By Jason Watson, CPA
Posted Monday, December 30, 2024

There are two types of education- one that is open-ended and has no business connection to your trade or profession, and one that helps you improve a current work skill.

Open-Ended Education Assistance

Your LLC or S Corp can pay up to $5,250 (for the 2025 tax year, and has not changed for a while) of an employee’s tuition and education expenses including your children who work for you. But there are some rules for your child. He or she must-

• Be age 21 or older,

• Be a legitimate employee of the LLC or S Corp,

• Not own more than 5% of the LLC or S Corp, and

• Not be your dependent.

The Age 21 rule stems from attribution rules whereby a child under the age of 21 is deemed to own the same percentage as his or her parents. So, if you own 100% and your child is 20, your child is considered to be a 100% owner for this benefit (and many others), which obviously exceeds the 5% rule.

For your amusement, IRC Section 1563(e) Constructive Ownership reads-

(6) Children, grandchildren, parents, and grandparents
(A) Minor children
An individual shall be considered as owning stock owned, directly or indirectly, by or for his children who have not attained the age of 21 years, and, if the individual has not attained the age of 21 years, the stock owned, directly or indirectly, by or for his parents.

And, IRC Section 127(b) Educational Assistance Programs-

(3) Principal shareholders or owners
Not more than 5 percent of the amounts paid or incurred by the employer for educational assistance during the year may be provided for the class of individuals who are shareholders or owners (or their spouses or dependents), each of whom (on any day of the year) owns more than 5 percent of the stock or of the capital or profits interest in the employer.

Therefore, your kids essentially (a) have constructive ownership until 21 year of age, (b) are considered a 5% shareholder and (c) are ineligible for education assistance. And as mentioned through this book, special rules kick in for a 2% shareholder (or 5% shareholder in this case) triggering tax consequences for benefits received. Therefore, the benefit might kick in around senior year in undergraduate school, and certainly for any graduate or post-degree education.

Under IRC Section 127, reimbursable education includes any form of instruction or training that improves or develops the capabilities of an individual, and is not limited to job-related or degree programs. However, qualified expenses do not include meals, lodging and transportation.

A written plan must be drafted, and employees must be notified of the benefit. Therefore we suggest having each employee sign a notice that explains the benefits, and that they have read and understand the benefits. And no other benefits can be offered as an alternative- in other words, you cannot provide additional pay or bonus for employees who do not use the educational assistance program.

Improving Current Work Skills

To be able to deduct education expense as a small business tax deduction, the education must either-

• Maintain or improves skills required in your existing business, or,

• Is required by law or regulation to maintain your professional status through continuing education credits such as attorneys, accountants, real estate agents, mortgage lenders, etc.

So, can you deduct your MBA? Perhaps. In Lori A. Singleton-Clarke v. Commissioner, Tax Court Summary Opinion 2009-182, the court ruled in Lori’s favor. She was an established nurse, and she went back to school to obtain an MBA in Health Care Management. She was already in charge of quality control from a management perspective, and the MBA did not lead to an additional and discernable skill. Additionally, the court stated that the MBA improved her current work skill as a quality control coordinator. Subtle difference.

Here are some more-

Mary Colliver v. Commissioner, Tax Court Summary Opinion 2017-93. Mary held a Bachelor’s degree in speech pathology and was offered a position with a hospital doing similar work. The hospital position required Mary to obtain her Master’s degree in speech pathology, but the hospital allowed her to complete her studies while performing the tasks of the position. Specifically the Master’s degree allowed her to be a medical speech pathologist.

Mary subsequently deducted about $8,500 in qualified education expenses, and upon examination the IRS disallowed the deduction. The Tax Court also agreed and their summary concluded that the tasks and activities before and after the additional education were different enough to qualify as a new trade or business. In other words, Mary could not work in hospitals without the Master’s degree, and her education allowed her to do so. The Court found this convincing enough to deny the qualified education expense deduction.

Our take is that this is certainly splitting hairs. Mary was a speech pathologist before and after, and she simply improved her current work skills as a speech pathologist to become a better one. It wasn’t like she was a high school counselor who wanted to become a medical speech pathologist. So, be wary that the Tax Court is creating very low thresholds for making the leap of “new trade or business.”

Here’s another, similar crummy deal in our opinion-

Czarnecki v. U.S., 120 AFTR 2d 2017-5372. Jerry Czarnecki was an engineer for most of his adult life and held a Bachelor’s degree in engineering and a Master’s degree in applied mathematics. In 1998 he started a Doctoral program at MIT. Yeah, total nerd, ridiculously smart and probably super rich. Calm down ladies, we’re sure he had a third eye and was married with a gaggle of unruly children who would drive you nuts.

In 2007 he started to work for the U.S. Navy as a Systems Engineer Level 3 ensuring that submarines wouldn’t crumple under water and to study the effects of submarine vibration on batteries. Again, super high-tech stuff. During 2010 he was a licensed professional engineer but was not as a structural engineer. Jerry deducted $8,712 in qualified education expenses on his 2010 amended tax return (first mistake… give an IRS human a reason to say, “yeah right.”).

His second mistake was not demonstrating how his Doctoral studies improved his current work skills. The Court said it was not enough to simply make the assertion as a global argument; the Court wanted very specific links between what Jerry did today and how his education improved his current set of skills.

As a result his deduction was disallowed

Before you drop $50,000 a semester for Wharton or Stanford, be careful. In our experience there is enough case law on either side of the MBA deduction issue to be wary. Having said that, get an MBA because you want the education, degree and ultimately more opportunities. If we can find a way to deduct it, great. If not, you still have improved yourself.

By Jason Watson, CPA
Posted Monday, December 30, 2024

Should you pay Junior to vacuum? Perhaps. While most parents can’t get their children to clean a counter or put away dishes, perhaps putting them to work at the office is a good option.

Tax Advantages

There are some minor tax advantages to paying your children- for example, you can pay your child $14,000 in wages, and since the standard deduction is $15,000 (for the 2025 tax year) the child will not have any taxable income. They can also gift this money back to you, or help pay for groceries.

Kidding aside, for you to give your child $15,000 to save for college or pay for college, it takes probably takes $19,000 or more in parental income because of the income taxes.

However, there are some pitfalls. If you are paying them through an S Corp, you must also pay Social Security and Medicare taxes at 15.3%. Therefore, your marginal tax rate needs to be 22% or higher for this to make sense. Conversely, if you pay yourself this income through a shareholder distribution and you are in the 10% tax bracket, you will unnecessarily pay about $795 in general taxes (since payroll taxes are 15.3% and your tax savings is 10%, 5.3% x $15,000 is $795).

You could also pay your child more money since their tax bracket is probably lower than yours.

For regular LLCs, if your child is under 18, the business does not have to pay employment taxes such as Social Security and Medicare. You can also avoid Unemployment taxes until the child turns 21. But for S Corps and C Corps, Social Security and Medicare taxes are paid regardless of age.

However, you can set up a Family Management LLC (there are other branded or marketing terms for this) where the S Corp pays a fee to an LLC which then turns around and processes payroll for the children. You can read more here-

wcginc.com/6177

Your children are going to take your money anyways- might as well make it tax-advantaged.

Retirement Accounts

Your child can contribute to a retirement account and reduce your taxes. Seriously? Seriously!

For example, a 14-year-old can have an IRA or a Roth IRA and contribute 100% of earned wages up to the maximum contribution. And since the wages to the child are a direct business expense, this reduces your overall taxable income (lower S Corporation income, lower pass-through income, and lower shareholder taxes).

Consider this-

IRA Scenario			Roth Scenario
Junior’s Earned Income	22,000		Junior’s Earned Income	15,000
Junior’s Standard Deduction	15,000		Junior’s Standard Deduction	15,000
Junior’s IRA Contribution	7,000		Junior’s Roth IRA Contribution	7,000
Taxable Income	0		Taxable Income	0
Payroll Taxes @15.3%	3,366		Payroll Taxes @15.3%	2,295
Mom/Dad Savings @10%	-1,166		Mom/Dad Savings @10%	-795
Mom/Dad Savings @22%	1,474		Mom/Dad Savings @22%	1,005
Mom/Dad Savings @37%	4,774		Mom/Dad Savings @37%	3,255

The standard deduction and IRA limits are for the 2025 tax year.

There are several things at play here. First, Junior must actually work, and this is the biggest bone of contention with the IRS. Consider a $30 an hour job would need 500 hours or about 10 per week to achieve $15,000 in wages. So, get that squared away.

Second, Junior can still have tax-free income although Mom and Dad are claiming him as a dependent on their individual tax return (Form 1040). This generally preserves certain tax credits.

Another issue to consider is support and claiming Junior as a dependent. If Junior is going to college and Mom and Dad are paying him to work at the family business, for Mom and Dad to claim Junior as a dependent they must provide over half of the Junior’s support. This includes the amounts spent to provide food, lodging, clothing, education, medical and dental care, recreation, transportation, and similar necessities.

This creates an interesting conundrum. If Junior makes $30,000 working for the family business, but socks all the money away into savings while Mom and Dad continue to pay over half of the support such as rent, food and education, they can still claim Junior as a dependent.

Yet another caveat to this is education credits. At times Mom and Dad’s income is too high to be eligible for certain education credits. By paying Junior, and having Junior claim the education credit (and he would have to pay for college too, but gifting can assist), the overall household might win.

So, there might be real savings and, in the example above, Junior is saving for retirement.

A Roth IRA contribution is not deductible while an IRA contribution is, which is why the IRA scenario can have a higher salary. There is not a minimum age for an IRA or Roth IRA- you simply need to have earned income to contribute. And Yes, the money is the child’s so when Junior turns 18 and wants to blow it on a new car, it’s gone plus penalty. You can’t fix everyone.

Company-Sponsored Retirement Plan

A company-sponsored plan could be a SIMPLE, SEP or 401k plan. The usual age for these types of plans is 21, but the plan may be created or adopted to be as low as 14 years of age. Therefore, if you hire your 14-year-old and you also have a 19-year-old working for the business, that 19-year-old suddenly becomes eligible if your company-sponsored plan allows 14-year-olds. There are hours of service thresholds you could implement as well.

But setting up the 401lk plan correctly allows your child to contribute $23,500 (for the 2025 tax year) to a 401k or the maximum limits on SIMPLE’s and SEP’s which can be significant. In turn the business gets an instant deduction, and the kid gets your money, albeit a bit early.

Conceivably, your child could have a $45,500 salary and contribute all kinds of money to his or her 401k plan and IRA. Here is a table-

IRA and 401k Plan Scenario
Junior’s Earned Income	44,600
Junior’s Standard Deduction	14,600
Junior’s 401k Contribution	23,000
Junior’s IRA Contribution	7,000
Taxable Income	0
Payroll Taxes @15.3%	6,824
Mom/Dad Savings @10%	-2,364
Mom/Dad Savings @22%	2,988
Mom/Dad Savings @37%	9,678

The standard deduction, 401k and IRA limits are for the 2025 tax year.

The rule is this- if you are covered by a retirement plan at work (what the IRS calls active participation), and you earn less than $77,000 (for the 2024 tax year) adjusted gross income (which Junior does), you can contribute both to a 401k plan and IRA, and get the IRA deduction.

Here is a link about the various options for small business owners to set up retirement-

wcginc.com/401k

Education Credits

You can also create some tax due to take advantage of the American Opportunity Tax Credit. Huh? Mom and Dad make too much money, and cannot take advantage of the AOTC education credit. But Junior, with a little bit of tax due on their 1040 tax return from a $30,000 salary (for example), can get all the tax back as a credit plus the refundable portion. There are some things to navigate through such as claiming them as a dependent, the work needed for a $30,000 salary, etc. but it is something to consider.

IRS and State Concerns

You must be mindful of child labor laws, and as far as the IRS is concerned there are some rules too.

First, the child must actually perform work. Some argue that cleaning bathrooms and stuffing envelopes are different since cleaning bathrooms is non-essential to the business operations and therefore not qualifying. The counter argument is that having your child clean bathrooms replaces your third-party janitorial expense. Our advice is to be as legitimate as possible- create a job description, list of expectations, etc. Ensure that the work they do has a business connection.

Also, the pay must be consistent, and the pay must be reasonable relative to what you pay others for similar work. Basically, you need to treat them like any other employee to avoid troubles. Lastly, you need to keep detailed records such as timecards and job descriptions (of course you do!). This must be perceived as an arms-length relationship.

Many states have labor laws that dictate the age your child can work, even for Mom and Dad. For example, Indiana allows a 14-year-old to work with a permit. Minors under 14 may work as newspaper carrier, golf caddy, domestic service worker in a private residence (sounds like chores) or farm laborer. Minors under 12 in Indiana can only be farm laborers. Again, in Indiana, there is no need for a work permit if the work is outside school hours of 7:30AM to 3:30PM. We bring these examples to light so you understand to check your state or local laws about hiring your kids.

WCG CPAs & Advisors will not process payroll for any child under the age of 12 unless there are special circumstances. For example, we have a client who has twin 9-year-old daughters who do quite well recording Tik Tok videos. We continue to be amazed at how people make money, and what the public is willing to pay for the efforts.

Mom and Dad (your parents)

The concepts above could also be applied to supporting your Mom and Dad. Aside from possibly making them minority owners and providing them with shareholder distributions, there could be some scenarios where a salary could make sense as well. Other sources of income and tax brackets of course all need to be considered.

By Jason Watson, CPA
Posted Monday, December 30, 2024

WCG consults with small business owners and tax clients on riveting topics like these-

• customized business structures for tax efficiency, flexibility and protection

• operating agreements, structuring deals with investors

• S Corp elections (even late S Corp election back to January 1, 2025, even in 2025)

• Section 199A Qualified Business Income Deduction and Specified Service Trade or Business Analysis

• reasonable shareholder salary determinations and defense

• accounting (bookkeeping + analysis), financial statement preparation and payroll processing

• tax advocacy, strategies and planning (bad news in August, OK… surprises in April, bad)

• business advisory services to leverage more from your business for you and your family (put more money in your pocket), including lovely yet detached children

• industry analysis, KPI analysis, benckmarking and peer to peer comparison

• executive and fringe benefits

• retirement planning (SEP IRA v. 401k, defined benefits and cash balance plans)

• business valuations, buy-sell support and exit strategies

• financial expert testimony, divorce litigation support

• tax representation (happy happy joy joy)

Outside of typical business services (accounting and payroll), consultation and tax preparation, we have focused on these niche competencies for our group of Colorado Springs CPAs and business advisors.

• Small business advisory services and administration including S Corp elections and tax planning.

• CRNA contractor business consulting including others in the medical community.

• Rental properties, including real estate investing strategies and management consultation.

• State income tax nexus, physical presence and substantial economic presence issues including income apportionment.

• Pass-through entity tax deductions and SALT workarounds.

• Expatriates, or Expats for short, including foreign earned income exclusion, FinCEN 114 FBAR filings including Form 8938, Form 5471 and 5472 and other international tax matters.

WCG CPAs & Advisors protects the fortress by not doing everything, but everything we do, we do very well. We also leave room for the individual tax client who does not own a business but has complex tax issues needing expertise, tax planning and wealth management.

In general our client base is primarily comprised of consultants, engineers, financial advisors, physicians, chiropractors, doctors, surgeons, dentists, anesthesiologists, nurse anesthetists, insurance agents, photographers (the profitable ones), attorneys, online retailers, FBA retailers, real estate agents, real estate investors and good old fashioned widget makers, and several others. A lot of our clients are one-person bands… W-2 one day, 1099 the next.

We also have several medical groups and financial advisor teams operating a tiered entity arrangement where each individual owns an S corporation.

By Jason Watson, CPA
Posted Monday, December 30, 2024

There are also several options and combination of options, and we can work with you to settle into the best plans. Here are some jumping off points-

One Person Show or Husband/Wife Team

Solo 401k plan with Roth Option is the best bet. Very low cost, efficient contributions, and has a good mix of pre-tax and after-tax contributions to hedge against future income tax rate risk.

Second best option is SEP IRA which allows conversion to Roth IRA each year. But this is usually after the fact, or when you are in crisis management mode and want to save taxes.

Multi Owner Partnership or MMLLC

Owners-Only 401k plan.

Multiple Employees

Company-sponsored 401k plan with Roth and Safe Harbor provisions is the best bet. Similar benefits to Solo 401ks. However, Safe Harbor provisions forces the business to make contributions to avoid highly compensated employee (HCE) testing.

Piggyback the profit sharing plan and cash balance plan to the 401k plan to super-size your contributions while retaining over 90% of the plan assets for the owners.

SIMPLE 401ks are not as attractive. While the non-elective business contributions are slightly lower than 401ks, the contribution limits are low in comparison. At $60,000 in salary, a 401k allows for a total plan injection of $38,500 ($23,500 + 25% of $60,000) whereas the SIMPLE 401k is only $17,300 for the 2025 tax year.

Multiple Entities

Company-sponsored 401k plan implemented at the multi-member LLC level and adopted at the subsidiary S Corp entity level. This would be an Affiliated Service Group and be subjected to controlled group testing.

Piggyback the profit sharing plan and cash balance plan to the 401k plan to super-size your contributions while retaining over 90% of the plan assets for the owners.

SIMPLE 401ks are not as attractive. While the non-elective business contributions are slightly lower than 401ks, the contribution limits are low in comparison. At $60,000 in salary, a 401k allows for a total plan injection of $38,000 ($23,000 + 25% of $60,000) whereas the SIMPLE 401k is only $17,300 for the 2024 tax year.

Multiple Entities

Company-sponsored 401k plan implemented at the multi-member LLC level and adopted at the subsidiary S Corp entity level. This would be an Affiliated Service Group and be subjected to controlled group testing.

By Jason Watson, CPA
Posted Monday, December 30, 2024

For our small business owners or contractors working overseas, there is a consideration when it comes to tax deferred retirement planning. Currently the amount of foreign earned income that can be excluded from ordinary income tax is $130,000 (for the 2025 tax year). Therefore, if you qualify as an expat and your income is less than $130,000 all your income is excluded.

Fast forward, if you elect to defer some of your earnings into a tax deferred retirement account you might be creating a tax liability unnecessarily. In other words, if your income was already being excluded from income tax, why put money into a tax deferred retirement account just to pay tax on the money later when that money was never supposed to be taxed in the first place. Huh? Stay with us.

You make $130,000. You pay $0 in taxes. You put $7,000 in a normal trading account. This $7,000 was never taxed and never will be. You make $10,000 on it because you’re smart. You sell the investments and recognize a $10,000 taxable gain all at capital gains rates.

Same situation, but with an IRA-

You make $130,000. You pay $0 in taxes. You put $7,000 (for the 2025 tax year) in an IRA. This $7,000 is not taxed. You make $10,000 on it because you’re smart. You sell the investments, withdraw the money and recognized a $17,000 taxable gain, all at ordinary income tax rates.

There are more devils in the details of course, but you get the general idea. To put money away in a tax deferred retirement account when that income was already going to be excluded generally does not make sense. A Roth IRA in this situation would be more ideal.

Implementing a 401k plan doesn’t solve any problems either. According to the IRS and specifically IRC Sections 1402(a)(11), 3401(a)(8) and 911, and Revenue Ruling 70-491, if all your income is excluded using the foreign earned income exclusion, then you cannot contribute to a 401k plan.

Revenue Ruling 70-491 sums it up from 1970 (when the foreign earned income exclusion was $25,000). An attorney established a profit-sharing plan and earned $40,000. The ruling stated only $15,000 was considered earned income for the purposes of Section 401 (which is where we get 401k plan stuff).

By Jason Watson, CPA
Posted Monday, December 30, 2024

Two arguments abound when considering a pre-tax 401k contribution. The argument goes like this- your retirement tax rate will be lower than your wage-earning tax rate. For those in the 32%, 35% or 37% marginal tax brackets, this is likely true. However, those earning big bucks probably continue to earn big bucks during retirement from investments, real estate, consulting, etc.

The other argument is about the free loan from the IRS. If you contribute $31,000 ($23,500 + $7,500 catchup for the 2025 tax year) to your pre-tax 401k and you are in the 32% marginal tax bracket, you just put $9,920 in your pocket ($31,000 x 32%). Another way to look at this is that $31,000 only took $21,080 in cash.

Sure, at some point the IRS wants it back when you withdraw it during retirement and will tax the original contribution plus whatever you earned on it. But this might fall into the let’s worry about next time, next time category.

As such, the second argument is about using the IRS’s money to build additional wealth. You take your $9,920 and do something good with it. Yeah, this argument sort of works. $9,920 annually might not move the needles much on your wealth building strategies. You would need $9,920 x 10 years at 6% rate of return just to afford a down payment on an average rental property.

Rather, most wealth is built with after-tax dollars. The leveraging of the IRS free loan concept sounds great on paper until you gain perspective on the size of the lever.

Another side argument is completely avoiding state income taxes by reducing your state income and therefore income tax with 401k contributions during your wage-earning years, and then establish residency in a tax-free or a tax-friendly state during retirement.

The theories above make sense; however, we ask a basic question- is it easier to pay taxes during your wage-earning years or during retirement? Sure, it depends how much you withdraw during retirement. Please consider that to spend $150,000 during retirement, you might have to withdraw upwards of $180,000 to account for the income taxes.

During your wage-earning years you might have the ability to work a little harder to pay for taxes now. Pick up an extra shift. Close an extra deal. Get a few more tax returns out of the door if you are a tax accountant. Whatever it takes, right? During your retirement years, especially mid-70s or older, you pay taxes with retirement savings (or at least it feels like you do depending on your cash sources).

Also, keep in mind that your primary objective in life is to build wealth. Your second objective is to save taxes, and what a lot of people forget about is saving taxes is not done in a vacuum or just one year; it is done over your entire lifetime.

Finally, consider that the law of 72 suggests that your investments will double every 8 years. Huh? The average rate of return for the S&P 500 is 9.2% since inception. If you take 72 and divide it by 9 (the rate of return) this equals 8, and suggests that your investment will double in 8 years. Where are we going with this? If you have 2 or 3 “doubles” coming up, to have that growth be tax-free upon retirement might be nice.

As mentioned elsewhere, WCG CPAs & Advisors recommends financial planning by a qualified planner to determine your objectives and model your particular scenario.

By Jason Watson, CPA
Posted Monday, December 30, 2024

What if the structure did not have any employees and only had owners? This changes the rules a bit since now discrimination, or specifically, exclusions are allowed within 401k plan documents.

Let’s also go back to our example and say that Fred and Shaggy all had created solo 401k plans for each respective S Corp. This works, but only if there are no other employees other than owner-employees.

Here is how it looks-This would allow Fred and Shaggy’s S corporations to pay W-2 shareholder wages and make employer 401k contributions at the S Corp level. Beauty! Why should Fred and Shaggy have to plan for retirement in concert with each other, or worse be limited by Velma’s three ex-husbands who are bleeding her dry? You didn’t know that about Velma, did you? Messy.

In other words, Fred could put away $70,000 (for the 2025 tax year) into his 401k plan while Shaggy only contributes $15,000 into his 401k plan. These plans are independent and are not cross-tested, and as such each owner can do his or her own thing.

As you can see Affiliated Service Groups and 401k plans don’t defeat the beauty of the MMLLC – S Corp schematic, it just makes it a bit more complicated. There are more rules about FSOs, ASGs, A-Orgs and B-Orgs… nauseating. Just remember the possible issues and do the homework. WCG works with a handful of Third-Party Administrators (TPAs) who can give you deeper advice and defend the 401k and profit-sharing plans.

Here is a link to our referrals document-

wcginc.com/9500

401k plans are about $1,000 to $1,500 annually yet piggybacking a profit-sharing plan will add additional fees. You can custody the plan assets with any custodian who accepts outside retirement plans and TPA services.

By Jason Watson, CPA
Posted Monday, December 30, 2024

If you want your retirement savings to grow tax free, you need a Roth IRA or Roth 401k. If tax-free growth is generally preferred, you can accomplish this outside of the business. However, there are some problems, or at least potential problems.

A quick recap of the limitations of a garden variety Roth IRA- a Roth IRA is only available to those who earn less than $246,000 per year for married filing joint taxpayers ($165,000 for single taxpayers) for the 2025 tax year, and a Roth IRA has very low contribution limits of $7,000. What can be done? Two things- a Roth 401k, which grows tax free, can accept business profit sharing and has a much higher contribution limits of $23,500 (for the 2025 tax year) or $31,000 with catch-up as we’ve already discussed. That is option #1.

Another Roth like option involves two steps. You create a SEP IRA in 2024 and take your deduction on your 2024 tax return. You convert the SEP IRA into a Roth IRA in 2025, and this in turn creates a taxable event for 2025 but no penalty. You then create another SEP IRA in the same year to counter the tax consequence of the conversion. Imagine putting $70,000 (for the 2025 tax year) into a Roth IRA each year- amazing. Frankly the ability to convert might not last long, but we’ll take advantage of it as long as we can. However, SEP IRAs can be viewed as the middleman, and we always want to cut out an unnecessary stop. Implementing a 401k plan circumvents this.

If you have a traditional IRA you can do the same thing. Be careful about shooting your income into the stratosphere in terms of marginal tax brackets. Too many financial advisors and taxpayers mess this up. Let us help. Let us model this taxable event.

Another option along the IRA lines is to make a non-deductible traditional IRA contribution and then convert that into a Roth IRA the following year. This has zero tax consequence since it was never deducted in the first place. Therefore, if you make too much money for a Roth IRA contribution you can contribute to a non-deductible traditional IRA and later convert it.

You are limited to one rollover or conversion per year per account (there is mild controversy within the IRS publications and industry practices on the number of allowed rollovers).

By Jason Watson, CPA
Posted Monday, December 30, 2024

This might be the best option, especially if Section 179 depreciation is not going to benefit you much and/or you use the automobile personally more than you use it professionally. As the owner of the automobile, you would submit expense reports in the form of mileage logs. If you are a smart automobile owner, you would also use a smartphone app to keep track of your miles for you. Keep in mind that the IRS wants corroborating evidence to support your mileage logs, so keep those Jiffy Lube receipts or other service records showing odometer readings near the beginning and end of the year (so extrapolation can occur). Just whippin’ out a pretty color-coded spreadsheet during an IRS examination is not enough.

The business would reimburse you according to your mileage log submission. This can be a great option for a lot of reasons. First, you are reducing the net income of your business, and if you are an S Corp the lower business income could decrease the amount of reasonable salary you must take as a shareholder. Second, most automobiles generally operate for less than the federal mileage rate.

Let’s look at some numbers-

Business Miles	12,000
Miles Per Gallon (MPG)	25
Gallon of Gas	$4.50
Cost of Gas	2,160
Maintenance, Biz Portion	3,000
Total Cost	5,160
Reimbursement at $0.70 / Mile (for the 2025 tax year)	8,400
Difference	3,240

As such, you just took home $3,240 tax-free. All legit. All legal. AAA might consider these operating costs to be too low, but then again this would be representative of an older or thrifty automobile. Why is that?

For the 2025 tax year, the IRS designated $0.33 of the $0.70 standard mileage rate to be depreciation of your automobile (almost half) according to IRS Notice 2025-05. Therefore, if you have a $5,000 POS which will be worth $5,000 ten years from now, you are getting reimbursed for depreciation that never happens. Cool! 10,000 miles would be $3,300 in your pocket (but you will reduce your basis in the automobile from $5,000 to $1,700).

Let’s not forget that you took money out of the business tax-free, and you reduced your business’s overall taxable income through legitimate small business tax deductions. Therefore, if we are using net business income after expenses as one of the proxies for determining a reasonable S corporation salary, that salary starts off at a lower number and subsequently reduces Social Security and Medicare taxes (among others). Win win!

Time to pump the brakes a bit. There is some confusion out there about getting reimbursed for actual expenses. For example, a business owner will own the automobile personally but also wants to get reimbursed for actual expenses. This same business owner will use the business credit card for gas and oil changes. This is bad. If you want to get reimbursed for actual expenses, it must be a pro-rated amount. If you drive 18,000 miles and 12,000 are business miles, then the business should only reimburse 75% of all actual expenses.

If you have leased your automobile and you use the standard mileage rate for reimbursement, you must continue with that method for the entire lease term.

Your business must have an Accountable Plan to take advantage of the You Own the Automobile, Get Reimbursed scenario. As a general rule, any payment of an allowance or reimbursement of business expenses for which the employee does not provide an adequate accounting (i.e., substantiation with receipts or other records) is considered to have been provided under a non-Accountable Plan and is required to be treated as taxable wages for purposes of federal, state, and local (if applicable) income tax withholding, Social Security and Medicare taxes, and Federal and state unemployment taxes. Yuck!

As a reminder, please please please use your personal funds at the gas station and service center. If you want to be reimbursed for mileage, the business will absolutely pay for nothing except the reimbursement itself. You can certainly have the business pay for all automobile expenses, but then that becomes a business owned vehicle situation described above.

By Jason Watson, CPA
Posted Monday, December 30, 2024

Simplified Employee Pension Individual Retirement Arrangement. Yes, the A in IRA does not stand for Account, it technically is Arrangement but if you say Account, it’s okay. We know what you mean. But if you call your IRA a 401k, our OCD does not allow us to let that one go. IRAs are not 401ks and 401ks are not IRAs. From what we understand, we can no longer say “our OCD.” Our apologies. So many words and phrases we used to say… it’s probably better that we don’t anymore. We digress…

How about this? Our super highly stressful and highly technical profession coupled with the desire to be hyper accurate cannot let you call your 401k plan and IRA and vise versa. Bagels and donuts are both breakfast foods, but that is where it ends. Hopefully that explanation is better than the OCD reference.

Back to business. As an employee, you do not make contributions to a SEP IRA, the business does so on your behalf. Yes, it is a tax deduction to the business which is essentially a tax deduction to you. The business can contribute 20% of business income (for sole proprietors, single-member LLCs and partnerships) or 25% of your salary (for corporations such as S Corps). There are no catch-up provisions since the business is making the contribution.

All eligible employees must have a pro-rata employer contribution. So, if you make $100,000 and your assistant makes $30,000, if the business contributes 10% on your behalf it must do the same for your assistant.

Four reasons why these are fading (but there is a silver lining below)-

• SEP IRAs require much higher salaries to reach the $70,000 maximum retirement savings for the 2025 tax year,

• Pro-rata contributions strictly based on salaries is no more beneficial or less restrictive than a 401k with Safe Harbor, and

• The administrative costs of 401k plans have been reduced to that of a SEP IRA.

• Another consideration is that the SEP IRA does not allow for plan loans whereas 401k plans do (up to $50,000 for the 2024 tax year).

SEP IRA contributions are due with the associated tax return including extensions (similar to employer contributions in 401k plans). An interesting yet allowed tactic is to always file an extension for your tax returns. This allows you to file your tax returns any time up to the extension deadline, but not make the employer contribution until the extension deadline. Huh? Hang in there on this one. Here is another way of saying it-

You could file an extension on February 1. File your Form 1040 on March 1. And make the contribution on October 15. However, if you skipped the extension filing and simply filed your Form 1040 on March 1, your SEP IRA contribution is due April 15. Weird. Then again, we don’t make the rules, we just tell you about them.

SEP IRAs are old school in favor of the 401k plan. Prior to the SECURE Act, 401k plans must be implemented before the calendar year is over, SEP IRAs can be used for crisis management after the fact. As such, December 31st can come and go blowing up your desire to have a self-employed 401k plan, but a SEP IRA can be created after January 1 and allow for previous year contributions and tax deductions.

However, with the SECURE Act, you can open a 401k plan in 2025, and make employer contributions in 2025 but have them earmarked for the 2024 tax year. Employee deferrals are not available in this fashion. So, your 401k plan is not “retro’d” back to the previous year, but the SECURE Act provisions allows for prior year contributions. Subtle difference. You can think of this similar to a SEP IRA which can be opened in 2025, contributed in 2025, but applied to 2024.

By Jason Watson, CPA
Posted Monday, December 30, 2024

If you have employees beside your spouse, a SIMPLE 401k might be a good option. Under a SIMPLE 401k plan, an employee can elect to defer some of his or her compensation. But unlike a traditional 401k plan, the employer must make either-

• A matching contribution up to 3% of each employee’s pay up to $350,000 (for the 2025 tax year), or

• A non-elective contribution of 2% of each eligible employee’s pay (non-elective means that the business must do it without fail to maintain the plan’s integrity)

No other contributions, such as profit sharing, can be made and the employees are totally vested in any and all contributions. You can only have 100 or fewer employees, and no other retirement plan is allowed. SIMPLE 401ks are also not subjected to discriminatory testing of highly compensated employees (HCEs) unlike traditional 401k plans.

Contributions are $16,500 for the 2025 tax year plus $3,500 for catch-up.

SIMPLEs have fallen out of favor recently since the only real benefits were no testing and low costs- that has changed a lot lately since the landscape of 401k plan providers is much more competitive (low cost) and lawmakers have given us 401k with safe harbor provisions so therefore no highly compensation employee (HCE) testing.

We haven’t seen these plans get deployed with any kind of regularity since Bush was president. As in the first one.

By Jason Watson, CPA
Posted Monday, December 30, 2024

Oftentimes business owners want to put away a ton of money in a small business 401k plan, but cannot due to inherit limitations within the plan. Or business owners want to keep most of the plan money for themselves, which is shocking yet natural. For example, to have the business make a 10% profit sharing contribution, every eligible employee will also receive a 10% contribution which is usually undesirable. You only thought having a staff was a pain because of drama and turnover. Add this dilemma to the list.

You work hard to make money, and you shouldn’t have to work too hard to keep most of it. There are turbocharger kits you can add to your normally aspirated 401k plan. These usually work best with an underlying safe harbor 401k plan. Here we go-

• Age-Weighted / New Comparability Profit Sharing Plan, and

• Defined Benefits Pension / Cash Balance Plan

Age-Weighted

A profit sharing plan based on age allows older employees to receive more of the profits than younger employees (hence the tricky name of age-weighted). Another way to look at this is to consider those closer to retirement possibly needing the most assistance in saving for retirement. This also makes sense since older employees are usually more valuable, and therefore profit sharing plans can be used to discriminate in their favor.

Age-weighted profit-sharing plans are designed to be top heavy, and two people earning the same salary can have very different profit sharing contributions simply based on age which is perfectly acceptable. No, there is a not a weight-weighted formula where older employees are usually heavier and therefore get more of the profit sharing. That would be fun though. Brings a whole new meaning to a top heavy plan. There are probably some more jokes in there, yet we digress.

How the formula works is beyond this book, but an age-weighted profit sharing plan allows a business to contribute more to those employees who are older including owners.

New Comparability

The new comparability profit sharing formulas take age-weighted formulas one step further by grouping certain employees together such as officers, executives, clerical, etc. Officers are given a higher portion of the profit sharing, and within the officer group the older employees are given a higher portion. A double shot. For example, a crusty officer will have a much larger contribution than a new administrative assistant.

The new comparability method is also referred to as cross-tested, and will normally have underlying actuary consultants defending the plan’s provisions and discrimination. Remember, discrimination is not bad as long as it can be justified and supported. Yes, this adds to the cost. But let’s look at a real life example that WCG worked on to see how this works first.

The following is a husband and wife business with over $600,000 in net profits from 2016. Yeah, it is a bit old but the illustration remains meaningful.

Employee	Age	Salary	Deferral	NEC	Profit Sharing	Total
Mike	43	265,000	18,000	7,950	27,050	53,000
Susie	43	212,000	18,000	6,360	28,640	53,000
Linda	35	62,155	2,486	1,865	876	5,227
Aaron	29	39,868	1,595	1,196	562	3,353
Timothy	32	24,611	0	738	347	1,085
Blake	25	33,452	0	1,004	472	1,475
Jacqueline	31	34,411	1,376	1,032	485	2,894
Denise	23	27,529	0	826	388	1,214
Nate	32	22,104	0	663	312	975
Tony	26	22,086	0	663	311	974

Tilt. Analysis on the next page.

Here are some observations and clarifications-

• NEC refers to non-elective contributions, and in this example these are the contributions required under the safe harbor 401k plan provisions.

• Profit sharing is based on salary and age. Note the subtle differences for everyone except Mike and Susie.

• $53,000 was the maximum allowed under a 401k plan with tiered profit sharing for 2016.

• In this real case, the owners kept 75% of all monies put into the plan. Not shabby.

• The annual cost in 2016 to administer this plan was $2,500.

• The tax deferral savings was over $53,000 for these business owners including state income taxes too (based on 39.6% federal rate and 11% state rate). This was California, and the couple plan to retire in Nevada- instant 11% tax savings.

• Yes, those salaries for Mike and Susie are ridiculously high. Therefore, the increase in payroll taxes must be weighed against the savings and benefits. After $176,100 (for the 2025 tax year) only Medicare taxes are being “unnecessarily” paid at 2.9% plus the surtax of 0.9%. The benefits could outweigh this 3.8%.

Defined Benefits Pension / Cash Balance Plan

If the age-weighted or new comparability profit sharing plans supercharge a 401k plan, the defined benefits pension and cash balance plan turbocharges it. We can hear gear heads moaning all over the country above turbo and super charging your engine. Regardless, the defined benefits pension and cash balance plan adds a ton of meat to your 401k platter. Here we go.

A defined benefit is in contrast to a 401k plan since a 401k plan is a defined contribution. A defined contribution plan specifies the amount going into the plan and has nothing to do with how much will be available when you start taking withdrawals. It could be $0 or millions. A defined benefit is a calculus where some future benefit is defined and is usually a stream of payments similar to an annuity.

A cash balance plan is a form of a defined benefits pension, with one major difference. The participant can see his or her account balance grow over time similarly to an IRA or 401k plan. A cash balance plan can be considered a hybrid since it does not rely on formulas and salary histories although it falls under a defined benefits umbrella by definition.

This is important. Since it is a defined benefit, the business has an obligation to fund the plan. Unlike a defined contribution, defined benefit is a 3-to-4-year commitment and a business cannot adjust contributions into the plan based on performance or cash flow needs. There are provisions allowing a business to pause the plan, but that gets tricky really fast. We have heard of cases where the IRS has seized a business owner’s house and assets until the pension was correctly funded. Ouch.

A cash balance plan is usually piggybacked onto a safe harbor 401k plan, and it truly is a separate plan (the latter is a defined contribution, and the former is a defined benefit). So why would a small business want a cash balance plan in addition to a 401k plan? The usual reason- put more money into a self-employed retirement plan for the owners’ personal retirement and defer taxes.

Similar to age-weighted and new comparability profit sharing plans, cash balance plans use a person’s age to determine the amount that can be contributed and use actuary consultation to defend the plan’s discrimination.

Here is a quick list of the 2024 amounts that can be contributed into a cash balance plan based on age-

Age	401(k) only	401(k) with Profit Sharing	Cash Balance	Total	Tax Savings
66-70	30,500	76,500	376,000	452,500	181,000
60-65	30,500	76,500	336,000	412,500	165,000
55-59	30,500	76,500	274,000	350,500	140,200
50-54	30,500	76,500	214,000	290,500	116,200
45-49	23,000	69,000	167,000	236,500	94,600
40-44	23,000	69,000	130,000	199,500	79,800
35-39	23,000	69,000	101,000	170,500	68,200
30-34	23,000	69,000	79,000	148,500	59,400

Before you lose your mind on the tax savings (which is assumed to be at 40% total between federal and state), you need the cash to do so. To save $116,200 at age 50 you need to part ways with $290,500 in cash. Also, if your spouse is on the payroll, you can double it.

Here is a link to FuturePlan by Ascensus who provides a full table-

wcginc.com/6104

Here is another real life example that we consulted on in 2016 (outdated, but very illustrative and current in concept)-

Employee	Age	Salary	401k Deferral	Profit Sharing	Cash Balance	Total Contribution
Betty	45	265,000	18,000	35,000	75,000	128,000
Fred	47	115,385	18,000	35,000	0	53,000
Subtotals		380,385	36,000	70,000	75,000	181,000
Wilma	43	70,181	9,825	4,562	500	14,887
Dino	25	23,109	693	1,502	500	2,695
Pebbles	29	22,892	687	1,488	500	2,675
Barney	23	13,908	417	904	500	1,821
Mr. Slate	23	13,444	403	874	500	1,777
Arnold	26	11,670	350	0	0	350
Tex	51	7,088	213	0	0	213
Daisy	18	713	0	0	0	0
Subtotals		163,005	12,589	9,330	2,500	24,419
Totals		543,390	48,589	79,330	77,500	205,419

It is a lot to absorb, and we could have cut off the example after Pebbles but we wanted to give you a real case. More notes and clarifications-

• Betty and Fred are the owners, and were able to keep 92.5% of the money contributed to the 401k and cash balance plans. That is ridiculously good!

• Profit sharing can be on a gradual vesting schedule over 6 years (same holds true for standalone profit sharing plans without the cash balance piggyback).

• Cash balance contributions can have a cliff vesting over 3 years (remember the 3 to 4 year commitment previously mentioned).

• Total tax savings was 51% since this case was also in California, or about $92,000 combined for just the owners’ portion.

• The annual cost to administer this in 2016 was $1,750 for the 401k plan portion and $4,300 for the cash balance plan. Cash balance plans are pricey since actuary consultants are used to defend the plan’s discrimination. Worth every penny.

Ok, so we’ve covered the basics of how to turbocharge your 401k plan to allow for more contributions and tax savings. What are some of the downsides?

The plan costs are not low. Sure, the tax savings is much higher than the costs, but those tax savings are actually tax deferrals. And in most cases tax deferrals become tax savings, but you must be disciplined on using those savings to grow your business or invest wisely (which might be the same thing).

Asset management fees range from 1.5% to 3% for Vanguard, American Funds, Nationwide, etc. 401k plans and defined benefits pension plans have two cost elements- the direct plan cost including a per participant charge, plus the asset management fees. Granted asset management fees are everywhere you turn- but small 401k plans usually have the highest. Having said that, small 401k plans are also nimble and completely customizable so your investment options are vast.

The commitment on a defined benefits pension and cash balance can be huge. And there are some devils in details such as minimum interest rate credits and other things that can be challenging. This is not your problem- the people you retain to manage your defined benefits pension and cash balance plan take on this responsibility.

If a handful of employees are older than the owners, this will adversely affect how much the owners can contribute into the plan for themselves. As mentioned, profit sharing and cash balance plans are age-based. Ideally the owners are 8-10 years older than the rank and file for this to work well.

Total holdings in the defined benefits pension plan are limited to about $3.5 million (for the 2024 tax year), enough to cover the maximum allowed payment in retirement of $350,000 a year (for the 2025 tax year). The IRS also has strict required minimum contribution rules and a steady source of income is fairly important. Therefore, you cannot be a contingency based attorney with a huge stockpile of cash today without being able to demonstrate the ability to support the plan next year and the following years.

By Jason Watson, CPA
Posted Monday, December 30, 2024

Another twist. Let’s say you have a side business and a regular W-2 job where you max out your deferrals into the 401k plan. You cannot make employee deferrals to your side business solo 401k plan since you are collectively limited to $23,500 (for the 2025 tax year) or $31,000 with catch-up, but your business can make a discretionary non-elective contribution up to $70,000 or $77,500 with catch-up (for the 2025 tax year).

Here is the word for word example from the IRS using 2016 limits of $18,000 as an example (occasionally they illustrate things well)-

Greg, 46, is employed by an employer with a 401(k) plan and he also works as an independent contractor for an unrelated business. Greg sets up a solo 401(k) plan for his independent contracting business. Greg contributes the maximum amount to his employer’s 401(k) plan for 2016, $18,000. Greg would also like to contribute the maximum amount to his solo 401(k) plan. He is not able to make further elective deferrals to his solo 401(k) plan because he has already contributed his personal maximum, $18,000.

He has enough earned income from his business to contribute the overall maximum for the year, $53,000. Greg can make a non-elective contribution of $53,000 to his solo 401(k) plan. This limit is not reduced by the elective deferrals under his employer’s plan because the limit on annual additions applies to each plan separately.

Good ol’ Greg. From the employer or business perspective, a discretionary non-elective contribution is in contrast to a matching contribution. This means that a contribution can be without the employee making a deferral. This is key since in the tidy IRS example above, Greg has max’d out his deferrals at his regular job, so he cannot make additional deferrals with his side business. However, the business can make a non-elective contribution.

A non-elective contribution means that the business’s contribution is not dependent on the employee’s deferral. Seems counter-intuitive. In other words, you do not put anything into the 401k plan, but your business can contribute up to 20% of your income from the business as a garden variety LLC (or 25% of your W-2 from your business if electing S Corporation status). These are also referred to as discretionary contributions.

Sidebar: The phrase profit-sharing contributions is sometimes used as well. However, this is like interchanging 401k and IRA. Technically, a profit-sharing plan is different than a 401k plan, and it can either be standalone or deployed in combination with a 401k plan.

Therefore, if a company has excess profits (cash) and wants to make a contribution to the 401k plan, these are considered discretionary non-elective contributions and not profit-sharing contributions. This is because a 401k plan is being used and not a profit-sharing plan. Our apologies for splitting hairs and getting all nerdy on the nomenclature.

In summary, the $23,500 (for the 2025 tax year) limit is your limit as a person. But each 401k plan has a limit of $70,000 (see the last line of the IRS example on the previous page using 2016’s limits) which can add a lot of muscle to your self-employed retirement plan.

No, you cannot add your W-2s together (main job and side job) and use that for the basis of your side job / business employer contribution. That would be nice though.

Warning! Each year a handful of small business owners neglect to let us know they picked up W-2 income on the side, and they also forget to inform us that they contributed to their “side W-2 gig’s” 401k plan. Yes, we ask. We ask often. Therefore, keep in mind that the $23,500 deferral limit into a 401k plan (for the 2025 tax year) is for all plans, combined.

By Jason Watson, CPA
Posted Monday, December 30, 2024

If you want your retirement savings to grow tax free, you need a Roth IRA or Roth 401k. But don’t get too hung up on the phrase tax free growth. Roth IRAs and Roth 401k’s are not for everyone, and tax deferral today (non-Roth investments) might be the better answer as alluded to earlier (see Tax Savings and Tax Deferrals). Let’s back up the truck a bit and chat about the Roth tag on an IRA or 401k. Yes, a Roth IRA is different than a Roth 401k. The words have dramatically different meanings.

The 401k and traditional IRA came about because it was theorized that you had a much higher marginal tax rate during your wage-earning years than you would during retirement. For example, you could easily be in the 22% marginal bracket when you are 55, but be in the 12% bracket when you are 70. So, you would save taxes at 22% and pay them back at 12%. Not bad. This theory still holds true for hundreds of thousands of Americans but there have been some recent hiccups.

The data were shifting and suggested that the delta between wage earning marginal tax rate and retirement marginal tax rate was waning. So, some smart people got together and passed laws allowing the Roth IRA. Specifically, it was Senator William Roth from Delaware in 1997 who passed the legislation. Thankfully not much was going on in Delaware in the 90s and Senator Roth was able to create this excellent legislation. As you might be aware, the Roth IRA allows you to take after-tax dollars and invest it, and when you take the money out all of it is tax-free. Beauty!

So, the Roth IRA is not a tax deferral system like a traditional IRA. It is a pay tax now and avoid paying tax later system. But all that glitters is not gold as Robert Plant would say. A Roth IRA is only available to those who earn less than $246,000 per year for married filing joint taxpayers ($165,000 for single taxpayers) for the 2025 tax year, and a Roth IRA has very low contribution limits of $7,000 (for the 2025 tax year). Yuck. Now what?

Enter the Roth 401k which is a hybrid of a 401k and a Roth IRA, and can be a great selection among the small business retirement options. All the taste of a Roth IRA without the calories. Starting January 2006, many businesses amended their 401k plans and started introducing Roth options. So, even if your small business doesn’t adopt a 401k plan, your spouse’s job or your main job might benefit from the Roth 401k. Ask your benefits administrator to see if your other job or your spouse’s other job offers the Roth 401k option.

A Roth 401k has no income limitations and employees (you) can defer up to $23,500 (for the 2025 tax year) or $31,000 with catch-up. But business contributions cannot be designated as Roth. Since the business (employer) matching or profit-sharing is a deduction to the business, these funds are considered pre-tax and will not enjoy tax free growth. In other words, your contributions as an employee may be designated as after-tax or Roth type contributions, and the business’s contribution will be automatically designated as pre-tax or traditional type contributions.

Note: The SECURE Act of 2022 allowed for employer contributions to be post-tax (Roth). Many 401k plans are outdated and don’t allow for this, and need to be restated.

In essence, the Roth 401k has two accounts which can be managed separately within the 401k plan; one after-tax and another pre-tax.

Since the biggest challenge in deciding on using a Roth IRA or Roth 401k pivots on your marginal tax rate during retirement, and crystal balls don’t have the accuracy they used to, a good plan is to hedge against both. A Roth 401k has this feature built-in. Your deferrals as an employee can be Roth (post-tax) which hedge against retirement tax rates being similar to wage earning tax rates. Conversely, business funds are traditional (pre-tax) and hedge against retirement tax rates being lower than wage earning tax rates. Got it? How about this-

Employee deferral into 401k	Pre-Tax (deduction to you)
Employee deferral into Roth 401k	Post-Tax
Business contributions into 401k	Pre-Tax (deduction to you vis a vis the business)
Business contributions into Roth 401k	Allowed since SECURE Act of 2022

The mix between the two is the challenging part. 80% Roth and 20% pre-tax? 60-40%? Truly depends on your vision of retirement and your income sources. Bunch of rental income and residual earned income? Rich parents leaving you with thousands of dollars in dividend income? Gotta coin to flip? Two out of three? As mentioned earlier, financial planning and tax projections are the starting point for an answer that will unfortunately take a lifetime to validate. We can see your headstone now- “Her tax projections hit a 95% confidence interval. Kids are proud.” Small font or big stone. You decide.

Therefore, be careful of anyone telling you to always max out your Roth contributions without at least asking questions. Yes, there are zillions of calculators available on the internet- simply search for “ira versus roth ira calculator” and the inundation will be overwhelming. Or perhaps underwhelming.

Historically Roth options on a 401k plan used to be costly, but thanks to Adam Smith and his concept of economics, fierce competition has driven the pricing down. Many of WCG CPAs & Advisors small business owners leverage eTrade for their 401k plan.

By Jason Watson, CPA
Posted Monday, December 30, 2024

Solo 401k plans do not need a safe harbor provision- this is reserved for company-sponsored 401k plans. Regardless, we believe you should understand the rules.

Congress and the IRS want to ensure that self-employed 401k plans do not favor highly compensated employees (HCEs). To be a highly compensated employee you must

• either own more than 5% of the business or

• earn more than $160,000 in salary (for the 2025 tax year) and was in the company’s top 20% in terms of pay.

Therefore, nearly all small business owners are HCEs from an ownership perspective regardless of salary. There are three tests-

• You cannot defer more than 2% above the average deferral of non-HCEs. Take a standard deviation curve, go out 2%, and draw a line in the sand. This is the ADP test (Actual Deferral Percentage).

• Another test looks at matching contributions from the employer (your business). This is the ACP test (Actual Contribution Percentage).

• Lastly, the top-heavy test ensures that HCEs don’t have more than 60% of the entire plan’s value.

As a small business owner, it is easy to fail any of these tests and more likely all three. A common example is where you have several plan participants, but only your HCEs are deferring close to the maximum. This creates a top-heaviness to your small business 401k plan, and the tax code will fail your plan by suggesting it discriminates in favor of a few highly compensated employees. Not your fault of course since you cannot force your staff to make deferrals into the 401k plan, but if the cookie crumbles that way the plan fails.

If your 401k fails the ADP or ACP testing, there are two methods to bring the 401k plan back into compliance. One method is to make an employer contribution for all non-HCEs. The second method is more individualized where each HCE is refunded a portion of their contributions and those amounts are also contributed by the employer to all non-HCEs. Messy and complicated. Read IRS Revenue Procedure 2013-12 for more information.

But isn’t that the point? Isn’t the point of a self-employed retirement plan to give the people who are worth the most, the most of the business’s benefits and resources (i.e., the owners)? Of course, it is. At the same time, we must play by the rules. So, help is on the way through the Safe Harbor provision. You can defer the maximum, and also have the business match it, without the HCE testing. What’s the catch? There’s always a catch in the “harbor.”

A Safe Harbor plan must satisfy four requirements, with required contributions being the main one. This entails using one of the following formulas-

• Basic- Match 100% of the first 3% of compensation, plus 50% of the next 2% of compensation, or

• Enhanced- Match 100% on the first 4% of the compensation, or

• Non-Elective- Contribute 3% of compensation to all eligible employees

The first two options appear to be more in favor with small business owners than the third since you can take the chance that not all employees will contribute. In addition, the safe harbor 401k plan must have-

• 100% vesting for the required contributions,

• provide an annual notice to all participants, and

• contain withdrawal restrictions (no hardship withdrawals, for example).

However, if the business contributes more than the safe harbor amount, that portion may follow a vesting schedule.

Therefore, don’t run out and make your 401k a 401k plan with safe harbor provisioning just because you think you need it. If you do not see a problem passing the discrimination tests, then skip it. For example, you have a small business, the disparity of salaries is low, everyone is participating well and you as the owner are not overloading the plan. Your 401k plan might pass testing as is without having to add the safe harbor provision. Remember, under the safe harbor provision, the employer is required to make contributions according to one of the options above. So, there’s your catch.

One planning strategy is that if you require a 401k with safe harbor, you could use the required contribution to defer an annual raise. In other words, you could attempt to pass on an employee raise by contributing the obligatory 3% (for example) employer portion of a safe harbor 401k plan. Probably only one time though, unless you enjoy posting jobs and conducting interviews. Even the first attempt might be a bust.

As a side note, those employee groups that have a collective bargaining agreement can have a separate 401k plan. For example, airlines have pilots who are a large employee group and who have the most discretionary income among the other groups. Therefore, if the airline had one single 401k plan, it would probably fail ADP or ACP testing. Instead of electing safe harbor provisioning, the pilot group is allowed to have its own 401k plan under a collective bargaining agreement which isolates the plan from flight attendants, customer service, mechanics, etc. Who knew? I’ll take 401k plans for $600, Ken.

By Jason Watson, CPA
Posted Monday, December 30, 2024

The i401k, solo 401k, solo k, uni k, or owners-only 401k (or whatever marketing name a bank or securities firm is selling) is a great small business retirement plan for-

• a one-person show,

• a one-person show with a spouse who also works for the business, or,

• a group of members in a multi-member LLC that does not have any employees. The Economic Growth and Tax Relief Reconciliation Act of 2001 modified the contribution limits and rules, and allowed for an emergence of the owners-only 401k plan.

Due to special tax rules, you can contribute more to this type of plan than other comparable retirement plans. The previous table in the beginning of this chapter illustrated this point with real life numbers. Under the usual rules for defined contribution plans such as SEP IRAs and profit-sharing plans, the deductible contribution is capped at-

• 25% of your salary or 20% of your earned income (as adjusted), or

• $70,000 for the 2025 tax year (plus $7,500 for catch-up) whichever is more restrictive.

But your deferrals as an employee into your solo 401k plan do not count towards the 20% and 25% caps, and this rule extends to your spouse. This is why the owner-only or solo 401k plan allows for the largest contribution because you have three sources of funding-

• You at $23,500 (for the 2025 tax year) plus $7,500 for catch-up (employee deferral), and

• Ditto for your spouse, and

• The business contribution up to 25% of your W-2 compensation or 20% of your self-employed earnings, and

• The funding is independent of each other (deferrals are deferrals, and contributions are contributions).

Read that again. Let’s say you have a $60,000 salary, $39,000 to invest into retirement savings and you are married. If only one person draws a salary, he or she can only defer a maximum of $23,500. But if a married couple pays a $30,000 salary to each person, then the total retirement deferral can be $47,000 without having to increase salaries to allow for a larger business contribution.

With a SEP IRA, in contrast, you would need a 4 x $47,000 or $188,000 salary to make the same retirement contribution (alternative math is $47,000 from the example above divided by 25%). The increase in payroll costs would wipe out your returns for at least two years. Not good. We’ll talk more about why a SEP IRA is used for crisis management and not for self-employed retirement plans (although the recent passage of the SECURE Act makes this moot, but we’ll explain anyway).

Here is an illustrative table showing this concept in a different way from Chapter 10 (Adding Your Spouse to Payroll, page 269) where we show Susan earning $100,000 versus Susan earning $65,000 and Mark earning $35,000.

	Option A		Option B
	Susan		Susan	Mark
Salary	110,000		70,000	40,000
401k Deferral	31,00		31,000	31,000
Business Contribution	27,500		17,500	10,000
Total 401k	58,500		89,500

Deferrals and contributions are discretionary, so you can cut back as cash flow and objectives change. The deadline for funding the business (employer) matching or non-elective contribution to your solo 401k plan is the tax filing deadline for your business including extensions. So, if you are an S Corp, the business tax return (Form 1120S) is due March 15. But with a tax return extension you could delay the funding until September 15. However, sole proprietors have until April 15 (the tax return filing deadline) or October 15 (if you file an extension) to make his or her deposits.

Employee deferrals for corporations (such as an S Corp) must be deposited by the 15th of the following month. So, a March 27 paycheck for Q1 would require you to deposit employee funds by April 15, which is typically a slow day around the WCG office (kidding, we’re celebrating at the local taco bar).

These deadlines are true for all 401k plans (solo, company-sponsored, Roth option, Safe Harbor provision, etc.). However, there is more wiggle room and less scrutiny for when employee deferrals are deposited since discovery is a challenge (in other words, you won’t rat on yourself). To keep things simple and elegant, we recommend following the same schedule as “big person” 401k plans.

As a side note, there is nothing saying you cannot wait until Q4 to make all your deferrals into your 401k plan, or any other quarter where perhaps a little bit of market timing or dollar cost averaging might be beneficial. Being the boss gives you flexibility with your small business retirement options.

Side Note: There is nothing saying you cannot wait until the last few months to make all your deferrals into your 401k plan, or any other quarter where perhaps a little bit of market timing or dollar cost averaging might be beneficial. Being the boss gives you flexibility with your small business retirement options.

Sidebar to the Side Note: Be careful about running out of room on your last few paychecks of the year. If you are paying yourself $60,000 a year or $5,000 a month, your November and December paychecks will be $10,000 and will not have enough room for a one and done $23,500 (for the 2025 tax year) employee 401k deferral. Then again, nothing that a bunch of payroll amendments can’t solve. Yeah, that sounds cheap and easy.

Unlike company-sponsored 401k plans, the individual or solo 401k plan does not need to perform discrimination testing of highly compensated employees (HCEs). More on that in a bit.

Solo 401k plans are also very economical to administer, allow for attractive retirement savings for you and your spouse, and remain simple enough to avoid all the hassles of a full company-sponsored plan. A company-sponsored plan (in contrast to a solo 401k plan) will cost about $1,000 to $1,500 per year (as of December 2024, WCG CPAs & Advisors has 80 team members and our 401k plan with Sure401k, a sister company to SurePayroll, was about $1,700 annually).

However, most solo 401k plans only charge for the commission or sales charge of the investments. For example, if you invest in A share mutual funds, there is a one-time sales load or commission of 5.75% (which might vary a bit between funds and fund classes). On that particular investment there are not any additional commissions, and the account fees are very small or non-existent. A shares (as opposed to C shares) are desirable for long-term investing since the commission paid is a one and done, and this cost is essentially amortized over several years.

The only downside is you cannot have a solo 401k or an owners-only 401k if you have employees. Even one part-time admin might blow this up depending on their hours and years of service (see below).

By Jason Watson, CPA
Posted Monday, December 30, 2024

Many taxpayers walk into our offices at WCG CPAs & Advisors and tell us they want to pay fewer taxes. Who doesn’t? We usually chuckle, and tell the client that he or she is the only one and it is sooooo refreshing to hear someone want to pay fewer taxes. Sorry for being snarky, but taxes are a way of life. Yes, our job is to have you pay the least amount of taxes permitted by law and not a dollar more, but that isn’t the only objective.

Tax savings comes in four variants- you can lie, cheat and steal, or you can understand the allowances, deductions and credits alongside the wiggle room afforded by the IRS code. We prefer the latter of course although the audit rate risk of 0.4% for S Corps and partnerships makes it all too tempting. Darn laws and ethics!

However, notice how 401k plans, IRAs, and other tax-deferred vehicles are not listed as one of the four ways to save taxes within self-employed retirement plans. A tax deferral is not automatically a tax-savings technique- it might be. It might not be. In true accountant fashion, it depends.

This is a real-life case- we have two Boeing engineers who saved about $1 million in the company 401k plan. The employee deferrals were all pre-tax, so they avoided about $250,000 in taxes since they were in the 25% marginal tax rate. Not bad.

However, they currently have four children, a house mortgage, and the usual tax deductions of a household of this size and age. When this couple retires in 2025, their marginal tax rate will increase to 32% due to their pension income and other income sources, and the dramatic reduction in tax deductions and credits.

So, they saved at 25% and they will pay it back at 32%. Bummer. But wait! There is more to the story. Just like Paul Harvey, there is a page 2, or in the case of this book, on the next page. Yes, we are dating ourselves by referring to Paul Harvey but when that is all your parents listened to in the car, it is hard to forget.

What about all tax deferrals? Where does that money go? Usually to buy stuff like cars, vacations, food, and other consumables which don’t offer a return on investment. But what if this same couple invested the current tax deferrals into a conservative portfolio which yields a nice 5% rate of return (after tax consequence)? Things tilt in their favor- so we are back to having a tax benefit from tax deferrals. Huh?

The following is a ridiculously overly simplified table to demonstrate what we are talking about. Here are the assumptions-

• Defer $23,500 (for the 2025 tax year) per year for 10 years.

• Marginal tax rate is 22% during wage earning years.

• Rate of return on investing tax deferral savings is 5% net of taxes.

Year	Defer		Tax Savings @ 22%		Growth at 5%
1	23,500		5,170		5,480
2	23,500		5,170		11,289
3	23,500		5,170		17,447
4	23,500		5,170		23,974
5	23,500		5,170		30,892
6	23,500		5,170		38,226
7	23,500		5,170		46,000
8	23,500		5,170		54,240
9	23,500		5,170		62,975
10	23,500		5,170		72,233
Total	235,000		51,700		72,233

A quick recap- you deferred $235,000 and deferred $51,700 in taxes. That deferral grew to $72,233 because you invested it in a safe 5% investment portfolio. Great. What does this do?

Here is the realized savings for a 22% marginal tax rate during retirement-

Withdrawals Taxed at 22%	51,700
Growth on Tax Savings	72,233
Realized Savings (difference)	20,533

If your marginal tax rate remains the same at 22% you still see a savings of $20,533 as shown above. Again, this is predicated on you taking the tax you normally would have paid and investing it wisely. Not all of us are this disciplined.

But if your marginal tax rate increases from 22% to 35%, your savings is zero. Granted, to jump 13% in marginal tax rate between wage earning years and retirement years seems rare, but you get the point.

The moral of the story is this. Yes, tax deferrals can lead to tax savings, but you must work the system and be disciplined. Not just today, but for several years, and you need a jump in marginal tax rate that is 9% or less (in general). Assuming you have an increase at all. See below-

Withdrawals Taxed at 32%	75,200
Growth on Tax Savings	72,233
Realized Loss (difference)	-2,967

The bummer of this table is the leap from 22% to 32% marginal tax rate. Recall that you deferred tax at the 22% marginal tax rate. If you pay it back at 22%, then you are golden. You pay it back at 32% (the next marginal tax rate), then you lose money.

What should you do? Financial planning and review with your financial advisor is a must. Generally, we see people in the 10 and 12% marginal taxes doing post-tax (Roth). We see people in the 32, 35 and 37% marginal tax rates doing pre-tax. Then, we see people in the 22 and 24% marginal tax rates doing a mixture of post-tax and pre-tax retirement contributions.

We’ll talk about the hedge with the employer (your business) contributions being made with pre-tax dollars. In other words, your 401k deferrals are Roth (post-tax) and your employer contributions are pre-tax. This combination is a great hedge.

Note: The SECURE Act of 2022 allowed for employer contributions to be post-tax (Roth). Many 401k plans are outdated and don’t allow for this, and need to be restated.

There is also the RMD angle. RMD is a common TLA (three letter acronym) tossed around at bingo parlors and country clubs, and stands for required minimum distributions. In a nutshell, the IRS forces you to take out a portion of your pre-tax retirement savings every year so they can collect on the IOU you gave them several years ago.

RMD calculations are simple. You take your age, find your life expectancy factor and divide that into your aggregate pre-tax account balance. Do you remember science class and discussing a molecule’s half-life? RMDs are very similar- over the course of retirement, you must withdraw pre-tax retirement dollars, but the calculus doesn’t force you to take it all out over your lifetime. It always has some factor of your age, and depending on your frugality you might die with a pile of money since the minimum leaves behind a lot.

The IRS released updated life expectancy tables and distribution periods in November 2020. The last time this was done was nearly 20 years ago! Here is snippet of the IRS RMD table which can be found in the appendix of IRS Publication 590-B (the most recent is for the 2022 tax year)-

Age	Factor
72	27.4
75	24.6
80	20.2
85	16.0
90	12.2

So, if you are 75 years old and had $1M in pre-tax money, your RMD would be $40,650 ($1,000,000 divided by 24.6).

What does this have to do with tax deferrals becoming tax savings? At some point you die, and if you only take out the minimum amount from your accounts, you will die with money in the bank. And this now-inherited IRA, for example, is taxed at your heirs’ rate. Under the new SECURE Act from December 2019, distributions from inherited IRAs to individuals other than spouses must be fully distributed in 10 years. There are some exceptions and other issues such as disabled individuals and minors, but that is the general gist.

The IRS wants to collect your previous IOU to them, like a Vegas bookie, and they don’t want to watch you keep kicking the can down the road.

So, for you there is tax savings built into the RMD system since not all the money is taken out and taxed. If you add in your heirs’ marginal tax rates, perhaps this changes from a “family unit” perspective. Heck, you’re the dead person- let your kids worry about your taxes by assuming them as their own. It takes a while to payback for all those sleepless nights and stinky diapers, but eventually it happens.

All kidding aside, here is something to consider- with life expectancy well into the 90s, your children might be retired too when you pass. Crazy but realistic, especially if you had kids before you had a career.

By Jason Watson, CPA
Posted Monday, December 30, 2024

Most people have a pretty good handle on personal finance and basic retirement savings, and while the principles are generally the same in the small business world, a lot of business owners have a deer caught in your headlights at 2:00AM look when it comes to leveraging their business for retirement. And there is good reason- retirement planning within your small business carries a bunch more options and potential pitfalls (sounds like life in general, doesn’t it?).

Reasons for Small Business Financial Planning

There are three major wealth considerations for small business owners (or anyone for that matter)-

• Accumulation (fun and exciting part)

• Preservation (the tricky part)

• Transfer (the necessary evil part)

Each of these major wealth considerations are interwoven, needs comprehensive focus to ensure the necessary dots are connected, and should have no gaps or holes exist during transitions. That is where financial planning comes into play.

Accumulation is easy. Most people think if they toss some money at a mutual fund they are planning for retirement. Nope.

Preservation gets tricky since we need to have our money outlast our lives. And with people living well into their 90s, this can be tough. Let’s put it another way- if you work for 40 years, from age 25 to 65, you need to save enough to live for another 25-30 years. That is incredible. If you are spending $100,000 at age 55, you better be making $180,000 and putting the $80,000 into a moderate growth retirement vehicle.

Preservation also includes proper insurance, asset protection through trusts, pro-active maneuvering and other tools in the toolbox.

Transfer of wealth is automatic. We have yet to see a hearse with a trailer hitch. Or, said in a completely starker way, every life comes with a death sentence. How it is executed is partially up to you. Did we just ruin your appetite? Sorry.

Transfer of wealth can also be tricky. The current federal estate tax exemption is $13.99 million (for the 2025 tax year) per person, and a passed spouse can posthumously port his or her exemption to the surviving spouse. Not bad. And most people don’t have over $26 million in estate value. Rich people problems (now referred to as high net worth… the most over-used and water-downed phrase today).

Sidebar: According to a November 2019 Forbes article, over $30 trillion in wealth will be transferred by baby boomers. Furthermore, according to a 2018 study from Bankrate.com, millennials are less inclined to invest in the stock market. So, where this wealth goes is certainly unclear.

These federal exemption amounts are indexed each year, and while Congress can always vote to repeal, this estate tax exemption was written in stone with passing of the American Taxpayer Relief Act of 2012. However, various states have much lower exemptions. For the 2022 tax year, Connecticut was $9.1 million, Hawaii was $5.5 million, among other examples.

Nebraska does not have an estate tax, but they do have an inheritance tax (the recipient pays depending on relationship and could be as high as 13%). California, the class favorite, is one of 33 states that do not impose an inheritance tax. Apparently, you’ve been taxed to death and there is nothing left to tax when you die in California.

Therefore, just because you are out of woods federally, doesn’t mean the transfer your wealth is free of taxation. Get a plan.

What about your business? Does it have an exit strategy or wealth transfer strategy? Businesses are like marriages; easy to get into, hard to get out. Add this to the plan.

The reasons for financial planning are-

Goals and Objectives

Define your goals and objectives, determine your current position and discover unmanaged risks. This sounds simple and makes sense, but defining goals and objectives is a fluid concept. They change. And as they change, the plan needs to be malleable enough to adapt. Financial plans are modified annually or whenever a major life change as occurred, whichever is more frequent. This is important.

The Plan

Financial plans also create a blueprint and chart a course on how to reach goals and objectives while managing risk. Again, this sounds simple. But even the most basic house needs a blueprint for framers, plumbers, electricians and even inspectors to review and implement. And in the case of a financial plan, these same players are your financial advisors, tax professionals, attorneys and insurance specialists.

Accountability

Financial plans also provide confidence, measure success and hold everyone accountable. If everyone agrees that your financial plan will ensure financial security in your life, then it becomes a measuring stick for determining success along the way. Anyone can throw some money at an investment, but what does it mean? And does it fit the plan? And is the selection of that investment meeting the plan’s objectives.

WCG CPAs & Advisors can always assist you with retirement and financial planning as it relates to your small business and taxation. If you need a referral for a financial advisor, we might be able to help with that too. However, we have fallen out of favor with a lot of the assets under management fee schedules, so we have trouble endorsing an advisor since most charge a percentage based on your asset values. We are not quite sure how the size of your portfolio translates into time and expertise, and in turn the value for services provided, but we digress.

Small Business Retirement Plans Comparison

We are going to put the carriage in front of the horse, and show you a comparison of basic small business retirement plans before explaining each plan. We cheated, and used Pacific Life’s online calculator to demonstrate these differences. Why re-invent the wheel? And frankly, they do a fantastic job at this type of stuff. Here is their link-

wcginc.com/6103

We took a handful of salaries (for corporations including S corporations) and net incomes (for sole proprietors and partners in partnerships) and plugged them into Pacific Life’s calculator, and came up with the following table based on the 2025 tax year limits-

Salary/Income	Entity	Max 401k	Max SEP IRA	Max SIMPLE
60,000	Sole Prop / Partner	34,662	11,152	18,162
60,000	Corporation	38,500	15,000	18,300
125,000	Sole Prop / Partner	46,734	23,234	19,963
125,000	Corporation	54,750	31,250	20,250
150,000	Sole Prop / Partner	51,381	27,881	20,656
150,000	Corporation	61,000	37,500	21,000
186,000	Sole Prop / Partner	58,111	34,611	21,653
186,000	Corporation	70,000	46,500	22,080
246,000	Sole Prop / Partner	70,000	46,451	23,315
246,000	Corporation	70,000	61,500	23,880
280,000	Sole Prop / Partner	70,000	53,159	24,257
280,000	Corporation	70,000	70,000	24,900
365,000	Sole Prop / Partner	70,000	70,000	25,086
365,000	Corporation	70,000	70,000	27,450

 

Note the bolded $70,000 number. This is the maximum defined contribution amount permitted in 2025 per plan (and Yes, you can have two plans- we’ll talk about Greg and his two plans in an example later).

Crazy! The following are some quick observations-

• In 2025, the maximum you can contribute to a qualified retirement plan is $70,000 ($69,000 for the 2024 tax year). You can go above this with a defined benefits pension (cash balance)- more on that later.

• Partnerships (those required to file Form 1065) follow the same limits as Sole Prop above.

• $186,000 in W-2 salary from your C Corp or S Corp is the magic number for maximizing your 401k. After that, any increase in salary does not help. Your fastest way to reach your contribution limit is through a 401k plan.

• $280,000 in W-2 income from your S Corp is the minimum salary for a max SEP IRA contribution.

• $365,000 from your small business or K-1 partnership income from your Schedule E as reported on your individual tax return is the magic number for maximizing your SEP IRA contribution. SEPs are old school and used for crisis management rather than planning (more on that too).

• Earned income from a sole proprietor is net profit minus 50% of your self-employment (SE) tax minus your contribution. Since the contribution actually adjusts the maximum contribution, this can be a circular reference. And No, 401k or SEP contributions do not reduce SE tax.

• 401k max is computed by taking $23,500 employee (you) contribution, plus 25% of your W-2 or earned income (as adjusted). This is for the 2025 tax year.

• SEP IRA max is computed by taking 25% of your W-2 or earned income (as adjusted).

• Max SIMPLE 401k is basically $16,500 plus 3% of your W-2 or earned income (as adjusted). Don’t spend too much time thinking about SIMPLE 401k plans.

• You can add $7,500 for catch-up contributions if you are 50 years old or older.

Note: With the SECURE 2.0 Act, those aged 60-63 can do “super catch-up” allowing $11,250 versus $7,500 catch-up contributions into a 401k plan for the 2025 tax year. The $11,250 number is 150% of the regular catch-up limit, and in the case of a 401k plan, that is $7,500. If this should change, the super catch-up automatically adjusts.

Let’s talk about each of these qualified plans in turn, starting with the 401k. Out of the box, or non-traditional retirement plans will follow (profit sharing plans, defined benefits pensions, cash balance plans, Section 79 plans, etc.). Exciting!

By Jason Watson, CPA
Posted Monday, December 30, 2024

Is there a way to have the business reimburse, compensate, or otherwise pay for my home office? Can I still take a home office deduction with an S corporation? Yes, there is a way to claim a home office deduction with an S Corp.

Prior to the IRS making a recommendation to use the Accountable Plan and subsequent reimbursements to the employee (or shareholders), taxpayers would charge their corporation rent and declare the rent as income on Schedule E. Ok, but not elegant.

In the garden variety LLC world, the beauty of this was to take money out of the business as passive income. Since you were changing the color of money from earned income to passive income you were also sidestepping self-employment taxes. In the S corporation world, the beauty of this was to reduce the S Corp’s overall income, and therefore reduce the reasonable salary heuristics or thresholds for shareholders while still taking money out of the business as passive income (again reducing self-employment taxes).

The IRS got sick of this (among other things of course).

The new school way is to use an Accountable Plan and reimburse the employee (you) for expenses associated with the home office. Remember, if you are an S Corp owner, you are both shareholder and employee. Imagine yourself as an employee of Google- the relationship would be arms-length, and you would submit expenses to Google just like you should with your own S corporation. Maintaining an arms-length perspective in your dealings as an employee of your S Corp will help you in the long run.

Your business must have an Accountable Plan to take advantage of this scenario and the basic housekeeping must be satisfied.

Section 280A of the Internal Revenue Code reads in part, “Except as otherwise provided in this section, in the case of a taxpayer who is an individual or an S corporation, no deduction otherwise allowable under this chapter shall be allowed with respect to the use of a dwelling unit which is used by the taxpayer during the taxable year as a residence.”

So, what are the exceptions?

• Certain business use (typical home office, and discussed more here)

• Certain storage use

• Rental use (tax free… 14-day “Master’s” rule or “Augusta” rule)

• Providing day care services

Section 280A continues by reading-

Subsection (a) shall not apply to any item to the extent such item is allocable to a portion of the dwelling unit which is exclusively used on a regular basis-

(A) as the principal place of business for any trade or business of the taxpayer, or

(B) as a place of business which is used by patients, clients, or customers in … the normal course of trade or business,

(C) in the case of a separate structure which is not attached to the dwelling unit, in connection with … trade or business.”

We highlighted the buzzwords intentionally. Let’s define these more carefully-

• Exclusive means the identifiable space or room is used only for business purposes (so let’s not have a bed in your home office).

• Regular is a squishier since it is a facts and circumstances evaluation. Spending 4 hours a month selling Etsy stuff online probably won’t win too many arguments.

• Principal place of business was once a hot topic but has been tightened up with this language right out of the tax code- “For purposes of subparagraph (A), the term “principal place of business” includes a place of business which is used by the taxpayer for the administrative or management activities of any trade or business of the taxpayer if there is no other fixed location of such trade or business where the taxpayer conducts substantial administrative or management activities of such trade or business.”

• Trade or business has been defined in Commissioner v. Groetzinger, 480 U.S. 23, and reads in part, “to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be for income or profit. A sporadic activity, a hobby, or an amusement does not qualify.”

Administrative or management activities include a nice list from IRS Publication 587 such as billing customers, clients, or patients, keeping books and records, ordering supplies, setting up appointments, forwarding orders or writing reports (we list more below).

Multiple Work Locations

You can have multiple work locations. The IRS states that if you use a home office as your primary location for substantial administrative activities you are allowed to essentially have two work locations. For example, you own a landscaping business and you have an office in your shop. You perform all your administrative activities such as hiring and firing employees, accounting, balancing your checkbook, talking to your attorney, chatting it up with your Colorado Springs CPAs at WCG etc. in your home office, that office counts as a work location in addition to your office in your shop. Here is the play-by play-blurb from the IRS-

You can have more than one business location, including your home, for a single trade or business. To qualify to deduct the expenses for the business use of your home under the principal place of business test, your home must be your principal place of business for that trade or business. To determine whether your home is your principal place of business, you must consider:

1. The relative importance of the activities performed at each place where you conduct business, and

2. The amount of time spent at each place where you conduct business.

Your home office will qualify as your principal place of business if you meet the following requirements.

1. You use it exclusively and regularly for administrative or management activities of your trade or business.

2. You have no other fixed location where you conduct substantial administrative or management activities of your trade or business.

This also works well for the consultant who works out of his or her home office, but also spends a ton of time on site with the client.

Don’t forget that commuting miles between your residence and your office are not deductible, but if you have a home office suddenly these miles become business miles and therefore deductible. Boom! The use of Boom! is apparently out of fashion. Whatever.

You can read the full IRS Publication 587 (Business Use of your Home) by using the link below-

wcginc.com/5322

We will discuss the question, “What is my tax home?” in a few pages.

Get Reimbursed for the Home Office

The expense report should detail the space used as a home office or storage of business items (inventory, supplies, etc.) as a percentage of overall square footage of the home. This percentage is then applied against rent, mortgage interest, property tax, utilities, HOA dues, insurance and repairs to determine the expense amount to be reimbursed. The reimbursement can be monthly or quarterly or annually- your choice.

Keep in mind that two major expenses associated with a home office are mortgage interest and property taxes. These expenses are already 100% deductible on Schedule A (assuming your state and local taxes (SALT) do not exceed $10,000), so for most taxpayers the home office deduction or reimbursement is relatively small. And you must reduce your mortgage interest and property taxes being deducted on Schedule A by the amounts reimbursed by your business. No double dipping.

Here is quick table on what we mean-

Total Home Size	2,500
Home Office Size	150
Home Office %	6.00%
Expense	Amount	Reimbursed	Schedule A
Mortgage Interest	15,000	900	14,100
Property Taxes	2,500	150	2,350
Hazard Insurance	1,100	66	NA
Utilities	3,600	216	NA
HOA Dues	600	36	NA
Depreciation ($400,000 building)	10,256	615	NA
Totals	33,056	1,983
Total Non Sched A	15,556	933
Savings @ 22%		205
Savings @ 37%		345

What are we showing here? Good question! The $933 number above represents a reimbursement to you and a deduction to the business that would otherwise not have been deductible except through an Accountable Plan reimbursement. In essence with a home office you are deducting portions of Hazard Insurance, Utilities, HOA Dues and Depreciation.

So, a home office reimbursement as a business deduction might put $200 to $350 in your pocket. Might be worth it based on that alone, but where the home office has a ton of weight is now your commute is from the bedroom to the basement or den, and all travel from your home office is business travel.

Here is another consideration. For those taxpayers who are seeing Schedule A deductions being phased out due to high income, SALT limitations and / or Alternative Minimum Tax (AMT), using the home office reimbursement is a way to ensure these deductions are not reduced.

This can be a huge swing in taxes. This is one of the largest compelling reasons to have WCG (formerly Watson CPA Group) prepare both your corporate and individual tax returns- we can move things around to ensure the maximum deduction is obtained.

There are other examples. A quick example would be where you own an office building 100% through an LLC and the business is operating as a separate LLC or S Corp. The rent must be market rent- we suggest using Zillow or a realtor to periodically update your comparables for market rent analysis. This is outside the home office world (see our chapter on self-rentals).

Home Office Safe Harbor

There is a safe harbor provision for home office deductions where you can deduct $5 per square foot. This would be on Form 8829 for LLCs without an S Corp election. However, for S Corps where you choose to reimburse yourself for the use of the home office, you cannot use the safe harbor method.

According to IRS Revenue Procedure 2013-13 which reads in part-

.02 Reimbursement or other expense allowance arrangement. The safe harbor method provided by this revenue procedure does not apply to an employee with a home office if the employee receives advances, allowances, or reimbursements for expenses related to the qualified business use of the employee’s home under a reimbursement or other expense allowance arrangement (as defined in § 1.62-2) with his or her employer.

An expense allowance arrangement is synonymous with an Accountable Plan which we discuss in detail in Chapter 10 (Accountable Plan Expense Reimbursements, page 277). Therefore, you must use actual expenses! This is in stark contrast to the mileage reimbursement since the IRS simply gives you a rate per mile regardless of what you spend.

For disregarded LLCs and sole proprietors, there are some real advantages for using the safe harbor method such as being able to use all mortgage interest on Schedule A instead of a proration. But there are also some limitations that need to be considered. We typically optimize for both methods in these situations.

Home Office Issues with Multiple Owners

We broached this concern in Chapter 2 (Multi-Member LLC That Issues Invoices, page 48) but we’ll tackle it again here. Let’s say you and another person own a business together, and you elect to have the entity taxed as an S Corp. You also create an Accountable Plan to reimburse home office expenses among other things.

As you have learned, you cannot use the simplified method and therefore only actual expenses are reimbursed. No biggie right? Well, perhaps. However, what happens if your home office is smaller as a percentage of your overall home size? In other words, your room is 150 square feet and your house is 3,000 square feet… this is 5%. But your business partner has 180 square feet within a 2,500 square foot house… or about 7.2%.

Perhaps we are splitting hairs… but wait… there’s more! What if your property taxes are substantially lower than your business partner’s? HOA dues? Insurance? Housekeeper? We could go on and on.

You could limit your Accountable Plan expense reimbursements to a certain dollar amount, but doesn’t that hose the other guy? You could reimburse without regard to limits or amounts, but doesn’t that hose the guy with a smaller reimbursement? We’ll find a new word for hose.

Yes, all those things are true except finding a synonym for getting hosed. One solution is to split up into a multi-entity arrangement as shown in Chapter 2 (Multi-Member LLC That Issues Invoices, page 45). Talk to us and we can help!

Home Office With Partnerships

If you are a partner in partnership (member of a multi-member LLC) that is not being taxed as an S corporation, you might be able to reduce partnership income through a tax mechanism called Unreimbursed Partnership Expenses, or UPE for short. UPE is a slamma-jamma version of old school Form 2106 unreimbursed employee expenses, and is a singular line on Schedule E Page 2 reducing partner income.

Here is the blurb from the IRS website on completing Schedule E if you can’t get enough-

You can deduct unreimbursed ordinary and necessary partnership expenses you paid on behalf of the partnership on Schedule E if you were required to pay these expenses under the partnership agreement. You only can deduct unreimbursed expenses on Schedule E that are trade or business expenses under section 162. Don’t report unreimbursed partnership expenses separately if the expenses are from a passive activity and you are required to file Form 8582.

If your partnership agreement or operating agreement allows for it, partners can deduct UPE. However, an Accountable Plan-esque method must be used to create the workpapers and math behind the calculation since it is one big fat number without supporting statements or supplemental forms on your individual tax return (Form 1040).

Home Office Depreciation

Similar to rental properties (among other things), depreciation on a home office is required by the IRS. Here is a Q&A from their website under Sale or Trade of Business, Depreciation, Rentals > Depreciation & Recapture.

Question- I have a home office. Can I deduct expenses like mortgage, utilities, etc., but not deduct depreciation so that when I sell this house the basis won’t be affected?

Answer- No. All allowed or allowable depreciation must be considered at the time of sale. You can generally figure depreciation on the business use portion of your home up to the gross income limitation, over a 39-year recovery period and using the mid-month convention. As long as you determine actual expenses and the correct amount of allowed or allowable depreciation, the depreciation reduces the basis of your home accordingly, whether or not you actually claim it on your tax return.

Note that last phrase, “whether or not you actually claim it on your tax return.” That is the kicker. Truth be known, when a client sells their primary residence most tax professionals do not ask if it was ever used as a home office. Right, wrong or indifferent, it is often overlooked.

Additionally, home office depreciation is tough to track within a tax return. Sure, if you are a disregarded LLC or sole proprietor and reporting your business activities on Schedule C, you will use Form 8829 to generate the home office deduction and that form helps track home office depreciation. Easy.

If you use the simplified method for the home office deduction, you do not have a depreciation recapture problem since you do not have to depreciate your home office. Easy again. But as you know, using an Accountable Plan for reimbursing the S Corp shareholders (recall the two hats- employee and investor) requires actual expenses for home office reimbursement including depreciation.

What makes matters worse is that the depreciation deduction for home office reimbursement is truly done at the business entity level (Form 1120S or 1120). The individual tax return (Form 1040) is not affected, but when the home is sold, depreciation recapture is picked up as income by the individual who was reimbursed.

The tax theory goes like this- if you are reimbursed for depreciation then the cost basis of the asset is reduced by the amount of depreciation. When the asset is sold your reduced cost basis could increase your taxable capital gain (for houses, Yes, for automobiles and other things, probably No).

Sidebar: Having your S corporation reimburse you for business mileage also reduces the cost basis of your automobile by 33 cents per mile (for the 2025 tax year). If you think home office depreciation is often overlooked, the reduction in cost basis for your automobile because of reimbursed mileage is flat-out ignored by most.

WCG CPAs & Advisors tracks home office depreciation within an individual tax return (Form 1040) by creating an out-of-service asset, and updating the historical depreciation each year. Not ideal, but at least it is contained within the owner’s individual tax return for tracking, eventual sale and recapture.

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

Single 2025
From	To	Rate	Marginal Tax	Total Tax
0	11,925	10%	1,193	1,193
11,926	48,475	12%	4,386	5,579
48,476	103,350	22%	12,073	17,651
103,351	197,300	24%	22,548	40,199
197,301*	250,525	32%	17,032	57,231
250,526	626,350	35%	131,539	188,770
626,351	forever	37%
Married Filing Jointly 2025
From	To	Rate	Marginal Tax	Total Tax
0	23,850	10%	2,385	2,385
23,851	96,950	12%	8,772	11,157
96,951	206,700	22%	24,145	35,302
206,701	394,600	24%	45,096	80,398
394,601*	501,050	32%	34,064	114,462
501,051	751,600	35%	87,693	202,155
751,601	forever	37%

* Start of Section 199A qualified business income phaseout for small business owners.

 

Standard Deduction Single	15,000
Standard Deduction Married Filing Joint	30,000
Social Security Wage Limit	176,100
IRA Contribution Limit	7,000 + 1,000 catch-up
Roth Income Phaseout Single	150,000
Roth Income Phaseout Married Filing Joint	246,000
401k Employee	23,500 + 7,500 catch-up
401k Employer	46,500
Max 401k Total	70,000 + 7,500 catch-up

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

We broached this little devil in a the previous section, but we want to expand on it. If you buy Google stock for $100 and later sell it for $150, you have a $50 gain. Easy. The first $100 represents a return of your capital and the next $50 represents your gain. Done. How does this to relate to S corporations?

If you inject $5,000 into your business, your business earns $100,000 and your business checking account has $105,000, you have $105,000 in shareholder basis. You can take all $105,000 out without trouble.

There are at least four scenarios where this breaks down, and we’ll review each one.

Depreciation

Please forgive us for reiterating this little issue, and to make matters worse we use a different data set for the example.

Depreciation bites people all the time, and bites hard! Same situation as above. $100,000 in net business income (profit) but you also financed a brand-new Ford F150 pickup truck for $60,000, and used 60% bonus depreciation to deduct it (for the 2024 tax year). Therefore, you have $105,000 in the business checking account and $64,000 in net ordinary business income after expenses and deductions (you had $100,000 in initial profit but deducted $36,000 in truck depreciation). Yes, we are not considering Section 179 expensing in this example yet it remains a good illustration.

Your shareholder basis is $5,000 (original injection of cash) plus $64,000 in net business income, or $69,000. If you take out $100,000 as a shareholder distribution, you have $31,000 of the $100,000 exceeding your shareholder basis and that portion will be taxed as a capital gain on your individual tax return. Yuck!

How do you fix this? Easy. You can either not take the cash out in the form of a shareholder distribution, or don’t use bonus depreciation on the new truck and pay more immediate income taxes. Wow. Not desirable at all!

You could use another depreciation method that spreads the deduction across several tax years. Sure, you will pay more income taxes in the year of purchase, but you won’t have the capital gain on the excess distributions. Moreover, you have a nice depreciation deduction in the future to offset hopefully increasing incomes (and associated tax rates).

Loans

This one can bite too! WCG has a client who is a very successful Amazon reseller. To add to the excitement, Amazon offered a low-cost $250,000 loan to the business presumably with the hopes that the business would buy more stuff to sell on Amazon. The business didn’t. The sole shareholder took the loan proceeds plus some extra cash out of the business as a shareholder distribution. Let’s breakdown what happened using our basic example above.

You inject $5,000 into your business and the business earned $100,000 in net ordinary business income after expenses and deductions. The business also took on a $250,000 Amazon loan and received cash. Therefore, your business checking account reads $355,000 but your shareholder basis is only $105,000. You can only take a $105,000 distribution leaving $250,000 behind without triggering a distribution in excess of shareholder basis. Another yuck!

When cash loans like above happen and the shareholder has a distribution in excess of his or her basis, we advise the client to return the cash to the business.

Recall that a business loan made directly to an S corporation from an external lender does not create shareholder basis even if the shareholder personally guarantees the loan. This is contrary to a partnership where each partner personally guarantees the loan, and adds to his or her partner basis. However, a shareholder who lends money directly to the S corporation does add to his or her basis (we typically suggest not making this is a loan, but rather a capital injection from the shareholder).

Business debt and capitalization must be handled carefully.

Payables

Along the same lines of loans are payables. Let’s say you record a $25,000 employer 401k match expense on December 31, but you haven’t sent the check yet. This would be recorded as a debit to 401k Company Contribution as an expense and a credit to a 401k Payable liability account. Additionally, this payable isn’t due until March 15 the following year, so you have some extra cash in your business checking account that is earmarked for the 401k payment. But it’s Christmas, and baby needs new shoes, so you pull this $25,000 as a shareholder distribution knowing that you’ll earn enough between January 1 and March 15 to make the 401k payment.

This distribution could exceed your shareholder basis as well. How? You reduced the amount of business profits by recording the 401k Company Contribution expense, but didn’t use cash to do so. You used a payable or an IOU if you will, freeing up some cash albeit temporarily. This cash-less reduction of business profits combined with a distribution can be bad.

Credit cards can create this little fiasco too and are very similar to the 401k example above. The IRS allows you to recognize the expenses as soon as you are liable for the payment (swipe the credit card, and boom you are liable). This is true even in a cash-based accounting system. Therefore, if you rack up a bunch of deductible business expenses in December with your credit card, you will have a gaggle of debits (expenses) and a Credit Card Payable as the corresponding liability (credit) on your balance sheet.

This in turn reduces your net business income (profits) but creates an artificial sense in available cash (since you haven’t paid the credit card bill yet). Here is what we mean-

Starting Shareholder Basis on Jan 1	5,000
Net Income Before Credit Card	100,000
Expenses Paid with Credit Card	25,000
Net Income (profit) on K-1	75,000
Available Cash in Business on Dec 31	100,000
Ending Shareholder Basis	80,000

If you take $90,000 out as a shareholder distribution on December 31, you will have exceeded your shareholder basis by $10,000.

What can be done here? Wait until January 1 to take the money out rather than December 31. Show the cash on the books for the ending cash number which is a part of your business entity tax return, wait 24 hours, and then do the money-grab.

Bad Basis Data

Most tax software will maintain shareholder basis using worksheets and other supporting documentation within the tax return. This information is typically not filed with the IRS or state, but it is a part of the tax return documents. Cool, right? If you switch tax professionals, your new person can easily take this data and enter it into the tax software to preserve your shareholder basis data. More cool.

This sounds great until it isn’t. Let’s say you’ve been in business for 20 years, and for some reason or another you’ve had four different tax professionals over the years. What if in year 4, a tax professional messed something up which caused your shareholder basis to get slightly out of whack; nothing huge, but certainly wrong. Your next tax professional simply took last year’s worksheets… did a quick sanity check… and plopped a number in as your shareholder basis that was too low. Ten years later, you are pulling some money out as a distribution and get hit with long-term capital gains.

Everyone is scratching their chin asking What happened here?

What makes matters worse is that a lazy tax professional who doesn’t want to dig into the numbers or have an awkward conversation with the business owner might create a shareholder loan to avoid the capital gain conundrum. In other words, he or she will take the portion of the shareholder distribution that exceeds the basis and call it a loan to the shareholder. Great, now we’ve taken a dumpster fire and threw a 55-gallon drum of gas on it. The IRS cannot stand shareholder loans since they are usually disguised distributions.

Lazy might be a strong word. And why are dumpster fires considered bad? They are safely contained in a thick metal box, no? We should say that someone is a camp fire in high winds. We digress…

What can be done? We usually advise pumping the brakes on the current year’s tax return and re-building the shareholder basis data from business inception. WCG just recently did this for a client who owned a bunch of Arby’s over several years; the shareholder basis on the worksheet from the previous CPA was understated by over $240,000. Yeah, a big number.

The lesson here is to be careful on seeing a bunch of cash and thinking you can do a money-grab without pain. Better yet! The lesson is to engage a team of wonderful Certified Public Accountants and business consultants to keep you out of trouble. We can fix things during the year. After the year is over, it might be hard to put toothpaste back in the tube.

Tax Planning Opportunity

But wait! There’s more. There might be a tax planning trick to welcome this capital gain on distributions in excess of shareholder basis. Huh? Well, the capital gain is considered long-term and as such has favorable tax rates versus ordinary income tax rates. In other words, if you are going to pay taxes on the income your business earns anyway, do you want to do it at ordinary income tax rates or capital gain tax rates?

You might have long-term capital losses that are quite large and might take a long time to recoup. For example, and for whatever reason, you have $100,000 in capital losses that are being carried forward. In addition, you don’t see yourself using these losses anytime soon. Under current tax law, you can only deduct $3,000 per year so quick math suggests needing 34 years to fully deduct these capital losses. Sounds like a long time, right? As such, having a shareholder distribution in excess of your basis which in turn causes a capital gain just to be absorbed by these losses doesn’t seem so bad.

We are saying this in the abstract, but there could also be tax planning opportunities when allowing this capital gain to occur.

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

With an S corporation or partnership you need sufficient shareholder / partnership basis in your business to deduct losses. For example, if you invested $10,000 into your business but the business lost $30,000, as an S Corp shareholder you can only deduct losses up to the amount of your shareholder basis (in this example, $10,000).

Think of Google. You invested $10,000 into Google stock and they go out of business, you only lose $10,000. Remember that with an S corporation you wear two hats- one as an employee, and one as an investor (shareholder).

Section 179 Expensing Losses

How does a loss in a small S corporation happen? A lot of small businesses are cash based and don’t have a lot of equipment (dentists are a common exception). However, for the sake of argument we will assume you bought a piece of equipment for $100,000 and borrowed $100,000 to pay for it. The equipment also qualified for Section 179 expensing deduction allowing you to deduct (or attempt to deduct) the full amount against business income. Great! The benevolent IRS king is alive and well.

Let’s assume that the business income prior to depreciation was $60,000 (and Section 179 expensing was $100,000). The S corporation tax return would still show a $60,000 net business income amount, but your K-1 would show a $70,000 amount for Section 179 deduction. Why $70,000? You had $10,000 in basis (using the example above) plus the $60,000 net business income. 10k + 60k = 70k, even in Canada. Sorry Canada… just too easy to pick on.

You would be able to deduct $70,000 as a loss. The $30,000 remainder of the Section 179 deduction that was not taken or used would be carried forward to future years. Yuck! Sorry, the once-benevolent IRS king is now asking you to be patient and wait.

Here is a table to demonstrate the depreciation conundrum more clearly. We love tables.

Taxable Income Prior to Section 179	60,000
Section 179 Expensing	100,000
Beginning Shareholder Basis	10,000
Net Biz Income (profit) on K-1, Box 1	60,000
Section 179 Expensing on K-1, Box 11	70,000
Loss Taken on 1040 Tax Return	-70,000
Section 179 Carryover, Form 4562	30,000

Bonus Depreciation Losses

Here is another example, that is just slightly different and shows a small difference between Section 179 and bonus depreciation. Similar example to above, but you used bonus depreciation.

Starting Shareholder Basis	10,000
Net Income Before Depreciation	60,000
Bonus Depreciation (80%, 2023)	80,000
Net Income (loss) on K-1, Box 1	-20,000
Available Cash in Business	60,000
Allowed Losses	-10,000
Ending Shareholder Basis	0
Disallowed Losses Carryover, Form 8582	10,000

Bonus depreciation is 40% for the 2025 tax year barring changes in tax legislation. The table above uses 80% bonus depreciation as an illustration.

What we are showing here are two things- first, your losses created by the bonus depreciation will be limited because of your shareholder basis. You started with $10,000 but didn’t have any net business income (profits). Rather, you had a $20,000 loss. $10,000 of this $20,000 was allowed and the remainder will be carried forward to future years.

The second thing we are showing is how your cash is trapped. You had profits before bonus depreciation of $60,000 and for the sake of argument this also is your ending cash balance in your checking account. This cash is trapped since you cannot distribute it without creating a distribution in excess of basis.

We will expand on this some more in a bit. The big takeaway is that business losses created by depreciation created by a financed equipment purchase can be painfully and unknowingly limited.

Wait! Looks like we talk about shareholder distributions and basis next. Yay!

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

State tax laws might not treat S Corp income and subsequent K-1 income in the same benevolent manner as the IRS. Recall that S corporations do not pay a federal income tax directly. Rather the income is passed onto the shareholders who are then taxed on that income at their individual tax rates. However, some states impose an additional tax. For example, California imposes a 1.5% franchise tax on S Corp net ordinary business income (profit) after expenses and deductions with a minimum of $800. Yuck. So, your 8% savings in federal tax turns into 6.5% after you pay California.

Other income tax free states, such as Texas, have similar taxations and various exemptions too. Franchise tax is another buzzword you might come across. Why do they call it a franchise tax, or a business and operating tax as they do in Washington State? They can’t call it an income tax because of the Interstate Income Act of 1959. Yup. Way back when, and it is battled every year in court, in various representations. Consider that in 1959, interstate commerce was quite small compared to what we have today with Amazon and all the interwebs. States are tired of businesses skirting local income taxes.

Before we get into that, there are two issues at play here and we’ll pick on California to illustrate some points. One, if you are an S corporation headquartered in California you will be subjected to the franchise tax. Period. End of story.

But the other side of the coin is state nexus (which was broached earlier) where you are not physically headquartered in California but have a nexus either physically or economically in California. This too would subject your income sourced from California to the franchise tax.

In some cases, you might have nexus in California but not have any California sourced income, and you will unfortunately be subjected to the minimum franchise tax of $800 (for the 2025 tax year). Nutty. You have nexus, but no taxable income, and you still pay the minimum franchise tax? Yes. This happens when you create an LLC, but all your income sources are outside California and they exceed certain thresholds. There are other situations where this can happen.

Conversely, if you are a sole proprietor in California (and not an LLC or corporation), you do not pay a franchise tax. Yes, you will be subjected to federal self-employment taxes which is why you want to consider an S Corp election. So therein lies the rub. Franchise tax versus self-employment tax.

About half of the states have some sort of franchise, business or excise tax. Back to the Interstate Income Act of 1959- it is against Federal Public Law 86-272 for states to charge an income tax on foreign businesses in certain circumstances. Remember, foreign does not mean domestic and international. Foreign is a business registered in Nevada doing business in California, as an example.

Here is a snippet of Federal Public Law 86-272–

States are therefore prevented under Public Law 86-272

• from taxing out-of-state businesses on income derived from activities within the state

• if the activities are limited to mere solicitations of tangible personal property, and

• the orders are processed from outside the state.

Note how this focuses on tangible property and not services. Huge distinction! Is internet hosting a service or tangible personal property? How about an eBook? This is discussed more in a later chapter, and the current news is not great. The future isn’t good either.

Let’s have California’s Franchise Tax Board offer a few words on Public Law 86-272-

Public Law 86-272 (15 USC Section 381) prevents States from asserting their right to impose a tax based on net income, such as the corporate income tax or franchise tax. Public Law 86-272 protection is available to out-of-state business entities that:

Sell tangible personal property in this state

Who’s in-state activities are limited to the solicitation of orders for their goods

As a result, if a taxpayer is protected by Public Law 86-272, they will not be required to pay the franchise tax or the corporate income tax, as both are measured by net income. However, even if protected by Public Law 86-272, an out-of-state entity that is doing business (R&TC Section 23101) in California is still obligated to file a tax return and pay taxes that are not measured upon net income, unless certain exceptions apply, such as:

The minimum franchise tax

Annual limited liability company tax

The limited liability company fee

You are probably asking, “What does this mean, how does this work?” First of all, protection under Public Law 86-272 does not apply to businesses that derive in-state income from the solicitation or sale of:

Intangible property

Services

Any combination of goods and services

Technical Advice Memorandum: 2018-03 addresses the application and interpretation of Public Law 86-272 in the context of delivering goods by company owned delivery vehicles. This memorandum concluded the delivery via a private delivery truck is protected activity under Public Law 86-272. However, any activity that goes beyond the scope of delivery, such as backhauling, is not protected activity.

For example: Corporation C, an out-of-state corporation that does not file a combined return, sells tangible goods over the internet and qualifies for protection under Public Law 86-272. For the 2019 taxable year, Corporation C has $1,000,000 of California sales but no property or payroll in California. Corporation C, though considered doing business in California because it has $1,000,000 in California sales, will not be subject to California’s franchise tax as it is protected under Public Law 86-272. This is true even if the tangible goods are delivered using Corporation C’s vehicles. However, Corporation C must still file a California return and pay the minimum franchise tax of $800. If Corporation C’s vehicles are used for any other business activity along with the delivery, such as backhaul of goods (like hauling off the customer’s old items), this activity would go beyond the solicitation of orders and would no longer be protected.

California has a lot to say!

So the wizards at various states came up with a tax that is not based on income or at least not called an income tax. Some states tax your gross receipts, no matter what your expenses are! Amazing. It is also noteworthy that Public Law 86-272 does not protect businesses located in and doing business in the respective state (only interstate activities, not intrastate activities). But it appears that states keep things consistent, and impose a franchise tax, a business tax or an excise tax on local businesses just the same. Genius.

Here are some sample state links-

wcginc.com/1304	California
wcginc.com/1302	Oregon
wcginc.com/1307	New York City
wcginc.com/1311	Tennessee
wcginc.com/1314	Texas

New York City S Corp tax rate is 8.85%. Tennessee is 6.5%. Texas is about 1% on gross receipts exceeding $1 million. Washington DC has a tax it imposes on S corporations, but tax is exempt if over 80% of the revenue is from personal service. All kinds of rules!

Do you want more wrinkles? Here you go- California (we just love to pick on them) has a unique rule to their franchise tax. As a garden-variety LLC, you are taxed on gross receipts in addition to the $800 franchise tax. For example, you could have $1,000,000 in gross receipts and $1,000,000 in expenses. Your franchise tax would be $800 + $6,000 (for the 2025 tax year) although you do not have any net income. Yuck.

However, if this LLC is taxed as an S corporation, then it would pay 1.5% of the net income (profits) or $800, whichever is higher. Using the example above California’s franchise tax would be $800 versus $6,800. Therefore, the lesson is that you might be forced into electing S corporation status in California just to avoid its silly gross receipts tax.

To complicate things even more, you must apply nexus rules to all this. You might not be subjected to another state’s franchise or business tax if you don’t have an economic or physical presence in that state.

The issue of state business taxes and nexus is discussed in nauseating detail later in a chapter dedicated to state nexus. More buzzwords such as economic presence, throwback rules, tangible personal property, commerce and due process clauses, etc. Bottom line- talk to your nexus experts at WCG CPAs & Advisors to nail this down. It is extremely tricky, and states are extremely aggressive.

Before that, here are some big takeaways with this section-

• Income tax nexus and sales tax nexus are woefully different, and one doesn’t invite the other to the nexus party. Income tax cannot just show up with a plus 1.

• Each state is unique and different, like snowflakes, but without the innocence and the ability to be shoveled away.

• Tripping nexus wires can unwittingly expose your business to additional taxes beyond income taxes.

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

You might not reap all the benefits of an S Corp election and subsequent self-employment tax savings if you have other W-2 income. But there is a lot to unpack here-

• You have Medicare savings versus forfeited Social Security taxes.

• You have the pass-through entity tax (PTET) deduction that is only available in an S Corp or partnership environment.

• You have the qualified business income deduction (QBID) that might be wage limited once you hit the 32% marginal tax bracket.

These all interplay. We’ll start with forfeited Social Security taxes first.

Medicare Tax Savings

You might not reap all the benefits of an S Corp election and subsequent self-employment tax savings if you have other W-2 income. Let’s say you are an IT consultant for ABC Company, and you also do some outside consulting. If ABC Company pays you $170,000 in wages, you are already max’ing out your Social Security contributions, and therefore any supplementary income regardless of your entity will automatically avoid additional Social Security taxes.

You still obtain a small savings in Medicare taxes, which is generally immaterial at 2.9% or 3.8% of the side gig income. Then again, a tiny number multiplied by a big number can be a big number. We’ll talk more about when forfeited taxes exceed the reduction in Medicare taxes in a bit.

We find this very common among medical professions. Many times, a surgeon or anesthesiologist will be full-time for a hospital or medical group, but also moonlight on the side for smaller towns with smaller hospitals with even smaller budgets.

The problem with piling extra W-2 salary from your S corporation onto W-2 salary from your main job is the S Corp’s portion of payroll taxes. While both salaries might exceed your individual Social Security cap ($176,100 for the 2025 tax year), any salary in excess will unnecessarily increase the tax burden of your S Corp by 6.2% (the employer portion of Social Security taxes). Huh?

In other words, your main job will stop collecting and paying Social Security taxes once you reach the annual limit. However, since Social Security taxes are paid by both the employee (you) and the business, when you run payroll with your S corporation, the business will collect and pay Social Security taxes just like your main job.

On your individual tax return, you will get your portion of excess Social Security taxes refunded to you on Line 11 on Schedule 3 of Form 1040. That’s the good news. The bad news is that the S Corp’s portion will not be refunded. This is lost forever, and we call this a forfeited tax.

Here is yet another table to explain this further-

Salary from Main Job	200,000
Income from Business	200,000
Medicare Tax w/o S Corp	7,600
Salary	66,000
Payroll Tax w/ S Corp
ER Social Security	4,092
ER Medicare	957
EE Medicare w/ Surtax	1,551
Total Payroll Taxes w/ S Corp	6,600
Initial Savings	1,000		(7,600 less 6,600)
Fees for Payroll, Tax Prep (typical)
S Corp Tax Prep	1,500
Payroll Processing	1,200
Net Savings (loss)	-1,700

Ok… here we go. Let’s say you had a main job that earned $200,000 and you also run an online retailer business where you plan to make $200,000 net income after expenses (profit). You eclipsed your Social Security maximum with your main job salary, so the $200,000 is only subject to Medicare taxes plus the surtax, or $7,600 ($200,000 x 3.8%).

Now we elect S Corp for your business and pay a salary of $66,000. The total taxes paid not considering your portion of Social Security which will be refunded is $6,600. ER is shorthand for “employer” and EE refers to “employee.” The initial savings is $1,000. However, now you must run payroll and file a corporate tax return. Therefore, the savings are gobbled up by normal professional fees.

Therefore, in this situation perhaps a garden-variety LLC is more prudent from a cost-benefit and headache analysis. Having other W-2 income, however, could actually work in your favor- more on that later.

Sidebar: Having multiple sources of income can mess up your withholdings. Each source of income on its own might withhold correctly, but when combined, the total income will be in a higher tax bracket and unfortunately will have under-withheld as a household. Again, payroll tables don’t know about other jobs or sources of income and can only make assumptions. Some tax planning is a must. More about tax planning within your S corporation payroll in a later chapter.

Here is an internal table that we use during business consultations-

	28% Salary			33% Salary
Salary	28.0%			33.0%
ER Social Security	6.2%			6.2%
Forfeited Tax	1.7%			2.0%
K-1 Income	72.0%			67.0%
Medicare	3.8%			3.8%
Medicare Savings	2.7%			2.5%
Delta	1.0%			0.5%
Net Biz Income (profit)	200,000	275,000		200,000	275,000
Salary	56,000	77,000		66,000	90,750
Forfeited Tax*	3,472	4,774		4,092	5,627
Medicare Savings	5,472	7,524		5,092	7,002
Delta (cash savings)	2,000	2,750		1,000	1,375

Tilt. OMG. We have four scenarios; salaries of 28% and 33%, and business incomes of $200,000 and $275,000. Let’s take one and quickly dissect it.

• The forfeited tax is your S Corp’s portion of Social Security taxes that must be paid but cannot be refunded. This is 28% x 6.2% or 1.7%. This 28% will be meaningful once we get into the Section 199A deduction.
• The Medicare savings is the remaining S Corp income that will now avoid this tax. This is 72% x 3.8% or 2.7%. The 72% is in the inverse of the salary percentage.
• The first delta is simply the forfeited tax less the Medicare savings, or 1.0%. The second delta is the calculated savings, and it ties out to the first delta since $200,000 x 1.0% is $2,000.

Wait! There’s more to consider when your main W-2 exceeds the SSA wage base.

Pass-Through Entity Tax (PTET) Deduction

We touched on this in an earlier chapter, but we need to bring it up again here. As you recall, with the Tax Cuts and Jobs Act, Congress wanted to limit state and local taxes (SALT) to $10,000. This means either state income taxes or real estate taxes, or both, were severely muted on their deductions.

States got creative and created a state tax that was deducted on partnerships and S corporations tax returns (otherwise called pass-through entities… or PTE if you are a cool kid) resulting in lower federal taxable income. This tax, paid by the PTE, is then credited on the business owner’s state income tax return (or in some cases the taxable state income is reduced by the PTE’s income). This is also called the great SALT work-around.

Cash is cash to a business owner whether it is spent by the business or the human, right? There are all kinds of rules, and not every business owner will benefit from the PTET deduction. Shocker, we know.

Bottomline is this- does it feel better to pay your state income tax with personal dollars or business dollars? It’s a bit rhetorical… no need to say it out loud or call us. However, you need to have a pass-through entity, which is either a partnership or an S Corp. A single-member LLC disregarded for tax purposes or a sole proprietorship does not qualify! Read more here-

wcginc.com/ptet

Qualified Business Income Deduction (QBID)

You are likely getting tired of this section, but there is one more consideration. As mentioned elsewhere, once your household taxable income reaches the 32% marginal tax rate, your QBID has a second test. If you are a specified service trade or business (SSTB) such as attorney, accountant, physician, consultant, etc. you are mostly hosed. But if you are not an SSTB such as a retailer or an architect or realtor or the zillion other business owners, then read on.

The qualified business income deduction is 20% of your business income. Easy. Once you hit the 32% marginal tax rate, then your QBI deduction is 20% of your business income or 50% of wages whichever is lower. Lower. As such, if you do not pay wages (complete with payroll filings and W-2s), you might be limited on your QBI deduction. Keep in mind that you cannot pay wages to yourself in a sole proprietorship or a single-member LLC that has not elected an S corporation election. You also cannot pay partners a wage in a partnership.

As such, you might have regular W-2 wages that exceed the Social Security wage base and you might still need to S Corp elect your business entity just to capture the full effect of the qualified business income deduction.

Net Net

What do we do with all this data? We compare all the possible savings to the additional fees associated with an S Corp which are specifically business entity tax return preparation (Form 1120S) and payroll processing. From there, a simple cost-benefit analysis is done. It is not all dollars and cents, however. Please recall from another chapter that S corporations enjoy a significantly lower audit rate risk than plopping all this side gig income and expenses on Schedule C of your 1040 tax return.

Make $200,000 with your W-2, and $150,000 with your used copier sales gig, and you live in California? S Corp is not shabby with about $7,500 in savings (factoring in franchise tax too by the way).

It is not all dollars and cents, however. Please recall from another chapter that S corporations enjoy a significantly lower audit rate risk than plopping all this side gig income and expenses on Schedule C of your 1040 tax return.

Ok, enough of that nonsense. Please contact us if you want your unique situation projected and analyzed.

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

If you earned $100,000 in your garden-variety LLC, your SEP IRA deduction is $18,587. How do we get there?

Net Business Income (profit)	100,000
Reduction for Biz Portion of SE Tax	7,650		(100,000 x 7.65%)
Self-Employment Income	92,350
SE Tax at 15.3%	14,130		(92,350 x 15.3%)
Deduction for Half of SE Tax	7,065
Net Business Income	100,000
Deduction for Half of SE Tax	7,065
Income Base for SEP IRA Calcs	92,935
20% SEP IRA Contribution	18,587

It is a two-step process. First, we need to calculate the deduction for half of the self-employment tax ($7,065). Second, we take the net business income and subtract half of the SE tax. This difference ($92,935) is then multiplied by 20%.

The 7,065 number should mean something. If you recall in a previous chapter, the self-employment (SE) tax rate is 15.3% but the effective rate is 14.13%. This is because of the reduction of the business income subject to the SE tax by the “employer” portion of SE tax. 7,065 x 2 is 14,130 or 14.13%. In other words, if you made $100,000 you would pay $14,130 in self-employment taxes.

Therefore, the SEP IRA calculation in our example is reduced to $100,000 x (1- half of 14.13%) x 20% = $18,587. Or simply $100,000 x 0.9294 x 20%.

Wow, did we belabor the heck out of that? Admit it; you’re better for it… you can wow your friends at the next cocktail party… or… proudly announce on Jeopardy, “I’ll take self-employment retirement calculations for $200 please Aaron.” We certainly miss you, Alex. Sorry, Aaron, not many miss you.

Do you want another way to calculate self-employment taxes? Business income x 92.35% x 15.3%. The 92.35 is simply the inverse of 7.65 which is half of the self-employment tax rate.

Back to the issue at hand- if you elect S corporation taxation, your SEP IRA is now 25% of your W-2. Let’s say you paid yourself $40,000 in wages, your SEP IRA contribution would be $10,000 versus $18,587. That is a huge difference!

However, if you leveraged a solo 401k plan instead, your total contribution is now $23,500 (for the 2025 tax year) plus 25% of your W-2 or $33,500. Another way to look at the SEP IRA versus 401k calculation is 401k = SEP IRA + $23,500+ $7,500 (if 50 or older).

The reduction in what you can save in your SEP IRA or solo 401k cannot be viewed in isolation. In the $100,000 example above, your S Corp savings might exceed $9,000. Also recall that tax deferrals are merely little IOU’s to the IRS. As such, the small reduction in contribution limits and the small tax deferrals and even smaller ultimate tax savings (provided your retirement marginal tax rate is less than your current tax rate) are shadowed by the savings of an S corporation.

Sidebar: While WCG CPAs & Advisors defers to your financial planner, we usually recommend Roth (post-tax) deferrals into your solo 401k plan. Yes, pay taxes now, but then your growth and distributions are tax-free later in life. Tax savings is a lifelong perspective. Also, keep in mind that the discretionary employer (your business) contribution are usually pre-tax. Therefore, you are achieving some immediate tax savings and hedging your tax bets at the same time. If you are going to have a tax bill, would you prefer it today during your working years or when you are watching Matlock reruns? More about this in our retirement chapter.

Note To The Sidebar: The SECURE Act of 2022 allowed for employer contributions to be post-tax (Roth). Many 401k plans are outdated and don’t allow for this, and need to be restated.

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

The IRS will expect unemployment taxes (FUTA) on all W-2 wages paid, including corporate officers. According to IRS Topic Number 759, for the 2025 tax year the first $7,000 will be taxed at 6% with a credit of up to 5.4% for unemployment taxes paid to your state (SUTA). This $7,000 has not changed since 1983. Crazy!

Some states such as Alaska, Kansas, Minnesota, Nebraska, Oregon, Washington state and Washington D.C. will allow you to opt out of state unemployment.

Before you opt out of your state unemployment taxes, consider two things. First, you get a credit for the state unemployment taxes paid when you file your federal unemployment taxes on Form 940. This is a big deal. Here is how it works-

Minnesota (for example) has a wage base of $40,000 (for the 2023 tax year). Let’s say the average SUTA rate is 2.6% and your salary is $42,000. You would pay $910 to Minnesota for unemployment. Then, because you paid into Minnesota’s unemployment system, the IRS only charges you 0.6% of the first $7,000 or $42. So… $910 + $42 = $952. If you opted out, you would only pay 6% of the first $7,000 or $420. Opting out in Minnesota at this wage base makes sense.

In Colorado, where you cannot opt-out but provides a good illustration, the wage base is $20,400 (for the 2023 tax year). If your SUTA rate was 2.1% then you would pay $428 to Colorado and $42 to the IRS for a total of $470. If you could opt out and did opt out, the IRS would charge you 6% of the first $7,000 or $420. A tiny savings, but a savings nonetheless (you just covered 10% of your wine pairing dinner at Ski Tip Lodge in Keystone).

Some states, such as California, were in arrears with the federal government on unemployment debt payments and as such the credit the IRS provides was reduced. For example, the FUTA rate is 0.6% if you pay SUTA, but for California businesses the FUTA rate is 2.7% in addition to the SUTA rate. California caught up on its federal unemployment debt in 2018 thanks to the backs of resident taxpayers, and the FUTA rate will revert to 0.6%.

Note the subtle difference- full FUTA rate is 6% and the reduced rate is 0.6%. The simple decimal move is sneaky.

The COVID unemployment craziness will certainly put more states into arrears with the federal government. It will be interesting to see how this plays out. There could be debt payments made on the backs of small businesses as they see a higher unemployment tax. Remember, unemployment is a payroll tax that is wholly paid by the employer.

Second… and this one you might laugh at… second, if you shut down your S corporation you might be eligible for unemployment benefits. Remember, unemployment benefits are administered by the state and if you opt out because of your corporate officer exemption, you could be limiting yourself unintentionally. Yeah, this is crazy but beware just the same.

Pre-COVID and from direct experience with some of our clients, Colorado fights the heck out of a former business owner collecting unemployment benefits; the business owner must show that his or her business suffered a catastrophic event; one that prevented future business income. Many other states are similar. During 2020 and 2021, all kinds of nutty things were happening with small business owners and unemployment benefits being paid to them. It’ll take some time to unravel and settle back into a predictable future.

COVID also shined a light on sick pay and disability, including medical leaves. Therefore, many states recently passed legislation to fund various state-ran programs to address these issues.

For example, California, Hawaii, New Jersey, New York and Rhode Island impose a state disability insurance (SDI) payroll tax when you run payroll on the shareholders (as of 2022). Colorado has the FAMLI program which stands for Family and Medical Leave Insurance. As of October 2023, over 20 states have some sort of paid family leave.

Critical Note: Specifically, California charges 0.9% with a maximum of $1,378 (0.9% x $153,164). Starting in 2024, however, California’s SB 951 eliminated the wage limit but lowered the tax to 0.9%. Yuck.

You can opt-out of California’s SDI if your underlying entity is a corporation or if you obtain voluntary disability insurance from an approved insurance provider. Read that again. This is for corporations. An LLC taxed as an S Corp remains an LLC with the Secretary of State and as such cannot opt-out of SDI. A C or professional corporation taxed as an S Corp may. Subtle difference, but one that bites people all the time.

But there is an interesting situation with California (and perhaps other SDI states). In California, employees pay into the insurance fund and not the employer. So, if you were paid a W-2 salary of $100,000 and then was converted to a 1099 contractor, you are suddenly saving $1,000 in state disability insurance taxes. Then again, if you create a corporation and also elect S Corp status, you suddenly pay at least $800 in franchise taxes. They get you… always… eventually.

To summarize some of these various terms that you might hear-

• FUTA and SUTA- unemployment tax. Unavoidable. You might be able to opt out, and as the Minnesota example above illustrates, there is a tax savings by doing so.

• SDI- state disability insurance. Might be able to opt out for single-owner corporate officers in California or with supplemental insurance.

• Workers Compensation Insurance-has nothing to do with unemployment or state disability insurance, and is not interchangeable with those terms. This is purely insurance coverage for on-the-job injuries and is provided by private insurance such as State Farm, All State, Farmers, etc.Washington state runs their own program but allows business owners to opt-out. Ask your local insurance agent if you can opt out. Typically, you can since you don’t plan on suing yourself for a paper cut or a rogue paperclip stabbing.

Be aware that additional payroll taxes can nibble at the S Corp savings, but frankly it is relatively small at approximately $500. We are not trying to value-assess your money since $500 is still a big number. However, it is dwarfed by the savings.

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

Paying shareholders through payroll and filing a corporate tax return costs money- but with a potential 8% to 10% savings of net income, the benefits will exceed the costs especially if the net ordinary business income (profit) after expenses and deductions exceeds $48,000. This is net income after expenses (profit)- not gross revenue. So many business owners think in terms of gross income- we don’t care about gross income necessarily when contemplating an S corporation election, and the IRS doesn’t care about gross income when it comes to taxable income.

Since the cost of payroll services and corporate tax return preparation is relatively fixed, the more profit you earn the more you’ll save. Something to discuss and consider.

Quick Numbers: Let’s say $100,000 in net income saves you $9,000. WCG charges $4,500 ($375 per month) for business entity and individual tax returns, payroll and estimated taxes, income tax modeling and planning, and business consultation under our Vail Business Advisory Services plan. Therefore, a $100,000 S corporation saves you close to $4,500 after our fee, and we do all the work (and give you wonderful tax planning, the forgotten art of most accountants).

Here is a link to our transparent fee structure including our Business Advisory Service plans (a CPA firm who publishes fees?!)-

wcginc.com/fee

If you already have a partnership or multi-member LLC, and you file a partnership tax return (Form 1065) your break-even point is about half, or $20,000 based on the sunk cost of the business entity tax return preparation.

Sidebar: The savings illustrated here and throughout our book is per person. If you have a multi-member LLC with three partners, and the business has profits of $300,000 (as an example), an S Corp election could easily save the group $27,000 as a whole.

If you also run payroll within your business because you have a staff, then the annual cost of having an S Corp could be zero. So, now your $100,000 actually puts $8,000ish in your pocket (there are some other expenses like unemployment taxes, keep reading).

In other words, a large chunk of the $4,500 is business tax return preparation and payroll (about $3,500). Therefore, if you already pay for these services within your business then they are considered sunk costs when contemplating the S Corp election.

Sidebar: Consideration of sunk costs should be removed from decision making. One and done costs, like business formation and set up fees should be amortized over the projected life of the business. Yes, it is real money. Yes, it hurts especially all at once. Yes, the pain goes away with time. Just ask a Jets or Browns fan.

If you break-even on the fees as compared to your savings, keep in mind the additional benefits. With our business advisory service packages you are getting individual tax return preparation plus routine tax planning and consultation. There is value there, so if you break-even in terms of cost-benefit analysis, you might actually be ahead.

We are not considering the huge benefits from pass-through qualified business income tax deductions as outlined in Section 199A of the Tax Cuts & Jobs Act of 2017. At this point, in this chapter, one of our primary focuses is the delta between a non-S Corp and an S Corp. Real numbers and real examples used to be contained in this book, but are now parsed out to be a separate addendum.

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

Not everything that glitters is gold so there are a handful of downsides, some manageable, to the S Corp election or having an LLC. A lot of these examples stand alone, and some of these depend on the net income of the business and other external factors. WCG can help guide you through the decision-making process.

And No, there are not 185 reasons- it was just a self-proclaimed catchy number. Most of these reasons in the beginning of this chapter focus on S corporations. However, there are some general pains with having any type of formalized entity, and those are near the end.

Specifically, in this chapter we will review these disadvantages to having an S corporation-

• Increased cost (tax preparation, payroll taxes)

• 401k or SEP IRA limitations

• Trapped assets

• Disparate distributions not allowed (but we have a work-around)

• Other W-2 income

• Deducting losses, trapped cash

• Expanding ownership

• State taxes

• Among other smaller issues

Specific to S corporations, we ask these general questions of each business owner before diving into the nitty-gritty-

• Does your business earn over $50,000 net income after expenses (profit)? Say Yes.

• Are you located in New York City or Tennessee where S corporation tax rates are egregious and suck up all the federal tax savings? New Hampshire? Say No (unless you are being limited by Section 199A for lack of wages).

• Do you have other W-2 income that exceeds or comes close to exceeding the Social Security limits of $176,100 (for the 2025 tax year)? Say No.. If you say Yes, we need net ordinary business income after expenses and deductions to exceed $250,000 in #1 above.

• Are your state and local taxes limited on Schedule A of your individual tax return? If so, an S corporation might create what has been deemed the SALT work-around where state income taxes are paid and deducted by the business. Say Maybe.

• Is this a going concern? In other words, is the business going to continue to earn the same income or more each year? Say Yes.

• Do you have an LLC or some other entity in place that can be elected to be taxed as an S Corp? Say Yes. If you say No, we have options just not elegant ones.

Are you still here? Excellent news… then read on!

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