Dave Cain: Welcome to unsuitable on Rea Radio, the award-winning financial services and business advisory podcast that challenges your old school business practices and the traditional business suit culture. Our guest are industry professionals and experts who will challenge you to think beyond the suit and tie while offering you meaningful modern solutions to help enhance your company’s growth. I’m your host Dave Cain.
So far this year on the podcast we’ve talk a awful lot about tax planning, business planning for businesses, and how difficult tax planning can be as we move forward into these complicated times. Here to share some really great tax planning advice is Chris Axene. Chris is a principal with Rea & Associates attached to the Dublin office. Chris is responsible for overseeing the firm’s federal tax practice and is a newly appointed member of the board of directors for Rea & Associates, quite an impressive resume. Welcome to unsuitable Chris.
Chris Axene: Thanks Dave, glad to be here.
Dave: I want to share a little story with you. Our listeners can go on SoundCloud and iTunes and write reviews and comments. We have a long time listener over in the western part of Ohio who’s listening to I think all 75 approximately shows. His comment was, he says, “I’m a self proclaimed nerd. I would like, my suggestion is, that you have more nerds on the podcast.” So we shared that with the marketing team and they went to work and apparently they came up with you.
Chris: I’m the first one at the top of the list.
Dave: Yeah.
Chris: I own it. I made a career out of it.
Dave: Would you say that it fits?
Chris: Classify as a nerd? Absolutely.
Dave: See, I don’t know if I’d go quite that far. Obviously you have a pilot’s license, you’re 19 handicap, you’re a gin drinker, occasionally like to have a cocktail as neat. I don’t know that those are attributes of a pure nerd.
Chris: Well, they certainly seem to be a list of vices, so thanks for broadcasting that.
Dave: Yeah. Now we know. That’s where you go to get a lot of your aggressive tax plan.
Chris: That’s where I get all my inspiration from.
Dave: You do. You do, but anyway, one of the things that is upon us is tax reform. It’s going to happen, you know that and our listeners know that. One of the items that I think you and I talked about that we wanted to explore today is the choice of business entity. That can be very complicated and very, very detailed, but decided we’ll give it a go.
Chris: Sure.
Dave: Let’s start out, what is “choice of entity” and what does it mean?
Chris: Sure. Choice of entity for business owners is a decision that you make at the start of the life cycle of the business. How will they organize themselves? Both from a legal and a tax perspective. There are choices that you can make. You make that choice and you move forward. One of the reasons that I like to talk about choice of entities is because in that world I get to play with shapes. You have squares and triangles.
Dave: And buckets.
Chris: No buckets in choice of entity, that’s a different podcast. But then you have squares with circles in them, all those things have meaning in the planners’ world with regard to the type of entity that you are.
Dave: How many types of entities are there? What are my choices? Do I have to be a sole proprietor?
Chris: Sure. So, nowadays what you see are those that startup a business, and maybe you’re working out of your home and you’re making tchotchkes and using Amazon to sell them and ship them out, you might be a sole proprietor. That really isn’t an entity, that’s Dave Cain doing business as Dave Cain. That’s been around as long as creation has been around. When we start to get into choice and formally moving into an entity type, we may get lawyers involved to set up an entity. It might be an LLC, nowadays that’s a common type of entity.
Dave: Limited Liability Company.
Chris: Limited Liability Company. Then you have your old guard type entities, an S-Corp or a C-Corp. They all have meanings both in the legal world and the tax world.
Dave: Different entities depending on what industry, is that the starting place?
Chris: Sure. Yeah, the type of industry you’re in, the type of capital you might be trying to attract to invest into your firm can dictate what type of entity you setup or change to. As well as long term goals in terms of do you want to go public? If you are in a type of industry or business where the exit strategy is to go public and be listed on a stock exchange you need to be C-Corp to do that.
Dave: Okay, let me give you a couple examples, maybe you can respond to those. Let’s say I’m a startup company, I’m starting up a manufacturing firm.
Chris: Okay.
Dave: Just purchased a manufacture, what would be my choices and maybe your recommendations in that field?
Chris: Yeah. Certainly you want to create a legal entity so that you, as the lawyers would say, you can insulate exposure of the business to your personal assets as the owner of the business. What we see nowadays most of the time is using an LLC because of the flexibility that a Limited Liability Company offers. In particular within that, a Limited Liability Company can make an election, a tax election, to be treated as something else for tax purposes, either an S-Corp or a C-Corp.
When you’re starting up a manufacturing company, and we’re going to assume you’re going to go with an LLC with one owner, the nice thing about that in the short run is most business go through a period where they incur startup losses as the business gets ramped up, they’re incurring more expenditures than revenues coming in, and in those early years you want those losses to pass through to the owner’s tax returns. A lot of what we see in the beginning is an LLC that there’s only one owner, they don’t make an election to be something else and so those losses that are incurred, the whole business gets reported on their individual’s tax return and then the loss flows through.
Dave: As we move towards tax reform, is the single member LLC on the table for discussion? Anything you’re hearing in that front?
Chris: What’s interesting is that the prevailing wisdom for the last 40 years has been by and large, C-Corps are not good from a tax perspective. They have traps to them and so you want to be a flow through type of entity, whether that’s an S-Corporation or if you have multiple partners you might be an LLC taxed as a partnership. The dialog around where is tax reform going is all about tax rates, and a C-Corporation is itself a tax payer, a tax paying entity. It has a different set of tax rates.
The highest tax rate in a C-Corp for most businesses that are not public companies is 34%. Contrast that with the highest individual tax rate right now, 39.6%, you can see there’s a difference and president Trump and members of the congress have all said that individual tax rates are too high. They’ve also said that the tax rates on corporations are among the least competitive in the world, if not the least competitive. The dialog has been, “Well, we need to reduce corporate tax rates and we need to reduce individual tax rates,” but the plan to do that hasn’t been discussed at all and thought out and so we don’t know today, as we’re recording this, we don’t know where that will end up.
Dave: Let’s go back to information that we talked about in the intro to the podcast. We talked about you being a 19 handicap, can you win money this summer with a 19 handicap?
Chris: You can if you play with the right players.
Dave: You could probably be a 16 handicap if you’d lay off that gin.
Chris: I tell people that I’m a five handicap on the range, it’s just when I get to the course, when the money’s on the line, that the handicap goes up.
Dave: I want to follow up on something you said about flow through entity. That’s a term that is tossed around in the professional advisor community, but sometimes it’s misunderstood out in the everyday world. Let’s talk about a flow through entity. Can you go back and define what a flow through entity is?
Chris: Sure. In the tax world, as I said, a C-Corporation is not a flow through entity because it itself is taxed. It files a tax return, it reports the income and it pays tax. A flow through entity in contrast, either a C-Corporation or a partnership, the entity while there’s a information return that gets files, the entity itself is not taxed. The income, the business income from the entity, flows through to the owners and is taxed on their personal tax returns. Therein is where the term flow through comes from.
Dave: Good, thank you for clarifying that.
Again, there’s a lot of information out there. One of the items, you talked about the Limited Liability Company, what are the items that we see on a more frequent basis than I can imagine, or would like to see, is that owners of LLCs are receiving W2s. Does that pose a risk?
Chris: Yeah. The LLC has been around since the late ’70s. The tax rule of what you do with an LLC have only been around since 1997. From that perspective and in that regard there’s still much to be worked out and payroll is one of those areas. The IRS’ position on that is an LLC owner as a partner in a flow through type arrangement is not an employee. Employees are the only class of worker that gets W2s, so if you’re not an employee they consider the LLC owner a sole proprietor in that regard, and sole proprietors don’t get paid via a paycheck. When you have more than one owner in a flow through entity that’s a partnership, you get what’s called a guaranteed payment.
Dave: Okay, so if I’m, quote, “violating the rules,” unintentionally, can the protection that the Limited Liability Company gives me, can that be pierced?
Chris: What happens is the exposure comes about because of … It’s all about paying employment taxes. If the owner’s on the payroll with the rest of the employees of the partnership, the payroll taxes have been paid but they’ve been paid in the wrong way, in the wrong mechanism. It’s been rare that I’ve seen it, actually happened in reality where an agent on an exam says, “Well gee, why is the partner on the W2?” Because of this we know we don’t like that so we’re going to assess penalties on you over here individual because you didn’t remit timely those payroll taxes, even though they were remitted timely just via the W2.
Dave: It’s just a different way, and I think that’s an understanding, I think there is a misunderstanding out there on how that’s to work. Chris I’ve heard mention in your elevator speech a number of times that you’re a planner and a fixer, and certainly entity selection fits in that. Can you share with our audience the difference between a planner and a fixer and the fees I’m going to pay you?
Chris: Sure.
As I tell clients a prospective clients, I’m far more effective as a professional advisor and as a tax advisor when I have the luxury of time upfront before they’ve done something and to be a planner, to plan for the transaction, to plan to advise them on: “Okay, based on what you’ve told me this may lead to a bad tax answer, so can we restructure what you want to do and still achieve your business goals but fix our bad tax answer?” Therein lies the value of what I do on a daily basis, and CPAs, when you know ahead of time what the client’s going to do, as opposed to the client comes after the fact and says: “This is what I’d done.” It’s already done, and then the fixer mode has to kick in, is there something I can do at that point to try to mitigate the bad tax answer that resulted?
Dave: Another example, and I think you’ve share this story, that the internet is a powerful tool but it’s not a place to go to get a copy of an operating document or the articles of incorporation. This is not a do-it-yourself, do the dry wall, hang a door, this is certainly very, very complicated. I think that’s where the planning versus fixer comes in.
Chris: Sure. We all see the commercials for the services out there that you basically give them your name, your address and a phone number, and they spit out a legal document for you. The problem with that is those are by design and on purpose very generic, and what happens is is that it can’t address the realities of the specific situation you have with your business and your partners that you may have with it. That’s why it’s important in the whole discussion of tax planning in general, and certainly with choice of entity, you need to have both the tax planner or CPA at the table, as well as the attorney. Because the attorney’s going to be the one drafting the documents and they’ll provide input on the discussion and the conversation of the legal ramifications of the choice that is on the table to decide.
Dave: Pretty soft spoken today, usually you’re very loud and boisterous. Are you trying to act important today? Or you got that nerd voice going?
Chris: Yeah. It’s a serious topic. I have a scratchy voice so I’m trying to make sure that I can hang in there through the entire-
Dave: Need to gargle with some brown liquor.
Chris: Maybe.
Dave: Maybe? Maybe after the podcast.
Chris: Maybe after.
Dave: Chris we talked about the startup entities and the sole proprietor and the schedule C, certainly that I think you’ve given some great insight, but what if I’ve been in business for 20 years? I may be an S-Corporation or a C-Corporation, should I continue status quo, or do I have to have that looked at? Should I look at that as we go forward with some pending changes?
Chris: Yeah, great question. The answer is, it’s not something that you start, that you create in the beginning and then you put it, metaphorically, in a drawer and forget about it, because the business changes as it goes through its life cycle and therefore the type of entity can change as well. You don’t want to set it and forget it, to use a phrase on TV. It can have negative ramifications down the road, particularly when you are looking at exit strategy.
Dave: That was the next question on the list, would be, when I go to sell the business, and every business that you start at some point you’re going to give it away or you’re going to sell it, choice of entity come into play there? Can I make a mistake?
Chris: Sure. This is where the planning part of it really comes into play. If for whatever reason we find ourselves with a business owner that’s a C-Corp, and I’ve mentioned that a C-Corp is itself a tax payer. C-Corp is known for having two layers of tax on a dollar of profits generated, you have the tax at the entity level and then you have the tax on the net cash distributed to the owners, which is not a good thing versus a flow through. In addition there is only, unlike individuals who have a lower capital gain rate on income that’s capital gain income, the C-Corp doesn’t have a special capital gain rate, it’s all taxed at one rate.
Dave: So you have to look at the capital gain, where that stands.
Chris: A lot of, most, business owners will say: “Well, you know, you got this to whether I own a C-Corp or whether I own an S-Corp, I’m going to sell my stock because I know that gives me capital gain.” I smile and I say, “Well, who’s holding the cards in the transaction?” In every transaction somebody’s holding the cards. If you’ve got a strategic buyer that really wants your business, then maybe you can sell your stock, but in my experience most of the time buyers want to buy assets because they don’t want to lock up their purchase price in the stock that sits there and does nothing for them for the period that they own this company, rather they’d want it in the assets because they can recover their purchase price over a shorter period of time.
Dave: I think I hear what you’re saying, is that in the next year, year and a half, as the new tax law unfolds; it’s time. It’s time to take a look at the entity again, every business owner should do that. I think that’s a great piece of advice because there may be some changes in the tax law that will impact what type of entity.
Chris: Yeah. I have a little saying that I’ll throw at you here, to me choice of entity is like your HVAC or your hot water tank, you don’t pay it much attention as long as it’s doing what you think it should be doing, you’re fine. Until the point in time when it lets you down, and normally that’s a surprise. In the tax planning world with choice of entity and particularly an exit strategy, you don’t want that surprise at the end.
Dave: Great. Let me give an example as we close down the podcast. Again our guest today is Chris Axene, a federal tax specialist with Rea & Associates. Chris, let’s say you and I want to start a new business. Let’s say that we want to have a web design or a podcast design company and we want to start a business. I want to use my 401k money to start that, can I do that?
Chris: Yeah. Your question is a good one because it gets to the heart of every entrepreneur, is where does the capital come to start up the business? There’s only, you have your savings, your checking, your credit cards and then if you were employed some place else you may have a 401k. While that’s supposed to be for retirement, far off down the road, it is an enticing pool of money that potentially can be used. The answer is yes it can be used, and I have a client that has done it. It’s called a Rollover Business Stock transaction, so called ROBS as an acronym. It’s complicated, it’s fraught with traps because you are using tax deferred money to fund a personal business. It’s not for the faint of heart, it has cost associated with it, but I have a current client that’s done it and I have another one that’s investigating looking into it now.
Dave: Great, fantastic. Thanks again for joining us on Unsuitable Chris. I think we responded to our listeners, they wanted some nerds and I think we at least tried to get that on tape here.
Chris: Thank you for having me. I’m happy that I was able to please the audience.
Dave: Important listeners, please do not play a Nassau game with Chris, he’ll run into a 25 foot put and break your heart. Giving us a lot to think about, thanks Chris, you’re very famous in this area.
Listeners, if you have more questions for Chris or you want us to cover more topics like this in the future, let us know. Send an email to podcast@reacpa.com. You can also get more information about this topic on our website at www.reacpa.com.
Until next time I’m Dave Cain, encouraging you to loosen up your tie and think outside the box.