Tax Strategies You Can Grow Into Based On Your Long-Term Goals, Part One

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Employee Stock Ownership Plans (ESOPs) can offer lucrative tax benefits for your business – as well as contribute to a smart exit strategy

Watching your business grow is rewarding, but it can also be daunting when higher revenue leads to a bigger tax bite from Uncle Sam. Understanding how taxes impact your business and your long-term goals will help you evolve from ad hoc tax compliance to a carefully considered tax strategy that can drive the success of your company.

In this installment of our series on long-term tax strategies, we explore how Employee Stock Ownership Plans (ESOPs) can help proactive owners reap tax benefits as their businesses expand into new lifecycles. ESOPs emerged relatively unscathed from the new Tax Cuts and Jobs Act of 2017, and an experienced certified public accountant can help you incorporate them into a thoughtful, long-term tax plan – one that evolves as your business does.

What is an ESOP?

It usually goes something like this: A majority partner wants to retire, but the remaining partners can’t afford to buy him or her out – or maybe they also are ready to enjoy their golden years. Employees get their resumés together as rumors abound that the company will be sold to a competitor. Other interested parties – important customers, suppliers, lenders – start to ask pointed questions about the owners’ succession plan.

More and more owners are turning to ESOPs as a solution. Created by the Employee Retirement Income Security Act of 1974, ESOPs have evolved into a powerful exit planning option for business owners – with major tax benefits.

An ESOP is a tax-qualified defined contribution employee benefits program that primarily invests in the stock of the company that sponsors the plan. Put simply, it’s a tax-exempt trust that gives employees a chance to reap rewards from an increase in the value of their company.

ESOPs are “qualified” because the sponsoring company, the selling shareholder, and any participants receive various tax benefits. They are almost always a contribution to the employee and not an employee purchase.

ESOPs are most commonly used to provide a market for the shares of departing owners of successful, closely-held companies. They are also a strategic way to motivate and reward employees and can be used to enhance the viability of growth transactions by making debt repayments fully deductible. They are different from most benefit plans in their ability to borrow money.

The National Center for Employee Ownership estimates that more than 6,600 ESOPs currently exist, covering 14 million people.

Biggest tax benefits

  • Stock contributions are tax-deductible. Companies can get a current cash flow advantage by issuing new shares or treasury shares to the ESOP. Just be sure to think this action through carefully: It dilutes existing owners.
  • Ditto for cash contributions. A company can contribute cash to an ESOP on a discretionary basis and claim a tax deduction for it, whether the contribution is used to buy shares from current owners or build a cash reserve for future use.
  • Contributions used to repay a loan by ESOP – used to buy company shares – are tax-deductible. The plan can borrow money to purchase new, current, or treasury shares. No matter the use, raising or changing the balance of equity is done in pretax dollars.
  • Pre-tax dollars can be used to support acquisitions and expansions. Instead of repaying loans or equity investments that were part of a growth strategy with after-tax dollars, a company can sell stock to the ESOP on terms that mirror the required payments. Within applicable limits, this effectively lets the company making the payments with pre-tax dollars.
  • Along those lines …Reasonable dividends used to repay an ESOP loan – passed through to employees or reinvested by employees in company stock – are tax-deductible.
  • Sellers in a C corporation are eligible for a tax deferral. Once an ESOP owns 30 percent of all the shares in a C corporation, the seller can reinvest the proceeds of the sale in other securities and defer any tax on the gain.
  • In S corporations, the percentage of ownership held by the ESOP is not subject to federal income tax (and often state tax). If an ESOP holds 20 percent of the stock, there is no tax on 20 percent of the profits.
  • Employees pay no tax on contributions to the ESOP– only the distribution of their accounts, which are generally done at more favorable rates. Employees can roll over their distributions in an IRA or other retirement plans – or pay current tax on the distribution – with any gains accumulated over time taxed as capital gains.

A few caveats

  • The 2017 tax bill states that net interest deductions for businesses are capped at 30 percent of EBITDA (earnings before interest, taxes, depreciation, and amortization) for four years. From that point onward, the cap lowers to 30 percent of EBIT.
    Companies that leverage their ESOPs to borrow an amount that is large relative to their EBITDA could find that their deductible expenses become lower – while their taxable income becomes higher.
  • ESOPs can’t be used in partnerships and most professional service corporations.
  • Private companies must repurchase shares of departing employees, which can become a major expense.
  • ESOPs can be expensive to set up; a qualified CPA can help you weigh the costs against the tax, employee motivation, and exit plan benefits they provide.

ESOPs can serve as a lucrative option for companies searching for tax strategies that can grow with their company. They are not, however, for everyone, and an experienced CPA can help determine if they are the right strategy for your business. When properly structured, ESOPs can be valuable assets that contribute to a company’s competitiveness and long-term success.

Of course, ESOPs are not the only long-term strategy that can offer lucrative tax benefits to your company. Watch for additional installments of our series, where we show how captive insurance programs can be a wise choice for certain businesses.

Provident CPA & Business Advisors serves successful professionals, entrepreneurs, and investors who want to get more out of their business and work less, so they can make a positive impact in their lives and communities. Typically, our clients reduce their taxes by 20 percent or more and create tax-free wealth for life. Contact us for expert advice on long-term tax strategies, and to find out how we can help your business exceed your expectations.

Surprising Tax Deductions: Understanding the “Augusta Rule”

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Why you may not have to pay taxes on rental income

In the mid-70s, Section 280A of the U.S. tax code was enacted. Among other things, this allowed people to rent their homes for a certain amount of time and not have to pay taxes on this income.

Since Congress was spurred on in part by taxpayers from Augusta, Georgia, this rule is often known as the Augusta Rule. Because renting out a home during the Masters Tournament can be extremely lucrative, this is also sometimes referred to as the Masters Rule.

How the Augusta Rule works

This rule only applies to a home that isn’t a full-time rental property. In order to benefit, your home can only be rented for up to 14 days per year. And there is no exception to that: If you rent it for 15 days, all of the income you make has to be reported to the government. However, those 14 days do not have to be consecutive.

It doesn’t matter how much you make

Regardless of how much rental income you bring in, as long as you stick to the 14-day cutoff, it is all tax-free. While you may not live in Augusta, it is possible your city will host a big event, such as the Super Bowl, a music festival, or maybe even the Olympics. And whether you rent your home for $100 a day or $1,000, you will not have to worry about taking a tax hit on this income.

You can also rent your home to your business

In addition to renting to individual people, you can also rent your home to your business to claim the same tax benefit.

In order to do this, you need to show how your home is being used for business purposes – such as for meetings or events – and document everything, including who attended and what was discussed. You also need to demonstrate that the rent you charge is reasonable, which is why you should get rate quotes from hotels, locally-rented homes, and other similar venues.

For example, let’s say you want to plan a three-day business retreat for your employees. You do some research and find out that hotels in your area will charge you an average of $2,000 for that duration. If you use your home instead, all you need to do is have your company write you a check for that amount, in addition to compiling the supporting documentation. It can then go right into your personal account.

Even more tax deductions

On top of not having to pay taxes on rental income, you can also take standard deductions on property taxes and mortgage interest. You can’t, however, deduct individual expenses that resulted from the rental, such as utilities.

The taxes that may apply

While you won’t have to add this rental revenue to your yearly income, you may have to pay other taxes. For rentals that are considered short-term – usually a month or shorter – you might have to pay state or local lodging taxes.

These are often calculated using a percentage of what was earned from the rental. It is always a wise idea to learn about your local laws and how they could affect you.

Provident CPA & Business Advisors serves successful professionals, entrepreneurs, and investors who want to get more out of their business and work less, so they can make a positive impact in their lives and communities. Typically, our clients reduce their taxes by 20 percent or more and create tax-free wealth for life. Contact us for expert advice on the new tax code, and to find out how we can help your business exceed your expectations.

The Elements of Realizing Your Company’s Vision

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Successful organizations have a vision and the explicitly-defined goals and processes to achieve it

Growth by chance is a possibility, but do you want to bet on it? Growth through purposeful planning is a smarter choice, and there’s an approach that offers actionable steps which create a roadmap to business success.

The most successful organizations have a strong vision and fully define the steps to execute it. They have distinct organizational clarity. Leadership roles and benchmarks are set and accountability is increased. There’s much greater visibility into and control over business drivers. It’s a complete definition of an organization that enables it to gain traction.

We help our clients reach this growth state by working with them to use our Vision/Traction Organizer™.

Everything starts with a vision

You’re planning a future state, and every part of your organization has to understand it. It starts with determining the vision.

Developing a vision and the processes to achieve it involves identifying who you are as an organization; outlining why you do what you do – and what it is exactly what you do; figuring out where you are going in 10 years, 3 years, and 1 year; defining who your clients are; and designating everyone’s role in the organization.

Five questions to accomplish the vision

A great vision answers five questions which define your business and create traction:

  1. What are your company’s core values? These define your people and what drives them. They describe what you care about and what you value. Together, the core values you select should help explain who you are as an organization.
  2. What is your core focus? This is where you’ll describe your purpose, cause, or passion. It’s the one thing your organization truly excels at doing. This is not meant to be a general overview. What’s your niche? You’ll make all of your essential decisions based on this core focus. A core focus is where the why meets the what.
  3. What is your 10-year target? If you maintain your focus, what is the state that you’ll achieve in 10 years? Your answer should be clear and ambitious. In Built to Last: Successful Habits of Visionary Companies, Jim Collins and Jerry Porras called this the BHAG (Big Hairy Audacious Goal).
    An example could be as detailed as “Achieve revenues of $50 million, serve 2,000 clients, serve every state touching yours with remote offices, build out to a staff of 200 with employee stock options at 49%, achieve a net profit of 30%, and become debt free.” But a great target can also be as simple as “have 90% of market share” or Nike’s legendary (and possibly apocryphal) founding mission: “Crush Adidas.”
  4. What’s your marketing strategy? You’ve determined where you plan to be in 10 years. What are the marketing and sales efforts that get you there?
    This question should push you to describe your target market and message in detail. Define the demographic, geographic, and psychographic elements of your audience, as well as your three unique selling propositions (USPs).
  5. What is your three-year picture? This is a snapshot of the future three years from now, looking at revenue, profit and five to 15 metrics of what the business looks like.

Three traction questions

Answering these shorter-term questions helps you assess the sustainability of your business and whether you are definitively making progress toward your longer-term goals:

  1. What’s your one-year picture? You’ve locked in the targets you want to hit in 10 years, and then you brought the picture closer by looking at a three-year snapshot. This question specifically examines what must be done in the next 12 months to be on track to meet the three-year picture.These goals will include revenue, profit, and client numbers, and may include things like client retention rate, the number of employee and the nature of their benefits programs, and your measurable status within the industry. Don’t forget how much time you spend on the business vs. the time you have for your family and personal life.
  2. What are your “rocks”?These are your highest priorities that must be accomplished within the next 90 days to move your organization closer to nail the goals you established for your one-year picture. Rocks also depend on defining the individual roles and responsibilities to achieve them.
  3. What are your remaining issues? These are the challenges that you’ll resolve along the way to your targets.

Legendary management consultant Peter Drucker famously said that “you can’t manage what you can’t measure.” With a well-defined Vision/Traction Organizer, you can define your company’s vision and closely track the metrics that are essential to its success.

Discover how we can help you strategically grow your business.

Explaining Tax Reform: The Section 199A Business Deduction

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The new law creates the most significant tax break for small business owners in decades

The Tax Cuts and Jobs Act is the nation’s first major tax overhaul in 30 years – and introduces a completely new concept to the Internal Revenue Code. For the first time, IRC Section 199A allows individual taxpayers (other than corporations) a deduction of 20 percent of qualified business income earned in a qualified trade or business.

The deduction – known as the Qualified Business Income deduction – stands as a significant tax break for small business owners – within rules and limitations, of course.

The rules for calculating the deduction can be quite complicated; its generosity depends on many factors, including the nature of the business activity, the business owner’s total taxable income, the wages paid by the business, and the value of the business property.

An experienced certified public accountant is best suited to help you maximize this tricky but beneficial deduction for your business, which is on the books through the end of 2025. Here’s an overview to help you understand the basics.

Who qualifies for the pass-through deduction?

The IRS and many states tax the business profits or losses that “pass through” to the business owner, who pays personal income tax on the earnings at an individual tax rate.

Businesses that qualify for the deduction include:

  • Sole proprietorships
  • S corporations
  • LLCs
  • LLPs
  • Trusts and estates that own an interest in a pass-through business

Most small businesses are pass-through entities. In fact, more than 86 percent of businesses with employees are sole proprietorships.

Are there any businesses that don’t qualify?

A qualified business is defined as any trade or business other than a high-income specified service business, or a trade or a business that performs services as an employee. Individuals who own those types of companies can only claim the deduction if their annual income falls below $315,000 for married couples and $157,500 for single people.

That’s because the bill is meant to provide a break on capital income, which comes from assets that accrue value over time, instead of labor income, which is generated by workers.

A specified service business is any business in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing, investment management, trading or dealing in securities, partnership interests or commodities, or any trade or business where the principal asset is the reputation or skill of one or more of its owners or employees. Excluded from this definition are architectural and engineering services.

Regular C corporations also do not qualify for this deduction – but the new tax code entitles them to a low 21 percent corporate tax rate.

What is the pass-through tax deduction?

Put simply, the pass-through deduction allows qualifying business owners to deduct up to 20 percent of qualifying business income (QBI) from each pass-through business they own. The deduction is calculated per business, not per taxpayer.

It applies to net income – business income minus expenses – and includes self-employment earnings and money received from qualified rental properties, publicly traded partnerships, real estate investment trusts, and qualified cooperatives.

QBI does not include capital gain or loss (short or long-term), dividend income, interest income, wages paid to S corporation shareholders or that you earn as an employee, guaranteed payments to partners or LLC members, or money earned outside the U.S.

Now read this carefully: QBI is calculated separately for each business you own. If any of your businesses lose money, you deduct the loss from the QBI of your profitable businesses. If you have a qualified business loss – that is, your net QBI is zero or less – you get no pass-through deduction for the year. And, as a penalty for having a money-losing business, the loss is carried forward and deducted from the next year’s QBI, too.

Confused?

Let’s say you have $100,000 in business revenue and $20,000 in business expenses in 2018. Your QBI is $80,000 and you may be able to claim a pass-through deduction worth up to $16,000. But if you have another pass-through business that lost $90,000 in the same year – you wind up with a $10,000 QBI loss. This means no 20% deduction and the $10,000 loss must be carried forward and deducted from your QBI in 2019.

How do I know how much of a deduction I’m entitled to?

  • If your taxable income is below $315,000 for married filing jointly, or $157,500 for singles, you are entitled to the maximum 20 percent pass-through deduction based on your QBI.
  • If your taxable income exceeds $415,000 for married filing jointly or $207,500 for singles and your business does not qualify as a service provider, you are still entitled to the maximum 20 percent deduction. However, a W-2 wage/business property limitation also kicks in, and your deduction is limited to the greater of:
    –  50 percent of your share W-2 employee wages paid by the business, or
    –   25 percent of W-2 wages plus 2.5 percent of the acquisition cost of your depreciable business property
    Basically, this means if you don’t have employees or depreciable property, you won’t get any deduction. This is intended to encourage pass-through owners to hire employees and buy property for their business.
  • If your taxable income falls between $315,000 and $415,000 for married filing jointly, or $157,500 and $207,500 for singles, the W-2 wages/property limitation is phased in – meaning only part of your deduction is subject to the limit and the rest is based on 20 percent of your QBI.
  • If your taxable income exceeds $315,000 for marrieds and $157,500 for singles, and your business does qualify as a service provider, the pass-through deduction is gradually phased out. If your income reaches or exceeds $415,000 for marrieds and $157,500 for singles, you don’t get any deduction at all.This cap was intended to prevent highly-compensated employees who provide personal services (like lawyers) from asking companies to change them to independent contractors so they can use the pass-through deduction.

What are some legal ways to maximize my deduction?

  • Become an independent contractor instead of an employee. Such a move could offer substantial tax savings thanks to the QBI deduction. Just be sure to adjust for other employee benefits you may be receiving that will no longer be available if you make the change, such as employer-paid health insurance or matching retirement plan contributions.
  • Hire employees for your business. Non-service businesses over the $315,000/$157,500 limit could potentially increase their deductions by hiring or paying employees more due to the 50 percent of wages rule.
  • Funnel income to another business you own. If you have too much income to take advantage of the pass-through deduction, you can funnel some of your income to a C corporation or an LLC you also own that provides a service. For example, your S corp can pay your C corp to provide a consulting service, and every dollar the S corp spends counts as an expense and reduces its taxable income.
  • Take advantage of other deductions. If your taxable income is close to the limitations, consider utilizing deductions that can reduce your adjusted gross income, such as contributing to a tax-deferred retirement account or contributing to a charity.
  • Restructure your sole proprietorship as an S corporation. If your business doesn’t qualify for the pass-through deduction due to too much income and a lack of wages or depreciable property, a switch to the S corp may produce the tax savings you want by enabling you to pay yourself a reasonable salary.
  • Pay yourself more. If you’re a non-service business S corporation, and your deduction is limited by the wages you’re paying yourself, consider paying yourself more. The downside is that you will also have to pay more Medicare tax, but the lower tax bill may be worth it.

The new tax law provides the best small business tax break in decades – if you know how to take advantage of it. An experienced certified public accountant can help you navigate the complex regulations and create concrete strategies that maximize its benefit for your business.

Provident CPA & Business Advisors serves successful professionals, entrepreneurs, and investors who want to get more out of their business and work less, so they can make a positive impact in their lives and communities. Typically, our clients reduce their taxes by 20 percent or more and create tax-free wealth for life. Contact us for expert advice on the new tax code, and to find out how we can help your business exceed your expectations.