by Neil Jesani
Both a PC and a PLLC have such similar features that it is difficult to tell them apart. Taxation is one area where they differ. The PLLC has pass-through taxation. A PC also allows pass-through taxation if it files as an S corp; otherwise, it will be taxed as a C corp at the maximum corporate rate of 21 percent. When deciding to go with a PC or PLLC, it is important to weigh all of the pros and cons, including the state of residence and taxation options.
Selection of State to Incorporate
When setting up a corporation, the topic of what state to establish in usually comes up. This is definitely something that you need to research, especially if you are planning to grow faster and bring in outside investments. For the most part, it comes down to the ease of filing the documents and the fees involved. States like Delaware and Nevada are popular for filing because it is a fairly simple task compared to other states. Often, that is the only advantage. If you form your corporation in one state but operate in another, you are still subject to the taxes and regulations of the state you are physically located in.
Summary
This brings us back to one of the main points from the beginning of the chapter. This is a very general outline of the various advantages and disadvantages of forming a corporation or LLC for your business. Terms like LLC, C corp, PLLC, etc. are thrown around a great deal, but a business owner often doesn’t think about or have time to look into the options for how to establish a company. Hopefully, this chapter gave you some food for thought and helpful guidance as you establish or expand your business.
In very broad general terms, for a typical professional company, an LLC incorporated as an S corporation offers the flexibility and tax savings that many desire. It will be a perfect option for estate planning purposes later on. You need to do the necessary research on your own or discuss the option that is best for you with a qualified professional.
Now that we have looked at ways to organize your business, we are going to move into more detail on how to reduce the amount of money you pay to the government in taxes every year. The great thing is that you can position yourself for both short-term and long-term gain. That is not usually an option we have for many things in life.
CHAPTER 3
Retirement Plans – A Big Tax Reduction Vehicle
“There may be liberty and justice for all,
but there are tax breaks only for some.”
Martin A. Sullivan
M
ost of us do not want to work all of our lives. At the same time, not too many people look forward to retirement as just sitting on the front porch watching life go by. With people staying healthy longer and a zest for life increasing with age, many look at retirement as a way to do even more. This might mean travel, starting or working for a charity you believe in, hitting a golf course in every state, or even starting a completely different business than the one you worked in for the last 30 years. Whatever a person’s desires, having a decent amount of money saved up to finance those dreams is imperative.
We spent the last chapter looking at how to establish a company in a manner that will work best for you in terms of structure and tax considerations. Next, we want to look at how to reduce those income tax obligations. What fits very nicely is that here is a case in your personal business where you can truly kill two birds with one stone. That is because one of the best ways to maximize your income tax deductions will also secure a very successful retirement!
A skilled CPA will help you determine business deductions. If you own your own business, you will have many. A problem occurs when you reach that threshold of “success.” When your business thrives and your gross revenues are growing, your business deductions are only going to do so much for you. This is the opportune time in your career to start planning for what happens when your working days are done. While that may seem far away, the brilliant component of starting your retirement fund now is that you will begin to realize sizable tax deductions that will keep more money in your pocket now and in the future.
The history of setting up retirement plans in the United States started in 1875 when the American Express Company established the first private pension plan in an effort to create a stable, loyal workforce. Since that time, retirement plans have gone through a long evolution in both the government sector in terms of regulations, and with finance companies in how they construct plans. Both sides of the aisle are always tweaking laws and programs to serve the workforce. In the case of a small business, the owner and owner’s family are the primary workforce.
To summarize before we go into detail, there are several ways to invest your money in retirement plans. While there are limits to the amount you can put into a plan each year, the money you place into a qualified account is totally tax deductible.
All retirement plans have their own particular structure and regulations. In general, the money you put away for retirement is not available until you reach a certain age, usually 59.5. Many do have provisions for early withdrawal criteria, but there is usually a penalty. When withdrawing from a retirement plan after retirement age, you will pay taxes on that money and whatever it earned when you take it out. Typically, you will be in a lower tax bracket after retiring, so that money will be taxed at a lower rate than it would be now.
Types of Retirement Plans
The retirement plans we are examining here are the “qualified” plans. That means they are IRS approved and your contributions are tax deductible. We will discuss different ones, as there are choices that you can make that will best fit your situation. Non-qualified retirement plans would include a deferred compensation plan, Section 162 executive bonus plan, or Section 7702 private pension using cash value life insurance. While some of these vehicles have earnings that may be tax deferred, you cannot take any tax deductions for the contributions you make to them unless the cash value life insurance purchased was in a qualified plan.
There are two broad categories of qualified retirement plans that a business owner can utilize. One is the defined contribution plan and the other is the defined benefit plan. As their names imply, they both work within IRS limits to determine how much can go into the plan each year. These plans have different components that a business owner has to weigh to determine what fits their situation best. Examples of qualified plans are profit sharing plans, a SEP plan, defined benefit plan, solo-defined benefit plan, 412i defined benefit plan, and the cash balance plan. If that seems confusing, don’t worry. In the next chapters, we will look at specific ways these plans can be set up in terms of the investment aspect for the money, but we will now look at the two categories of qualified plans.
Defined Contribution Plans
As the name suggests, in this plan, IRS has defined the contribution you make. For example, you would contribute the lesser of $56,000 or 25% of your FICA eligible compensation into your defined contribution plan for the year 2019. To illustrate, a business owner makes $200,000 in W2 income from his or her business. That business owner could contribute the lower of $56,000 or 25% of his or her total compensation, which was $200,000 for the year. Since that amount would total $50,000, the lower amount of $50,000 is all they could place in their defined contribution plan. These defined contribution plans include profit sharing and IRA-based SEP plans.
SEP is an acronym for Simplified Employee Pension. This retirement plan is especially ideal for a self-employed business owner. The costs are low, the administration is easy, and, as mentioned, you can contribute that 25% of your compensation or $56,000, whichever is lower. The implementation costs and paperwork for starting a SEP are minimal. In fact, the annual operating costs for a SEP are low as compared to other types of plans. Any size business can establish a SEP, and there is no filing requirement for the employer.
If you have employees, the downside with a SEP is you also have to make the same contribution to their accounts as you do for yours: the lower amount of 25% of their salary, or $56,000. If you have an employee that is 21 year old, worked for your business in at le
ast 3 of the last 5 years and received at least $600 in compensation, you are required to pay into a SEP plan for them.
Let’s say Lori is your office manager, and you pay her $40,000/year. At the three-year mark, she needs to go onto your SEP plan, and you will have to pay an additional $10,000 into the plan on her behalf in addition to her salary. Furthermore, there is no vesting schedule requirement on a SEP plan. If Lori takes another position after you pay into her plan during the first year of her eligibility, she can take all that money with her.
A word on vesting here, because it leads into the next topic, the Profit Sharing plan. Vesting is the amount of time an employee needs to wait before they can access a partial or total amount of their pension plan. An employer can establish two vesting options with a pension plan. One is “cliff vesting” where the employee is not eligible to withdraw any of their pension money for at least three years of being employed by that company; then they have 100% access. “Graded vesting” is when they are eligible for a certain percentage over their first five years. They are entitled to 20% after one year, 40% after two, and so on until they are 100% vested after five years.
As you saw, the SEP plan is fine if you are the only employee of your company, but definitely has other considerations if you employ others. With Profit Sharing, you have greater flexibility. It has the 25% of salary or the $56,000 limit (whichever is lower) that is a component of all defined contribution plans for the year 2019. While you still have to pay into the plan for other employees, the requirements are different from the SEP plan. Two years of working before they have to put into the plan still holds, but they also have to work at least 1,000 hours a year for you. Furthermore, the amount you need to put into the plan for them is subject to a different schedule so it will be lower. Finally, you can set a vesting schedule for the plan for all employees.
Correctly setting up and administering a Profit Sharing Plan is the key to its success, as well as meeting the regulations of the IRS and the Labor Department. If you, as a self-employed or a company owner, consider this option as the way to go for a retirement plan for yourself and your business, work with an expert in this field with a reputation of success as they can bring the best design to help you maximize the power of your money. It is important to establish such a program that meets all requirements and will run smoothly for you and your workers.
Finally, both defined contribution plans have a limitation of maximum $56,000 deduction. If you are looking to contribute higher amounts than the current IRS limit of $56,000, then you should consider a defined benefit plan where you would be able to take a much higher income deduction and would be able to contribute much more for yourself.
Defined Benefit Plans
Until 1970, most large corporations used the defined benefit plan to guarantee the retirement of their employees. Today they are very popular among high income earning self-employed professionals like physicians, lawyers and business owners due to the many favorable changes in the tax code. For these successful self-employed professionals and business owners, a defined benefit plan is a big income tax deduction tool.
In a defined benefit plan, the IRS does not define the contribution made to the plan, but rather, the amount of the retirement benefit at the retirement age. A qualified pension actuary or attorney will take your current age and income to calculate your allowable retirement benefit when you reach age 65. In 2019, this amount is $225,000. The next step is to calculate the contribution amount to ensure this benefit at retirement. Contributions to the plan are calculated based on your current age, your highest income in the last three years, and the years left until your retirement. The pension actuary calculates the annual contribution needed to reach the benefit number, and you receive an income tax deduction for your annual contribution into the plan.
Essentially the biggest bonus to a defined benefit plan is that it will give you a significantly larger deduction — up to $350,000 — as compared to the maximum of the $56,000 you can place into a defined contribution plan.
New IRS rules make defined benefit plans very attractive. The government repealed Section 415(e) of the Tax Code. Because of this change in law, a business owner can now use a defined benefit plan to build assets without taking into consideration money already accumulated in other retirement plans. Other changes the IRS made were to Section 415(b)(1)(A) to increase the maximum retirement benefit allowed. Section 415(b)(2)(C) was amended to lower the age at which the maximum retirement benefit could be received.
In addition, the 2006 Pension Protection Act provides additional flexibility by allowing contributions of no more than 6.0% to a defined contribution plan, in addition to salary deferrals, without impacting the contribution to a defined benefit plan. The Tax Cuts and Jobs Act of 2017 added 20 percent qualified business income (QBI) deduction. Together, all these changes allow small business owners to contribute more to a defined benefit plan than ever before.
To show the power of a defined benefit plan, let’s look at a successful pharmacy owner who is 48 years old. He is looking to take the highest income deduction possible and still allow himself a high degree of flexibility.
1. W-2 earnings: $235,000
2. Corporation profit: $350,000
3. Maximum Defined Benefit & 401(k) contribution: $189,000
4. Annual tax savings: (at 40% combined tax rate) $75,600
There are different designs of defined benefit pension plans. A cash balance plan is a type of defined benefit plan that resembles a defined contribution plan. For this reason, these plans are referred to as hybrid plans. A traditional defined benefit plan promises a fixed monthly benefit at retirement that is usually based upon a formula that takes into account the employee’s compensation and years of service. A cash balance plan looks like a defined contribution plan because the employee’s benefit is expressed as a hypothetical account balance instead of a monthly benefit.
The defined benefit plan also offers employers great flexibility in the scheduled amount and vesting requirements when offered to employees. The impact on taxes, how much you can put away for retirement, and the options it gives you in regards to your staff makes this plan worth looking into for your business.
Other Aggressive Tax Deduction Plans
There are some other aggressive retirement and benefit plans that could provide much higher income tax deductions, but they come with their own perils. Following are some examples:
1. Captive Insurance Company
2. Restricted Property Trust
3. Delaware Statutory Trust
4. Section 79 plan
5. 419 plan
Summary
Pension plans are a great income tax and retirement planning tool to start with, but they require special expertise to get the maximum benefits possible. There are many IRS rules to be followed in regards to setting up the proper plan documents (including and excluding the employees, contribution limits to the plan, validating a plan and filing the annual 5500 pension tax return to IRS.)
You can see the incredible tax deductions that both the defined benefit plan, and to a lesser extent, the defined contribution plan provides. When you own a profitable business, no single deduction is going to knock more off your personal taxes than this approach without unnecessarily raising any red flags to the IRS. You save a great deal of money now, and are putting a large sum away for the future. In addition, the money you are investing will grow even bigger.
This chapter is meant to give you a basic understanding of the different retirement plans, and their short-term and long-term impact to your finances. This plan might be using tax-deduction tools primarily for self-employed and business owners, but there are some strategies such as IRS Section 7702 individual private pension plan that will work equally for W-2 employees and the self-employed.
Please keep in mind that this book was written in 2019. The amounts stated are current for 2019, but remember that they do change. Many of the limits talked about are subject to annual cost of living
adjustments. While the basic information about the plans will not change much over time, it is always important to see what the current limits are for funding and tax deductions in any given year.
If your business or medical practice is successful, you should run the numbers on how much you will save in taxes, and how much you will accumulate for retirement over a twenty-, or even ten-year period. The amount will stagger you. The recent changes in the defined benefit plan have made this plan even work with large number of employees, while in the past it was meant to work with high income earner/owners with only few younger, low-income employees.
CHAPTER 4
Understanding the Intricate Nature of Money
“Successful investing is anticipating the anticipation of others.”
John Maynard Keynes
M
oney has been around for a long time. Before its invention, early civilization worked on something of a barter system. As cultures advanced, so did the way they conducted business. Perhaps the first money was the Mesopotamian shekel from around 3000 BC. The Lydians first started minting coins around 650–600 BC. For centuries, money was based on a certain commodity, like gold or silver, and governments made currency from those metals. Early paper money was more of a promissory note based on the gold they represented. These days, money is simply backed by good faith in the government’s ability to convert the money into goods via payment.
It is important to understand certain properties of money when you are spending it, saving it, or investing it. Many times, we think of money as a bunch of bundled up bills that just sit there. We also know that the more bundles, the better! However, money is not a stagnant object. It is very liquid, and an understanding of how this works with investments and savings is enlightening.