Tax Planning

Creating a new business is exciting. Yet, knowing which legal business entity to operate under can be difficult since there are several options, each with its benefits and concerns. [1]

When choosing a business entity, you must consider the legal aspects, such as asset protection, who owns the entity, and how it will be taxed. Moreover, consideration needs to be given to the amount of annual administration needed to maintain the business entity. For example, corporations need to hold annual meetings and maintain minutes, or else there is a possibility that if sued, the liability protection afforded by the corporate structure may be lost. 

It is extremely important in operating a business entity to respect the formalities. Many business owners operate the business like their personal piggy bank, which could bring about unwanted legal and tax issues.

There is always a need to save money during the initial setup of starting a business, but you shouldn’t skimp on forming the business entity. You should always consult a qualified attorney and a CPA before making any decisions on the business structure. Do your research and understand the pros and cons of each business entity and how it protects your personal assets. 

While not a replacement for professional advice, this overview of the common business entities can help you choose the right one for your situation.

Sole Proprietorship

Sole proprietorships are businesses owned by just one person and easily established. A sole proprietorship provides no personal asset protection to the business owner. 

Forming and maintaining a sole proprietorship is easy, and no separate income tax return is needed. The business income must be reported on the Schedule C of the owner’s income tax return. [2]

With no protection between personal and business assets, owners become personally liable for their business’s financial obligations. However, it is recommended the business owner maintain a separate checking account for the business and keep appropriate accounting records.

This entity is generally best suited for businesses such as consulting, retail, freelance work, or other services provided directly by the owner and with no employees other than the owner. Since the owner is the sole employee and provides all services, other business entities may offer little asset protection.

Partnership

These are business entities owned by at least two people. Partnerships are not taxed at the partnership level but pass through their taxable income and losses to each partner based on their ownership percentage. The partners report the income or loss on their personal income tax return. [3]

If you are a general partner in a partnership, you will have exposure to the partnership’s liabilities. However, if you serve as a limited partner, your liability is generally limited to the money invested.

As for business control, general partners usually run the business. The operations are defined by a partnership agreement. As a limited partner, you have by definition, a “limited” say in the business operations. 

Additionally, partnerships cost more to form than sole proprietorships due to the fact an attorney will need to draft the partnership agreement.

Finally, smaller groups of similar or complementary professionals, such as medical professionals, lawyers, and CPAs, generally operate as a partnership since they are looking to market their services under a single name and share business operations and control. 

Limited Liability Company (LLC)

An LLC is treated as a separate legal entity that is distinct from its owners. It provides a layer of asset protection for the owner’s personal assets. However, an LLC provides great flexibility on how it is taxed. Depending on the number of owners, it may be taxed as a sole proprietor, partnership, corporation, or S-Corporation. LLCs can provide great flexibility. [4]

There is a default tax treatment for an LLC based on the number of owners and whether it is foreign or domestic. However, owners may elect to be treated differently for tax purposes under certain circumstances. [4]

Also, certain states, such as Wyoming, Nevada, and Delaware, provide better laws for forming and operating an LLC. However, when forming an out-of-state LLC, there are additional costs. 

Businesses and their owners looking for the protection and separation of personal assets from the business while gaining ultimate flexibility with the corporate formalities may consider forming an LLC.

C-Corporation

A C-Corporation, also commonly known as a C-Corp, operates as its own distinct entity and offers personal liability protection to its shareholders. However, C-Corps also require more annual administration, such as meetings and recording of meeting minutes. Moreover, the corporation files its own income tax return and pays its own taxes on profits. Additionally, it may pay a higher corporate income tax rate than an individual shareholder might pay if the income were taxed on their personal tax return. 

Full personal protection, the ability to generate funds through the sale of stocks, and potential tax advantages give C-Corps the support to operate for years to come. Additionally, the Federal tax code provides for gain exclusion in certain circumstances on the sale of corporate stock. [5]

The inherent disadvantage to operating a C-Corp is double taxation. C-Corps are taxed on their profits, and shareholders are taxed when they receive their dividends. This can result in a Federal tax as high as 39.8%.

With the introduction of the Qualified Business Income Deduction on pass-through entities, operating as a C-Corp may just be too costly. [6]

On the other hand, for businesses that will earn little money in the start-up phase but provide a large gain on a future sale, C-Corps may be a good operating structure.

S-Corporation

S-Corporations, also commonly known as an S-Corp, provide the same personal liability protection as a C-Corp while eliminating double taxation. However, S-Corps have their own restrictions on who can be a shareholder. [7]

S-Corps cannot tap into some of the tax advantages of a C-Corp and are required to have no more than 100 shareholders, all of whom must be U.S. citizens. [1] 

Businesses and owners may gain advantages from the C-Corp structure while avoiding double taxation. Additionally, business owners who meet certain requirements may qualify for the Qualified Business Income Deduction, thus lowering the effective Federal income tax rate on taxable income. [6]

Consult a Tax or Legal Professional

Keep this information in mind as you go through the process of establishing your business entity, but remember that this is only a general overview and should not replace professional, personalized advice and recommendations you may receive when collaborating with a lawyer or CPA. Make sure to consult an expert and do not be penny wise, pound foolish when starting a new venture. 

If you are considering starting a new business and need a complimentary consultation, please reach out to Rx Wealth.

Sources: 

1. https://www.sba.gov/business-guide/launch-your-business/choose-business-structure
2. https://www.irs.gov/businesses/small-businesses-self-employed/sole-proprietorships
3. https://www.irs.gov/businesses/partnerships
4. https://www.irs.gov/businesses/small-businesses-self-employed/limited-liability-company-llc
5. https://www.law.cornell.edu/uscode/text/26/1202
6. https://www.law.cornell.edu/uscode/text/26/199A
7. https://www.law.cornell.edu/uscode/text/26/1361

This content is developed from sources believed to be providing accurate information, and provided by Rx Wealth Advisors, in conjunction with Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security.

Rx Wealth Advisors is a physician-focused financial advisory firm. Their primary focus is to help medical doctors maximize their earnings, keep more money in their pocket, and cultivate wealth so they can live the life they’ve earned and deserve. Rx Wealth can be reached at 412-227-9007, via email at croe@rxwealthadvisors.com, or on the web at rxwealthadvisors.com.

Ideally, tax planning should be a continuous process undertaken all year long, possibly over multiple years, to achieve the greatest gain. However, it tends to be more top of mind at the end of the year when the time to take action to lower the current year’s tax burden is running out. Here is a list of a few tax planning strategies you may want to take advantage of as we approach the end of 2022. 

• Shift ownership of business entities to lower-income taxpayers or entities. This may also help you take advantage of the Section 199A deduction, which allows qualified trades or businesses to deduct 20% of qualified business income, subject to certain limitations.
• Consider “bunching” charitable donations through a donor-advised fund (DAF), especially if you are in a high tax bracket this year and expect to be in a lower one in the future.
• Another reason to consider bunching donations: The $300 above-the-line charitable contribution deduction was not extended past 2021, so the only way to deduct your charitable contributions this year is to itemize rather than take the standard deduction. Bunching donations for multiple years into a single year will help you accumulate enough deductions to make that possible.
• If you have children in a lower tax bracket, hiring them to work for you in the business can be advantageous. You’ll receive a nice tax deduction for the salary you pay them, and they will pay little to no taxes on the income (depending, of course, on their tax bracket). For example, in 2022, your child will be exempt from Federal income tax for the first $12,950 of earnings. (Physicians, read my full article on the benefits of hiring your child here: Should I Hire My Child in My Physician Practice?)
• If you are considering selling your business before year-end or next year, consider setting up a defective beneficiary trust for your child in a lower tax bracket and gifting an ownership interest. This may allow for capital gains to be taxed in a lower bracket.
• If you are selling your business and you’re charitably inclined, consider contributing the shares of the business to a donor-advised fund or using a charitable remainder trust to defer gain. Note that if you are taxed as an S Corp, gifts to donor-advised funds come with special rules, and a charitable remainder trust is not an eligible shareholder.
• If your 2022 income is low, consider triggering tax on your accounts receivable to accelerate income into the low tax bracket year.  Also, consider deferring your accounts payable until next year when you are in a higher tax bracket.
• If your business is generating a net operating loss this year, consider a Roth IRA conversion. The income created by the Roth can be offset by the net operating loss, and there’s no limit on the amount of income that can be offset. This can reduce or eliminate the income tax liability on the Roth.
• So long as you have no Traditional IRAs at the end of 2022, you can make a backdoor Roth IRA contribution.
• Make sure you are on track to maximize your 401(k) employee contributions of $20,500 if you are under 50 and an additional $6,500 if you are 50 or older for a total of $27,000.
• Evaluate your business retirement plan and see if it is designed to allow the owner(s) to maximize profit-sharing contributions. 
• Consider if a cash balance plan is right for you and your business. This type of retirement plan allows for large tax deductions.
• If you are in a lower tax bracket than you expect to be in the future, you may want to consider contributing to a Roth 401(k) rather than a tax-deductible retirement plan such as a traditional 401(k). This way, you pay taxes on your contributions now at your lower tax rate.
• Consider converting a vacation home to a rental property. If the property is rented, and you later sell the home at a loss, you will get to claim a capital loss. Otherwise, the property is considered personal use, and capital losses are not allowed. 
• Depending on your current tax structure, it may be beneficial to set up a complex trust to make charitable contributions from in the future. While individuals can only take a charitable contribution deduction of 50% of their adjusted gross income (AGI), complex trusts can deduct up to 100% of their net income.
• If you own mutual funds, check to see if you’ll be receiving any distributions this year, and if so, determine if it is more cost-effective to sell the mutual fund before the distribution.
• Evaluate the tax efficiency of your taxable portfolio. For greater tax efficiency, consider reinvesting any distributions or new cash using exchange-traded funds instead of mutual funds.
• If you are over 70 ½ and have not yet taken your required minimum distribution from your IRA for 2022, consider donating part of it to charity as a QCD – Qualified Charitable Donation. This allows you to reduce your AGI without having to itemize your deductions. 

These are just a few opportunities to save tax dollars. Should you need advice on your personal situation or want to discuss a strategy you believe will work for you, please feel free to reach out for a free consultation.

While we are providing this as general advice, you should always consult your tax advisor or attorney before implementing any of these strategies.

Rx Wealth Advisors is a physician-focused financial advisory firm. Their primary focus is to help medical doctors maximize their earnings, keep more money in their pocket, and cultivate wealth so they can live the life they’ve earned and deserve. Rx Wealth can be reached at 412-227-9007, via email at croe@rxwealthadvisors.com, or on the web at rxwealthadvisors.com.

As a practice-owning physician, what a great opportunity you have to employ your child in your practice! Employment helps develop life skills, such as responsibility, work ethic, and money management, while simultaneously providing you with some income tax benefits.

But before you run out and hire your child, there are a few things you need to know.

Staying Within the Law

In Pennsylvania, a minor must be 14 years old to be employed. Additionally, the child needs to obtain a work permit. Each state has its own child labor laws and hours that minors can work during the school year, so be sure to speak to an employment attorney or accountant to ensure state law compliance. 

After ensuring compliance with state law, you need your child to do actual work within your practice—not be a ghost employee—to get paid. Develop a job description and use a timesheet to track hours worked to ensure compliance. Some of the common things your child can do around the office are filing, helping to promote your medical practice, cleaning, answering phones, taking notes, or setting appointments. 

Whatever tasks you choose to have your child perform, their duties should be discussed and documented in their employee file. And when it comes to payday, your child should be included in your payroll and paid on the same schedule as your other employees.

Income Tax Benefits

Employing your child is just like employing any other individual, with a few exceptions. Suppose you operate as a sole proprietor, single-member LLC, or a partnership in which all partners are the child’s parents, and the child is under the age of 18. In that case, you will need to withhold income taxes, but the child is not subject to social security and Medicare taxes. However, if your child is 18 years or older, the wages would be subject to social security and Medicare. If you operate as a corporation or an S-Corporation, the child’s wages will be subject to employment taxes regardless of age.

Additionally, your child will be exempt from Federal income tax for the first $12,950 of earnings (in 2022), while you get a tax deduction for paying them. Depending on your marginal tax bracket, you may save $2,500 – $4,000 plus per year in income taxes—a nice added benefit for working with your child and teaching them life skills.

What Should My Child Do with the Paycheck?

A common concern amongst physicians is that they are reluctant to give their children all this money. We recommend opening a bank account in the child’s name to deposit their paychecks. Rather than having their check conveniently deposited electronically, pay them by paper check so they can have the experience of walking into the bank and working with a teller.

Secondly, have your child begin to pay for some expenses you usually cover, such as clothes, meals, or activities. This will help them learn to budget their own money and understand the cost of such items. 

Third, have your child save some money for future schooling needs.

Finally, have your child contribute some money to their Roth IRA. Since your child is in the zero or lower tax bracket, it makes sense to contribute to a Roth IRA and get tax-free accumulation over their very long lifetime. It is almost certain they will be in a higher tax bracket later in life.

Below is a chart from Fidelity Investments showing the value of contributing early in life to a Roth IRA.

At Rx Wealth, we work with you to coordinate your child’s employment and other areas of your financial life. To schedule a free consultation, please contact us or schedule your consultation here.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.