Is It Time to Tack?

I recently read an interesting article about "tacking."  I guess it will be helpful to define this term for those of you who aren't familiar with sailboats.

Tack (n.) : The act of changing from one position or direction to another

First off, I'm not familiar with sailboats either.  I have never actually been on a sailboat.  I can imagine that it might be difficult to turn any ship or boat when there is severe wind or an immediate need to change course. I'm not a sailor, but even I know you would run the risk of capsizing.  

Tacking, as defined by multiple websites, is also known as "coming about."  The process involves turning the bow of a sailboat up through the wind to change course.  However, the danger you face is in not having enough speed to carry the boat through the turn.  If you turn too sharply, you'll lose speed and stall.  I also read that a turn of the rudder by 33 degrees will provide a smooth and controlled turn without much loss of speed.

Why in the world am I telling you this?

Godwin & Associates, CPA is in the process of changing its business model.  If you've looked at our website lately (www.godwincpa.com) you've no doubt noticed the changes.  We are focused entirely on businesses and the owners of those businesses.  No longer do we accept individual tax clients who are not also working with us on business issues.  This was a HUGE change from our old business model, and certainly a massive change from what most CPA firms do.  But we decided that we didn't want to be "most CPA firms."  We wanted to make a difference in our clients' lives, and you can't accomplish that by preparing a 1040.  We can't change your world with something that a here-today, gone-tomorrow tax preparation office in a strip mall can do for you.  We can't add value to your life with a well-done Schedule A. But if you own a business, we can change your life.  That's strong stuff.

To make a change like that takes intentional and purposeful work....hard work....and a vision that is unaffected by fear or queasiness.  Believe me, there was a lot of fear and heartburn when the thought first crossed my mind.  But the benefits far outweighed the potential risks.  So, with the wind at our backs, we decided to change course.  With some fantastic business coaching from a CPA friend of mine, we have begun our 33 degree turn, hoping that we can maintain speed and not stall.  When the turn is complete, I'll let you know how it went.

I have such a great career, and as I have mentioned on many occasions, I work with some fantastic entrepreneurs who share their stories with me.  Just today, I had breakfast with two owners of a company that started almost a year ago.  One of the owners remarked that the work he's doing now is nothing like what he thought he'd be doing when he drafted his business plan, but he absolutely loves it.  He hasn't given up on the other work, but the income-producing work just didn't fall into that category.  It will later, but not today.  In a start-up, sometimes the tacking is done more out of necessity than just desire to change things up.  You need income; you change course from looking at type A work because type B work just walked in the door; you dive into type B work and then take type A work as it arrives.  Done.

Existing businesses that change course have it a little tougher because breaking habits is hard.  Tie your income to that habit and you have some serious decisions to make.  We were fortunate enough to be able to consciously decide to change our business model.  Is there anything about your current business model that needs adjustment?  Is it time for you to tack? 

Jason Fried of 37 Signals, Basecamp & Rework fame spoke about this at the GROWCO conference in Nashville, TN in May.  We liked what he had to say.  If you have 6 1/2 minutes, you might to! Check it out:

http://www.inc.com/jason-fried/inc-live-why-you-should-power-pivot-your-mission.html

Keeping Wealth in Your Family's Future

According to a new study by Merrill Lynch’s Private Banking and Investment Group, family wealth fails to outlive the generation following the one that created that wealth in more than two out of three instances; 90% of the time, “assets are exhausted before the end of the third generation.” 

This report focuses on investors with more than $5 million, but the principles apply just as well to those with $500,000 or even $50,000 to invest. If you are concerned about the financial security of your children and grandchildren, you should set a good example and discuss money matters regularly with your descendants.

Savvy spending

One reason that family wealth may not last very long is simple: people spend too much. 

In the Merrill Lynch study, more than half of the respondents either expressed confidence that a 6% distribution rate could sustain an investment portfolio indefinitely or did not have any idea of how much could be withdrawn prudently. 
To put this in perspective, research indicates that a sustainable distribution rate might be as low as 2% of portfolio value a year.

           
 Obviously, the less you spend the more that can pass to a surviving spouse and to your descendants. Spending moderately will signal to your loved ones that this is how one builds and maintains net worth. In addition, you can make sure that your heirs know that your spending habits are designed to minimize the chance of depleting the family’s coffers.

Continuing the conversation

Indeed, perhaps the most important thing you can do to preserve wealth in your family is to regularly talk to your children about finances. Remember to keep the discussions age appropriate. With very young children, you might talk about how money is earned by working, how some money goes to taxes to pay for schools and other services, and how what’s left might be either saved or spent. Avoid getting into too much detail with youngsters, who probably will be overwhelmed and, therefore, intimidated rather than educated.

           
 Once your children are ready for college, you can have practical conversations about their choice of study and eventual career path. A student who knows a substantial inheritance lies in the future, or who can play a possible role in a thriving family business, might be inclined to consider a course of study that relates to a personal passion; another student, one who understands that his or her lifestyle will depend on his or her earnings, could go in another direction.

            
Similar conversations might take place when children are about to become parents or are shopping for a home. The more they know about your finances, and about their own prospects for an inheritance, the greater the likelihood they’ll make informed decisions.

            
On the flip side, holding these ongoing conversations with your children can educate you, too. You might discover a need for gifts or loans that you hadn’t known about. Conversely, you might realize that your children are uninterested in financial matters and may make poor decisions if they inherit money outright. If so, you may have the opportunity to build safeguards into your estate plan, such as giving or leaving money to a trust for a child’s benefit.

Hitting the highlights

Of course, some parents will not want to reveal all the details of their financial affairs to their children. In truth, that’s not really necessary. You might give your children an overview, with enough information to impart what you are willing and able to provide during your life and a general idea of what they might inherit someday. In addition, you can tell your children where to find key documents and also provide contact information for your professional advisors.

           
 Once you bring your advisors into the inheritance conversation, keep in mind that some studies show that both parents and children may be more comfortable discussing their circumstances with a financial professional (CPA, attorney, financial planner) than with each other. If that’s the case in your situation, you might ask a professional with whom you work to suggest and even host a meeting of the generations. Our office would be pleased to help you get the conversation started.

Ask us for our Personal Cash Flow spreadsheet to help keep track of your expenses!

"Reasonbable Compensation" for S Corp Owners

For regular C corporations, “reasonable compensation” can be a troublesome tax issue. The IRS doesn't want shareholder executives to inflate their deductible salaries while minimizing the corporation’s nondeductible dividend payouts.

            
For S corporation owners, the opposite is true. If owner employees take what the IRS considers “unreasonably low” compensation, the IRS may recast the earnings to reflect higher payroll taxes, along with interest and penalties.

One pocket to pick

Eligible corporations that elect S status avoid corporate income taxes. Instead, all income flows through to the shareholders’ personal tax returns.

            
Example 1: 
Ivan Nelson owns a plumbing supply firm structured as an S corporation. Ivan’s salary is $250,000 a year while the company’s profits are $400,000. The $650,000 total is reported on Ivan’s personal tax return.

            
In 2014, Ivan pays 12.4% as the employer and employee shares of Social Security tax on $117,000 of earnings. He also pays 2.9% Medicare tax on his $250,000 of salary. As a result of recent tax legislation, Ivan—who is not married—owes an additional 0.9% Medicare tax on $50,000, the amount over the $200,000 earnings threshold (the threshold is $250,000 on a joint tax return). Altogether, Ivan pays well over $20,000 in these payroll taxes.

Going low

Often, S corporation owners have a great deal of leeway in determining their salary and any bonus. Holding down these earnings may reduce payroll taxes.

 Example 2: 
Jenny Maxwell owns an electrical supply firm across the street from Ivan’s business. Jenny’s company also is an S corporation. She reports the same $650,000 of income from the business but Jenny classes only $75,000 as salary and $575,000 as profits from the business. Thus, she pays thousands of dollars less than Ivan pays for Social Security and Medicare taxes.

Proving your payout

As mentioned, the IRS might target S corporation owners suspected of lowballing earned income. Therefore, all S corporation shareholders should take steps to justify the reasonableness of their compensation.

If you own an S corporation, consider spelling out your salary level in your corporate minutes. Where possible, give examples and quote industry statistics that show your compensation is in line with the amounts paid to executives at similar firms. Other explanations also might help.

            

• Depending on the situation, you might say that business is slow, in the current economy, so the minutes will report that you are keeping your salary low to provide working capital for the company. 
• If your business is young, the minutes could explain that you’re holding fixed costs down, so the company can grow, but you expect to earn more in the future. 
• In still another scenario, you might say that you are nearing retirement and making an effort to rely more on valued employees, so a modest level of earnings reflects the actual work you’re now contributing.

As illustrated above, holding down S corporation compensation can result in sizable payroll tax savings. (Our office can help you establish a reasonable, tax-efficient plan for your salary and bonus.)

Calculating coverage

Beyond compensation, health insurance also may affect the payroll tax paid by an S corporation owner. Special rules apply to anyone owning more than 2% of the company’s stock.

            
If the company has a health plan and pays some or all of the costs for coverage of such a so-called “2% shareholder,” the payments will be reported to the IRS as taxable income. However, that amount will not be subject to payroll taxes, including those for Medicare and Social Security. 
The company can take a deduction for these payments, effectively reducing corporate profits passed through as taxable income for the shareholder.

            
In addition, the S corporation shareholder may be able to deduct the premiums paid by the company—this deduction can be taken on page 1 of his or her personal tax return, which may provide other tax benefits. However, such an “above-the-line” deduction cannot be taken in any month when the shareholder or spouse is eligible to participate in another employer-sponsored health plan. Also, this deduction can’t exceed the amount of the shareholder’s earned income for the year.

            
This can be a complicated issue, especially if your state law prevents a corporation from buying group health insurance for a single employee. If you own an S corporation, our office can help you decide the best way to hold down payroll tax as well as income tax from your health plan.