Bill and Sue started their business several years ago. After a few years, it began to yield good profits and the tax man began knocking. During tax season they asked their accountant what they could do to get this tax bill down and, after consideration, they settled on setting up an S-Corp. This was a great solution at the time. It kept Social Security and Medicare taxes away from their profits and saved them a little more than 13% on this money. Great! Right?
We wrote an article discussing that the answer you are looking for now may not work in the long-run. The case of an S-Corp is a prime example of this.
You ask your professionals, what can I do to lower my taxes? And they work to give you an answer.
Eugene Lonesco said it best, “It is not the answer that enlightens, but the question.” Your answer should be met with a question or questions. The first one should be something like this:
What are the long-term plans for the company? Maybe this leads to more questions. What do you expect the growth to look like? Would you ever sell it? Would you like your kids to be part of it? What about the rest of your assets? What do they look like? What are the plans for these? What about other income? Will you be working in this business forever? Will there be spin-off companies? What are other thoughts that pull at your heart-strings or get your juices going?
Most people look at a list of questions like this and say…I can’t think about that now. I have no idea. Let’s just do something and kick the can down the road.
The problem is that you aren’t kicking the can down the road. Every day you are successful it means you are continuing to build a bigger and bigger tax bomb! Yes. That is correct. S-Corps are great for the mom-and-pop shop that has little to no assets and nothing to really sell when mom and dad retire. They are not great for transferring to another generation, selling to a third party, or for giving you flexibility as you grow.
Let’s go back to Bill and Sue. After decades of success, they decided to sell the business lock, stock and barrel. Granted, they don’t have a fortune 500 company, but they are excited. A potential buyer is offering $5 million! Their hard work is paying off. Their accountant runs the numbers for them on what the sale will look like and what they will have after paying taxes. “Well… it could be one of two numbers,” he states. “It will depend on what your capital gains rates look like after the reconciliation bill in Congress. You will either owe about $1.2 million or $2.2 million. This means you will net $3.8 million or $2.8 million from your $5 million-dollar sale.” By the way—that was just federal taxes.
Bill and Sue have sticker shock and find us through a friend. Well, coming to the table in the final hour is never easy anyway, but the S-Corp is a problem in itself. Under another structure, we may have been able to design a sale where there are no upfront taxes or lower them drastically now and in the future. We may have had the flexibility to curtail the risk of a tax rate change. And frankly, keep more money for Bill and Sue, their family, and the causes they have that are near and dear to their heart.
S-Corp = Limitations
Don’t get me wrong. There are pros and cons to every type of ownership. These should be thoroughly weighed by your legal advisors and tax professionals. But…and this is a big but…they also should be weighed against the prospects of what your future might hold, not limited to your current situation. You should always “begin with the end in mind” as Dr. Stephen Covey says.
There is an old saying we use over and over again: You don’t know what you don’t know. And that is the very thing that may end up hurting you. So don’t let it. Let us help you plan to live your full Life on purpose starting today!