The new tax code offers the possibility to pay less tax now and no taxes when you sell your business. Tom highlights specific provisions that allow business owners historic tax advantages. This is a must-listen show for any business owner and anyone aspiring to start a business.
02:30 – How Did The New Tax Code Affect Businesses?
04:40 – How Did Taxes Change in 2017?
06:36 – How Do You Become A C-Corporation & Pay Less Tax?
10:13 – How Do You Pay No Tax When You Sell A Business?
13:07 – Why You Should Be Flexible With Entities.
14:35 – How Should Business Owners Speak To Their CPAs?
19:27 – Why Are Business Owners Patriotic?
Announcer: This is The WealthAbility® Show with Tom Wheelwright. Way more money, way less taxes.
Announcer: This is The WealthAbility® Show with Tom Wheelwright. Way more money, way less taxes.
Tom Wheelwright: Welcome to The WealthAbility® Show, where we're always learning how to make way more money and pay way less taxes. Hi, this is Tom Wheelwright, your host, founder and CEO of WealthAbility®.
Tom Wheelwright: If you are a business owner and you're getting killed with taxes, then you want to listen to this program because, today, you're going to discover how to lower your taxes now and never pay taxes when you sell your business. You heard that right. Never pay taxes when you sell your business.
Tom Wheelwright: There's a special provision in the law that now makes sense because of what changed in 2017, and it's something to take advantage of, something to look at. Every single business should be looking to this, every single one, anybody who wants lower taxes now, and especially those who are thinking about perhaps someday in the future selling their business. Now, here's the challenge.
Tom Wheelwright: I've said this before. If you're an employee, typically, there's not much I can do to help you. What you have to do is to change your situation. We always say you want to change your tax, you got to change your facts. Now, if you're an employee, a W-2 employee, you're maxing out your 401(k), you're pretty much done. I mean, there no more investment expenses. You've just lost your income tax deduction for the most part. What are you gonna do?
Tom Wheelwright: What the government is actually telling you to do is it's time to shift some of your focus. Perhaps doing what the government rewards would be a good idea. The government rewards businesses. The government rewards owning a business. If you've not started a business before, if you've thought about starting a business, you can even start a little small business, now would be the time because never in the history of the US have businesses been more rewarded under the tax law.
Tom Wheelwright: Here's what happened that we all know about in the new tax law. The government lowered tax rates. Now, pretty much did that across the board. Some people didn't feel it a lot. Some people did feel a lot. Who felt that the most? Well, the big corporations felt it the most because their tax rate went from 35% to 21% overnight. Overnight. Their taxes went down 40% overnight. Small businesses, they also felt it because their taxes went down 20% because of the new 20% qualified business income deduction. Businesses felt a much bigger impact than individuals who are only employees. Real estate investors felt a big impact.
Tom Wheelwright: We're going to focus today on the impact to businesses, and what I want to discuss is, again, looking at a different way perhaps to operate your business than you may have in the past from a tax standpoint. This doesn't change how you operate your business from an operation standpoint on a day-to-day basis. This changes what you do from a tech standpoint.
Tom Wheelwright: Historically, with corporation tax rates up in the 35% range, and they could actually get higher at certain points of the 38%, 39%, and then you have a double tax because, of course, when you distribute income from a business, that's taxed again at anywhere from 15-24%, so a lot of people go, “Well, why would I ever want to be a corporation?” a C corporation, a corporation that's taxed. Not an S corporation, that's a pass-through, but a corporation's that taxed, we call it a C corporation for Subchapter C of the Internal Revenue Code. “Why would I ever want to do that?” Pretty much all small businesses, with the exception of a few in Silicon Valley who were looking to get investors, and the investors wanted BC corps, pretty much everybody set up as a pass-through entity, either a partnership or an S corporation.
Tom Wheelwright: Well, things changed in 2017. All of a sudden, corporate tax rates are 21%. Well, you go, “Well, 21% versus a high,” technically a high of, well, a high of 37% for individuals. For most businesses, with a few exceptions, service businesses, for most businesses, the real top rate's about 30%. 29.6%, because the 20% deduction effectively lowers the tax rate to about 29.6%. You're going, “Okay, 21% versus 29.6% or 30%. Well, 21%'s better.”
Tom Wheelwright: It is now. Still, we have the double taxation, so when you distribute the money, you might be taxed at 21% now, but 20% on what you distribute. The effective rate could still be about 37%. I mean, if you distributed all of your income after paying your 21% tax, you'd basically be distributing 80%, approximately, and 80% of 20% is 16%, so you're back up to 37% tax bracket. Businesses who distribute all their money and use the money, either spend it on personal purposes or they're using it for investing in real estate or other investments outside of their business, should be a pass-through entity in my opinion. For the most part, they should be a pass-through entity.
Tom Wheelwright: However, there's a lot of businesses that they take out, the business owner… Let's say you're one of these businesses. You go, “You know what? What I'm really doing here is I'm building a business. Now, I'm going to take some out, a salary because I have to live, but most of the money I'm going to reinvest in my business. I'm not going to leave it in there.” If that's the case, then you really ought to consider being a C corporation.
Tom Wheelwright: Now, the question is how do you become a C corporation? You have two choices. Most people think, “Well, I'm just going to revoke my S election and become a C corporation,” or, “I'm going to turn my partnership, my LLC that's taxed as a partnership, and then I'm just going to convert to a C corporation.” That's not very hard to do. If you do that though, you lose an advantage than if you do it under option number two. Option number two is you keep your business, whether it's an S corporation, you keep that entity as corporation or partnership, and then you form a new corporation as a subsidiary.
Tom Wheelwright: Now, a C corporation can be owned by anybody. It can even be owned by an S corporation, partnership, individual trust, anybody. What you do is you take all of your assets, your operating assets of your business, and you actually contribute them to the new C corporation in exchange for stock of that C corporation.
Tom Wheelwright: What does that do? It's magic because that C corporation, all of the appreciation in that c corporation from the day you set it up, all the appreciation from the day you set it up… Now, not the appreciation that happened before you set it up, but all of the appreciation in the business that happened after you set it up, set up that new C corporation, when you go to sell it, as long as you hold it for five years, it's tax-free.
Tom Wheelwright: You heard me right. It's 100% tax-free. Now, people will tell you, “Well, there's a $10 million limit.” Well, most people, first of all, most people won't sell their business for more than $10 million. Second of all, let's say you do. It's $10 million per shareholder. How hard is it to create multiple shareholders? Not hard at all. That's something where you sit down with a tax advisor, and you actually decide who you want to own it. It may be that you want to own all of the entities, but you can have multiple entities. We call them trusts, the owners, and you can multiply that $10 million as many times as you want. There's effectively no limit on this.
Tom Wheelwright: Now, I know you're going, “Wait a minute. Wait a minute. What you're saying is that I can get a 21% tax rate now,” correct, “and, by the way, deduct my state income taxes.” Remember, we're in a flow-through entity. Those state income taxes are paid at the individual level. Well, now we have that $10,000 Cap. Corporations do not have a $10,000 cap. Now we get to deduct our state income taxes within the corporation. There's still deductible in corporations.
Tom Wheelwright: We get to deduct to the state income taxes, and we only pay 21% instead of paying anywhere from 29.6-37% on the current income. Now, we're still going to pay our regular income tax rates on the salary we take out, so anything we consume, we're going to pay, or anything we take out for something else.
Tom Wheelwright: Now, you're going, “Well, wait a minute. I still want to invest in real estate. I still want, do a thing.” Great. Leave some of your business in your S corporation, and put part of the business in the C corporation. When you sell, you'll probably sell all of it. Now, the portion that's in the S corporation is going to be taxable. The portion that you do in the C corporation will be non-taxable. You're just going to sell the whole structure to whoever the buyer is. You can break this up any way you want to.
Tom Wheelwright: It's interesting when we were talking about the, when the bill had first been passed and we are talking about the 20% deduction, there's this whole scheme we would call it called crack and pack where you'd actually break up a service business into multiple different businesses so that some of the businesses would be able to get the 20% deduction even though, say, the law firm that actually practiced law didn't. Well, the IRS put an end to that. But when you talk about crack and pack with respect to a business and a C corp, you can do that all day long.
Tom Wheelwright: If you look at most multinational corporations have many, many subsidiaries. They've been doing the crack and pack all day long for hundreds of years because it makes sense from a business standpoint to have multiple subsidiaries who do independent functions have independent businesses. You might have different products. You might even have services in one, and you might decide, “You know what? Those services, they may not qualify for this not getting capital gain,” we call it the 1202 rule, “They may not qualify for the 1202 rule where I don't get capital gains so,” because some businesses don't. For example, accounting firms, law firms, consulting firms, physicians, healthcare services don't qualify for either the 20% deduction or the 1202.
Tom Wheelwright: Actually, pretty much the same people don't qualify for both except that architects and engineers qualify for the 20% deduction, but they do not qualify for 1202. Professional services generally don't qualify, but let's say you have professional services in your business, but you also have something else. Let's say you have an education business. Let's say you have some business that actually does qualify, that would qualify.
Tom Wheelwright: Well, let's drop that part of the business into the C corporation. Let's contribute that to the C corporation, and let's go ahead and retain the services, or maybe what we do is we drop the services into another subsidiary that's an LLC, a limited liability company that's disregarded for tax purposes, so it's taxed at the S corporation or partnership level, but it's actually in a separate LLC so that we don't have this extra layer of liability so we break up our company. We do a breakup. We actually break up our company into pieces.
Tom Wheelwright: The point here is, remember, one of our goals with tax planning is flexibility. We have so much flexibility when it comes to the different entities we use, the way we own our business and how we set up our business that most people never even consider. For example, be able to go, “Well, look. If you have an established business,” excuse me, “if you have established business, you can't convert from S corporation to C corporation and get the 1202 benefit.” That is an accurate statement. You can, however, set up a subsidiary to your S corporation, contribute all your assets to the subsidiary and get 1202 treatment because that subsidiary now is original issue stock, and so it qualifies for Section 1202.
Tom Wheelwright: My point is, is that don't think that just because somebody says, “Well, that doesn't qualify,” that that is the final answer. The question always should be, “How can I make it qualify? How can I get this tax benefit? How can I make this deductible? How can I do it?” When you work with your tax advisor and your attorney, because those two are going to need to work together on this, when you do that, make sure that the question is always, “How can I do this?”
Tom Wheelwright: I have actually never run into a client that wanted to know what they can't do. Not even once. Now, they may ask, “Can I do this?” That's not really what they're asking. What they're really asking is “How can I do what I want to do?” I would suggest as business owners that when you work with your advisors that you frame your questions that way. Frame the question, “How can I do what I want to do?”
Tom Wheelwright: Now, let me make the decision whether I want to make those changes. Let me make the decision whether I want the added complexity of a C corporation. Let me make the decision as to whether I'm going to take all my money out of the corporation. Tell me how I can do this, and give me the parameters. Then I will make the business decision.
Tom Wheelwright: What happens a lot is advisors say, “Well, you can't do that,” not thinking that you may be willing to change some things so that you can do it. It drives me a little nutty, as you can probably tell as I'm here on my soapbox, it drives me a little nutty when we have the deal breakers, and accountants and attorneys tend to be deal breakers. They tend to be preventers, and they're gonna say, “Well, you can't do that. You can't do that.” “Can I deduct the lunch I eat at home?” Most people would say, “No.” I would say, “Rephrase that question. Would you like to know how you can deduct your meals that you eat at home?” because we can create a scenario where you can do that.
Tom Wheelwright: Now, you may not want to do that because there are certain restrictions, certain rules that apply; however, can you do it? Absolutely. “Can I deduct my car?” Well, sometimes the answer is, “Well, I don't know. Would you like to ask the question, how can I deduct my car?” “Can I avoid tax when I sell my business?” The answer is absolutely. Then rephrase the question, “How can I do that?” Okay.
Tom Wheelwright: Now, there's actually multiple options. One is you can, if you get bought out by a big company, chances are, it's going to be a stock-for-stock deal, and you're going to end up stuck with the new company. That's a tax-free transaction, but it's not permanently tax-free, whereas Section 1202, you don't have to pick up the gain ever. You pay 21% now, deduct your state income taxes, and never pay tax when you actually sell the business.
Tom Wheelwright: Now, obviously, the devil is in the details, so sitting down with a tax advise who understands Section 1202, understands the entity rules, understands how you have to put this together is going to be critical to your success. Do not do this on your own. That old adage, “If I want it done right, I've got to do it myself,” is the dumbest adage anybody ever came up with.
Tom Wheelwright: If I want something done right, I want a professional to help me do it. I want somebody who knows how to do it to help me do it. I don't want to learn how to do it myself. I want somebody else to show me who already has done it. Make sure that your tax advisor really does understand this and walks you through it.
Tom Wheelwright: One of the things you can do to help your tax advisor though is help them understand what changes you're willing to make. Say, “Look. I'm willing to make some changes in order to lower my taxes.” If I were interviewing a tax advisor, I would ask, “Now, I'm willing,” I would say, “I'm willing to make some changes. How could you help me make the changes I need to make in order to lower my taxes?”
Tom Wheelwright: Well, one of those may be you may want to be a C corporation. Now, even if you don't qualify for Section 1201, you may want to be a C corporation. I think there are some professional service companies, firms who should be C corporations because they're not pulling their money out. They're building by adding employees. They're building by adding… They're investing a lot in their company. They probably… There are some professional service companies.
Tom Wheelwright: It used to be we had this huge tax. It used to be, prior to 2018, if you are a professional service company, you had to pay the maximum corporate rate on 100% of your income. You didn't get any tax brackets like the rest of the world did. You had to… so it was a penalty. Now, it's a flat 21% rate, so it doesn't matter. Even professional service corporations, some should absolutely be C corporations.
Tom Wheelwright: “How can I lower my taxes” is great. “How can I do it and still take out money? How can I do it and still get the Section 1202 and not pay tax when I sell my business?” These are the questions that make us actually better taxpayers and actually help us be better citizens because the reality is, when we're doing what the government wants us do, we are much more patriotic. We're saying, “We want to help the government.” What does the government want us to do? The government wants us to build a business. Great, let's build a business. If you're an employee and you're wondering… and you go, “I'm patriotic,” great, guess what? Let me tell you how the government wants you to be patriotic.
Tom Wheelwright: They don't just want you to be waving a flag. That's all fine and good. What they really want you to do is build a business, invest in real estate, create jobs, do research and development. Look at what the tax law's telling you that the government wants you to do. One of them is business. When you have a business… If you already have a business, congratulations. If you're building a business that you think you're going to sell five years, 10 years down the road, then consider Section 1202. Sit down with an advisor, and you might be breaking up your company. You may do a crack and pack with your company. That has nothing to do with the 20% pass-through deduction. It has everything to do with 1202.
Tom Wheelwright: Getting that tax benefit now by lower taxes, deducting your state taxes, and getting the great tax benefit later, you sell your business for $10 million, and guess what? Instead of paying $2 million of tax, you pay zero. What always happens is, guess what that encourages us to do? Encourage us is to build a business, encourages us to be better business owners because every single time we do with what the government wants us to do, what happens is we make way more money and we pay way less tax.
Announcer: You've been listening to The WealthAbility® Show with Tom Wheelwright. Way more money, way less taxes. To learn more. Go to wealthability.com.