If you stop and think about it, the Section 199A deduction is a scam. Even taxpayers who are eligible to claim the full 20 percent deduction on QBI will incur a maximum effective rate of 26.9 percent, which is beneficial. However, the government is dangling a carrot before you, lowering the C Corporation rate to 21 percent. It’s time to do some thinking.
We have all been brainwashed that C Corporations are bad, because of double taxation. However, let’s think about this in a different way. In an S Corporation, we have our clients pay a reasonable salary and then take distributions. I am suggesting that we raise these salaries.
For instance, let’s say we have a client paying $100,000 in salary and taking $300,000 in distributions. We simply raise the salary to $275,000. Suppose this company has employees. We start a Safe Harbor 401(k) that we have to offer to the employees. For the owner they can put $18,500 through salary deferrals, provided they are less than 50 years of age. They can put those deferrals into the Roth portion of the 401(k) and then can match their salary by 25 percent, up to $55,000 in 2018.
For the employees, the company simply offers them the plan. For whatever reason, most employees don’t want to participate. For the ones who do, you only have to match 3 percent of their salary. At year end, if you like giving bonuses, there is a profit sharing piece that you can give to the employees.
As an S Corporation, a more than 2 percent shareholder cannot participate in fringe benefits. So, you get group health insurance and couple it with a Health Reimbursement Account (HRA). HRAs have unlimited contribution limits. However, what you do for yourself, you have to do for your employees, and you can put some restrictions on HRAs.
For instance, if you are married and have five years of service, you can put $10,000 into the HRA and then go down from there. If you have children, you can pay $5,000 in dependent care benefits. Another thought is to retitle your car into the name of the corporation or LLC and purchase commercial insurance so that you can write off your company car. All of these fringes are tax deductible.
The point is that we did all of that without double taxation. Let’s look at this scenario in dollars. We presume that the S Corporation’s shareholder made salary of $100,000 and the distributions of $300,000 were from current profits. For the C Corporation, we took a salary of $275,000 and put $55,000 into a retirement plan. We take $18,500, which went in due to salary deferrals, into the Roth IRA, and take $36,500 as a deduction. All of our employees participated in the 401(k), and our out-of-pocket costs were $10,000. Group health was $20,000, and we put a total of $25,000 into an HRA. We retitled our car and got a $10,000 of depreciation, paid $5,000 in insurance and $10,000 in vehicle expenses. That turned our $300,000 profit into $8,500.
This scenario can work with smaller numbers. The things to consider are what happens when you sell the company? Wouldn’t there be double taxation? I was asked this at a luncheon where I spoke, by a business broker on how to get out of double taxation on sale. I reminded him of IRC §1202 Stock. Upon conversion to a C Corporation you issue Section 1202 stock, hold the stock for five years, and when you sell it, the first $10 million is tax free. His retort was that the Securities and Exchange Commission (SEC) would not allow him to sell stock. I told him that obviously he recluses himself from the sale.
I was as scared of C Corporations as much as anyone else. But about five years ago I started working with them and realized that there was nothing to be worried about. All you have to do is quarterly tax planning, because the income and situations will change. For the most part this can work with any pass-through.
Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as...