By Christopher Hynes, JD, CFP®
It was the best of times, it was the worst of times…
The modern day version of this eternal Dickensian societal observation is embodied in the 2017 Tax Cuts and Jobs Act (TCJA). The TCJA will be a windfall for some and a tax increase for others.
Understanding how to capitalize on the latent financial opportunities presented by the TCJA is an intricate and important task. So much for firing your accountant and submitting your tax return on a postcard…
By now, most physicians realize that they are not among the ‘chosen’ service professionals—such as architects and engineers—who will benefit from the 20% Qualified Business Income deduction (QBI) in “pass-through” businesses. Moreover, the vast majority of those who are residents of high tax states and high income earners will have their state/local tax deduction limited to $10,000. As a result, many physicians will see their taxes increase despite the rate reduction across all income tax brackets.
Are regular “C Corportions” the answer?
Given the reduced “flat” 21% tax available for C Corporations, many clients with whom I have spoken who cannot take advantage of the QBI deduction have a feeling of wanderlust: would it make sense to “convert” their S Corp or partnership (“Pass-Through Entity”) to a C Corporation? Moreover, this option has become ostensibly more attractive now that the “personal services” flat tax of 35%, a longstanding tax plague on the medical profession, has been effectively eliminated by the TCJA. Superficially, it would seem to be mathematically sensible to ‘swap’ 37% money for 21% money. However, as with most issues that deal with the Internal Revenue Code, the decision is not that simple.
In the context of C corporation tax analysis, one of the first topics that emerges is the fear of “double taxation.” Because a C corporation is a separate taxpayer, it will file its own tax return and pay taxes at a 21% flat tax rate on all of its income. After-tax income can then be paid to the shareholder (frequently also an employee of closely held C Corps.) of the C Corporation as either salary or a “dividend”. Income paid as salary is deductible to the C Corporation. So, in essence, it is taxed once. By contrast, income paid as a dividend is not deductible to the C Corporation. It is therefore taxed twice—once on the corporation’s return and again on the shareholder’s return. As such, the typical federal tax rate calculation on a dividend paid by a C corporation to a shareholder is as follows: 21% (Corp Tax) + 20% (dividend tax) + 3.8% (Medicare tax on investment earnings)=44.8%.
The above calculation begs the obvious question: why not simply take all of the compensation of the C Corp in salary? Treas. Reg. §1.162-8 provides that the income tax liability of the recipient of the purported salary will depend upon the fact and circumstances of each case. If payments “…are found to be a distribution of earnings and profits, the excessive payments will be treated as a dividend.” In other words, the IRS requires that amounts paid to a shareholder-employee of a C corporation for services constitute “reasonable compensation.” If compensation is unreasonably high, the excess amounts may be re-characterized as dividends. This exposes the shareholder-employee to double taxation.
More significantly, for those who are weighing the net difference between a Pass-Through Entity vs. a C Corporation, the idea of taking a salary to avoid double taxation is the proverbial tempest in a teapot. Since the salary will be taxed at “regular” income tax rates (i.e., 37%) plus employment taxes, the S-C issue is rendered moot. You end up in essentially the same place as you would be in an S Corp.
Advanced Tax Planning
When carefully and properly structured, a C Corporation that works in concert with your pass-through operating business can help you reduce your federal tax rate on a substantial portion of your income to 21%. Moreover, using some advanced tax and corporate planning, clients can receive large amounts of tax-free dollars out of their C Corporations. Additionally, the C Corporation can be used to build a discretionary (i.e., none of the employees of your Pass-Through operating business need be included) retirement plan using deferred compensation. To clarify, these benefits are neither available in Pass-Through Entities nor in improperly structured C Corps. As always, please do not attempt to do this at home.
Deferred compensation is simply an arrangement in which a portion of an employee’s income is not immediately paid out after the income has been earned. Instead, it is held by the company and the terms under which it will be paid out are detailed in a written plan between the company and the employee. Like salary, deferred compensation payments (i.e., when they are actually paid to the employee) are deductible to the C Corp (i.e., no double taxation to the shareholder-employee) and not currently taxable to the employee. Stated differently, the tax on the income is deferred to the employee and the deduction is deferred to the Corporation.
While the funds are deferred, they are invested by the C Corp. Since investment earnings are taxed to the C Corp, it is very common for the funds to be invested in a cash value life insurance policy to neutralize the corrosive effect of current income tax on investment gains. The insurance policy that serves as the investment vehicle is typically structured with the minimum contractual death benefit allowed by the IRS in order to reduce the overhead cost of the policy and maximize the potential for cash value growth.
Benefits of Deferred Compensation
For those who are already funding life insurance or would like to incorporate cash value life insurance as a piece of their retirement puzzle, this C Corp structure enables premiums to be paid with 21% after-tax money instead of 37% post-tax funds—a 43% discount! Moreover, although traditional deferred compensation is taxable to the employee when received, a smart tax attorney (is this description redundant?) can help you receive your entire deferred compensation amount tax-free. This is an esoteric yet proven exit strategy that greatly amplifies the tax benefit of an already powerful “discriminatory” retirement plan. Lastly, for those who are near the cusp of the income thresholds for the “specified services” limitation to be phased out or eliminated ($157,500 single/$315,000 married), deferring income that, if taken in the current year would make you ineligible for the 20% QBI deduction, could have an enormous impact.
Clearly, the best of times are here for those who understand how to properly structure and integrate a C Corporation into their tax and retirement planning.