A Little Tax Planning

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A Little Tax Planning
Seated here with my niece Pauline at The Fish Market in Irvine, California, one of my favorite restaurants, certainly ends the week on a high note. While waiting for the Manhattan clam chowder, Pauline is bringing me up to date on her family. " . . . so Barbara is starting her senior year at high school and Randy will be a sophomore. It’s hard to realize, Uncle Al, that Jim and I will be celebrating our twentieth anniversary in just a few months."

"It’s sort of unreal to me too," I said. "It seems as though I attended your wedding only a few years ago, and Jim had just started with Barnes and Standard in the shipping department. Tell me, how are things going for him now?"

"Couldn’t be better. He received another promotion last month—he’s assistant to the plant manager now."

"Why, that’s great. It’s a fine fellow you’ve got. Oh, and by the way, how is that little antique business you started up a few years ago. Is it finally showing some signs of life?"

"Yes, it is . . . at last. I’m working with a woman that does furniture restoring, and that’s breathed some life into things. I’ve developed several sources for locating fine old pieces, and I’m starting to build a base of repeat clients. The fact is, I made almost forty thousand dollars last year and as things are going, it should be fifty this year."

"Um, that’s wonderful . . . " I remarked, but as the words came out, several discomforting thoughts came to mind. After a few moments, I leaned a little closer across the table and said: "Pauline, do you mind if I ask you a few specific questions about your business?"

"Why, not at all, Uncle Al. What do you want to know?"

"Well, first off, what form of business entity do you use?"

"I’m not sure what you mean," she said.

"Well, did you organize as a partnership, or perhaps an S corp, or simply as a sole proprietor?"

"Eh, that last one, I guess. I just filed a business notice in the name Pauline’s Antiques."

"That’s what I thought, which means your accountant lists income and expense as part of your and Jim’s 1040 tax return on a Schedule C."

"Yes, that’s right. Is that good or bad?"

Pushing the now empty clam chowder bowl to the side, I reached for a slice of The Fish Market’s exquisite sourdough bread. "Well, I’ll give you the facts and then you can decide whether it’s good or bad—but first I have to ask a personal question."

"Anything," she said.

"How much is Jim’s salary now at Barnes and Standard?"

"He’s getting sixty-five thousand a year."

As I leaned back in my chair once again, I mentally added numbers as the picture came into clear focus. Then peering directly at Pauline, I said: "Here’s the way it is: Though you may make fifty thousand this year, you’ll only get to keep about half of it."

I watched as a look of disbelief formed on the face in front of me. "What do you mean that I’ll only get to keep half of it?" she exclaimed.

"Here’s the way it works," I said. "With the joint return that you and Jim file, your income is simply added on to the top of your federal tax bracket, which is 25 percent up to about $115,000, and goes to 28 percent above that. You can then add on another 9.3 percent for California tax. Finally, every dime you make will have an additional 15.3 percent for FICA tax—that’s your contribution to the Social Security system. All together, almost 50 percent comes right off the top. You’ll get to keep maybe $25,000. Now you tell me, is it good or bad?"

"It’s terrible! How can they do such a thing?"

"That’s something that would take me about six hours to explain," I said, as the waitress arrived with two luscious orders of rainbow trout."

Pauline grimaced. "I think I’ve lost my appetite,"

I smiled slightly as I said: "Maybe things aren’t all that bad. There’s another way to skin this cat, if you’d like to hear about it."

"Anything."

"It’s fairly simple. You run your business as a corporation instead of as a sole proprietorship."

"How does that change things?"

"I’ll explain. To begin with, federal corporate income tax on the first $50,000 is 15 percent. In the second place, income to the corporation that’s not passed on as salaries is exempt from the FICA tax. And even the state helps a little with a slightly lower corporate rate of 8.84 percent. So these three items will represent a savings to you of almost $13,000. Now, does that strike you a little better?"

"Uncle Al, your suggestion certainly sounds reasonable. But just one thing: what are the drawbacks?"

"Pauline, you’re starting to ask the right questions. Yeah, there are a few things to consider. Most important, do you have to draw out any of your profits for living expenses, or can you, Jim, and the kids get by on his salary?"

"We do just fine on that. I don’t need to dip into any of the business income."

"Good, then you can pull it off. It means that the corporate profit will remain as undisbursed assets. There is, however, one complication that you’ll eventually have to face, but it’s manageable."

"And what’s that?"

"It’s something called accumulated earnings surtax, which is 15 percent collected on top of normal corporate income tax. You see, the IRS doesn’t like corporations to hoard earnings. That interferes with the double taxation they understandably find to their liking. Fortunately, however, there’s some leeway. An accumulated earnings credit of $250,000 prevents assessment of the tax until the aggregation reaches that amount. That’ll give ample time to arrange things; I’ll help you with that when the time comes. In the meanwhile, with the services of a law firm I can recommend, together with your accountant’s help, you can be set up and functioning in no time at all."

"Uncle Al, you’re a lifesaver. I’ll get on it right away. I certainly feel better."

"Pauline, it’s a pleasure. Now, is there anything else I can do?"

"Yes there is," she said, with a broad grin. "Pass the tartar sauce . . . my appetite’s come back.".