Most closely held/family businesses are S corporations, which means they do not pay taxes. Almost all profitable small businesses should be an S corporation, as opposed to a tax-paying C corporation. Yet, one of my standard lines is, “Every small business owner is entitled to one good dog and one good C corporation.”
With that said, this is the corporate setup I usually recommend to profitable family businesses: Your operating company should be an S corporation, which I will call Success Co. An LLC is acceptable, too. A new C corporation, Newco, should be created for federal income tax purposes. Its business purpose would be to provide sales, marketing and administrative services to Success Co. On a regular basis, Newco will receive payment for its services. The compensation that Success Co. pays is deductible, and it is income to Newco.
Listed below are some of the tax benefits that Newco could provide for the owner and other selected employees:
Qualified retirement plan benefits. Newco should adopt a qualified retirement plan such as a 401(k) or profit-sharing plan that allows significant contributions for the benefit of its few employees. (This is usually the owner of Success Co. and his or her family members.)
Health care insurance. Newco can pay for and deduct (a) 100 percent of the health insurance premiums and (b) any uninsured medical or dental expenses that the employees, their spouses and dependents incur. These benefits are tax-free to the employees.
Entertainment expenses. Newco, as a C corporation, is taxed at the rate of 15 percent on the first $50,000 of taxable income. Under current tax laws, only 50 percent of entertainment expenses can be deducted. The remaining 50 percent is essentially paid out of after-tax dollars. Assume that Success Co. is in the highest tax bracket. When these non-deductible expenses are paid by Newco, they are paid with 85-percent, after-tax dollars rather than 65-percent, (Success Co.) after-tax dollars.
Long-term care. Newco could buy long-term care insurance for each of its employees and their spouses and deduct 100 percent of the cost, while the employees receive the entire benefit tax-free.
Now, none of the benefits offered by Newco to its hand-picked employees are required by tax law to be offered to any of the other employees of Success Co. Simply put, you have found an easy way to avoid those blasted discrimination rules that apply to Success Co. and all closely held businesses.
A benefit that applies only to some owners is that if Success Co. does business in more than one state, then this Newco strategy can easily be set up to incur income tax only in the state with the lowest tax rate. If you (the owner) winter in a no-income tax state like Florida, then this little gem of a strategy easily eliminates all of the income tax on your salary from Success Co.
One final point: Regular readers of this column realize that two plans need to make up their estate plan: (1) the traditional will and trust, which is really a death plan, and (2) a lifetime plan that keeps the IRS out of the estate tax game when you die.The “Newco Strategy” outlined above is just one of the many strategies I use when doing the lifetime portion of your estate plan. Of course, the lifetime plan dovetails with your estate plan.
The nice part of the Newco Strategy is that it is easy to start, and maintaining it also provides flexiblity for adding or eliminating employees.