Small Business Tax Briefs: August 2018
Keep it SIMPLE: A tax-advantaged retirement plan solution for small businesses
If your small business doesn’t offer its employees a retirement plan, you may want to consider a SIMPLE IRA. Offering a retirement plan can provide your business with valuable tax deductions and help you attract and retain employees. For a variety of reasons, a SIMPLE IRA can be a particularly appealing option for small businesses. The deadline for setting one up for this year is October 1, 2018.
The basics. SIMPLE stands for "savings incentive match plan for employees." As the name implies, these plans are simple to set up and administer. Unlike 401(k) plans, SIMPLE IRAs don’t require annual filings or discrimination testing.
SIMPLE IRAs are available to businesses with 100 or fewer employees. Employers must contribute and employees have the option to contribute. The contributions are pretax, and accounts can grow tax-deferred like a traditional IRA or 401(k) plan, with distributions taxed when taken in retirement.
As the employer, you can choose from two contribution options:
- Make a "nonelective" contribution equal to 2% of compensation for all eligible employees. You must make the contribution regardless of whether the employee contributes. This applies to compensation up to the annual limit of $275,000 for 2018 (annually adjusted for inflation).
- Match employee contributions up to 3% of compensation. Here, you contribute only if the employee contributes. This isn’t subject to the annual compensation limit.
Employees are immediately 100% vested in all SIMPLE IRA contributions.
Employee contribution limits. Any employee who has compensation of at least $5,000 in any prior two years, and is reasonably expected to earn $5,000 in the current year, can elect to have a percentage of compensation put into a SIMPLE IRA.
SIMPLE IRAs offer greater income deferral opportunities than ordinary IRAs, but lower limits than 401(k)s. An employee may contribute up to $12,500 to a SIMPLE IRA in 2018. Employees age 50 or older can also make a catch-up contribution of up to $3,000. This compares to $5,500 and $1,000, respectively, for ordinary IRAs, and to $18,500 and $6,000 for 401(k)s. (Some or all of these limits may increase for 2019 under annual cost-of-living adjustments.)
You’ve got options. A SIMPLE IRA might be a good choice for your small business, but it isn’t the only option. The more-complex 401(k) plan we’ve already mentioned is one alternative. Some others are a Simplified Employee Pension (SEP) and a defined-benefit pension plan. These two plans don’t allow employee contributions and have other pluses and minuses. Contact us to learn more about a SIMPLE IRA or to hear about other retirement plan alternatives for your business.
Assessing the S corp
The S corporation business structure offers many advantages, including limited liability for owners and no double taxation (at least at the federal level). But not all businesses are eligible and, with the new 21% flat income tax rate that now applies to C corporations, S corps may not be quite as attractive as they once were.
Tax comparison. The primary reason for electing S status is the combination of the limited liability of a corporation and the ability to pass corporate income, losses, deductions and credits through to shareholders. In other words, S corps generally avoid double taxation of corporate income — once at the corporate level and again when distributed to the shareholder. Instead, S corp tax items pass through to the shareholders’ personal returns and the shareholders pay tax at their individual income tax rates.
But now that the C corp rate is only 21% and the top rate on qualified dividends remains at 20%, while the top individual rate is 37%, double taxation might be less of a concern. On the other hand, S corp owners may be able to take advantage of the new qualified business income (QBI) deduction, which can be equal to as much as 20% of QBI.
You have to run the numbers with your tax advisor, factoring in state taxes, too, to determine which structure will be the most tax efficient for you and your business.
S eligibility requirements. If S corp status makes tax sense for your business, you need to make sure you qualify and stay qualified. To be eligible to elect to be an S corp or to convert to S status, your business must:
- Be a domestic corporation and have only one class of stock,
- Have no more than 100 shareholders, and
- Have only "allowable" shareholders, including individuals, certain trusts and estates. Shareholders can’t include partnerships, corporations and nonresident alien shareholders.
- In addition, certain businesses are ineligible, such as insurance companies.
Reasonable compensation. Another important consideration when electing S status is shareholder compensation. The IRS is on the lookout for S corps that pay shareholder-employees an unreasonably low salary to avoid paying Social Security and Medicare taxes and then make distributions that aren’t subject to payroll taxes.
Compensation paid to a shareholder should be reasonable considering what a nonowner would be paid for a comparable position. If a shareholder’s compensation doesn’t reflect the fair market value of the services he or she provides, the IRS may reclassify a portion of distributions as unpaid wages. The company will then owe payroll taxes, interest and penalties on the reclassified wages.
Pros and cons. S corp status isn’t the best option for every business. To ensure that you’ve considered all the pros and cons, contact us. Assessing the tax differences can be tricky — especially with the tax law changes going into effect this year.
Choosing the right accounting method for tax purposes
The Tax Cuts and Jobs Act (TCJA) liberalized the eligibility rules for using the cash method of accounting, making this method — which is simpler than the accrual method — available to more businesses. Now the IRS has provided procedures a small business taxpayer can use to obtain automatic consent to change its method of accounting under the TCJA. If you have the option to use either accounting method, it pays to consider whether switching methods would be beneficial.
Cash vs. accrual. Generally, cash-basis businesses recognize income when it’s received and deduct expenses when they’re paid. Accrual-basis businesses, on the other hand, recognize income when it’s earned and deduct expenses when they’re incurred, without regard to the timing of cash receipts or payments.
In most cases, a business is permitted to use the cash method of accounting for tax purposes unless it’s:
- Expressly prohibited from using the cash method, or
- Expressly required to use the accrual method.
Cash method advantages. The cash method offers several advantages, including:
- Simplicity. It’s easier and cheaper to implement and maintain.
- Tax-planning flexibility. It offers greater flexibility to control the timing of income and deductible expenses. For example, it allows you to defer income to next year by delaying invoices or to shift deductions into this year by accelerating the payment of expenses. An accrual-basis business doesn’t enjoy this flexibility. For example, to defer income, delaying invoices wouldn’t be enough; the business would have to put off shipping products or performing services.
- Cash flow benefits. Because income is taxed in the year it’s received, the cash method does a better job of ensuring that a business has the funds it needs to pay its tax bill.
Accrual method advantages. In some cases, the accrual method may offer tax advantages. For example, accrual-basis businesses may be able to use certain tax-planning strategies that aren’t available to cash-basis businesses, such as deducting year-end bonuses that are paid within the first 2½ months of the following year and deferring income on certain advance payments.
The accrual method also does a better job of matching income and expenses, so it provides a more accurate picture of a business’s financial performance. That’s why it’s required under Generally Accepted Accounting Principles (GAAP).
If your business prepares GAAP-compliant financial statements, you can still use the cash method for tax purposes. But weigh the cost of maintaining two sets of books against the potential tax benefits.
Making a change. Keep in mind that cash and accrual are the two primary tax accounting methods, but they’re not the only ones. Some businesses may qualify for a different method, such as a hybrid of the cash and accrual methods.
If your business is eligible for more than one method, we can help you determine whether switching methods would make sense and can execute the change for you if appropriate.
An FLP can save tax in a family business succession
One of the biggest concerns for family business owners is succession planning — transferring ownership and control of the company to the next generation. Often, the best time tax-wise to start transferring ownership is long before the owner is ready to give up control of the business.
A family limited partnership (FLP) can help owners enjoy the tax benefits of gradually transferring ownership yet allow them to retain control of the business.
How it works. To establish an FLP, you transfer your ownership interests to a partnership in exchange for both general and limited partnership interests. You then transfer limited partnership interests to your children.
You retain the general partnership interest, which may be as little as 1% of the assets. But as general partner, you can still run day-to-day operations and make business decisions.
Tax benefits. As you transfer the FLP interests, their value is removed from your taxable estate. What’s more, the future business income and asset appreciation associated with those interests move to the next generation.
Because your children hold limited partnership interests, they have no control over the FLP, and thus no control over the business. They also can’t sell their interests without your consent or force the FLP’s liquidation.
The lack of control and lack of an outside market for the FLP interests generally mean the interests can be valued at a discount — so greater portions of the business can be transferred before triggering gift tax. For example, if the discount is 25%, in 2018 you could gift an FLP interest equal to as much as $20,000 tax-free because the discounted value wouldn’t exceed the $15,000 annual gift tax exclusion.
To transfer interests in excess of the annual exclusion, you can apply your lifetime gift tax exemption. And 2018 may be a particularly good year to do so, because the Tax Cuts and Jobs Act raised it to a record-high $11.18 million. The exemption is scheduled to be indexed for inflation through 2025 and then drop back down to an inflation-adjusted $5 million in 2026. While Congress could extend the higher exemption, using as much of it as possible now may be tax-smart.
There also may be income tax benefits. The FLP’s income will flow through to the partners for income tax purposes. Your children may be in a lower tax bracket, potentially reducing the amount of income tax paid overall by the family.
FLP risks. Perhaps the biggest downside is that the IRS scrutinizes FLPs. If it determines that discounts were excessive or that your FLP had no valid business purpose beyond minimizing taxes, it could assess additional taxes, interest and penalties.
The IRS pays close attention to how FLPs are administered. Lack of attention to partnership formalities, for example, can indicate that an FLP was set up solely as a tax-reduction strategy.
Right for you? An FLP can be an effective succession and estate planning tool, but it isn’t risk free. Please contact us for help determining whether an FLP is right for you.