Posted by lyal on September 18, 2001 at 17:21:02:
This is something my accountant has “reminded” me of. Haven’t taken it prior to this year and I don’t want to stretch my luck.
Thanks, Lyal
Retained Earnings, Unemployment Taxes and a C Corp - Posted by Ron (MD)
Posted by Ron (MD) on September 17, 2001 at 11:44:34:
My C Corp has growing retained earnings. My CPA tells me that the only way to get the money out, and avoid double taxation, is to generate current expenses (including salaries) high enough to show a net loss for the current period. In this way, I can go back up to three years to recapture the taxes related to these retained earnings.
Since my C Corp is steadily profitable, it seems that I must discontinue my rehab operations in this corp while still paying my salary and other expenses to drain out the retained earnings and, at the same time, recover the taxes that I’ve paid.
Does this sound right?
Second question relates to unemployment (or self employment) taxes. My CPA is encouraging me to convert to an S Corp (as opposed to a C Corp) for two reasons: 1.) to avoid this retained earnings problem described above and 2.) to avoid unemployment taxes. It seems to me that the reason that an S Corp avoids the retained earnings issue is that it distributes (to me) all profits in each year. This doesn’t seem very different than simply paying myself all profits in the form of a salary each period. However, he says that a C Corp salary creates 15% unemployment taxes, while S Corp distributions do not. This sounds fishy to me…it seems to me that if an S Corp avoided self employment taxes, everybody would be using them instead of C Corps. What am I missing here?
Thx.
Ron Guy
I’m probably gonna get… - Posted by David Alexander
Posted by David Alexander on September 17, 2001 at 21:44:03:
flamed and hard for a couple things I say… so listen to Hyre when it’s all said and done.
But, here goes…
First buy more things, spend more money. Lease Office space… (not home office space)C Corps do it all the time… That could even be a house… It could be a weekly rental instead of a monthly rental for corporate officers and weekly meetings.
Lease everything you can think of fax, computer, desks, etc.
Management company… Gives you more time to spend the money if you have different year ends…Be sure and check and understand the rules regarding contolled group status.
By stock in other companies and take advantage of the 70% exclusion rule on taxes from dividends.
Put everything you can in Pension Plans.
And then finally find out more about VEBA Trusts, this is what they are specifically for and have been around since 1928.
David Alexander
C-Corp/S-Corp - Posted by JHyre in Ohio
Posted by JHyre in Ohio on September 17, 2001 at 14:49:15:
?My C Corp has growing retained earnings. My CPA tells me that the only way to get the money out, and avoid double taxation, is to generate current expenses (including salaries) high enough to show a net loss for the current period. In this way, I can go back up to three years to recapture the taxes related to these retained earnings.?
Your CPA is presumably talking about generating Net Operating Losses (NOLs) now and then carrying them back to get refunds on prior taxes paid. The effect of generating such losses must be weighed against the taxable income that is created elsewhere?for example, if you pay yourself a salary, you create income in your personal bracket + possible employment taxes, but the ?carryback? generated for the corporation may end up offsetting 15% income. As a general rule, I prefer leasing things (except home office space!) to the corporation?at least that avoids the employment tax issue?the comparison then becomes a simple comparison of inside (corporate) and outside (personal) tax brackets. That comparison determines whether you should rob Peter to pay Paul.
?Since my C Corp is steadily profitable, it seems that I must discontinue my rehab operations in this corp while still paying my salary and other expenses to drain out the retained earnings and, at the same time, recover the taxes that I’ve paid.?
The problem there is a lack of business purpose. If you continue the business elsewhere and drain the corporation while it is inactive, you are tempting an auditor to reclassify salary or lease payments as dividends. Why would the corporation pay you a salary or pay to lease items if it is not conducting business? Thumbies down on draining an inactive C-corp.
?Second question relates to unemployment (or self employment) taxes. My CPA is encouraging me to convert to an S Corp (as opposed to a C Corp) for two reasons: 1.) to avoid this retained earnings problem described above and 2.) to avoid unemployment taxes. It seems to me that the reason that an S Corp avoids the retained earnings issue is that it distributes (to me) all profits in each year. This doesn’t seem very different than simply paying myself all profits in the form of a salary each period. However, he says that a C Corp salary creates 15% unemployment taxes, while S Corp distributions do not. This sounds fishy to me…it seems to me that if an S Corp avoided self employment taxes, everybody would be using them instead of C Corps. What am I missing here??
This is probably sound advice. Your C-corp appears to have reached the stage in its life where you cannot generate rational deductions to reduce its income?though be sure to try all techniques of bailing money out (salary and leases we?ve mentioned, loans to officers we haven?t). Converting to S-corp eliminates double taxation issue?but you must still pay yourself a reasonable salary (i.e.- not too LOW)- and that salary is subject to employment taxes. The S-corp can help avoid employment taxes by distributing profits to you so long as a reasonable salary (when viewed in comparison with the profits)< @ $80,000. If the company profits are so high ($250k+?) that you cannot justify a salary less than $80,000, then no employment tax savings are properly realized. For example, if the S-corp generates $120,000 in profits and you can justify a salary of $45,000, then you?ve avoided the employment taxes on @ $35,000. The reason everybody isn?t using S-corps to avoid employment taxes: Too much profit drives what a ?reasonable salary? is over the maximum threshold of @ $80,000.
By the way, the accounting for a S-corp that was once a C-corp is annoying and will add to conversion costs. Not a reason to not convert, just another factor. Overall sounds like your CPA is on the right track?but ONLY a DETAILED analysis of the numbers and opportunities to bail income from the C-corp wil yield the right answer.
I should also mention- keeping a pet C-corp is often worthwhile for the benefits unique to that entity type (medical, retirement, etc.). A small business that will never produce too much income is ideal?.like a property management C-corporation separate from the flipping business. Best of both worlds ASSUMING that the savings from C-corp perquisites are greater than the additional transaction costs (tax returns, etc.) of which I am a proud part!
John Hyre
Re: Retained Earnings, Unemployment Taxes and … - Posted by Frank Chin
Posted by Frank Chin on September 17, 2001 at 13:05:26:
Hi Ron:
I would like to know the full answer on this as well since I’ve had discussions on “C” Corp vs “S” Corp with my CPA and others including my wife who was a commerical loan officer and dealt with companies with “excess accumulation” problems.
Currently, I have an “S” Corp, but considering a “C” Corp to deal with full deductability of medical and other expenses.
According to what I’m told, on an annual basis, you should pay yourself a one time bonus to clean out the retained earnings. The “C” Corp will show zero earnings. This way, you’re taxed once, personally, on the bonus. The “C” Corp will pay no taxes.
Granted, the reason for maintaining excess cash may have to do with providng liqudidty to do rehabs, ie buying houses with cash. To accomplish this, you provide personal loans to your “C” Corp, and have the “C” Corp pay it back when the property is sold.
For instance, if the “C” Corp has earnings of 100K after paying your salary, all expenses etc., then pay yourself a 100K bonus, and pay the tax on it. Then turn around and lend what’s left, lets say, 70K back to the “C” Corp.
The whole purpose of the IRS rule is to force you to cough up the taxes. So pay the taxes. If you’re making good money doing rehabs, I see no reason why you have to stop for tax reasons.
The other way is provide a business purpose for the retained eanings accumulation. A friend of mine in the alarm business had large retained earings, for the purpose of buying other alarm companies. He claims his CPA cleared it with the IRS. I didn’t check further as it was none of my business at the time.
In your case, why not argue that you need a certain level of cash to PAY CASH for houses.
I always thought about this because Microsoft has about 30 billion in cash and no-ones complaining about its retained eanings.
At least, this is my .02.
Frank Chin
Retained Earnings, Unemployment Taxes and a C Corp - Posted by Dave T
Posted by Dave T on September 17, 2001 at 12:24:02:
Ron,
You say your accountant talked to you about the S-Corp avoiding UNEMPLOYMENT Taxes, but later refer to SELF-EMPLOYMENT taxes. I think these are two different animals.
Actually… - Posted by JHyre in Ohio
Posted by JHyre in Ohio on September 18, 2001 at 06:10:51:
these are all legitimate ideas…in fact, I caveated (as usual!) the “conversion to an S” option in my answers with ensuring that all techniques to bail income out of a C-corp are examined. The utility and cost of RATIONAL deductions should be examined…costs include paying for implementation (VEBAs are generally pretty expensive, by the way) as well as “fit”. The dividend exclusion is not that big a deal…it allows one to more efficiently invest in other C-corps than would be the case of a mere individual BUT those dividends are still trapped in a C-corp structure and begging for a way to get out…if the purpose here is to bail money OUT of the C-corp, then putting more into it is not very helpful…particularly if equivalent returns can be had by directly investing in non-corporate items. In fact, if only 70% of the dividend is excludable, comparable investments in an LLP as an individual provide better after-tax return.
So in summary, some good ideas, though VEBAs are generally pretty expensive and the corporate dividend deduction is overrated. You didn’t expect me to agree with EVERYTHING, now, did you?
John Hyre
Re: C-Corp/S-Corp - Excellent Response! - Posted by Kev (NC)
Posted by Kev (NC) on September 17, 2001 at 17:51:45:
Right on the money John! In addition to the benefits you mentioned, it’s also worth mentioning that a C-Corp is a nice little tool for accumulating cash at a lower tax rate and keeping income off of your personal return.
For example: if a person is earning around $200k from all activities they are probably sitting in the 36% federal tax bracket. They are also losing the benefits of passive activity losses, certain tax credits and have hefty itemized deduction phaseouts. If they shift $50k to a C-corp (with a business purpose), that income is subject to a 15% tax rate ($10k tax savings) plus they get to realize the benefits of PALs and certain tax credits if they can lower their personal AGI below $150k. My clients love that one!
Kevin
Re: C-Corp/S-Corp - So the conclusion is … - Posted by Frank Chin
Posted by Frank Chin on September 17, 2001 at 15:28:49:
Hi John:
Good analysis. Its an issue that was never that clear to me.
What you’re saying is the Short Term “excess accumulation” problem can only be handled via conversion to an “S” Corp.
Then, for the long term, the conclusion is to have a “C” Corp (Ron Corp #1)do enough business to soak up enough salary, medical, auto, 401K etc expenses.
Then do more business through “S” Corp (Ron Corp #2) to flow the excess profits to avoid excess accumulation?
Or, another way is to have Ron Corp #1 employ Ron Corp #2 in some capacity and split the earnings through some intercompany pricing scheme. For example, Ron Corp #1 does wholesale flipping to Ron Corp #2 that does Rehabs.
With all that, you’ll need a CIO to get it straight.
Did I get it right?
Frank Chin
Re: Retained Earnings, Unemployment Taxes and … - Posted by JHyre in Ohio
Posted by JHyre in Ohio on September 17, 2001 at 15:03:06:
Matt: I only addressed the stuff not already discussed in my answer to Ron:
?For instance, if the “C” Corp has earnings of 100K after paying your salary, all expenses etc., then pay yourself a 100K bonus, and pay the tax on it. Then turn around and lend what’s left, lets say, 70K back to the “C” Corp. ?
Works if you?re never caught. If an agent sees the pattern, the ?bonus payments? will be properly disallowed as a sham. You CAN make bonus payments that are ?reasonable??whatever that is. But if the payments conveniently follow the amount of profit in the corporation, you?re asking to have them reclassified as dividends- retroactively, with penalty and interest.
?The other way is provide a business purpose for the retained eanings accumulation. A friend of mine in the alarm business had large retained earings, for the purpose of buying other alarm companies. He claims his CPA cleared it with the IRS. I didn’t check further as it was none of my business at the time. ?
That gets you around the corporate accumulated earnings tax?but all of the acquired businesses remain in corporate solution?possibly aggrevating the problems above, unless friend sells stock at capital gains rates?though many buyers will discount the price based on the tax ?built-in? to the corporate structure. Basically, Ron is focused on the problem of imminent double taxation because he wants to distribute cash, while you are focused on the taxation of accumulated earnings that you do not necessarily want to distribute?related, but not identical problems. Ron?s problem is harder to get around and probably calls for conversion to S-corp if techniques to bail money out of C-corp without 2x tax have been exhausted. Your problem is easy, as you?ve suggested- just buy more things?.though that only defers the eventual reckoning.
John Hyre
Why the caution… - Posted by lyal
Posted by lyal on September 18, 2001 at 06:24:31:
against leasing home office space?? This is a technique that Bronchick promotes instead of the home office deduction.
Thanks, Lyal
Re: C-Corp/S-Corp - Excellent Response! - Posted by Kent C
Posted by Kent C on January 27, 2002 at 04:51:24:
Kevin,
If I leave money in a C-Corp from one year to another, is it taxed again the next year? Or is that amount excluded from the 15% hit the next year?
Re: C-Corp/S-Corp - So the conclusion is … - Posted by JHyre in Ohio
Posted by JHyre in Ohio on September 17, 2001 at 16:22:14:
Yep, sounds like you got it over all. Solution to excess earnings that you do not wish to distribute = spend more, buy things, at least in the near term. Solution if you want to distribute more than reasonably possible via loans, salaries, etc. = conversion to S-corp.
With high income levels, use S-corp for bulk of earnings because one can no longer generate rational tax deductions/bail-out strategies to avoid 2x tax in C-corp. Have a C-corp to (essentially) siphon earnings from S-corp for certain perks…even better, do some C-corp business with third parties so “related party” aspect doesn’t smell bad.
Of course, these determinations are intensly fact sensitive…and we’re only talking general principles here. How’s that for CYA?
John Hyre
Re: Why the caution… - Posted by JHyre in Ohio
Posted by JHyre in Ohio on September 18, 2001 at 06:33:53:
You lose the home office deduction when you lease to your employer…which is what the C-corp is. Granted, some may prefer to lose the personal deduction and take the deduction at the corporate level, but then the lease payments hit your individual return. So is it better to get an individual deduction or a corporate deduction AND offsetting income to the individual? Generally, the first option strikes me as more favorable.
John Hyre
Re: Why the caution… - Posted by lyal
Posted by lyal on September 18, 2001 at 07:53:24:
I have an S Corp so I guess this would really be a moot point.
Thanks, Lyal
Not necessarily… - Posted by JHyre in Ohio
Posted by JHyre in Ohio on September 18, 2001 at 10:26:00:
moot. S-corp should also be employing you…no salary or unreasonably low salary is an audit issue with S-Corps. So if it’s not your employer, it should be!
John Hyre