Part II of this series focused on the ideal corporate setup for existing or new small business owners. The article provided a broad overview of the benefits of the recommended structure. The recommended structure is a limited partnership with a corporate general partner. The corporate general partner controls the management and administration of the limited partnership. This article focuses with greater scrutiny on the potential tax benefits of the structure.
Many taxpayers are business owners without even realizing it. The corporate executive that owns several rental properties and trades his own investment portfolio has two businesses. The plumbing contractor that owns rental real estate along with several laundromats while trading stocks has three different businesses. Many Americans sat at home during the pandemic and became day traders chasing the record setting level of market performance. Congratulations, you are a new business owner!
What is the Optimal Corporate Set Up?
The basic structure is a limited partnership that has a corporate general partner. The business owner forms a new limited partnership (LP) and a new C corporation to serve as the corporate general partner. The business owner owns 100 percent of the shares of the new C corporation or shares ownership with a spouse. These shares could also be owned by the business owner's revocable living trust. The C corporation serves as the sole general partner owns a 1-2 percent interest in the new limited partnership from Day 1. The business owner personally initially owns a 98-99 percent in the new limited partnership. These limited partnerships can subsequently be gifted to children or trusts for various family members. These gifts may create an opportunity to shift income into lower tax brackets. The business owner creates a new limited liability (LLC) company for each separate business or real estate activity. Existing LLCs are assigned to the limited partnership.
What is the Tax Benefit of the Optimal Corporate Set Up?
If you have an existing operating business that is structured as a S corporation, consider making an election to have the corporation taxed as a LLC. The potential tax consequences of the conversion from S status to LLC status must be considered. The liquidation of the S corporation will trigger a capital gains tax on any appreciated assets owned by the S corporation. One of the limitations of S corporations is the limitation on permissible shareholders and the limitation to a single class of stock. A non-tax benefit of the LLC is “charging order” protection. Under the "charging order" protection of most states, a creditor of a debtor-member of an LLC does not just get the member’s interest in the LLC, the creditor only gets the charge against the economic interest of the member. This does not confer on the creditor any management or voting rights, but simply diverts the debtor-member’s distributions and allocations to the creditor. If no distributions are made to the member, the creditor will be taxable on any income allocated (but not distributed) to the member. This phenomenon is referred to as "Ko'd by the K-1."
One of the benefits of the suggested limited partnership format is the opportunity to eliminate the need to contribute to FICA and Medicare due to a special provision in IRC Sec 1402(a)(10) which exempts limited partners from FICA and Medicare taxes. Over the course of a business career, the level of FICA/Medicare savings invested at over twenty-five years at 7 percent amounts to a significant amount approximately $1.4 million over that time. The maximum limit on earnings for self-employment withholdings for social security and Medicare is $137,700 in 2020. The self-employment tax rate is 15.3%. The rate consists of two parts: 12.4% for social security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance). These savings can be reinvested. The reinvestment of the maximum amount of FICA/Medicare taxes ($21,068) at 7.5 percent each year over a thirty-year period would accumulate to $2.34 million dollars. That amount is nothing to sneeze at!
The general partner of the limited partnership should be structured as a regular corporation (C corporation). The general controls the management and administration of the limited partnership's operations. From a tax planning perspective, an important planning benefit is the ability to select a tax year end other than a calendar year end (12/31)/ creating staggered year ends for tax purposes. Using our planning structure, the corporate general partner elects a corporate year end that is not a calendar year end (12/31). Individuals, limited liability companies, partnerships and S corporations are generally required to have a tax year ending on December 31st in a given year. Professional service corporations are also required to have a calendar year end. The proposed structure provides an interesting vehicle to create a tax deferral vehicle at the corporate general partner level through the selection of a staggered year end by electing a year end other than a calendar year end. The corporate general partner's tax return is due three months after its year end with the ability to secure a six-month extension. A corporate general partner with a November 30th year end could defer the payment of income paid by the limited partnership as a management fee for approximately 18 months.
An additional planning opportunity is the ability for the corporate general partner to create a Qualified Self-Employment Health Reimbursement Account (QSEHRA) which would allow the corporate general to establish a Health Reimbursement Account that can be used to be used to make contributions for the payment of health insurance premiums and payment of medical expenses that subject to deductibles and copayments or otherwise are not covered by the health insurance plan. The annual limit for a family in 2020 is $10,600 or $883.33 per month. The annual limit for a single taxpayer is $5,250 or $420.83 per month. This is an important benefit for taxpayers who otherwise pay health insurance premiums with after-tax dollars.
A corporation is generally able to deduct all necessary and ordinary expenses for tax purposes. One planning measure for consideration is the transfer of the personal vehicle that you own or lease to the corporation. Following the transfer of the vehicle, the vehicle becomes a company owned car making all the vehicle’s expenses associated with the vehicle tax deductible.
The corporate general partner has the option to create a qualified retirement plan. Children might be added as employees at the corporate general partner level so that they can participate in the corporate general partner’s 401k or Roth 401k. the contribution level per employee in 2020 is $19,500 per employee. A future article will articulate how this type of arrangement can benefit the children’s savings for college or the down payment of a house or "seed capital" for a new business.