Now that the election is over, it looks like the expiring Bush tax cuts will indeed expire. There is a little time left before the December 31 expiration date. Taking the right steps now can result in some real tax savings.
The tax rate on long-term capital gains will increase from 15% to 20%, plus if your joint income is over $250,000, the gain and all other investment income will be subject to an additional 3.8% Medicare tax. What does this mean? If you have a $100,000 long-term capital gain, you will pay $8,800 of additional tax if you wait until 2013 to realize the gain. Take a close look at your portfolio, and if there are any investments with gains that you are considering selling in the near future, sell them before the end of this year. It will save you a lot of tax. On the other hand, if you have any losses, you may consider delaying the sale of those investments until 2013, when the loss will save you greater tax dollars.
The tax rate on qualified dividends, currently 15%, will increase to your ordinary income tax rate, which can be as high as 43.4% (39.6% regular + 3.8% Medicare). If you have dividend income, you should consider rearranging your portfolio to investments that do not generate taxable investment income, such as tax exempt municipals, variable annuities, growth stocks, or life insurance.
The $5.12 million estate and gift tax exemption will drop to $1.0 million after December 31. This is a great opportunity to transfer wealth free of federal estate or gift tax, and for states that have no gift tax, completely free of state transfer taxes. Stocks and bonds, real estate, cash, and closely held business interests are assets that many people have transferred. Another use of this exemption is the purchase of life insurance, which will generate future tax free benefits far in excess of the premium paid.
In addition to the Medicare related taxes, ordinary income tax rates will increase across the board. The current 35% rate is scheduled to increase to 39.6%, which represents a 13.1% increase. If you have any control over the receipt of ordinary income, you will be wise to consider accelerating as much as possible into 2012. This will save a lot of tax.
There are many other provisions ffecting both individuals and businesses. Each individual's situation is unique and no advice is applicable to everyone. Please contact me if you have any questions on how the changes will affect you.
November 20, 2012
August 26, 2012
A Call for Transparency in Health Care Pricing
A couple of months ago, my son was in a bicycle accident. Fortunately, he was not seriously injured, but he did need several MRI's for which we received a hospital bill for $3,000. My wife called the hospital to provide our health insurance information and was told, "Oh, we didn't know that you have insurance. Our insurance company rate for your son's MRI's is $6,000." Since we have a high deductible insurance plan, and do not expect to meet the deductible this year, my wife told the hospital to disregard the insurance and that we would pay the $3,000 charge. The hospital told her that would be a mistake on our part, because in the end, we would only have to pay the amount approved by the insurance company, which might wind up being around $1,200.
One of the major problems with health care is that no one ever knows or understands the costs. When a health care service is provided, the consumer does not have the slightest idea what the charges will be, but the provider has no idea either! In our case, there are at least three different prices for the same diagnostic service, and there may be many more, depending on which insurance company covers the patient. I don't see how the service changed, as it has already been provided. This is the craziest system I have ever heard of, and is bad for all participants. Not only do patients have no idea of the cost of care, providers have no idea of how much they will receive for their services.
Health care is the only industry I can think of that has this type pricing structure. And to make matters worse, the pricing is kept secret. No one ever understands the charges. Why can't physicians, hospitals, and laboratories establish and make public fixed pricing for fixed services, and have the same pricing for all patients, regardless of if they are insured or who they are insured by? As far as I know, a blood test is a blood test and an X-ray is an X-ray. A little competition is healthy. If people can save by price shopping for health care services, everyone will benefit. Not everyone will use the lowest cost provider, but at least they will have the information to make an informed decision. Health care costs are out of control because there is no price competition. Imagine what would happen to those costs if consumers knew in advance what they were.
One of the major problems with health care is that no one ever knows or understands the costs. When a health care service is provided, the consumer does not have the slightest idea what the charges will be, but the provider has no idea either! In our case, there are at least three different prices for the same diagnostic service, and there may be many more, depending on which insurance company covers the patient. I don't see how the service changed, as it has already been provided. This is the craziest system I have ever heard of, and is bad for all participants. Not only do patients have no idea of the cost of care, providers have no idea of how much they will receive for their services.
Health care is the only industry I can think of that has this type pricing structure. And to make matters worse, the pricing is kept secret. No one ever understands the charges. Why can't physicians, hospitals, and laboratories establish and make public fixed pricing for fixed services, and have the same pricing for all patients, regardless of if they are insured or who they are insured by? As far as I know, a blood test is a blood test and an X-ray is an X-ray. A little competition is healthy. If people can save by price shopping for health care services, everyone will benefit. Not everyone will use the lowest cost provider, but at least they will have the information to make an informed decision. Health care costs are out of control because there is no price competition. Imagine what would happen to those costs if consumers knew in advance what they were.
August 12, 2012
The System Doesn't Work After All
In June and August 2011 I wrote about attending a dinner and meeting New Jersey Assemblyman Jon Bramnick. I told Assemblyman Bramnick about a problem one of my clients was having with a particularly unfair provision in the New Jersey Unemployment Law. In a situation in which a business engages another business to perform a service, and the hired business does not properly pay its New Jersey Unemployment Tax liability, the first business can be held responsible for the unpaid unemployment tax. For example, if you own an office building and hire a landscaping company to take care of the the grounds, and the landscaping company does not pay its NJ Unemployment Tax, you can be held liable to for the tax. In my client's case, it was a transportation company that did not pay the tax on their drivers' wages.
Anyway, I described this situation to Assemblyman Bramnick, who agreed with me and proceeded to stand up at the dinner and announce to all that he would be introducing a bill to repeal this unfair provision. A proposed bill was actually written and sent to me so that I could offer my opinion about whether the bill actually accomplished the purpose we discussed. It did.
Several months went by and I heard nothing else regarding this matter, so I sent an email to the Assemblyman's office to inquire of its status. The response was that the Unemployment Division had a problem with the bill. What a surprise! An objection to their ability to arbitrarily and unfairly assess tax! I guess the system doesn't work after all, and it is clear that Assemblyman Bramnick's office follows the first rule of Fight Club.
Tomorrow I am taking my daughter to start her freshman year at Indiana University. I am going to miss her a lot. I know that she doesn't read this, but I have always been very proud of her, and I know that she will continue to make me proud. I hope that the next eighteen years don't go by as quickly as the last eighteen.
Any comments on this or anything else, contact me at GShanker@krscpas.com. I would like to hear from you.
I took this picture at Kips Castle in Verona, NJ. It's a pretty cool place. If you click on the picture, you will get a larger version.
Anyway, I described this situation to Assemblyman Bramnick, who agreed with me and proceeded to stand up at the dinner and announce to all that he would be introducing a bill to repeal this unfair provision. A proposed bill was actually written and sent to me so that I could offer my opinion about whether the bill actually accomplished the purpose we discussed. It did.
Several months went by and I heard nothing else regarding this matter, so I sent an email to the Assemblyman's office to inquire of its status. The response was that the Unemployment Division had a problem with the bill. What a surprise! An objection to their ability to arbitrarily and unfairly assess tax! I guess the system doesn't work after all, and it is clear that Assemblyman Bramnick's office follows the first rule of Fight Club.
Any comments on this or anything else, contact me at GShanker@krscpas.com. I would like to hear from you.
I took this picture at Kips Castle in Verona, NJ. It's a pretty cool place. If you click on the picture, you will get a larger version.
August 2, 2012
Why Tax the Wealthy is Unfair to Business Owners
I have received strong positive and negative feedback on my blog entries regarding increasing tax rates on the "wealthy." After seeing these reactions, I understand why our Congress is unable to reach agreement on this issue. Based the feedback, it appears that business owners have the strongest objection to proposed tax increase.
Although I have many problems with increasing taxes, my biggest one is subjecting business owners to higher tax rates on income that they never receive. Since a significant 1987 tax law change concerning the tax on the sale or dissolution of a business, it has made sense for most closely held businesses to operate as a flow through entity for tax purposes. Flow through entities are S corporations, partnerships, and limited liability companies. In these entities, the business generally pays no federal income tax. The taxable income of the business is passed through to the owners for inclusion on their personal income tax returns. In this framework, the business owners are taxed on all company income, whether or not such income is actually received by the owner. In a growing business, it is common that business profits are reinvested in the business, in order to fund the growth. To the extent the profits are reinvested, they are not received by the business owner, although he (or she) is responsible for paying tax on this phantom income. My concern is that although it is not received by the business owner, this income will put him in the wealthy 2% category and subject him to higher tax rates.
Where will the money to pay the increased taxes come from? It is likely that it will come from the business. And if this money is used to pay taxes, it cannot be used to hire employees or be reinvested for business expansion. What is the solution to this problem? My proposal is that in determining who is a wealthy taxpayer, the only business income that should be considered is the income that was actually received by the business owner. Income that is reinvested in the business should be disregarded for the purpose of calculating the tax rates.
Unfortunately, the very few of the politicians who determine who and how much tax tax have ever faced the challenges of running a business. That is why this issue has never even been discussed.
Although I have many problems with increasing taxes, my biggest one is subjecting business owners to higher tax rates on income that they never receive. Since a significant 1987 tax law change concerning the tax on the sale or dissolution of a business, it has made sense for most closely held businesses to operate as a flow through entity for tax purposes. Flow through entities are S corporations, partnerships, and limited liability companies. In these entities, the business generally pays no federal income tax. The taxable income of the business is passed through to the owners for inclusion on their personal income tax returns. In this framework, the business owners are taxed on all company income, whether or not such income is actually received by the owner. In a growing business, it is common that business profits are reinvested in the business, in order to fund the growth. To the extent the profits are reinvested, they are not received by the business owner, although he (or she) is responsible for paying tax on this phantom income. My concern is that although it is not received by the business owner, this income will put him in the wealthy 2% category and subject him to higher tax rates.
Where will the money to pay the increased taxes come from? It is likely that it will come from the business. And if this money is used to pay taxes, it cannot be used to hire employees or be reinvested for business expansion. What is the solution to this problem? My proposal is that in determining who is a wealthy taxpayer, the only business income that should be considered is the income that was actually received by the business owner. Income that is reinvested in the business should be disregarded for the purpose of calculating the tax rates.
Unfortunately, the very few of the politicians who determine who and how much tax tax have ever faced the challenges of running a business. That is why this issue has never even been discussed.
July 28, 2012
This and That
Some stuff to think about:
A great estate planning opportunity expires on December 31, 2012. Time is growing short, but if you can get it done before that date, you can transfer $5 million, completely free of federal estate or gift tax. A bit of planning is involved, so this is not something that can be done overnight. If you want to take advantage, contact your CPA or estate planning attorney immediately. Even if you decide to do nothing, it is a good idea to review your estate plan every few years.
If you don't have a buy-sell agreement, or if you have one and have not reviewed it for a few years, now is the time. Do you even know what your buy-sell agreement says? When you review it and have to decide if it is fair, ask yourself if you would rather be a buyer or a seller. The fact is, you don't know which you will be, so it should be fair to all parties. Maybe you can even kill two birds with one stone, that is, do your estate planning in conjunction with your buy-sell agreement, and think about using the $5 million exemption to gift some business ownership to the next generation.
For those of you who are "too busy to do planning," you are planning, except your plan is to pay a ton more estate tax than you have to, and to let a judge decide how much your or your partners' business interests are worth. That is definitely a plan, but probably not a good one.
The IRS is getting a lot more aggressive in assessing penalties, and I mean serious penalties like the accuracy related penalty. We see these assessments more frequently, and they often appear to be arbitrarily based on the IRS' perception of the amount of tax underpayment, whether or not it is correct. Whether you are a business or individual taxpayer, it is important that you are able to support your tax return income and deductions with documentation. If you need help getting organized, call us. We can help you.
In case nobody noticed, states need more money. They get more money by collecting more tax. They are on the lookout for businesses that operate in a state and don't pay taxes to that state. If you enter a foreign state to make a delivery, a service call, provide customer training, or do practically anything else, your business is subject to tax in that state. If you don't file tax returns and get caught later, it will be really ugly. And the thing is, if you do it correctly you will not pay tax on the same income twice, but if you don't file and get caught later, you will, plus a lot of penalties and interest. If you have questions about this, call us.
My daughter is leaving for college in two weeks. After 18 years, this is really scary (for me). I'm happy that she is doing well and has a great future, but I am going to miss her a lot.
I enjoy photography, and will include pictures from time to time. I took this one in Grover Cleveland Park in Caldwell, NJ. Click on it to view a larger version.
A great estate planning opportunity expires on December 31, 2012. Time is growing short, but if you can get it done before that date, you can transfer $5 million, completely free of federal estate or gift tax. A bit of planning is involved, so this is not something that can be done overnight. If you want to take advantage, contact your CPA or estate planning attorney immediately. Even if you decide to do nothing, it is a good idea to review your estate plan every few years.
If you don't have a buy-sell agreement, or if you have one and have not reviewed it for a few years, now is the time. Do you even know what your buy-sell agreement says? When you review it and have to decide if it is fair, ask yourself if you would rather be a buyer or a seller. The fact is, you don't know which you will be, so it should be fair to all parties. Maybe you can even kill two birds with one stone, that is, do your estate planning in conjunction with your buy-sell agreement, and think about using the $5 million exemption to gift some business ownership to the next generation.
For those of you who are "too busy to do planning," you are planning, except your plan is to pay a ton more estate tax than you have to, and to let a judge decide how much your or your partners' business interests are worth. That is definitely a plan, but probably not a good one.
The IRS is getting a lot more aggressive in assessing penalties, and I mean serious penalties like the accuracy related penalty. We see these assessments more frequently, and they often appear to be arbitrarily based on the IRS' perception of the amount of tax underpayment, whether or not it is correct. Whether you are a business or individual taxpayer, it is important that you are able to support your tax return income and deductions with documentation. If you need help getting organized, call us. We can help you.
In case nobody noticed, states need more money. They get more money by collecting more tax. They are on the lookout for businesses that operate in a state and don't pay taxes to that state. If you enter a foreign state to make a delivery, a service call, provide customer training, or do practically anything else, your business is subject to tax in that state. If you don't file tax returns and get caught later, it will be really ugly. And the thing is, if you do it correctly you will not pay tax on the same income twice, but if you don't file and get caught later, you will, plus a lot of penalties and interest. If you have questions about this, call us.
My daughter is leaving for college in two weeks. After 18 years, this is really scary (for me). I'm happy that she is doing well and has a great future, but I am going to miss her a lot.
I enjoy photography, and will include pictures from time to time. I took this one in Grover Cleveland Park in Caldwell, NJ. Click on it to view a larger version.
July 21, 2012
Tax the Rich
The new health care law includes many provisions to "tax the wealthy," that is those of us whose annual income exceeds $250,000. Perhaps $250,000 of income makes you wealthy in some parts of America, but certainly not in the New York City metropolitan area. Many of us work hard to earn whatever we do, often working 60 or more hours per week and taking many business risks.
What do we do with all this excess wealth? Most of us send two or more children to college, and often help them with graduate school. Of course we do all this without financial aid, because, after all, we are the wealthy. We live in moderate homes, make our mortgage and property tax payments (which are among the highest in the country), without default. In New Jersey, we also pay the highest state taxes in the country. Those of us who are self employed pay our own health insurance, and of course we have the discipline to save for retirement because we don't expect any help when we retire. And all this is after we pay federal income, social security, and medicare tax.
Oh, I forgot the best part. We own businesses, provide jobs and provide health insurance to our employees. But we have to be careful, because if the health insurance we provide is too good, it is also subject to tax. The new law even contains a provision that provides for an additional tax on investment income. For as long as I can remember, I've been hearing about how bad the savings rate is in the United States. If this additional tax doesn't discourage savings, nothing will.
I do not disagree that all Americans should have access to affordable health care, but exactly who is it that decided that Americans with $250,000 of annual gross income are wealthy and should bear the majority of the costs of the health care plan? I guess it was a politician, probably one that has not had to work an honest job to support his family.
What do we do with all this excess wealth? Most of us send two or more children to college, and often help them with graduate school. Of course we do all this without financial aid, because, after all, we are the wealthy. We live in moderate homes, make our mortgage and property tax payments (which are among the highest in the country), without default. In New Jersey, we also pay the highest state taxes in the country. Those of us who are self employed pay our own health insurance, and of course we have the discipline to save for retirement because we don't expect any help when we retire. And all this is after we pay federal income, social security, and medicare tax.
Oh, I forgot the best part. We own businesses, provide jobs and provide health insurance to our employees. But we have to be careful, because if the health insurance we provide is too good, it is also subject to tax. The new law even contains a provision that provides for an additional tax on investment income. For as long as I can remember, I've been hearing about how bad the savings rate is in the United States. If this additional tax doesn't discourage savings, nothing will.
I do not disagree that all Americans should have access to affordable health care, but exactly who is it that decided that Americans with $250,000 of annual gross income are wealthy and should bear the majority of the costs of the health care plan? I guess it was a politician, probably one that has not had to work an honest job to support his family.
July 14, 2012
Obama Care & Your Business
I've been reading a lot about Obama Care, and thinking about how it will affect small business. Basically, if your business has more than fifty full time employees, it is not good. For the purposes of the Health Care Act, a full time employee is defined as one who works 30 hours per week. And the testing period to determine how many full time employees a business has is the calendar year preceding the year to which the Act applies. Since the insurance portion of the Act (Employer Shared Responsibility) is effective after 12/31/13, the 2013 calendar year is the testing period for 2014. If you plan to rearrange your workforce to fall below the fifty full time employee threshold, you should start working on it now. Since the test is based on annual averages, if you wait until the end of 2013 to address this issue, you will be too late.
The Act contains penalty provisions for businesses that fail to comply with the insurance requirements. For businesses that do not comply, it appears that the penalty is $2,000 per employee, after the first thirty employees. If your business has eighty full time employees who are not covered by health insurance, the penalty will be $100,000 per year. I observe many business owners who say that they will pay the penalty rather than provide health insurance, but I don't know if that is a wise choice. For federal tax purposes, penalties are not deductible expenses. To decide if the penalty less costly than the insurance coverage, one must analyze and compare the after tax cost of each.
For businesses that are labor intensive and low margin, the health insurance requirement will be devastating. It is unfortunate that President Obama has never run a business. Perhaps if he had, he would understand what he has done.
The Act contains penalty provisions for businesses that fail to comply with the insurance requirements. For businesses that do not comply, it appears that the penalty is $2,000 per employee, after the first thirty employees. If your business has eighty full time employees who are not covered by health insurance, the penalty will be $100,000 per year. I observe many business owners who say that they will pay the penalty rather than provide health insurance, but I don't know if that is a wise choice. For federal tax purposes, penalties are not deductible expenses. To decide if the penalty less costly than the insurance coverage, one must analyze and compare the after tax cost of each.
For businesses that are labor intensive and low margin, the health insurance requirement will be devastating. It is unfortunate that President Obama has never run a business. Perhaps if he had, he would understand what he has done.
February 23, 2012
S Corp Reasonable Comp Part II
In January, I wrote about a Tax Court case (David E. Watson, P.C.) which held that the wages paid to a CPA by his 100% owned S corporation were unreasonably low, and that the difference between these wages and the amount determined by the Tax Court to be reasonable compensation constituted wages subject to FICA tax. In addition to the tax liability, the CPA was assessed penalties and interest. The CPA appealed the Tax Court decision to the US Court of Appeals for the Eight Circuit, which upheld the lower court ruling in favor of the Internal Revenue Service.
In making its ruling, the Court of Appeals found that Mr. Watson was a well qualified and experienced accountant working in a reputable and well-established firm, and that the nominal salary paid to him was unreasonably low in comparison to what a reasonable person in his role would have expected to earn. Further, the Court held that the S corporation "dividend" paid to Mr. Watson was compensation for services paid to him as an employee/shareholder, rather than a distribution of the corporation's earnings and profits. In this case, Mr. Watson received $24,000 of annual wages. During the two years at issue, he received dividend distributions of approximately $203,000 and $175,000.
Many S corporation shareholders employ the same technique, that is, they take relatively low salary and large dividend distributions. In order for this to have any chance of success against an IRS challenge, the wages received must be reasonable in comparison industry standards and services provided, and in relation to the dividends paid. In any event, your case will be strengthened by contemporaneous written documentation of how and why the compensation was determined. In Mr. Watson's case, $91,000 was determined to be reasonable compensation. If his actual salary were not so very low, maybe $52,000 instead of $24,000, perhaps the IRS would not have even made an issue of it. Proper planning and documentation are the key to all successful tax positions.
Please contact me if you would like a copy of the Watson case, or have any comments or questions.
In making its ruling, the Court of Appeals found that Mr. Watson was a well qualified and experienced accountant working in a reputable and well-established firm, and that the nominal salary paid to him was unreasonably low in comparison to what a reasonable person in his role would have expected to earn. Further, the Court held that the S corporation "dividend" paid to Mr. Watson was compensation for services paid to him as an employee/shareholder, rather than a distribution of the corporation's earnings and profits. In this case, Mr. Watson received $24,000 of annual wages. During the two years at issue, he received dividend distributions of approximately $203,000 and $175,000.
Many S corporation shareholders employ the same technique, that is, they take relatively low salary and large dividend distributions. In order for this to have any chance of success against an IRS challenge, the wages received must be reasonable in comparison industry standards and services provided, and in relation to the dividends paid. In any event, your case will be strengthened by contemporaneous written documentation of how and why the compensation was determined. In Mr. Watson's case, $91,000 was determined to be reasonable compensation. If his actual salary were not so very low, maybe $52,000 instead of $24,000, perhaps the IRS would not have even made an issue of it. Proper planning and documentation are the key to all successful tax positions.
Please contact me if you would like a copy of the Watson case, or have any comments or questions.
January 26, 2012
Does Your Business Have an Effective Buy-Sell Agreement?
Buy-sell agreements are among the most important yet most often overlooked business agreements. If you are a business owner or partner and are suddenly unable to work, what would happen to your business? If the business has an effective buy-sell agreement, then you should not have to worry.
What is an effective buy-sell agreement? It is an agreement that is clearly written and yields results that are fair to the buyer and the seller. In working with closely held business owners as an advisor, and in working with attorneys as a business valuation professional and expert witness, I have seen the best and the worst of buy-sell agreements, and the results that they bring.
A bad but all too frequently used buy-sell provision calls for the buyer and seller to each have a valuation of the business interest performed, and if the two valuations do not agree, a third appraiser is agreed upon and hired to perform a binding valuation. Are you surprised to know that the first two valuations never agree, and it is always necessary to have a third one done? And for this process, you have paid for three appraisals, when only one was necessary. Furthermore, if the process is at all contentious, agreement on the third business appraiser is also very difficult. I was involved in a three appraiser dispute, and the legal and professional fees paid were more than two times the amount paid for the retiring partner's interest. What is the solution to these problems? Change the agreement now to require only one appraisal, and specify in the agreement who (or what firm) will perform that appraisal.
Another buy-sell provision that will often produce disastrous results is one that values the business based on a formula, such as a multiple of something such as sales, net income, or book value. Although the formula may have made sense when it was written, business conditions change, and the formula result may no longer be fair.
We recently helped a client where one of the owners became ill and passed away within one year of diagnosis. Although I had tried to get the business owners to address buy-sell issues for a number of years, they refused to focus on it until the illness was diagnosed. In this case, the owners were fair minded and reached an agreement that was equitable to all the parties. But this is the exception rather than the rule. If you wait until a triggering event such as disability or death to start negotiating the buy-sell agreement, it is very difficult to reach an agreement.
A fair buy-sell agreement is one in which no one is overpaid and no one is underpaid, and the payment structure does not place an unfair burden on the business. Although buy-sell agreements are frequently funded with life insurance, what is the funding mechanism if the seller is disabled and does not pass away? Can the business afford to make the required payments without the benefit of life insurance proceeds?
Do yourself a favor. Get out your buy-sell agreement and read it. If the price specified by the agreement is formula based, ask your CPA to use the formula to calculate the price for the business? Keeping in mind that you don't know if you will be a buyer or a seller, are you happy with the result? Is the agreement structured in a way that will minimize income taxes for both parties? If the answer to either question is no, it is time for a new agreement.
As always, we welcome your comments and thoughts, requests for additional information, and suggestions for new topics.
What is an effective buy-sell agreement? It is an agreement that is clearly written and yields results that are fair to the buyer and the seller. In working with closely held business owners as an advisor, and in working with attorneys as a business valuation professional and expert witness, I have seen the best and the worst of buy-sell agreements, and the results that they bring.
A bad but all too frequently used buy-sell provision calls for the buyer and seller to each have a valuation of the business interest performed, and if the two valuations do not agree, a third appraiser is agreed upon and hired to perform a binding valuation. Are you surprised to know that the first two valuations never agree, and it is always necessary to have a third one done? And for this process, you have paid for three appraisals, when only one was necessary. Furthermore, if the process is at all contentious, agreement on the third business appraiser is also very difficult. I was involved in a three appraiser dispute, and the legal and professional fees paid were more than two times the amount paid for the retiring partner's interest. What is the solution to these problems? Change the agreement now to require only one appraisal, and specify in the agreement who (or what firm) will perform that appraisal.
Another buy-sell provision that will often produce disastrous results is one that values the business based on a formula, such as a multiple of something such as sales, net income, or book value. Although the formula may have made sense when it was written, business conditions change, and the formula result may no longer be fair.
We recently helped a client where one of the owners became ill and passed away within one year of diagnosis. Although I had tried to get the business owners to address buy-sell issues for a number of years, they refused to focus on it until the illness was diagnosed. In this case, the owners were fair minded and reached an agreement that was equitable to all the parties. But this is the exception rather than the rule. If you wait until a triggering event such as disability or death to start negotiating the buy-sell agreement, it is very difficult to reach an agreement.
A fair buy-sell agreement is one in which no one is overpaid and no one is underpaid, and the payment structure does not place an unfair burden on the business. Although buy-sell agreements are frequently funded with life insurance, what is the funding mechanism if the seller is disabled and does not pass away? Can the business afford to make the required payments without the benefit of life insurance proceeds?
Do yourself a favor. Get out your buy-sell agreement and read it. If the price specified by the agreement is formula based, ask your CPA to use the formula to calculate the price for the business? Keeping in mind that you don't know if you will be a buyer or a seller, are you happy with the result? Is the agreement structured in a way that will minimize income taxes for both parties? If the answer to either question is no, it is time for a new agreement.
As always, we welcome your comments and thoughts, requests for additional information, and suggestions for new topics.
January 17, 2012
Why the Millionaires' Tax is Unfair
Over the past few months, there has been talk in Congress about increasing federal income taxes on "millionaires." Many people, including members of Congress, are concerned that such an increase will be counterproductive because tax increases will take away the millionaires' incentive to work. In fact, I heard a Congressman make that statement in a recent radio interview. This reason could not be further from the truth.
In 1987, tax laws were changed to encourage businesses operating in the corporate form to elect S corporation status. At that time, most closely held businesses that were not already S corporations elected S status. The main difference between a C corp and an S corp is that a C corp pays tax on its income, and an S corp does not. The S corp passes its income through to its shareholders, who include it on their personal income tax returns and pay personal income tax on the income, whether or not the income is distributed to them.
Why is this important? It is important because a person that has ownership in an S corporation, partnership, or limited liability company may report income high enough to throw them into the "millionaire" tax bracket, when they receive little or none of the income that they are required to report on their tax returns. The problem is compounded by other tax rules, which require many businesses to report taxable income on the accrual basis of accounting, that is, recognizing taxable income when the income is earned rather than when it is received. So now imagine this reality; the S corp shareholder is not only paying tax on income that he has not received, but is paying tax on income not even received by his corporation! And if any tax rate increase is enacted, it may very well be this phantom income that causes the shareholder to be subject to the millionaires' tax.
So if the S corp shareholders must pay tax on income that they have not received, where do they get the money to pay this tax? Sometimes it comes from the shareholders' personal funds, but most often it is distributed to the shareholders from the corporation. The theory is that if the business was a C corp, it would be required to pay its own income taxes, so it distributes an equivalent amount to reimburse the shareholders for the tax liability arising from reporting the S corp income. And if there is a tax increase, it is likely that this policy will continue, but the additional distribution will reduce the amount of money available to the business to create jobs, purchase equipment, and finance growth. This is the reason why business owners object to the proposed milionaires' tax. It is not because it takes away their incentive to work, but because it reduces their ability to reinvest in their business. The most troubling part of this whole story is that members of the United States Congress do not grasp this concept.
Can this problem be solved without upsetting our entire pass through entity tax structure? I think it can, and the solution is relatively simple. If any proposed millionaires' tax is enacted, the only pass through entity income that should be considered in calculating income subject to the tax should be the amount actually distributed by the S corp, partnership, or limited liability company. Furthermore, distributions used to pay federal or state income taxes on the pass through entity income should be excluded from the calculation and the increased tax rates. This will prevent business owners who report phantom income from being subject to increased taxes on income not received.
In 1987, tax laws were changed to encourage businesses operating in the corporate form to elect S corporation status. At that time, most closely held businesses that were not already S corporations elected S status. The main difference between a C corp and an S corp is that a C corp pays tax on its income, and an S corp does not. The S corp passes its income through to its shareholders, who include it on their personal income tax returns and pay personal income tax on the income, whether or not the income is distributed to them.
Why is this important? It is important because a person that has ownership in an S corporation, partnership, or limited liability company may report income high enough to throw them into the "millionaire" tax bracket, when they receive little or none of the income that they are required to report on their tax returns. The problem is compounded by other tax rules, which require many businesses to report taxable income on the accrual basis of accounting, that is, recognizing taxable income when the income is earned rather than when it is received. So now imagine this reality; the S corp shareholder is not only paying tax on income that he has not received, but is paying tax on income not even received by his corporation! And if any tax rate increase is enacted, it may very well be this phantom income that causes the shareholder to be subject to the millionaires' tax.
So if the S corp shareholders must pay tax on income that they have not received, where do they get the money to pay this tax? Sometimes it comes from the shareholders' personal funds, but most often it is distributed to the shareholders from the corporation. The theory is that if the business was a C corp, it would be required to pay its own income taxes, so it distributes an equivalent amount to reimburse the shareholders for the tax liability arising from reporting the S corp income. And if there is a tax increase, it is likely that this policy will continue, but the additional distribution will reduce the amount of money available to the business to create jobs, purchase equipment, and finance growth. This is the reason why business owners object to the proposed milionaires' tax. It is not because it takes away their incentive to work, but because it reduces their ability to reinvest in their business. The most troubling part of this whole story is that members of the United States Congress do not grasp this concept.
Can this problem be solved without upsetting our entire pass through entity tax structure? I think it can, and the solution is relatively simple. If any proposed millionaires' tax is enacted, the only pass through entity income that should be considered in calculating income subject to the tax should be the amount actually distributed by the S corp, partnership, or limited liability company. Furthermore, distributions used to pay federal or state income taxes on the pass through entity income should be excluded from the calculation and the increased tax rates. This will prevent business owners who report phantom income from being subject to increased taxes on income not received.
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