In my practice, I cater to businesses. The personal returns I end up doing are for the owners of those businesses. Most businesses pay me to do quarterly tax planning for them along with their write-up. The way I do tax planning is different from most accountants. I was taught to have a client buy a bunch of equipment, whether they needed it or not, and that was tax planning. That never made sense to me, so I adopted the theory of putting as much money in my client’s pocket tax free.
The simplest, and most obvious, way to accomplish that would be with either a solo 401(k) plan, if there are no employees, or a Safe Harbor 401(k), if there are employees. If the company is making a ton of money I would combine a 401(k) with a defined benefit plan (DBP).
A solo 401(k) is for a company with just the owner, or the owner and their spouse. They can put $18,500, if under 50, into the plan through salary deferrals. I usually like to use the Roth option for the deferrals. Then they can match 25 percent of their salary, up to $54,000.
A Safe Harbor 401(k) works the same. However they are designed for companies with employees. The 25 percent match is still valid for the owners, and the employees have to be offered the plan. If they participate, the company has to match their salary by 3 percent.
Then there’s the DBP. Depending on someone’s age, the amount they want to retire on, and other factors, the business owner can conceivably pay themselves $250,000, and then put another $250,000 into the DBP.
This is easy money. Yet, I get met with resistance all the time. The business owners like the tax deduction. However, they tell me that their plan is to sell their business, and that will be their retirement. Only in a service business can you sell your business for multiples of gross receipts — usually one to one and a half times gross. So, if you gross $500,000, the most that you can sell it for is $750,000.
Effectively, what you have done is you have sold your assets, or your client list. Your client list isn’t on your balance sheet, so your basis on the sale is the depreciable value of your assets. Most service businesses don’t have much in assets.
Let’s say that you have $35,000 in assets. They are depreciated out. You have to carry back the $35,000 in depreciation, which becomes ordinary income. There’s not much you can do to mitigate $35,000. Then you have a capital gain of $715,000, taxed at 20 percent. The total is $143,000 in tax. Still, let’s not forget alternative minimum tax (AMT), which could very well kick in, because you are using a tax-favored calculation. Let’s say AMT is $15,000. A rough tax calculation on the $35,000 of ordinary income would be $13,125. Total tax is $171,125. Your $750,000 has just been reduced to $578,875.
I had a client just do this very thing. Before I told him his tax liability, he gave his partners $75,000 apiece. There were two of them. That brings the total down to $428,875. Then he does something that blows my mind. Before I get into that, I offered to help with the sale and gave him a price. Apparently, I was too expensive, but wait until you hear what he did.
It’s never a good idea to take a liquid asset like cash, and tie it up in a fixed asset. He spends $300,000 to pay off his house. He could have invested the $300,000 and made the mortgage payment with the earnings the money made. Now we are down to $300,000 before tax. His son is moving to South Dakota, and asks his dad to buy the house, and he will make monthly mortgage payments to him. So, he gives his son $250,000. He is down to $50,000, and now wants me to figure the tax.
I give him the number, he freaks out and asks if there is anything that he can do about it. I explain that the majority of the tax is capital gains tax. The only thing that can lower that is a capital loss, which he has none. That’s not to mention the guy stays on as a consultant for three months with the new owner and doesn’t ask for any money to do so.
I believe that I quoted him $4,000 or something like that. For that drop in the bucket, I would have never let him do with the money what he did with it. He had been a client for 20 years, and I’ve been trying to get him to invest in a 401(k) for all of those years, and the answer was always my business is my retirement.
Other advice that I give, which is sometimes followed, is pay your kids a salary. You can pay them up to $12,000 without any tax consequences. In Florida we have something called the Florida Prepaid College Plan. You basically lock in today’s tuition for tomorrow’s education. Then you can put the remainder into a 529 plan to pay for books, lab fees, and everything else that Florida Prepaid doesn’t pay for. My wife and I did this for our kids when we were really young. I believe we made about $50,000 a year. We forwent meals out, vacations, new clothes — you name it. Then I see a client making $300,000, and they don’t want to save for their kid’s college.
Finally, most clients have a high deductible health insurance plan. They are healthy and never use the insurance. They have it because they have to. I read about three years ago an article that said seniors over 65 and on Medicare have to spend 60 percent to 70 percent of their disposable income on healthcare. They get this money by taking it out of their retirement plans, and it is taxable.
So, I had this idea. Why not have these clients max a Health Savings Account (HSA), each year? I present this to the client and explain that they can put $6,900 into the HSA, and the amount goes up every year. I explain to them that if they don’t use it, it simply rolls over. They can invest the funds and they grow tax-free. They get a tax deduction, and when they take the money out, provided it is used for medical expenses, it is tax-free. Then I explain about the article I read. Still it’s a hard sell.
I put all of this advice in writing, so when the client comes back and says that I never told them, I simply point to the report.
The question I have is, why would someone pay me a lot of money to do planning and then not follow my advice?
Craig W. Smalley, EA is the CEO and Founder of CWSEAPA®, PLLC, located in Orlando, Florida, with clients all over the country in every industry. He has been admitted to practice before the IRS as an Enrolled Agent, and has a Master's Certificate in Taxation from UCLA. He has been in practice since 1994, specializing in individual, partnership...