Money Talk

Episode 59

Forms of Businesses Organizations-Tax Implications

Chuck: Welcome to Money Talk. I’m Chuck.

Ed: I’m Ed. In today’s topic, forms of business organizations/tax implications.

Chuck: Revisited.

Ed: Revisited. Yes. This is-

Chuck: We touched on this before.

Ed: Yes, but I want to put it all together. When do you form an organization and for what reason? Folks say, well, to form a corporation- Let’s use a corporation, for example, versus a partnership and or limited liability versions of business organizations. You form the organization to insulate those activities from claims of creditors so you’re not going to be sued successfully and your assets lost.

The overlooked portion, and we see this in the professional organization with lawyers, doctors, actuaries, why would you form a corporation to do this? Well, we work with several lawyers around the country and talked about have a corporation and have it taxed as a regular corporation, because it’ll be taxed at the assets incoming community, 21%. You could do a lot of things. Oh, no. No, it’s a mess. In other words, so the tax, the income is taxed to the shareholder.

Well, Chuck, I subscribe to the regular corporation with a calendar year, and you go from there. Why do you do that? Well, there are things you could do. There’s the profit-sharing plan, there’s the pension plan, the 401K plan. You can do that with a self-employed individual, but it’s a little cleaner with a corporation. What you do is you don’t take your salary out until the end of the year, and you force your spouse, your significant other, to borrow to live on.

Guess what? It’s a form of budgeting. You’re not going to spend a lot of money on things that you shouldn’t. At the end of the year, you take your salary down. Say, December 15th.

Chuck: Right.

Ed: But, most importantly, you’re going to put some money away that’s going to grow tax deferred.

Chuck: Right.

Ed: With a cash balance plan that we’ve talked about, the amounts you can set aside are significant. This relates to, I’ll call it, a close-held corporation with fewer than 50 employees.

Chuck: Yes.

Ed: If you’re beyond that, then it is more difficult. But the ideal professional service organization, typically, this applies. The other aspect of it, not only the profit sharing and pension plan, but a medical reimbursement plan.

Chuck: Right.

Ed: By that I mean you can, after you set the eligibility requirements, you can reimburse each employee, that’s a participant, for all their medical expenses, including your own, and deduct those, and yet the individual will not be taxed on the income attributable to the payments on the reimbursement from the reimbursement plan. The Code Section is 105(a). It’s been around for a long time, but it’s not used often. You have these individual high earners that are going to be burned out in 15, 20 years. The idea is put as much money away as you possibly can, even borrowed to pay yourself the living expenses, repay the loan at the end of the year, but put as much money away as you possibly can as soon as you can and use these devices such as the medical reimbursement plan, a group term insurance plan. Get $50,000 of insurance.

Chuck: By the way, because it’s a corporation, when you do this for employees, that includes you.

Ed: Right.

Chuck: You’re an employee of your own corporation.

Ed: I can be the only employee of the corporation.

Chuck: Right. Suddenly, you’re not cap– You don’t have the 7.5% floor– Of AGI floor to be able to deduct.

Ed: Now, what do you mean by that?

Chuck: Well, if you pay your medical expenses as an individual and, let’s say, you have enough deductions on your individual income tax return that you’re itemizing your deductions, you don’t get to take any deductions for medical expenses until they’ve exceeded 7.5% of your adjusted gross income.

Ed: Adjusted gross income is, basically, income before alimony and that sort of stuff.

Chuck: Right, but with this mechanism, the corporation’s paying your medical expenses and the first dollar is deductible against the corporate income.

Ed: Putting it another way so there’s clear understanding, if you are a service organization, you’re out of your mind if you don’t have a regular or a C corporation taxed under Subchapter C of the Internal Revenue Code versus taxed under Subchapter S of the Internal Revenue Code. All this hogwash about you have to have the partnership, you have to– Well, no, you don’t put real estate into a corporation. It’s like a lobster pot, easy to get into. You can live, but you can’t get out of it.

Chuck: Right.

Ed: Never have real estate in a corporation, especially in a C corporation, and make sure, if you have relationships with other people, they’re all independent contractors. You’re going to contract with your outside accounting firm. They’re not going to be an employee.

Chuck: Right.

Ed: You’re going to contract with a service provider, not an employee, so they do what they want to do, and you make–

Chuck: They can have their own medical reimbursement-

Ed : They can do whatever they want.

Chuck: -and their own corporation.

Ed: That’s right. Then, so you can accumulate this money for working capital, but you’d never take your salary out until the end of the year.

Chuck: Yes.

Ed:  People can’t seem to subscribe to that.

Chuck: Well, I’ve only met two people who’ve ever done that, and they’re both people who are part of this broadcast.

Ed: It’s amazing to me. You’ll go over that with really sophisticated individuals, and it’s just deaf, dumb, and blind– “Oh that seems complicated.” No, it’s not complicated.

Chuck: No.

Ed: Yet, this perception that if it’s expressed in the Internal Revenue Code, it is complicated. That is so wrong.

Chuck: Right.

Ed:  I can’t believe it.

Chuck: Yea.

Ed: There’s nothing wrong with a profit-sharing plan, a pension plan, a combination, a stock bonus plan. These arrangements that permit you to defer.

Chuck: Right.

Ed: Convert, by the way, from ordinary income to income from an IRA which, typically, in Illinois, isn’t tax for Illinois purposes.

Chuck: Right.

Ed:  You’re saving, for every $100,000 you put away, you know how much you’re never going to pay? $25,000.

Chuck: Right, isn’t that amazing?

Ed: “Well, Ed, that can’t be.” No, that’s right. Well.

Chuck: What do I know?

Ed: Yes. I don’t know. I’ve never done this before.

Chuck: Right.

Ed: The point is, you never go to an old doctor or a young lawyer.

Chuck: Right.

Ed:  I’m saying that because all we value, all we do is, hopefully, confer value in the form of avoid mistakes I’ve made.

Chuck: Right.

Ed:  I’ll tell you, I’ve made so many mistakes in my life I don’t want to count them, but I do know I’m trying not to make the same mistake twice.

Chuck: Trying to let other people learn from the ones that you have made, right?

Ed: Yes. If you say you’ve never made a mistake you’re lying.

Chuck: Yea.

Ed: The point is, such things as a corporation, or a partnership with several corporations, either you can split up a business organization owning the equipment and owning that by your kids or not, or an ESOP, there are so many things you can do with tax-qualified arrangements.

Chuck: Right.

Ed:  The idea is, put the money away.

Chuck: We should clarify something here which is, some people might be confused because you’ve referred several times today about a regular corporation. I know that you never use the term C corp. When you say regular corporation, you’re talking about what a lot of people call a C corp.

Ed: That’s right.

Chuck: C corp is not a real word.

Ed: It is not a corporation.

Chuck: That’s not in the tax code, the phrase C corporation. S corporation is actually in the tax code.

Ed: That’s right.

Chuck: Referred to as S corporations. What is colloquially referred to as a C corporation is referred to in the tax code as a corporation.

Ed: Right. To clarify things, you could have a Wyoming corporation formed under the laws  of Wyoming. Illinois, California, Delaware. The state law governs the formation of that business organization, the rights and responsibilities of directors, shareholders, et cetera, but the tax code dictates, is it going to be taxed under Subchapter S, which means it’s going typically not going to be a corporation.

Chuck: It’s an S corp.

Ed: Yes, but people say it’s an S corp.

Chuck: Right.

Ed:  No, it’s taxed under, I want to make that very clear.

Chuck: Right.

Ed:  You’re taxed under Subchapter C, you’re taxed under Subchapter S, but you are a corporation under the applicable state law.

Chuck: Yes, under your state law, you don’t tell the state of Wyoming, “I’m forming an S corp.”

Chuck: No, they don’t even want to know and they don’t care.

Ed: You do that online by the way.

Ed: That’s the way things are going now. You press a button; you got a corporation.

Ed:  Or you go to Legal Zoom and you press a button and you got a corporate– It isn’t, the issue is what state you have. The issue is how is it taxed and whether you’ve created a separate taxpayer? You take advantage of that separate taxpayer with a bracket over the first 20% or 21% on everything.

Ed: That’s not a bad deal.

Chuck: No.

Ed: You use that as your incorporated “pocketbook” subject to some limitations. You can’t be greedy, can’t have too much in there. There’s a potential accumulated earnings tax.

Ed: The point is–

Chuck: Boy, you can accumulate a fair amount-

Ed: You can.

Chuck: -before you even have to worry about that.

Ed: That’s right, but the idea is borrow to live on and at the end of the year, then make your payments.

Chuck: Right.

Ed: Even make your payments, if you’re fortunate to have an IRA, make the payments from your IRA.

Chuck: Right.

Ed: Anyway, I hate to belabor the point, but I want to emphasize what I see and what I don’t see. Yet, Chuck, why is it I can’t convince the professionals to do that? Well, why?

Chuck: Well, because I think the person who cuts their hair disagrees with you.

Ed: Yes. Talk to your barber.

Chuck: Personally play golf with or whatever the case may be.

Ed: I had an interesting discussion with a client. We talked about the– How do you avoid the application of the only tax? Other than move from Illinois, there are things that you can do. I said, well, we have to do X, Y, and Z, and the whole plan. Where do you want to go with this? “Well, you know, Ed, I talked to this friend of mine, and he hauls grain and he’s got a lawyer friend, and for $2,000 he can do everything.” He said, “Well, what is it he can do?” “Oh, I don’t know, but he can do everything.” Be my guest.

Chuck: Right, deal.

Ed: Yes. Press a button, you can form a corporation.

Chuck: Right.

Ed: Go to your barber, you’ll get all the tax advice you need.

Chuck: Yea.

Ed: Just remember this. Consider the source.

Chuck: Yes.

Ed: Who’s expressing it? Is it the registered investment advisor? Is that your family doctor or dentist who are very dangerous financial people?

Chuck: Right.

Ed: The dentists and doctors. Man, they’ve got all the answers.

Chuck: Right.

Ed: Is it the professor? Is it the person that’s doing this for a living? Is it the person that has no wealth or some wealth? Consider the source.

Chuck: Right.

Ed: People don’t want to do that. They want to go to their friend.

Chuck: Oh, yes. Well, they trust their friends, and they, typically, don’t trust lawyers.

Ed: Why would anyone trust a lawyer?

Chuck: Well, I don’t know.

Ed: When I told my dad I was going to go to law school. “[Polish language],” which is that Polish says– Polish means, “What are you? Nuts?” I said, “Dad, it’s by default. I couldn’t do anything else.”

Chuck: He probably agreed with that part, right?

Ed: He said- That’s right. -“How did I possibly raise you? All you could do is this lawyer thing. There’s no one in the family that’s a lawyer.” I said, “Well, I can’t do anything else.” By default, I got into this. Why did you go to law school, Chuck?

Chuck: Why did I what?

Ed: Why did you go to law school?

Chuck: I actually was doing what people now call a gap year. There wasn’t a name for it back then, but I was wallowing around, just– I didn’t really have a career, had a job, and finally decided that, you know, I’ve seen what the world’s like with a bachelor’s degree. I had kind of started dabbling a little bit in the investment world. I’d gotten interested in that. Everything that I thought sounded interesting, questions that would come up, the answer was, well, you need to talk to a tax lawyer. This is a true story. The deeper I got into that, the more I thought, “Well, wait a minute. That’s the part I think sounds interesting about this field is all these questions where the answer is, go talk to a tax lawyer. I think I’d want to go be one of those because it sounds like they– that sounds like that would–.” Those were just the questions. I didn’t know the answers to them. I just knew that that was the training where you got those answers. Same as with my undergraduate degree. I studied math because I found it interesting to learn that.

Ed: How many how many D’s and C’s did you get in math?

Chuck: I didn’t get any D’s or C’s in math. The math classes were the only thing I did in college that I didn’t have to work very hard on.

Ed: All A’s as a matter of fact.

Chuck: I think I might have gotten a couple of B’s. I would be embarrassed to tell you the classes that I did get bad grades on because they’re the ones that most people would say those are write-off classes. I did not do well in all of those and nor were they easy for me.

Ed: Sociology wasn’t a big one.

Chuck: Yes. Like the entry-level sociology class, the entry-level psychology class. I don’t think I ended up with a bad grade, but I had to work much harder than people are supposed to have to work to get a decent grade in those classes. My very worst grade was a class called Introduction to Fiction. I got a C minus in that class. I was recently telling that story to a friend of mine who’s a professor at the same school where I got the C minus. He said, “Do you know what a C minus is?” I said, “No.” He said, “It’s a gift.” I was slow enough that he then had to explain that you actually failed the class. The teacher just gave you the gift of letting you pass with the C minus.

Ed: Sure.

Chuck: That just gives you an idea of how my brain is apparently wired. That was a write-off class for some kids. They didn’t have to even think.

Ed: I see, this may not be worth discussing, but in any event, I see some of the quants having a little difficulty with fiction and with creative concepts. That seems to be the case. It’s in the case of narrow and deep. If you’re an accountant accumulating data, you’re not paid to think out of the box. If you’re an actuary, you’re not paid to think out of the box.

Chuck: Yea.

Ed: Lawyers are, theoretically, paid to think, but I’m not sure that is always the case. The idea is this stuff that we’re talking about is largely conceptual with a grounding in math and numbers.

Chuck: Right.

Ed:  The beauty of it is everything’s– Tomorrow is different than today.

Chuck: Yes. It’s not boring work by any–

Ed: Oh, my gosh.

Chuck: It’s not repetitive by any stretch of the imagination.

Ed: You know why it’s not repetitive? Each client is different.

Chuck: Right.

Ed: Their concerns, their fears are completely different, but they’re all human beings, and they all want to succeed at what they’re doing. They want to provide, typically, for their descendants.

Chuck: It’s unique to our field. It’s not unique but it’s characteristic of our field and not all areas of law or business. Again, that goes back to what I was observing. If you’re doing investment management for somebody, that’s repetitive. That’s very rote, that’s very repetitive. It’s for that reason that as I was studying that and looking into that where the interesting stuff was the stuff that wasn’t repetitive. They were the oddball questions that came up or, wait a minute, there’s going to have to be a creative solution to this particular problem, but you need more training.

Ed: We haven’t addressed it, but part of this, I’ve always said more than a few times, it’s fear, greed, the government, and revenge is what we traffic in. Most importantly, the government. Within that broad classification are the tax litigation issues.

Chuck: Oh, yes.

Ed: The jury trial and the refund cases before a jury versus tax court. We won’t get in all that but part of it is the government is charged with the responsibility of, guess what, talking about the IRS, collecting taxes. They will use some devices that are over the top.

Chuck: Right.

Ed: You and I have experienced that. The only solution is let’s go to trial before a jury. You know what? That’s a cure-all because you can’t lie and get away with it in front of a jury.

Chuck: Right.

Ed: There’s something about that system. You can be very critical of the system, whatever. It’s the best system we have in the world.

Chuck: Yes. To paraphrase- I can’t remember who I’m paraphrasing. -but it’s the best system other than all the other ones that have been invented.

Ed: That’s right. Yes.

Chuck: It’s the worst system other than all the others that have been…

Ed: The friction costs are enormous.

Chuck: Yes.

Ed: There’s the emotional damage, the friction costs.

Chuck: The delays.

Ed: Oh, it goes on and on and on. It makes having a baby easy-

Chuck: Oh, yes.

Ed: I’m told. No, but the point is that there–

Chuck: You and I are not experts on that.

Ed: No. No, thank you. I wouldn’t do it. I think it’s a great process. I don’t a want part of it. The idea is the delay, the cost, the adversarial nature of it, and it takes a special personality to engage in tax refund activities. It’s the greatest thing since sliced bread, but it takes its toll. You can lose a lot of sleep.

Chuck: I agree.

Ed: Listen, this is a little departure and somewhat redundant from talks before, but I think it’s a good once in a while to– Good idea once in a while to summarize some of what’s going on. Everything we’ve said before remains the same. Concentration, narrow and deep, and be your own person, and read whatever you can read, and think.

Chuck: I agree with that.

Ed: Reading is a solution to all the ills of the world. Especially when you’re looking at it from the point of view of multiple authors. That’s the way this world works. Well, thanks. We’ll visit again next time on something as silly as this one. Have a good one.

Chuck: Yes.

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