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I find that most people have a good grasp of the basics when it comes to entities, but are often missing the little things that can have a huge impact (good and bad) on tax savings. I have a real-life story that captures this well.
Pierre is starting a business and calls his tax preparer to ask what type of entity he needs for his business. Pierre’s tax preparer responds with what Pierre refers to as “confusing accountant talk,” but Pierre is able to translate enough to learn that S Corporations are best for businesses. So Pierre forms his S Corporation and is off and running his new business.
At the beginning of the next year, it’s time for Pierre to do his tax returns. Pierre’s new business had losses its first year, which Pierre expected. While Pierre is not excited about the losses, he is excited that at least the losses will offset his wife’s salary so they will pay less in tax.
But Pierre is shocked and surprised when he receives his tax returns! First, he learns he can’t take his business losses currently because he didn’t fund the losses personally. Instead, his S Corporation funded the losses by getting a bank loan that Pierre guaranteed. Second, not only does Pierre have an unexpected tax liability, he also has higher tax return preparation fees because he now has 2 tax returns to file – his personal tax return and his S Corporation tax return.
Better Tax Results with a Sole Proprietorship than an S Corporation! Really? In this tax story, Pierre would have had better tax results if his business was taxed as a sole proprietorship. In a sole proprietorship, the losses would have been fully deductible and the business activity would have been included in Pierre’s individual tax return so there would have been only 1 tax return to file. Plus, this could have been done in such a way so Pierre could still have his business taxed as an S Corporation in the future.
Pierre was shocked to learn this! He had always heard that sole proprietorships were terrible and to avoid them by any means necessary!
STOP RIGHT HERE! The first time I shared this story, I received some emails from readers telling me I was crazy. Was I really suggesting a sole proprietorship over an S Corporation? The answer is yes and no. Yes, for tax savings purposes. No, for legal purposes. The good news is you can have it both ways because…
Tax Terms Do Not Have the Same Meaning as Legal Terms
Tax strategies and asset protection planning use the same terms but they have very different meanings.
Let me give you an example. You buy a rental property and put it in a Limited Liability Company (LLC). You are the only member of the LLC.
For legal purposes, your rental property is owned by an entity – your LLC. For tax purposes, your rental property is treated as if you owned it directly – meaning it is taxed as a sole proprietorship.
In this case, there is a sole proprietorship for tax purposes but not for legal purposes.
LLCs are extremely flexible in how they are treated for tax purposes, making it possible to have a sole proprietorship for tax purposes and an entity for legal purposes. Even better, LLCs can also be taxed as Corporations (C or S Corporations), so they are extremely effective when creating tax saving entity structures.
Why Didn’t Someone Tell Me This? Pierre learned all of this too late and of course asked his tax preparer, why didn’t I know this? And that’s the heart of this issue. Pierre did the right thing by asking his tax preparer about the entity early on, but it was an issue of – you don’t know what you don’t know.
In a perfect world, the tax preparer would have asked the right questions to learn more about Pierre’s goals and situation and would have translated “confusing accountant talk” into something clear and understandable. In general, S Corporations are good entities for businesses. But, they can be terrible when there are losses, and losses are common when a business first begins.
Expert Advice in a Cash Crunch
Tax advice is very specific to each person. When I first work with a new client, I spend at least 3 months with that client focusing on their goals in order to create a tax structure that works for them. And I coach them on the triggering events they need to be aware of that will change their tax structure so they learn when they need to ask questions.
Business owners and investors need expert advice when they are starting their business or investing and this is the same time when they feel the greatest cash pinch! It’s clear from the business owners and investors I talk to that they all want the expert advice, some believe (right or wrong) that they just aren’t in a position to pay for it at that moment. What they usually do is get a quick answer (like Pierre) and deal with it later. Unfortunately, the nightmare stories people share with me end with “deal with it later” meaning paying much more later.
Cost Effective Solution
Many people ask me if I have a “cost effective” solution. Translation: “I’m willing to spend a few hundred dollars, do some of the leg work myself and I want a lot of bang for my buck!”
I learned quickly that business owners not only want, but need, an inexpensive way to get up to speed on entities and tax structures so they can better prepare themselves to meet with their tax preparer.
Over the past year I have taken the key points, questions and scenarios I use to coach clients and created a “cost effective” solution – a 5 part teleseminar course designed to create awareness about the little things that have a huge impact on tax savings.
Behind Every Secret Remember, behind every one of my secrets is knowledge – the type of knowledge that makes you aware of what creates massive tax savings so you begin to see your daily routine a little differently…like the huge impact entities have on your tax savings!
