and supplies, and you then have a big tax deduction against your big W-2 income because your passive losses are no longer limited with your big material participation, it raises some eyebrows. Any large tax deduction raises eyebrows. Cute, electronic AI eyebrows, but eyebrows, nonetheless.

Second, with a partnership tax return, we can mechanically show your capital contribution (at-risk money) including recourse loan debt. Why does this matter? Let’s say you invest $250,000 into a new business, and that business loses money. The IRS sees your “partner basis,” the $250,000, within your 1040 tax return, and suddenly the $100,000 first-year loss doesn’t seem so out-of-whack. A short-term rental is certainly a business activity; sure, you might not have a profit right away, but you will make money someday (otherwise you wouldn’t do it, right?).

Conversely, a rental property reported on Schedule E of your 1040 tax return does not present the same way. The mathematical support relative to the allowed rental loss and tax deduction is simply not presented but rather assumed.

Third, all rental activities, including short-term rental (STR) activities, within a partnership tax return are reported on Form 8825. This is another layer of cloaking within the 1065 tax return and allows your rental income and deductions to fly just a little closer to the ground as compared to Schedule E page 1 of your 1040 tax return. There are three degrees of separation… the 1040 to the K-1 to the 1065 to the 8825, all wrapped with nice basis information. Wow, we really geeked out there.

Also, there is an additional reduction in audit rate risk and tax footprint with states. If you have an income-producing asset in a taxing jurisdiction, such as a rental property, then you have a tax return filing obligation even if the rental activity yields a tax loss. Why? A taxing jurisdiction, and in this case, a state department of revenue, has the right to inspect your books and records to ensure your loss is truly a loss. However, if you file a partnership tax return for the taxing jurisdiction, and that results in a tax loss, it is unlikely you need to file an income tax return as a person in that jurisdiction as well. This reduces your personal tax footprint among multiple states.

Other minor benefits include anonymity of the enterprise, orderly transfer of ownership within the LLC’s Operating Agreement (versus a trust or will), discounted gifting of interests to others such as your kids, and some enhanced protection with charging orders (super flimsy, but they still exist).

Downsides include the additional tax return preparation fees and perhaps unnecessary state taxes such as California’s franchise tax and LLC fee which can be summarized as money-grabs or pleasure to do business in our state fees. You need to consider your exposure versus the cost of reducing your exposure and therefore subsequent risk.

How do you create a partnership? If you are married, this is quite simple. You and your spouse would be members of a multi-member LLC. Not married? There are other options. You could have a sibling, parent or child who hold economic interests in the entity (LLC, for example). They would not hold equity interests, but the arrangement would be considered a partnership, and the rental activities would be reported on a partnership tax return (again, Form 8825 within Form 1065).

Of course, this second method might be more hassle than it is worth, but the first example, the spousal version, is easy. Don’t run off and get married just to make a partnership. That’s nutty.

Sidebar: Let’s talk briefly about the short-term rental (STR) loophole. If the average stay of your guests over the course of the tax year and only considering actual rented days is 7 days or fewer and you materially participate in the activity (think business owner versus investor), then your rental activity is not deemed passive.

Taking this one step further, and since your investment into the rental property is considered at-risk, losses from this type of activity are not limited and may be deducted against other sources of income such as W-2, K-1 from an S Corp, investment income, etc. Read more here-

wcginc.com/str

By Jason Watson, CPA
Posted Sunday, December 29, 2024

We just listed out the three most debtor-friendly states, but that’s where it ends. You might have heard that you can avoid taxes by forming an LLC in Wyoming or Nevada- is that true? Sure, if tax fraud comes easy to you. Sorry Charlie, your profits will technically be apportioned (fancy accounting speak for allocated or assigned) to the states in which you operate. Here is a super basic rubric on apportionment which some states use to calculate your tax liability-

• Payroll- One third of your profits are allocated based on payroll. So if you have payroll expenses only in Colorado and California, but are incorporated in Nevada, one third of your LLC’s profits are split between Colorado and California after applying California’s crazy rules. Nothing is allocated to Nevada.

• Property- The second third of your profits are allocated based on property ownership and where it is located, such as real estate, inventory, etc.

• Sales- The last third of your profits are allocated based on sales and sales nexus, but this can get extremely sticky since the definition of where a sale occurs is grey- is it point of sale (seller’s location), point of purchase (buyer’s location), title transfer, fulfillment centers, etc.? Where a sale actually occurs is an argument which states and taxpayers can go around and around with- you can only imagine how it will end fighting a state with virtually unlimited resources and time coupled with their presumption of being right.

So, yes, under nexus rules perhaps a small portion of your profit can be attributed to Nevada- yet, this is not because you were incorporated in Nevada, it’s because you had a presence in a state that does not impose an income tax. Same would be true for all your sales in Wyoming, Washington, Texas, South Dakota, etc. where strict corporate income taxes do not exist. In addition, several states impose a gross sales receipts tax and other forms of taxation (such as franchise tax) although their corporate income tax rate is zero.

Note: This is a super simple sample. Some states give sales a larger weight. Others ignore payroll and property entirely. Talk to your apportionment buddies at WCG. As gray tax positions go, income apportionment is right up there with the best of the “well, it depends” accountant responses.

State Nexus

State apportionment boils down to nexus, and states are getting much more aggressive with claiming nexus so that the income generated in that state is taxable. This might make people unhappy, but the reasoning behind it is fair in our opinion. You target a certain group of customers who live in a certain jurisdiction, and you sell computers. Why would Best Buy in the same tax jurisdiction have to pay income taxes in that jurisdiction while you do not? Please don’t use the “it’s just little ol’ me versus the big box store” excuse. Seems a bit unfair if you are Best Buy, or Wal-Mart, or Apple. Go and compete, just make it a level playing field.

Those customers in that jurisdiction perhaps enjoy a smaller tax rate and can have more purchasing power. That smaller tax rate might be offset by higher tax rates for the businesses. Business A (Best Buy in this example) must subsidize the customers in the taxing jurisdiction while Business B (you) does not. Best Buy would be a bit upset in this example.

Avoiding taxes is the American way. We get it. But something about the 14th Amendment and equality and pursuit of happiness comes to mind. Then there’s that darn 16th Amendment.

States define economic presence differently. Some states, such as California, use a sales dollar threshold (sometimes referred to as a bright-line) to determine nexus. WCG is getting close to having enough California business to necessitate filing as a foreign entity there just based on revenue. Yuck, since the income tax rate is twice as much as Colorado’s. California also has a presence test where if you have an agent working for you in California, then you have income tax nexus.

Remember, this is only income sourced to that taxing jurisdiction. About half the states have nexus rules and thresholds. Can’t get enough? Here is a Journal of Accountancy article from 2010 (yeah, it’s a little old but so are most accountants, and it provides a good base to learn from)-

wcginc.com/1515

Don’t forget the basics such as bank accounts, licenses and permits. If you must be licensed in another state to legally conduct business such as an agent for an insurance business, this in itself might create nexus.

This book dives deep into the issue of nexus in a later chapter, with topics such as sales tax, FBA (Fulfillment By Amazon), throwback rules, and interstate commerce rules. With the recent South Dakota v. Wayfair U.S. Supreme Court case, the sales tax nexus is going to be transformed over the next several years.

Massive Word of Caution: You might not have recognized it, but we introduced two nexus issues alongside each other. Income tax nexus and sales tax nexus. These are wholly different! Just because you have income tax nexus in a state does not mean you also have sales tax nexus, and vise-versa. This is akin to 401k and IRA. People muddy the waters by interchanging these terms, but they are vastly different. Income tax nexus and sales tax nexus is similar in terms of accidentally mixing the terms.

Foreign Qualification

This has nothing to do with international business. When your business has either a physical or economic presence in another state, you must register as a foreign entity. This is usually a formality, but some states might require your business to be in good standing with the home or “domicile” state. So keep up with your annual filings with the Secretary of State.

Conversely, you might simply want to create another LLC in the satellite state. This allows you to separate financial liability- for example, you might get sued in one state with unfavorable tax laws yet protect your interests in the other state (separate LLC). Bankruptcy laws change by state as well. Something to consider and be reviewed by a competent attorney.

Nevada Fallacy Recap

So, don’t believe the Nevada hype. You can probably get away with not paying state income taxes on your own, but as tax and accounting professionals we are bound by such inconveniences like ethics and law. Sorry.

Here is another example to chew on- you have a home office in Maryland. You commute to Washington, D.C. to work for your only client. You incorporate in Maryland since that is where your home office is, and you pay yourself a wage subject to Maryland income taxes. Wait there’s more. You also have a presence in D.C. requiring a D.C. corporate tax return as a foreign entity in addition to your Maryland corporate tax return. Thankfully these and other jurisdictions have reciprocity rules, and we can help navigate.

The bottom line is that Nevada tax laws benefit business owners with a presence in Nevada. As Zig Ziglar would say, “You might get a free lunch on consignment, but eventually you’ll have to pay.” We encourage you to not game the system, and if you want to, WCG cannot be a part of it- we have too many clients relying on us to do the right thing. Please pay your fair share of taxes, just not a dollar more.

Having said that, there are a zillion reasons why forming a corporation or an LLC in a tax friendly state does make sense. But those are case-by-case scenarios. Nothing is a slam-dunk or carte blanche either way. The right questions must be asked and answered to reach the best decision.

By Jason Watson, CPA
Posted Sunday, December 29, 2024

It is very easy to form an LLC and have it taxed as an S corporation. However, an S Corp is not formed by itself; another entity is created and then taxed as an S Corp. If you use a limited liability company as the underlying entity, at times people will refer to this as an LLC S Corp.

While LLC formation is easy, it is also very easy to screw it up. WCG CPAs & Advisors can assist with all the filings with the Secretary of State (for any state), and our fee is $625 plus the state filing fees ($50 to $200ish, some states are even $500). Some states such as Nevada require an initial report, and that will typically add $150 to our fee plus the initial report fee. As an aside, Nevada might have good corporate laws but it is an expensive state to form a business entity in. More on the Nevada hype in a bit.

Sure, you can form an LLC on your own or through LegalZoom, but we will provide consultation and advice during the startup process. You can also use an attorney but be careful since not all attorneys are the same. If you were an idiot before law school, getting a law degree doesn’t suddenly make you smart. We have seen many things messed up by attorneys who didn’t understand their client’s needs, didn’t understand the tax code, unnecessarily complicated the heck out of an otherwise simple entity structure, so on and so forth.

Accountants and doctors are not immune. How many quack doctors are there? Plenty. Accountants? Just a bunch of nerdy, socially awkward types. Thanks to Ben Affleck, us accountants are also secret assassins. Thanks Ben, the secret is out. Way to go, wizard.

Some of the kidding aside, we have seen some attorneys do some ingenious things as well. We work with business law and corporate attorneys all the time. It is a great relationship since they know corporate governance and contract law, and we know taxation and businesses. Do not think you only need an attorney- you need both an attorney and sharp consultants.

For your small business formation, WCG will do the following-

• Create Articles of Formation or Incorporation, and file with the Secretary of State,

• File an initial report if required,

• Check on local taxing jurisdictions for registrations (for example, San Francisco which has its own registration form and fee in addition to the State of California),

• Obtain your Employer Identification Number (EIN) from the IRS and,

• Create an Operating Agreement (for single-member LLCs only since rights are not being represented) or provide a MS-Word template set of Bylaws for corporations.

LLC, Professional Corporation or Corporation

Typically, we will want to form an LLC and later elect S corporation status. However, certain states require certain professions such as accountants, attorneys and doctors to be professional corporations. These entities can also elect S Corp taxation.

Side Note: California allows corporate officers to opt-out of the State Disability Insurance (SDI) tax, which can easily exceed $1,000 annually depending on your salary. However, if you create an LLC and have it taxed as an S corporation, California says No since the underlying entity remains an LLC.

If you create a corporation and elect S Corp taxation, then you can opt-out. Subtle difference, and the fees are virtually the same. Several states have nuances like this that LegalZoom and others might not be aware of since they don’t process payroll and prepare tax returns.

Operating Agreements

Multi-member LLCs and Partnerships need agreements between the members and partners respectively. As mentioned through this chapter, there are issues such as death, divorce, incapacitation, spending limits, required distributions (so you have cash to pay taxes), valuation techniques, offramps / exit strategies, etc. that need to be addressed. These agreements are legal in nature and represent rights, therefore WCG cannot assist in drafting these. However, we act in a consulting capacity with attorneys all the time to ensure a quality agreement is drafted that meets the client’s needs and objectives from all aspects.

We have more details on Operating Agreements later in Chapter 2 including deal structures and other way cooler stuff than entities alone. Please review yours for probable missing things.

Accountable Plan

If your underlying entity is a corporation then we also draft Corporate Minutes for your Book of Record to adopt an Accountable Plan which is used for employee reimbursements (see our fun-filled chapter on operating your S Corp).

The days of deducting out of pocket expenses such as mileage, cell phone and home office were not a good idea with S corporations prior to the Tax Cuts and Jobs Act of 2017, but today they are essentially gone. The Accountable Plan allows you to reimburse yourself as an employee, and as such the deduction is taken on the business tax return (which in turn reduces the amount net ordinary income being passed through to the shareholders). We will show you how this is a slick way of pulling money out of your business in the form of employee expense reimbursements.

Corporate Minutes and Books of Record

This is a bit old school. Back in the day, you needed an attorney and a $5,000 check to create a corporation since we didn’t have the use of an LLC. The process was very formalized since only large businesses did it, and the states used the process to track the comings and goings of businesses operating in their jurisdiction. Plus these documents were public and used by shareholders.

However, if your underlying entity is a corporation, WCG (formerly Watson CPA Group) recommends maintaining your Book of Record for three reasons- helps to maintains the integrity of the corporate veil, some banks and other institutions might ask for it to allow you, the controlling shareholder, to act on behalf of the corporation (such as buying an automobile in the business’ name), and the IRS from time to time will ask for it during an audit.

Corporate Minutes are generally not required for LLCs; again, because LLCs are not corporations.

Business Banking

The three typical small business formation documents (Articles of Organization / Formation, EIN and Operating Agreement) are required by most banks for a business checking account. An Operating Agreement is not always required. The Patriot Act, Bank Secrecy Act and Homeland Security want to clamp down on illegitimate business accounts and financial holdings. While it might throw off the Feds, Guido’s Money Laundering LLC is a no-go for your business checking account name unless you have an EIN, which defeats the purpose if you are Guido.

So, all banks will want either an EIN or a SSN to open a checking account regardless of it is a personal or business checking account. Your business EIN is also tied to your SSN. Follow the money, find the bad guys.

Note: You can also just get another personal checking account (typically for free from your current bank). However, if you plan on taking checks written in your business name, you’ll need a business checking account or a personal checking account with a DBA (doing business as). Then again, most people are utilizing direct deposit or some sort of ACH / EFT deposit which bypasses account names issues.

Remember, you can also create a DBA for your entity name. So, if your business is a franchise but you want a different LLC name on the checking account, you can be Big Bucks LLC dba Starbucks or Bad Coffee dba Starbucks. Remember, friends don’t let friends drink Starbucks. Please, find a decent coffee for yourself unless it is wintertime, and Starbuck’s chestnut and praline latte is in season. Yum!

We pick on Starbucks, but you have to admit while they might not have the best coffee, they are prolific and consistent throughout the world. You always know what you are going to get. Oh, and they made drinking $6 lattes fashionable and helped launch hundreds of thousands of small coffee shops. Wow, we really went off there.

S Corp Election

The S Corp election can wait. As mentioned throughout this book, $38,000 net income after expenses is the break-even point for an S Corp. Not sure? Not to worry, we can elect S Corp as far back as three and a half (3 ½) years using special IRS Revenue Procedure 2013-30 (as opposed to the 75 days provided in the Form 2553 instructions). WCG files about 150-175 late S Corp elections each year, and we are batting 100% on getting them pushed through.

Therefore, if net income is unknown or unpredictable, our advice is to wait until November or December to decide if the election makes sense, and then make it retroactive to the start of the LLC formation or January 1. So, get the LLC in place now and wait on the S Corp trigger until it makes sense- and Yes, we provide this consultation for you. Then again, if you are converting from W-2 to an independent contractor and your revenue is known, then we can form an LLC or corporation, and file the S Corp election right away.

Note that the last paragraph spoke of possibly delaying the S Corp election for an LLC. What if you are required to form a Professional Corporation (PC) because of your business activity (doctor, attorney, accountant, etc.)? Since a PC must file a separate tax return and incur a tax preparation fee, which is large chunk of the break-even analysis, an immediate S corporation election upon PC creation might be prudent.

More on the late election later but here is a spoiler-

• You could be in the middle of March 2026,

• Elect S Corp status back to January 2025 and

• Run a late 2025 payroll event dated 12/31/25 (or simulate Officer Compensation with a one-time 1099-NEC). Boom! You just save 8-10% of your net business income in taxes.

This is all legit, pain in the butt for us, but all legit and successful. Sure, there are some devils in the details in terms of your reasonable cause of the late election, and we will review those with you. WCG CPAs & Advisors did this about 160 times last year, and we’ve been doing this for more than a decade without major hiccups. Not the ideal way in the eyes of the IRS- but then again, hate the game not the player. We are just playing within the parameters of their game.

point where an S Corp makes sense is about $50,000 in net business income after expenses. Why? Simple cost benefit analysis. The expense of running an S Corporation such as payroll and tax preparation equals the savings at $50,000.

How did we calculate that? Our Vail business advisory service package is $4,500 per year. Take this number and divide it by an average savings of 9%, and that equals $50,000. Our business advisory service packages are discussed further, but it is basically your corporate tax return (Form 1120S), individual tax return (Form 1040 and state), shareholder payroll planning and processing via ADP, household tax planning and tax strategy sessions, and routine consultation.

Note: Our Telluride business advisory package is $4,980 and includes pro-active business entity tax planning for your state’s pass-through entity tax (PTET) calculation and any other business tax matters for the state.

What the heck is PTET? Check it out-

wcginc.com/ptet

Let’s say you are teetering on that income figure, and not sure about running payroll and all that jazz. You could still run your business income and expenses through your individual tax return (Schedule C on Form 1040) as a sole proprietor, and take the small self-employment tax hit. Then simply file a No Activity tax return for your S Corp. Legal. Legit. Sure, not perfectly elegant but certainly all good in the IRS hood.

If you expect to lose money the first two or three years, the S Corp election becomes a bit more complicated, and more discussion is required- it is generally better to delay the S Corp election so you can avoid the costs and hassles of filing a corporate tax return. More importantly, a single-member LLC or sole proprietor can theoretically have unlimited losses (assuming the money is all at-risk) where a partnership or S Corp cannot because of partner and shareholder basis rules. Briefly, as an S corporation you are both an investor and an employee. As an investor in any business, you cannot lose more than your investment (basis). Same thing here.

Here are some more gee-whiz stats (IRS is slow to release this stuff)-

Industry	Tax Returns	Share
Professional, Scientific & Technical Services	702,282	16.7%
Wholesale & Retail	652,750	15.5%
Construction	544,711	12.9%
Real Estate	461,284	11.0%
Health Care & Social Assistance	354,625	8.4%
Accommodation & Food Service	234,534	5.6%
Waste Management & Remediation	209,690	5.0%
Finance & Insurance	162,832	3.9%
Manufacturing	157,884	3.8%
Transportation & Warehousing	152,086	3.6%
Other	575,000	13.7%
Total	4,207,678	100.0%

By Jason Watson, CPA
Posted Sunday, December 29, 2024

This book is mostly about S corporations so we saved the best for last. The benefits of an S corporation election include-

• A low audit rate of 0.4% as compared to perhaps 3-5% (yawn)

• Allowing wages to be paid to the business owner to combat the Section 199A qualified business income deduction phaseout (more on that in a bit),

• Leveraging the pass-through entity tax (PTET) deduction, and

• The reduction of self-employment taxes (the big elephant).

Read that again. There is very little difference between a garden-variety LLC and an LLC with an S corporation election from an income tax perspective; the savings of an S Corp is from the reduction of self-employment taxes which comprise of Social Security and Medicare.

Recall that Social Security taxes stop at $176,100 (for the 2025 tax year) but Medicare continues into perpetuity. Don’t laugh! That 3.8% Medicare tax times a zillion dollars is a lot of money.

Spoiler Alert: At $2M in net income after expenses (profit), your S Corp tax savings is still above $60,000 even with a $400,000 salary… all because of Medicare taxes.

Other payroll taxes such as Unemployment, State Disability Insurance (SDA), etc. actually increase by electing S Corp taxation, but they are minor compared to the reduction of Social Security and Medicare (self-employment) taxes.

As mentioned earlier, S corporations are pass-through entities and therefore do not pay federal income taxes directly. However, various states might have different taxes such as a business or franchise tax. Additionally, the shareholders only pay Social Security and Medicare taxes on their salaries, yet do not pay these taxes on the net income after expenses (and shareholder salaries) from an S Corp.

Therefore, you would want a tiny salary and a large distribution from the net income, right? Well, sure, but there is a small little IRS rule called “reasonable shareholder salaries” that we spend an entire chapter on. We’ll also show in a later chapter that S corporations have various sweet spots in terms of income versus payroll tax savings from $30,000 to $2 million, between sole proprietorships, LLCs, partnerships and entities taxed as an S corporation.

S corporations are never formed contrary to popular belief. They are spawned from an entity such as a limited liability company, partnership or C corporation that elects to be taxed as an S corporation. After the election is made on Form 2553, you are treated as an S corporation for taxation purposes only. The underlying entity does not change! A lot of business owners rightfully say, “I have an LLC taxed as an S Corp” but they also say, “I have an S Corp.” Technically the former is more accurate, but both get the point across.

Oddly enough, the equity section in your balance sheet should then have a Capital Stock account and an Additional Paid-In Capital account. Again, while your underlying entity might be an LLC without stock (LLCs have interest not shares), it is being taxed as an S corporation so the balance sheet and tax return should look like a corporation. Yeah, it seems weird to have equity accounts that are for corporations while the underlying entity is a limited liability company. However, this coincides with representing the entity as a corporation for tax purposes, yet the underlying governance might be different. This is the whole S Corp vs LLC conundrum.

We can help with the journal entry to populate these accounts correctly so your equity section resembles that of a corporation. This also helps the tracking of basis in your S corporation. A later chapter has some examples.

To reiterate, you are in a weird limbo with electing to be taxed as an S corporation. You need to walk and talk like a corporation for taxes, but the underlying entity and what the Secretary of State will have on file is going to be an LLC, partnership or C corporation. More on the election, and the behind-the-scenes stuff in a later chapter plus our thoughts on corporate governance such as Meetings and Minutes.

Again, this book is mostly about S Corps. The last couple of pages were a slamma-jamma description of the basics.

By Jason Watson, CPA
Posted Sunday, December 29, 2024

The big knock on C Corps is that they might be tax inefficient. Wyoming was the first state allowing LLCs in 1970, but most states did not follow suit until the 1990’s. Therefore, if you wanted to avoid double taxation you had to first create a C corporation and then elect S corporation taxation.

Thanks to current tax law changes, corporations now enjoy a 21% income tax rate. But… not all that glitters is gold. Dividends are then taxable to you up to 23.8% (which is 15% to 20% capital gains plus 3.8% of Medicare surtax potentially). Therefore, your effective tax rate for using a C Corp as your entity choice ranges from 36% to 44.8% where the top individual rate of an S Corp shareholder is 37%. This is the double taxation part.

We don’t run into too many business owners who want to make money but never spend it. Sure, you can enjoy a lasting 21% corporate tax rate, but to spend it you need to be taxed again at your dividend rate. Read more in our recent blog post-

wcginc.com/8376

If you think you are clever and drive corporate profits down to zero with high owner salaries, this too unnecessarily pays more in overall taxes ultimately (payroll taxes being the main culprit). You will discover in a later chapter that the IRS requires reasonable salaries to be paid to materially participating shareholders in an S corporation (not too low); however, the same is true in a C corporation where an unreasonably high salary is a target for the IRS. Seems odd, but true.

In other words, C corporation plus high salary, Bad. S Corporation plus low salary, Bad. Like Goldilocks, it needs to be just right to the IRS.

Not all is bad with C Corporations.

C corporations generally enjoy better financial liability protection and have much easier transfer of ownership. Taxes are paid at the corporate level to the IRS and states (either through an income tax or a business tax) on Form 1120. Notice the subtle difference; 1120 and 1120S.

Because of the relatively low tax rate as compared to the highest individual tax rate, C Corps can leverage debt reduction at a cheaper rate. How? You buy a piece of equipment with a loan. A portion of the loan payment is principal and is basically paid with after-tax dollars since the interest portion is deducted. Said in another way, you make $1,000 in profits and use $1,000 of it as accelerated debt reduction. You will still pay tax on the $1,000. Yuck.

So, the question becomes, if you must pay taxes on the $1,000, would you rather do it at 21% than 37%? We’ll give you a minute to decide with an optional chin rub. Again, this is predicated on smart budgeting and using excess cash to pare down debt versus that European cruise you’ve been eyeing.

There might be an issue with accumulated earnings tax (AET), but don’t get too hung up on that since depreciation will reduce earnings (tax loss or tax neutrality, but cash “gain”). Then later on down the line you elect S Corp tax status on this C Corp and you have the best of both worlds… reduced income tax for some time, and then avoided double taxation as you start pulling out excess cash.

C corporations are also required for any type of self-directed IRA or 401k, and in some cases where a life insurance policy is being paid for by the corporation (and where the beneficiary is the corporation). For example, if you wanted to open a business with a rolled over IRA it would typically need to be a C corporation. However, some IRA trust providers are creating LLCs and funding them with a self-directed IRA. The jury is out on the legality of this, and there are enough attorneys and legal professionals on either side to warrant concern.

If you wanted a life insurance policy on your best sales producer, these are sometimes restricted to C corporations only (essentially, it cannot be a pass-through entity such as a multi-member LLC or partnership, or any entity taxed as an S corporation).

C corporations might also be necessary for exotic stock options, vesting schedules, different classes of voting stock (one share equals ten votes, Class A or one share equals one vote, Class B) and initial public offerings. If you have these needs, seek an attorney. A smart one.

Don’t forget the golden rule where the person who has the gold makes the rules. Said differently, if an investor or venture capitalist wants to put their money with you, and they will only do so under a C corporation regime, you are stuck between a rock and a hard place.

By Jason Watson, CPA
Posted Sunday, December 29, 2024

General Partnerships (GP) have unlimited liability exposure whereas Limited Liability Partnerships (LLP) have as the name would suggest limited exposure for the limited partners. Remember, this is financial exposure not necessarily other perils such as tort liability. More about that later.

We won’t discuss these entity types much either since they have fallen out of favor lately. Many attorneys are now creating two classes of members within a MMLLC to mimic the different groups that a true partnership would create. So, it walks and smells like an LLP but it is actually a MMLLC, without the burden of complication and cumbersome ordering rules. For example, “A Members” are the old-school version of General Partners, and “B Members” are the equivalent of Limited Partners. Most of the attorneys we work with don’t create partnerships anymore, including family limited partnerships (FLPs), opting instead for the use of MMLLCs.

Throughout this book we might refer to members as partners. More often than not we are referring to a member of a multi-member LLC. While partner and member are technically different, and the entity type will ultimately decide member or partner, these words are often interchanged by business owners; we are doing our best to reverse the trend.

What gets really obnoxious is shareholder and member. A C corporation has shareholders. An LLC has members. A C Corp taxed as an S Corp has shareholders (that one is easy). But an LLC taxed as an S Corp has members and shareholders. From an entity perspective, we use members. From a tax return perspective, we use shareholders. Why? Historically before the existence of LLCs, an S corporation’s underlying entity was predominantly a C corporation.

By Jason Watson, CPA
Posted Sunday, December 29, 2024

Once you take your single-member LLC and add a member, you are now a multi-member LLC (MMLLC). Boom! Instant increased complexity. The IRS will now call you a partnership since you have more than one member and as a result you will file a Form 1065 Partnership Tax Return.

However, you are technically not a partnership, but rather you are a multi-member LLC with an Operating Agreement as opposed to a partnership with a Partnership Agreement. Adding your spouse typically counts as a MMLLC unless you are in a community property state which is explained a bit later in this chapter (it’s underwhelming but important).

Therefore, we must be technically sound on the nomenclature. Smart people rarely interchange the Bears and professional football team, yet many people often interchange 401k and IRA, and multi-member LLC and partnership. This is incorrect. A MMLLC might be taxed as a partnership, but the underlying entity is a limited liability company which has different rules and state statutes as compared to partnerships. Governance, and the rules encompassing that, is different than taxation. Easy to confuse the two.

MMLLCs are similar to sole proprietorships and SMLLCs in terms of income and self-employment taxes, but enjoy a bit more financial protection through the concept of Charging Orders (more on that later in this chapter as well). Transfer of ownership is the same as a SMLLC since you have a member interest that can be gifted, sold, inherited, painted purple, etc. However, most MMLLCs will have an Operating Agreement governing the transaction of each members’ interest.

Operating Agreements will also define the sharing of expenses and income. For example, you could be an angel investor at 20% injection but demand 50% of the income. Expanding this concept further, a partnership tax return (Form 1065) generated from a MMLLC will have three “allocations” for each member; allocation of capital, profits and losses. Commonly profits and losses are tied together. Again, you could have a 20% allocation of capital and a 50% allocation of profits and losses (spoiler alert: S Corp blows this flexibility up… standby!).

Operating Agreements also become critical when the entity has value- issues like death, divorce, incapacitation, required distributions, dispute resolution and exit strategies must be handled within the agreement. Perhaps a separate Buy-Sell Agreement is required (usually funded with life insurance- we can help navigate on this).

You and your business partner are besties today, but our job at WCG is to not unnecessarily complicate things. Additionally, our job is to protect your future with a malleable arrangement that endures and provides for a graceful exit.

In terms of self-employment taxes, the taxation of a MMLLC is very similar to a sole proprietorship or SMLLC as alluded to earlier. Partnerships and those mimicking partnerships (MMLLC) commonly require a separate partnership tax return on Form 1065 (with an allowed exception for those living in community property states), which creates K-1s for each member or partner.

This might be your first brush with the term K-1. A K-1 is similar to a W-2 since it reports income and other items for each member, partner, shareholder, owner or beneficiary, and is coded to tell the IRS how the business activities should be treated.

A K-1 is generated by an entity since the entity is passing along the income tax obligation to the K-1 recipient (hence the concept pass-through entity, or PTE for TLA lovers). There are three basic sources for a K-1, and the source dictates how the income and other items on the K-1 are handled on your individual tax return (Form 1040). Here they are-

• Partnerships (Form 1065)

• S Corporations (Form 1120S)

• Estates and Trusts (Form 1041)

All of these are PTEs with the exception of a trust, which might or might not a be pass-through depending on the purpose of the trust. A K-1 is usually filed electronically as a part of the tax return that is generating the K-1. As such, it is preferred to prepare and file your individual income tax return after the PTE’s tax return is filed.

We say preferred because it is not absolutely required. However, you run two risks; the first risk is that the K-1 information could change once the PTE’s tax return is finalized. The second risk is that too much time lapses between the tax returns, and the IRS sends a tax notice based on a database mismatch (mismatch between what you report and what the IRS has… like a bad game of Go Fish… “Do you have a K-1?” “Go fish.”).

A K-1 from a Form 1065 Partnership Tax Return and a K-1 from a Form 1120S S Corporation Tax Return are scarily similar. We could hold two K-1s about three feet from your face and you couldn’t tell the difference- heck, we couldn’t either. What makes matters worse, is that they both are reported on Page 2 of your Schedule E, and ultimately on line 5 on Schedule 1 of your Form 1040.

But here is the crux of the matter, so please pay attention- one is generally subjected to self-employment taxes and the other is not simply based on which form created it (1065 versus 1120S). Read that again! There is another subtle difference. Expenses associated with K-1 income from Form 1065 are deducted immediately on Page 2 of Schedule E as Unreimbursed Partnership Expenses (UPE) while shareholders of S corporations do not have a place to deduct shareholder expenses.

Sidebar (we love these by the way): In Tax Court Memo 2011-289 McLauchlan v. Commissioner, the court states-

The parties dispute whether the expenses at issue are deductible as unreimbursed partnership expenses. Generally, a partner may not directly deduct the expenses of the partnership on his or her individual returns, even if the expenses were incurred by the partner in furtherance of partnership business. Cropland Chem. Corp. v. Commissioner, 75 T.C. 288, 295 (1980), affd. without published opinion 665 F.2d 1050 (7th Cir. 1981). An exception applies, however, when there is an agreement among partners, or a routine practice equal to an agreement, that requires a partner to use his or her own funds to pay a partnership expense. Id.; Klein v. Commissioner, 25 T.C. 1045, 1052 (1956).

Having said that, most S corporation shareholders are also considered employees so they would deduct unreimbursed employee business expenses on Form 2106 and Schedule A. With the passage of the Tax Cuts and Jobs Act of 2017, Form 2106 expenses are no longer deductible on Schedule A.

This can be a surprise to an unaware new S Corp owner. When WCG prepares a business entity tax return, we ask for Accountable Plan reimbursements (see Chapter 10) which include things like home office, mileage, cell phone and internet. At times the business owner figures that we do not need this information since they will deduct home office and mileage, as they’ve always done, on their 1040 tax return. To make matters worse, the business entity tax return is usually prepared and filed long before the 1040 tax return. We chat about this and other pitfalls in Chapter 10 – Operating Your S Corp.

Regardless of S corporation or partnership, expenses should be reimbursed by the business through an Accountable Plan and therefore deducted on the business entity tax return. We’ll talk about Accountable Plans, and the office politics when you have multiple shareholders, in a later chapter. Good stuff!

As a reminder, entities being taxed as a partnership or S Corp do not pay federal tax- the partners or the members of a MMLLC pay income taxes as individuals (again, hence the pass-through nature). But note the word federal. States can do a lot of crazy things, and there is a whole chapter about the 185 reasons not to elect S corporation taxation that touches on state related issues such as franchise taxes and obscene corporate taxes including what some call the “pleasure to do business in our state” tax.

Single-member limited liability companies (what we abbreviate as SMLLC) are treated the same way as a sole proprietorship since in the eyes of most taxing agencies SMLLCs are considered a disregarded entity. Just as the name suggests, the entity is disregarded for tax purposes and all business activities are reported on Schedule C with your Form 1040.

The disregarded entity stands in contrast to the pass-through entity (PTE) which are usually partnerships and S corporations.

While the IRS disregards the general SMLLC, several states have a separate form or filing. California uses Form 568. New York uses Form IT-204 LL. Texas has an annual franchise tax filing on Form 05-102 (even with their recent changes in reporting requirements the public information report is still required). We can keep going but you get the idea.

Therefore, SMLLC equals sole proprietor from a federal income taxation perspective and most states. However, keep in mind that a SMLLC enjoys some distinct benefits over a sole proprietor such as liability protection, anonymity and improved transfer of ownership through its Operating Agreement.

By Jason Watson, CPA
Posted Sunday, December 29, 2024

We don’t want to spend too much time on sole proprietorships since most people reading this book don’t want this arrangement. It also behooves us to say that you cannot elect a sole proprietorship to be taxed as an S corporation. Therefore, if you have been in business for several years without an underlying entity, such as an LLC, then you must first create one and then file an S Corp election to enjoy the benefits of an S corporation. What are those mysterious benefits we keep mentioning? Slow down love… we’re getting there!

As a sole proprietor you might still need a state registration or some licensing for your particular line of work (such as real estate agent, massage therapy, family counseling), but it is easy to do without needing to form an LLC. Additional downsides to sole proprietorships include zero financial liability protection, poor transfer of ownership upon expansion or death, and the ugly self-employment taxes. Income and expenses are reported on Schedule C and your Form 1040, a separate business tax return is not necessary.

Having said all this, in some cases a sole proprietorship is preferred. For example, in California, there is an $800 annual franchise tax. If your business is barely a side gig and perhaps more of a hobby that might turn into something one day, then $800 annually might seem expensive. You can easily make a business card with some marketing on it and open another personal checking account for the business activities. Done!

Also, be wary of annual Secretary of State filing fees. Nevada is $350. Massachusetts is massive at $500. These are annual fees for just having an LLC. The “pleasure to have an LLC in our state” fee, if you will. Other states vary between $100 to $250, and a few remain free after the initial filing fee like Texas.

There are three basic small business entities with variations within. The three basic entities are-

• Limited Liability Company (LLC), the crowd favorite

• Limited Liability Partnership (LLP) Limited Liability Limited Partnership (LLLP or triple “L” P as the cool kids say), or the legacy dinosaur General Partnership (GP)

• C Corporation (for profit), and the Personal Service Corp

There is an additional entity subtype with the “Professional” prefix. Some states require certain professionals, such as doctors, attorneys, accountants and engineers, to be a Professional LLC (the PLLC) or a Professional Corporation (the PC). Since you don’t see too many LLPs these days, you don’t see too many PLLPs either.

Two notables are missing from the list. First, sole proprietors are not an entity nor is the variant or close cousin of “Doing Business As” (DBA). If you wake up and want to sell used copiers, you can, right now, without any formalized structure. It is not smart, but certainly permissible. At times sole proprietors are interchanged with single-member limited liability companies (SMLLC) since the IRS and most states consider a SMLLC to be a disregarded entity for taxation, and both a sole proprietorship and a SMLLC will end up on Schedule C of your Form 1040. However, they are truly different in several underlying ways.

Also note how an S corporation is not listed. It is not an entity. It is a taxation election. The underlying entity has to be one of the above, and usually it is an LLC (either single-member or multi-member) for the ease of formation including documentation.

Spoiler Alert: In California, it is preferred to create a C corporation professional corporation (PC), or convert to one if you are also electing S Corp taxation. Why? When you pay a reasonable salary to the shareholders, they must pay into California’s State Disability Insurance (SDI) plan. However, as corporate officers, they can opt-out. But! LLCs do not have officers; they have managers and members. As you will learn in this book, when invoking the S Corp election, the underlying entity does not change. Ergo, LLCs taxed as an S corporation in California cannot opt-out of SDI which can save over $1,000 annually.

Let’s chat about each of these entities in turn. Here we go…

By Jason Watson, CPA
Posted Tuesday, April 22, 2024

This is aimed at business owners where they no longer materially participate in the business activity, and as such they are now considered passive investors. Seems easy right, but why would you care? For two big reasons- first, if you have other non-deductible passive losses due to income limitations, such as those from a rental property, you can now have your passive income absorb these passive losses. This allows you to enjoy your tax benefits now rather than delaying the pleasure to future years. Yay!

Second, as a passive owner you might be able to only draw distributions from your business (no salary) rather than salary plus distributions. Since you are pulling money from the business as passive income, this saves you several thousands of dollars in avoided Social Security and Medicare taxes. Every $10,000 in owner salary is about $1,500 in payroll taxes. Yay again!

The world is always trending towards harmony, so here are the passive business owner downsides. It is difficult to claim passive business owner given the material participation tests. The hardest one to overcome is #5 from IRS Publication 925 Passive Activity and At-Risk Rules. Here is the list-

Material participation tests.
You materially participated in a trade or business activity for a tax year if you satisfy any of the following tests.

1. You participated in the activity for more than 500 hours.

2. Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.

3. You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.

4. The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you didn’t materially participate under any of the material participation tests, other than this test. See Significant Participation Passive Activities under Recharacterization of Passive Income, later.

5. You materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.

6. The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor.

7. Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.

Let’s look at #5 again, but with some verbiage from the IRS Audit Techniques Guide (ATG) for Passive Activity Losses–

You materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.

IRS ATG: An activity is non-passive if the taxpayer would have been treated as materially participating in any 5 of the previous 10 years (whether or not consecutive). This test usually applies when a taxpayer “retires from material participation” but maintains an ownership interest in the activity. Yikes (emphasis added).

IRS Examination Techniques: Even if the taxpayer performs no services for a business currently, the examiner should inquire about involvement in prior years and review the returns to see if income or losses were treated as non-passive.

In other words, you need to look back for 10 years and if 5 of those years had material participation by you in the business activity as defined by any of the above, then the IRS will disallow your passive claim. Could you start a brand-new business without the history? Perhaps, but this might be viewed as an end-around especially if the new business magically looks, walks, talks and smells like the old. Transitioning from material participation to passive is certainly tough!

Just because you call yourself a limited partner in a limited liability limited-partnership or some other variant does not matter. It is all about your actions and the reliance on your participation by the entity or enterprise for its success. Should you be considered materially participating in the business, then your income will be typically considered self-employed income and subject to self-employment taxes (Social Security and Medicare taxes). If the entity is taxed as an S Corporation then you would need to be paid a reasonable salary.

A quick recap- you would like to be considered a passive business owner to either-

• have passive losses be deductible against your newfound passive income,
• to avoid having to pay yourself a reasonable salary in an S Corp environment (and only take shareholder distributions), or
• have your income avoid self-employment taxes in a sole proprietor, single-member LLC or partnership environment.

However, the tax code has seen you (and a zillion others) coming a mile away and mostly says No unless you can slip and slide around the rules above.

By Jason Watson, CPA
Posted Wednesday, October 18, 2023

We are not going to spend too much time on this. A corporation will be deemed a personal service corporation if-

• Substantially all of the corporation’s activities involve the personal of services such as health, law, engineering, accounting, consulting, among others.
• At least 95% of the stock is owned by the employee(s) performing the service.

Why do you care? You shouldn’t. Personal service corporations are taxed like regular C Corps, but must use cash-based accounting and have a calendar year-end. There is also a bit more pressure on accumulated earnings since the trigger is lower. Without proper justification for the big pile of cash, the IRS might require dividends to be paid or reclassify these earnings as dividends.

By Jason Watson, CPA
Posted Wednesday, October 18, 2023

The power of advertising, the ease and the hype have created this fervor surrounding the limited liability company. Note the word company. An LLC is not a limited liability corporation. An LLC is a company and a corporation is a corporation. Woefully different.

Some people think they must create an LLC just to operate a business- not true, you can be considered a sole proprietor the day you woke up, decided to ruin your life and started operating a business. Some people also think they save taxes by creating an LLC- not automatically true unless you take the additional steps to either elect S Corp status and / or implement executive benefits that are otherwise unavailable.

While there are benefits as explained throughout this book, there are also many misconceptions and downright pitfalls to forming and operating an LLC. Don’t be fooled, or at least keep it to yourself if you are.

By Jason Watson, CPA
Posted Wednesday, October 18, 2023

The next pay per view! UFC #58,723, The Apology… S Corp Versus LLC… Sunday Sunday Sunday!

Since this book is about LLCs and S Corps and we’ve already discussed a ton of stuff, we put together a small table to illustrate the S Corp vs LLC contrasts and comparisons; sounds like the start of a college essay. Yuck. Here we go-

	LLC	S Corp
Self-Employment Taxes	Yes	No
Section 199A Deduction Ability	Max*	Max
Business Tax Deductions	Max	Max
401k Plan	Yes	Yes
Liability Protection	Limited	Limited
Tax Return	1040 / 1065	1120S
Headaches	Yes	Yes

Quiz time! What’s the difference between an LLC and an S Corp? None, except the reduction of self-employment taxes and the tax return form number. That’s it! Ok, perhaps that is not entirely true.

The little asterisk above is referencing a phaseout of the Section 199A qualified business income deduction where a secondary test is used to determine (or limit) the deduction. Basically, it is 50% of the business income (profit) or 20% of the wages paid, whichever is lower. Since it is frowned upon for a non-S Corp’d LLC to pay wages to its owner(s), at times an S Corp election is required to “open up” the Section 199A deduction.

There are two additional burdens when exploring the LLC vs S Corp comparison.

One is tax return preparation, and subsequent fee. A Form 1120S is a business entity tax return and WCG’s fee is typically $1,500 to $1,800. The second burden is payroll processing; as an S corporation you must pay the shareholders a reasonable salary as employees. This too adds a financial burden as well as a series of administrative “touches.” But! As you will see, the savings can be significant. For a small increase in chores, you could easily save thousands of dollars. Yes, plural.

By Jason Watson, CPA
Posted Wednesday, October 18, 2023

Section 199A deduction also known as the Qualified Business Income deduction arises from the Tax Cuts & Jobs Act of 2017. This is a significant tax break for small business owners but there are rules and limits of course.

Section 199, without the A, is the section covering Domestic Production Activities Deduction. Section 199A is seemingly modeled after this (or at least a portion was ripped off by legislators) since the mathematics and reporting is similar between Section 199A and Section 199.

Section 199A Qualified Business Income deduction is a deduction from gross income on Line 13 on Page 1 of your individual tax return (Form 1040) for the 2020 tax year.

Section 199A Defining Terms

Pass-through entities and structures include-

• Sole proprietorships (no entity, Schedule C).

• Real estate investors (no entity, Schedule E).

• Disregarded entities (single-member LLCs).

• Multi-member LLCs.

• Any entity taxed as an S corporation.

• Trusts and estates, REITs and qualified cooperatives.

Specified Service Trade or Business (SSTB) is defined as-

• Traditional service professions such as doctors, attorneys, accountants, actuaries and consultants.

• Performing artists who perform on stage or in a studio.

• Paid athletes.

• Anyone who works in the financial services or brokerage industry.

• And now the hammer… “any trade or business where the principal asset is the reputation or skill” of the owner. Why didn’t they just start with this since everything else would have been moot. Oh well…

Interestingly, removed from the traditional service profession are engineers and architects. But an engineer operating a business based on his or her reputation or skill might still be a specified service trade or business. In other words, reputation or skill might trump the fact that engineers and architects were purposely left off the list. Every consultant is suddenly going to reclassify themselves as an engineer; software consultant is now a software engineer. Watson Business Engineers has a nice ring to it. Hmm….

Sit on the ledge, sure, but don’t jump off a bridge just yet. The specified service trade or business problem only comes up when your taxable income exceeds the limits. So, a financial advisor making $150,000 might still enjoy the Section 199A deduction. Keep reading!

Section 199A Income Limits

• Based on taxable income including all sources (not just business income). Also limited to 20% of taxable income. See Line 15 of Form 1040 to assess your taxable income.

• Single is $157,500 completely phased out by $207,500 (adjusted for inflation). $157,500 represents the end of the 24% marginal tax bracket using 2018 as the base year and is indexed each year (see quick reference in the beginning of our book for the current 24% marginal tax bracket).

• Married filing jointly is $315,000 completely phased out by $415,000 (adjusted for inflation). $315,000 represents the end of the 24% marginal tax bracket using 2018 as the base year and is indexed each year.

Calculating the Qualified Business Income Deduction

The basic Section 199A pass-through deduction is 20% of net qualified business income which is huge. If you make $200,000, the deduction is $40,000 times your marginal tax rate of 24% which equals $9,600 in your pocket. Who says Obamacare isn’t affordable now?

Here is the exact code-

(2) DETERMINATION OF DEDUCTIBLE AMOUNT FOR EACH TRADE OR BUSINESS. The amount determined under this paragraph with respect to any qualified trade or business is the lesser of-

(A) 20 percent of the taxpayer’s qualified business income with respect to the qualified trade or business, or

(B) the greater of-

(i) 50 percent of the W-2 wages with respect to the qualified trade or business, or

(ii) the sum of 25 percent of the W-2 wages with respect to the qualified trade or business, plus 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property.

There are some devils in the details of course. The best way is to show some examples-

• Wilma makes $100,000 in net business income from her sole proprietorship but also deducts $5,000 for self-employed health insurance, $7,065 for self-employment taxes and $10,000 for a SEP IRA. These are not business deductions- they are adjustments on Form 1040 to calculate adjusted gross income. Her deduction is the lessor of 20% of $100,000 (net business income) or 20% of her taxable income, which could be less (see Pebbles below). This might change as the IRS clarifies.

• Barney owns three rentals with net incomes of $20,000 and $5,000, with one losing $8,000 annually. These are aggregated to be $17,000. He would deduct 20% of $17,000.

• Barney has passive losses that carried forward and are “released” because he now has net rental income, those passive losses are taken first. With using the same example above with $10,000 in passive loss carried forward, Barney’s deduction would equal $17,000 less $10,000 or 20% of $7,000.

• Pebbles earns $100,000 from her pass-through business but reports $80,000 of taxable income on her tax return due to other deductions such as her itemized deductions. Her Section 199A deduction would be $16,000 since it limited by the lessor of 20% of $100,000 or $80,000.

• Mr. Slate operates an online retailer S corporation which pays $100,000 in W-2 wages and earns $400,000 in net qualified business income. Because he is considered a “high earner” by exceeding the income limits, his deduction is limited to 50% of the W-2 or $50,000 which is less than 20% of $400,000.

• If Mr. Slate instead operates as a sole proprietor and earns $500,000 but does not pay any W-2 wages, his deduction is the lessor of 50% of the W-2 wages (or $0 in this example) or 20% of the $500,000. If he paid out $200,000 in wages and had $300,000 in net business income, his Section 199A deduction would be the lessor of 50% of $200,000 or 20% of $300,000.In other words, he would deduct $60,000 ($60,000 is less than $100,000, even in Canada). He would want to create an LLC, tax it as an S corporation and pay out W-2 wages to maximize his Section 199A deduction.

• If Mr. Slate instead operates as a specified service trade as defined previously, he would completely phase out of the Section 199A deduction by exceeding the income limit of $207,500 and $415,000. This is the specified service trade “gotchya.”

• If Mr. Slate was married and operated a specified service trade, and the taxable income considering all income sources (spouse, investments, etc.) exceeded $315,000 but was less than $415,000, there would be a sliding scale of deduction eligibility. Silly rabbit, tax reform doesn’t mean tax simplification.

• Fred… yes, we can’t neglect Fred… is single and operates an S Corp as an accountant. Days of busting up rocks for Mr. Slate are in the rear-view mirror. He earns $100,000 in net qualified business income after paying $50,000 in W-2 wages to himself.He is a clearly a specified service trade but because he earns less than $157,500 total ($150,000 in this example) he can take advantage of the full Section 199A deduction of 20% of $100,000. The question of reasonable salary is not being entertained here… focus on the W-2 to income relationship.

• Betty becomes a slumlord and earns $500,000 in rental income. No W-2 since she is operating the properties as an individual (and converting passive income into earned income vis a vis a W-2 would be silly). Let’s say she purchased the properties for a $1,000,000 (unadjusted basis). The math would go like this-20% x $500,000 is $100,000 (straight calculation).50% of $0 is $0 (W-2 limit calculation).2.5% of $1,000,000 is $25,000 (depreciable asset limit calculation).

Section 199A is limited to the lessor of $100,000 as compared to the greater of $0 (W-2) and $25,000 (depreciable assets).

Section 199A Takeaways

No entity is penalized under this tax law. Some entities and situations might not qualify or be limited in some fashion, but the high-water mark in terms of taxation is the old crummy 2017 tax law.

Taxable income becomes a big deal for two reasons! First, $1 over $157,500 or $315,000 starts the specified service business disqualification and W-2 limitation (and there is also a depreciation component that we are glossing over in this summary). Second, the Section 199A deduction is limited by 20% of taxable income from all sources (what would be reported on your tax returns).

W-2 wages include all W-2 wages, not just those paid to the owner(s). Converting a 1099 contractor to a W-2 employee might be beneficial.

Note: The $157,500 and $315,000 taxable household income limits are the end of the 24% marginal tax rate using 2018 as the base year. These numbers are indexed each year. Said in another way, if your taxable household income exceeds the 24% marginal tax bracket, then you trigger the secondary Section 199A tests and possible limits.

Self-employment taxes will still be calculated on the net business income before the Section 199A deduction since the deduction is taken separately on Line 13 on Page 1 of your individual tax return (Form 1040) for the 2020 tax year. Therefore, you could earn $100,000 and deduct $20,000 under Section 199A, but still pay self-employment taxes on $100,000.

S corporations remain a critical tax saving tool for two reasons. First, the usual self-employment tax savings remains intact for all business owners including specified service trades or businesses. Second, a business owner might need to pay W-2 wages to himself or herself to not be Section 199A limited by income, and only corporations can pay W-2 wages to owners (in other words, an LLC cannot without an S Corp election).

Section 199A Pass-Thru Optimization

As you can see, there is some optimization that is necessary for a small business owner to get the most from the Section 199A deduction. On one hand we want to reduce W-2 salaries to shareholders to minimize self-employment taxes. On the other hand, we want to increase W-2 salaries so they do not limit the amount of Section 199A that is deducted.

This seems straightforward since payroll taxes are 15.3% plus some unemployment and other insidious stuff and the Section 199A Qualified Business Income deduction is 20%. However, the 20% Section 199A deduction must be multiplied by the marginal tax rate to obtain the true tax benefit. Even at a 37% marginal tax rate, the additional payroll taxes might exceed the Section 199A deduction tax benefit. Again, optimization is important.

Spoiler Alert: the optimal salary for Section 199A as a percentage of net business income before salary is 27.9% or about $28,000 salary paid on $100,000 business income.

Section 199A Deduction Decision Tree

Remember that taxable income is all income for the household.

Specified Service Trade or Business

• If taxable income is less than $157,500 (single) / $315,000 (married) then the 20% deduction for your pass-through entity is fully available.

• If taxable income is greater than $157,500 / $315,000 but less than $207,500 / $415,000 then a partial deduction is available. The phase-in of the limit is linear.

• If taxable income is greater than $207,500 / $415,000 then you are hosed. Sorry.

All Others

• If taxable income is less than $157,500 / $315,000 then the 20% deduction is fully available.

• If taxable income is greater than $157,500 / $315,000 but less than $207,500 / $415,000 then a partial deduction is available with the W-2 and depreciable asset limit calculations phase in.

• If taxable income is greater than $207,500 / $415,000 then the 20% deduction is compared to the full W-2 and depreciable asset limit calculations (see Betty above).

Please recall that these numbers are from 2018, and represent the top of the 24% marginal tax bracket. As such, these numbers are indexed each year. See the beginning of our book for current tables. Yes, we keep reiterating this concept. Sorry!

By Jason Watson, CPA
Posted Wednesday, October 18, 2023

Several states require certain professions such as accounting, law, medicine, architecture and engineering to be a Professional Corporation (PC). These have the same housekeeping and corporate governance as a C corporation, and they can also elect S corporation status. Other states only require these professions to create a Professional Limited Liability Company (PLLC). Again, PLLCs can also elect S Corp taxation. Not much else to say here.