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When Material Participation Really Starts (It’s Earlier Than Most People Think)

Stephen Nelson CPA — Wed, 10 Dec 2025 17:37:28 +0000

Material participation sits at the heart of many powerful tax strategies. Whether you’re running a small business, flipping houses, managing a short-term rental, or launching a new venture, your ability to deduct losses often hinges on whether you spent enough hours to “materially participate” for the year.

In most cases, taxpayers need to pass one of the seven material participation tests — commonly by working more than 100 hours, and no one else works more; or more than 500 hours during the year. (We’ve got a complete list of the seven tests here: Counting and Grouping Material Participation Hours.)

If you meet one of these tests, you materially participate. If you don’t, the activity is passive — and passive losses often get suspended.

A Simple Example Makes This Clear

Let’s look at a simple example. Say Tom and Dick each start new businesses in 2025. Both generate a $100,000 loss.

Tom materially participates → he can probably deduct the loss.
Dick does not materially participate → his loss is likely suspended under the passive activity rules.

So far, nothing surprising. But buried inside this area of the law is a question many professionals get wrong: When do you start counting hours toward material participation?

Let’s walk through the wrong answer and then share the right answer from the Treasury Regulations—which most practitioners never quote.

The Wrong Answer: “You start counting when the business starts.”

This is the conventional wisdom, and it sounds reasonable:

For a rental property: you start counting when the property is placed into service.
For a restaurant: when you open the doors.
For a consulting firm you purchased: when you take over operations.

IRS auditors say this. Many CPAs say this. Even tax attorneys say this.

But the regulations do not say this.

And in many cases, this answer causes taxpayers to incorrectly conclude they cannot materially participate in the first year of operation — when in fact they can.

What the Regulations Actually Say

Treas. Reg. §1.469-4(b)(1) defines what counts as an activity for purposes of material participation. And it includes three categories of work:

1. Conduct of the trade or business

This is the obvious one: the hours you work after the business is up and running.

This covers:

Tenant communication in a rental activity
Hosting guests in a short-term rental
Serving customers in a restaurant
Producing goods or services in an operating business

Nothing controversial here.

**2. Work performed in anticipation of the activity beginning**

This is the critical, widely misunderstood part. The regulation explicitly includes activities “conducted in anticipation of the commencement of a trade or business.”

In plain English: Pre-launch work counts.

Hours spent on:

Market research
Property searches
Drafting a business plan
Negotiating leases
Meeting with lenders
Designing a service offering
Sourcing suppliers
Setting up software and systems
Preparing for launch

… all count toward material participation, as long as they occur in the same taxable year as the business’s commencement (and none of the “throw-out rules” apply which I’ll talk about in a few paragraphs).

This is enormously important for taxpayers launching new ventures or buying real estate. (In many cases, it would not be possible to safely and intelligently start a new business without spending at least a 100 hours.)

3. Research and experimental activities under Section 174

If your business begins with:

software development
product research
formulation work
feasibility studies
experimentation

…those hours also count toward material participation.

This can matter a great deal for tech startups or any venture where the “R&D phase” consumes the majority of the first year.

Does This Apply to Rental Activities? Yes.

A technical point for tax accountants reading this and who have read the regulations. Many people assume rentals are different because the regulations define “rental activities” separately.

But Treas. Reg. §1.469-4(b)(2) simply cross-references the rental activity definition. It does not carve rentals out of the rule allowing:

pre-operation hours
hours in anticipation
research or planning hours

If you’re starting a short-term rental business and spend 200 hours in the spring:

touring properties
running revenue projections
negotiating with sellers
learning STR software
analyzing cleaning and maintenance options

… and then place the property into service later that year?

Those 200 hours count.

This can easily push a taxpayer over the 100-hour or even 500-hour thresholds.

Why This Matters So Much in First-Year Loss Situations

Many first-year businesses — including rentals — generate meaningful startup costs, depreciation, and operating losses.

Taxpayers and sometimes even preparers often assume:

“Well, I didn’t start operating until September, and I only have 60 hours over those last four months of year. I guess I can’t materially participate.”

But that assumption is almost always wrong.

If you spent substantial time preparing the business earlier in the year, those hours often count.

This is especially relevant for:

Short-term rentals (property acquisition is labor-intensive)
Real estate flips
New professional practices
Restaurants and hospitality businesses
Software development startups
Any venture with heavy pre-launch planning

A Practical Example with a Short-term Rental

Let’s look at a really common example where bungling this bit of law occurs. Say Sarah decides in January to start a short-term rental business. She spends:

120 hours researching markets
80 hours touring properties
40 hours negotiating financing
60 hours setting up software, décor planning, onboarding cleaners

She closes on a property in August and begins renting it in September. Once renting, she spends another 60 hours in operations.

Sarah’s total hours for the year:
120 + 80 + 40 + 60 + 60 = 360 hours

She easily exceeds the 100-hour test and often the 500-hour test depending on further operating activity.

Yet many preparers would mistakenly tell her she only has ~60 hours of participation.

A Few Final Guidelines

To make this all work in practice, taxpayers must do two things:

1. Keep contemporaneous records

A simple log — even in Outlook, Google Calendar, or a notes app — works. But it needs dates, times, and descriptions. You want to track the owner’s hours and the owner’s spouse’s hours. You also want to track the hours spent by your vendors.

2. Avoid the “throw-out” categories

Reg. §1.469-5T(f) excludes:

purely investor activities if not involved in daily operations
hours not customarily performed by owners if only performed to qualify as materially participating
capital acquisition work for someone who will not operate the business

These categories rarely apply to someone who will personally operate a short-term rental or a small business. But they matter for passive investors.

The Big Takeaway

The regulations make it clear: Material participation doesn’t start when the business starts. It starts when you start working on the business — so long as it’s in anticipation of beginning the activity.

For many taxpayers, this means more hours count than they realize. And it means first-year losses are more deductible than they thought, provided they meet one of the material participation tests.

And for short-term rental operators in particular, the hours spent searching for, analyzing, acquiring, furnishing, and preparing a property often form the majority of total participation hours.

That’s good news — as long as you keep good records.

Other Resources You May Find Useful

A Dozen Ways to Deduct Passive Losses

Short-term-rental Depreciation Deductions Calculator

The post When Material Participation Really Starts (It’s Earlier Than Most People Think) appeared first on Evergreen Small Business.

Trump Savings Accounts – Free Money from the Government

Christian Block CPA — Wed, 01 Oct 2025 17:59:58 +0000

Child focused tax benefits have taken on many forms over the years. We’ve had child tax credits, dependent care credits, education credits, 529 accounts, UTMA & UGMA accounts, and more. But, the recently passed One Big Beautiful Bill (OBBB) introduced something completely new: a federally seeded, tax deferred savings product for children known as Trump Savings Accounts.

This is a big deal that parents, grand parents, legal guardians, and even employers should pay attention to. The federal government is giving $1,000 to eligible new born babies. This isn’t a tax credit, a tax deduction, or anything else. It is actual cash the government deposits into a bank account. And that is just the beginning.

We’ll unpack what these new Trump Savings Accounts are, who qualifies, how to maximize contributions, and what they can be used for. We’ll also compare these to other accounts designed for children and see how they differ from what is already available.

What is a Trump Savings Account?

A Trump Savings Accounts is a tax-deferred custodial account that is structured like a Roth IRA. Qualifying children will receive a seed deposit of $1,000 from the federal government, beginning 1/1/2026.

To be absolutely clear, this is FREE money from the government! To qualify, a child only needs to:

Be a United States Citizen
Be born between 1/1/2025 and 12/31/2028
Have a Social Security number

No income limits for the parents or guardians exist. Every single qualifying child receives the seed deposit. However, parents and guardians can make additional deposits into the account as well. Lets dig into the details.

Contribution Rules and Limits

In addition to the government seed money, parents, relatives, friends, and even employers can make contributions into the savings account until the child reaches age 18.

The annual contribution limit is $5,000/child, indexed for inflation in future years. Employer’s can also contribute up to $2,500 per child, which counts towards the $5,000 contribution cap. Ignoring the inflation adjustments, it’s possible for a child to have $90,000 deposited into their account by the time they reach 18! That is serious money.

Contributions aren’t tax-deductible for the donor and aren’t treated as income to the child. The money grows tax deferred, however, until the child starts withdrawing the funds.

The IRS determines the tax rate on a distribution based on how the recipient uses the funds. The tax rate is the same as long term capital gains tax rates on qualified withdrawals. A qualified withdrawal includes the following:

Education, including tuition, supplies, & room and board.
Expanded definition of education to include certified trade and vocational programs
First time home purchase
Starting a business

If the recipient uses the money for anything else before turning 59½, they must pay ordinary income taxes and a 10% penalty on the amount withdrawn. These are the same consequences as taking a nonqualified distribution from a retirement account.

Account Investment Vehicles

The money must be invested within specific eligible investments as detailed in the OBBB. Eligible investment means any mutual fund or exchange traded fund which:

Tracks the returns of a qualified index
Does not use leverage
Does not have annual fees and expenses of more than 0.1% of the balance of the investment fund

The term “qualified index” means:

The S&P 500 market index, or
Any other index which is
- comprised of equity investments in primarily United States companies, and
- for which regulated futures contracts are traded on a qualified board or exchange

So how do you open an account?

Opening a Trump Savings Account

First, as previously discussed, you must have a qualifying child born between 1/1/2025 – 12/31/2028 to open an account. If qualified, there are two ways to establish an account:

Eligible custodians can manually open accounts after 12/31/2025 with an authorized financial institution.
If no eligible custodian establishes an account on behalf of a qualified child within 12 months of the child’s date of birth, the Secretary of Treasury shall cause an account to be opened in the name of such child and held by a designated institutional custodian.

The treasury hasn’t issued guidance or an approved list of authorized financial institutions at the time of this writing. But most likely, a majority of the major financial institutions (Fidelity, Vanguard, Ascensus, JP Morgan Chase etc.) will support the accounts.

Trump Savings Account Alternatives

Now let’s see how Trump Savings Accounts stack up against more familiar options like 529 plans and custodial accounts, and explore which might be the best fit for your financial goals.

As compared to Trump Savings accounts, Section 529 plans

Are designed to help families save for education-related expenses
Contributions are not federally deductible but are deductible in some states
No contribution limits and considered as gifts to minor
Can change beneficiary
Funds grow inside of the account tax free
Qualified withdrawals are not taxed, if used to pay for
- College tuition and fees
- K-12 tuition
- Room and board
- Books, supplies, and required technology
Non-qualified distributions are taxed at ordinary rates and subject to a 10% penalty

A Section 529 plan has the advantage over a Trump Savings Account IF the funds are used for college expenses. If flexibility is a priority, the advantage goes to the Trump Savings Account.

As compared to Trump Savings accounts, custodial Accounts (UTMA, UGMA)

Are designed to allow an adult custodian to manage assets of a minor child
Contributions are not federally or state deductible
No contribution limits and considered as gifts to minor
Cannot change beneficiary
Funds can be used for anything that benefits the child
No tax shelter treatment, income is subject to kiddie tax annually

A custodial account has the advantage over a Trump Savings Account when spending flexibility is the priority. However, there is little to no tax advantage like a Trump Savings Account provides. Verdict? Max out Trump Savings Account contributions first, fund a custodian account second.

Are Trump Savings Accounts a Good Deal?

For eligible families (those with children born between 2025 and 2028) they present a rare opportunity: a $1,000 head start, tax-deferred investment growth, and potential employer contributions.

While they don’t replace the role of Section 529s for education savings or offer the flexibility of UGMA/UTMA custodial accounts, they fill a new niche by helping families build long-term wealth for their children with minimal upfront cost. Like any financial tool, the value depends on your goals, but for many, opening one is a low-risk, high-upside way to diversify a child’s financial future.

The post Trump Savings Accounts – Free Money from the Government appeared first on Evergreen Small Business.

Six Hacks to Simplify Small Business Accounting and Taxes

Stephen Nelson CPA — Mon, 01 May 2023 19:25:09 +0000

Starting a new business? This suggestion: Keep your small business accounting and your taxes simple. Really simple. The reason? In the post-pandemic era, small businesses, especially new ones, struggle to find good CPAs and good CPA firms. Ditto for bookkeeping help.

And how do you do this? Consider the following six hacks to simplify your small business accounting and taxes:

Operate Sole Proprietorship

You can operate a business using a variety of entities: sole proprietorship, corporation, partnership, and so on.

But to keep things simplest? At least in the beginning? Use a sole proprietorship. That simplifies your accounting. (You’ll only need a profit and loss statement.) And it simplifies your taxes. (You’ll just report your income on a Schedule C form inside your regular individual income tax return.)

Use Limited Liability Company

Concerned about your legal liability? Tempted to incorporate? Maybe reconsider that.

You should be able to form a limited liability company, or LLC. And if the LLC has a single owner—called a member—you’ll get to use the sole proprietorship entity classification. Even though you’ve limited your liability risks.

Note: We give away free copies of do-it-yourself kits for forming LLCs for most states.

Go with Cash Basis Accounting

Here’s another tactic. Keep your bookkeeping simple by using cash basis accounting. Count income when you receive payments, for example. And count expenses when you make payments.

The alternative to cash balance accounting? Accrual accounting. But accrual accounting greatly complicates your work.

Use Equity Not Debt

Your capital structure will either make your accounting and bookkeeping harder or easier.

But one thing you can do to keep things easier? Use owners equity to fund the business. In other words, don’t use a bunch of debt to fund the business. Or parts of the business.

Leveraging up your small business with debt obviously increases your financial risks. But even beyond that? It makes your accounting way too complicated.

Keep Balance Sheet Sparse

A related suggestion? Keep your balance sheet lean. Clean. As sparse as you can.

So of course your balance will show cash. Maybe some inventory. But anything else? Try to avoid that.

If you avoid debt, that of course keeps your balance sheet lean and clean.

And then the other thing to do: Don’t put a bunch of assets onto the balance sheet. Write off as supplies anything that costs $2500 or less. Or that probably lasts less than a year.(See this blog post for more information: Tangential Property Regulations.)

And then, sorry, don’t buy vehicles and put them onto the balance sheet. Or anything that IRS considered a so-called “listed asset” which triggers extra reporting. (Cars are listed assets. And so is other stuff that’s likely to be used personally.)

Use a SEP as Pension Option

The easiest pension option? Just skip a formal pension and use an Individual Retirement Account. Maybe one for your spouse, too, if you’re married.

If you want to put bigger numbers onto your return, look at using a SEP-IRA plan. That’ll let you contribute up to 20 percent (roughly) of your business profit up to about $60,000 a year. (The limit in 2022 is $61,000 but that limit gets adjusted for inflation.)

With a SEP-IRA? You just shuffle some paperwork. And then sometime before the tax return filing, decide whether or not you want to contribute to the SEP-IRA account.

Outsource Payroll

When or if you hire employees? Outsource the payroll. Do not do this yourself. Or even a worse idea do this for your spouse’s business.

You can outsource payroll to someone like Gusto.com. Pay a few hundred bucks a year. And get all your payroll taken care of: quarterly returns, tax deposits, W-2s and so on.

Shoulder Season Scheduling

A final idea: If you do need help from a CPA or bookkeeper?

Well, first, don’t wait until the last minute. Terrible labor shortages exist in the world of accounting right now. And that will probably continue, especially for CPAs, for years. (It takes about five years to get the schooling necessary to become a CPA. And it probably takes another five years to really know how to do the job.)

And then if you can, try to schedule your work outside of tax season. Schedule your working with CPAs and bookkeepers in the shoulder season that falls between April 15 and the fall extended tax return season.

The post Six Hacks to Simplify Small Business Accounting and Taxes appeared first on Evergreen Small Business.

Twin Problems of Unprofitable Customers and Services

Stephen Nelson CPA — Mon, 20 Jan 2020 13:37:46 +0000

I’ve been coaching some new CPA firm owners about how to build a profitable professional services firm. And to jump to the punchline? The twin tricks are avoid unprofitable customers and unprofitable services.

But many of the strategies and tactics apply to any small firm that sells services: haircuts, yard maintenance, legal advice, dry cleaning, construction and so on.

Accordingly, I thought it would make sense to share my coaching comments. And then also some other ideas that veteran managers and entrepreneurs suggest.

In the paragraphs that follow, I’ll sort of talk in terms of a CPA firm… but much what the follows applies to any service business.

But What is Profitability?

Let’s quickly start with definition of profitability, though.

I don’t mean (or necessarily mean) you get small business profits that let you drive some fancy car… or live in some expensive home or condo… or spend lavishly on toys and vacations.

What I mean by profitability is this. Your business, once you get it rolling, needs to pay you and your employees reasonable, competitive wages and salaries. And market-rate fringe benefits.

Your business also needs to pay an extra amount that represents a return on the capital you’ve invested in the business. This might include easily paying the bank on some loan.

Finally, the profitability needs to provide some cushioning. The operation needs to not run on a shoestring.

Let me give you an example of what I mean. And to make the math easy for everyone, I’m just going to use very round numbers.

Example: Assume other organizations pay someone who does your job $100,000 in salary and fringe benefits. Assume your small business requires $100,000 of fixtures, technology and working capital and you want to earn 20% or $20,000 on this investment. Finally, say you want $10,000 a year of cushioning. Profitability in this case means $130,000: $100,000 salary and benefits plus $20,000 return on investment plus $10,000 of cushioning.

And just to say this out loud? Sure. For some folks, profitability means bottom-line profits equal to $50,000. Or less. And then for some folks, profitability equal to $500,000 falls short.

The point is, profitability requirements vary. But a profitable small business pays its owner a salary, a return on her or his investment, and a little extra for cushioning.

The Two Lies Service Providers Tell Themselves

One comment related to profitability, too. You and I want to avoid telling two “profitability lies” to ourselves. Because either lie lets you or me pretend we don’t have the “unprofitable customers” problem. Or the “unprofitable services” problem.

Lie number one goes like this: On paper, a business makes the owner $50,000. But if the owner worked for well-run employer with good customers and clients and good products and services, she would earn $100,000.

In this situation, sure, the business “technically” shows a profit. But the owner actually loses (per the example) $50,000. Annually.

That makes sense, right? She earns $50,000 in her own business. But working someplace else, she would earn $100,000. That $50,000 lost income represents her business loss.

Lie number two resembles lie number one. And it goes like this: The business owner makes $50,000 running his own show. And that number works and counts as profitable. The problem here is the owner may not actually have one profitable $50,000 job but two $25,000 jobs.

In this situation, this owner may be selling his time at a giant discount and then making up the difference by working a million hours. That’s also not profitability. That’s self-exploitation.

And now, with that background, let’s quickly step through the strategies and tactics that small service businesses can often use to solve the unprofitable customer and unprofitable service problems…

Most of these ideas are pretty simple to understand. Note that not all will work or be available as options in every situation… But some large handful of options is often available.

Idea #1: Target Customers Who Understand Profitability

A first simple idea for dealing with unprofitable customers? Focus on and target customers or clients who understand profitability.

In other words, go for the folks who understand costs, expenses, revenue, overhead… and then also the impact of this stuff on the profitability of your relationship with the customer.

Probably this means business clients or customers.

Customers and clients want you and me to stay in business. So we can continue to provide them services. And savvy customers “get” we need profits.

Idea #2: Watch for Early Warning Signs

Something else easy to do? Watch out for any early warning signs that suggest a customer or client relationship may be one you or I want to avoid: abusive behavior, requests for undeserved credits and discounts and free services, general aggravation, or unpredictability.

Some people suggest only twenty percent of your or my customers or clients are actually profitable. (I don’t think that’s necessarily right as I’ll talk about later.) But surely many customers and clients aren’t practical or profitable to serve. So, stay away from the problems from the very start.

Idea #3: Homogeneity Helps

You and I want to do a lot of the same thing. Homogeneity in customers, products and services makes spotting problems easier. Homogeneity lets a firm optimize workflow. And homogeneity means a firm can create “hacks” and “work-arounds” for a smaller list of exceptions.

Note: This is a good place, I think, to mention my favorite fast restaurant, In-N-Out Burger, and a blog post we did to recognize and discuss their excellence: In-N-Out Burger a Masterpiece Business.

Idea #4: Say No to Price Shoppers

Service businesses don’t scale well. You and I get limited very quickly by the hours in a day.

Accordingly, you and I can’t compete on price. And we don’t want to work with people shopping on price.

If someone calls our CPA offices, for example, and the first question is “how much does it cost?” Yeah, we immediately disqualify the person. You should do the same.

A price shopper–someone who first looks at the price–has a high probability of being an unprofitable customer for a service business.

Idea #5: No One-off Projects

In some service businesses, like professional services and construction, clients or customers ask for special, customized projects that no customer or client has asked for before… and probably no customer or client will ask for again.

Almost no customer or client can afford a truly personalized service. Even the ultra-wealthy.

You and I want to avoid these “assignments.” Rather, we want to explore whether an existing service–already well-designed in terms of quality and value–works.

Idea #6: No Customer- or Client-led Design of Products or Services

A related point. Customers and clients should not design the product or service a firm delivers. Or the procedures or systems a firm uses.

Customers and clients design a “non-system” that works for their unique, special circumstances… and no one else… at high cost… and which delivers lower-quality results.

Note: You know a good model for product design? Henry Ford. See this blog post for more information: Henry Ford and the Problem of Customer-ization.

Idea #7: Sell Quality or Specialization

If you and I shouldn’t sell services based on price, how should we sell? I think we have two better options. We can sell on the basis of quality. Or we can sell on the basis of being specialists.

With tax return preparation, for example, one shouldn’t sell the cheapest return.

Rather, sell the more complex tax returns that someone can’t do themselves with TurboTax or similar software. Or sell a tax return for a niche of taxpayers with special issues and concerns.

Idea #8: Renegotiate Value Proposition

A great idea from a Harvard Business Review whitepaper, the Right Way to Manage Unprofitable Customers: For the inevitable low-profit product or service and the inevitable low-profit customer or client, discuss with them whether there’s a way to jack the value your firm delivers and so bump the price and the profitability.

A secondary advantage of this renegotiation? If it fails, the renegotiation can be the way we professionally and ethically and kindly wind up the relationship.

Idea #9: Divest No and Low Profit Customers and Clients

Another idea from the aforementioned Harvard Business Review whitepaper? You may be able to divest or sell or giveaway no-profit and low-profit clients and customers.

This weird reality? Customers or clients you or I can’t profitably serve? They may be great folks for some other “competitor.”

And by the way, the reverse is true too. Some customer or client that a “competitor” can’t profitably serve? That sort may work great for you or me. (See Idea #3 and Idea #5 for the reasons why this might be the case.)

Idea #10: Understand Unprofitable Customers and Services “Chronic”

A final helpful notion, I think. Unprofitable customers and unprofitable services represent a “chronic” problem.

No miracle cure exists. Accordingly, you and I simply need manage and mitigate these problems.

About the 80/20 Rule

If you poke around the web and blog-sphere researching the subject of “customer profitability,” you quickly encounter a theory. That theory? The notion that the 80/20 rule applies.

Restated in terms of customer or client profitability, the 80/20 rule postulates that 80 percent of a firm’s profits flow from 20 percent of its customers. Or from 20 percent of its products or services.

And then the “actionable insight” that falls out of this assertion: You and I need to identify the profitable 20 percent… and then cull the unprofitable 80 percent.

Let me unequivocally state I believe this is nonsense. In our service business, I know that more than 80 percent of our client relationships are profitable. Further, the few percent who are low or no profit?

Often, those clients are in transition. Maybe our firm hasn’t yet moved far enough up the learning curve to profitably serve the client. Or to deliver the service. (Which is our responsibility.)

Or maybe a long-time client is temporarily low or no profit due to some bad luck.

Here, however, is the other side of this issue. And boy is this awkward. Surely some service firms serve mostly unprofitable clients and customers.

So maybe, gosh I think probably, the 80/20 rule applies overall.

But that 20 percent of the market that’s profitable to serve? Smart firms target and capture a big share.

And then the 80 percent of the market that’s low profit or not profitable? Those clients and customers are getting served by service businesses who don’t yet know how to identify, capture and keep profitable clients.

A Closing Thought

A closing thought. The work of building up and then maintaining a collection of profitable services and profitable clients? It takes time. And we all need to show both patience and discipline.

The post Twin Problems of Unprofitable Customers and Services appeared first on Evergreen Small Business.

Section 1202 Qualified Small Business Stock Pitfalls

Christian Block CPA — Mon, 06 Jan 2020 13:04:10 +0000

I wrote a post a few weeks ago about all of the great benefits of Section 1202 Qualified Small Business Stock (QSBS). But frankly? It would be irresponsible of me not to follow up and point out some qualified small business stock pitfalls.

Accordingly, in this post, I discuss the four big ways the Section 1202 “qualified small business stock” exclusion can blow up and cause taxpayers problems.

Double Taxation of C Corporations

A first potential problem? C corporations, or “C corps,” burden business owners with two layers of tax: one layer at the corporate level and another layer at the owner level if or when profits are distributed.

This double layer of taxation is the reason pass-through entities are generally more advantageous for small business owners. Not only do pass-through owners enjoy a single layer of tax, but beginning in 2018 they get a Qualified Business Income Deduction (QBID), allowing them to avoid income taxes on 20% of their business income (with some caveats).

Let’s look at a couple examples.

Example 1: A C corporation owner earns net income equal to $100,000 and wants to distribute all $100,000 of the profits. The C Corp pays $21,000 in tax at the entity level (because of the 21% C corporation tax rate). That leaves $79,000 to distribute. The owner will then pay another $15,800 in taxes on the qualified dividends (because the $79,000 gets subjected to a 20% dividend tax rate) and then possibly also $3,000 in net investment income taxes (because the $79,000 also gets subjected possibly to a 3.8% net investment income tax.) In the end, the taxes total about $40,000 and the net payout equals roughly $60,000.

Example 2: An S corporation owner also earns net income equal to $100,000 and also wants to distribute all $100,000 of the profits. Assume she or he pays a personal tax rate of 30%. The shareholder takes an immediate $20,000 Section 199A “QBID” deduction (calculated as $100,000 times the 20% QBID rate) leaving $80k of taxable income. Using the 30% tax rate, the shareholder pays $24,000 of tax and therefore enjoys a net payout equal to $76,000.

That’s a $16,000 difference in taxes paid, or as much as a 16% higher combined tax rate with the C corporation.

How much in capital gains would you need to exclude using QSBS to justify paying more in taxes as a C Corp for some number of years? Obviously, this will take some financial analysis and modeling to figure out. But you want to consider this issue.

Asset vs Stock Sales

A second issue to ponder…

Typically, businesses get sold by either selling stock or selling assets. But buyers may prefer asset sales. Why? The buyer of business assets probably gets to allocate the purchase price to those assets, and then usually gets to deduct that cost over time in the form of depreciation or amortization.

Example 3: The assets of an existing firm include $15,000,000 of goodwill. A corporation can either buy the existing firm’s stock or its assets. If the buyer purchases the assets, the buyer adds a $1,000,000 “goodwill amortization” deduction to its tax return for 15 years. That large additional annual tax deduction saves the buyer millions in income taxes.

So what does this mean? A buyer should be willing to pay a higher price for business assets than business stock. If the additional bump in price is greater than the money saved on the Section 1202 gain exclusion, you are probably better off staying a pass-through.

Untimely Stock Sales

A third thing to consider: You must hold your QSBS stock for at least 5 years to exclude capital gains, so let’s play the “what if” scenarios. A situation forces you to sell your stock early and you have a large taxable gain; all the while running your company as a C Corp and forgoing the advantages of a pass-through. This is bad. On the flip side, you might end up selling at a loss and again forgo years of benefits operating as a pass-through. This is also bad.

Appreciated Assets at Incorporation

A fourth subtle thing to consider if an existing business incorporates to create qualified small business stock: net investment income tax on any “built in” gains on contributed assets.

Why? That “built in” gain can’t be sheltered by Section 1202. As I.R.C. § 1202(i)(1) states, “the basis of such stock in the hands of the taxpayer shall in no event be less than the fair market value of the property exchanged.”

Predictably, then, if the business later sells its stock, that the “built in” gain or appreciation gets subjected to capital gains tax. And then, because of the incorporation, the “built in” gain also gets subjected net investment income tax.

Incorporation, then, essentially triggers the net investment income tax on the “built in” gain that Section 1202 doesn’t shelter.

Example 4: A single member LLC operating as a disregarded entity owns $10,000,000 of inventory and $10,000,000 of “goodwill.” The inventory originally cost $10,000,000. The entrepreneur didn’t, however, pay anything for the goodwill. She or he created that value through hard work. If the LLC sells its assets, the LLC member probably pays a 20% capital gains tax on the $10,000,000 of goodwill, or $2,000,000. However, if the LLC incorporates, the $10,000,000 of goodwill may be taxed at 23.8% (a combination of the 20% capital gain tax plus the 3.8% net investment income tax) for a total of $2,380,000.

Final Thoughts Section 1202 Qualified Small Business Stock Pitfalls

The Section 1202 exclusion on qualified small business stock seems very attractive at first glance. Start doing some financial modeling, however, and it is easy to see the some qualified small business stock pitfalls.

I would encourage anyone considering this to first meet with their tax adviser and see if they can make the numbers work.

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The Hidden Magic of Arithmetic Growth

Stephen Nelson CPA — Tue, 20 Aug 2019 17:00:26 +0000

Many investors know about geometric growth, which is what compound interest is.

Investors, for example, know that if you earn an annual 5 percent return on some investment, over time the investment grows large.

Every retirement savings plan employs geometric growth.

But small business owners want to know about another sort of growth, arithmetic growth.

In a manner similar to the way compound interest rewards investors, arithmetic growth rewards new business owners.

But let’s quickly contrast geometric growth and arithmetic growth. Then, we can describe an example of arithmetic growth. Finally, after that, we can discuss some possible actionable insights.

Geometric Growth vs. Arithmetic Growth

Geometric growth grows some value by a percentage.

If you save $10,000 in a retirement account and earn 5 percent interest annually, the balance grows by a percentage (the interest rate) each year. Or you can say the balance geometrically grows.

At the end of year 1, an initial $10,000 investment earning 5 percent, or .05, grows to $10,500:

$10,000+$10,000*.05=$10,500

That’s geometric growth.

But not all growth is geometric. Some growth, like the growth a new small business experiences, works arithmetically. Meaning, by the simple addition of customers.

If you start a small business and add a customer a week, growth occurs arithmetically. Over five weeks, you accumulate five new customers:

1+1+1+1+1=5

That’s arithmetic growth.

Arithmetic growth sounds a little simplistic. And boring.

But here’s the deal: Arithmetic growth makes all the difference to small business entrepreneurs.

And now let’s talk about my new favorite Mexican restaurant…

The Restaurant Was Nearly Empty

My first visit, I counted four customers eating their lunches.

I expected a full lunchtime crowd. The restaurant served an excellent regional Mexican cuisine. The location? A popular a tourist spot… And then this bit of good luck for the owner: A local weekly newspaper reviewed the place at its opening and called it wonderful.

A little while later, my wife and I finished lunch. And the only unpleasant part of the experience? I felt really bad for the restaurateur who had worked so hard, done so much right, only to seemingly stall at launch.

Early Days Look Bleak

I can only guess what the new restaurant’s daily profit and loss statement looked like with four lunchtime customers.

To make the math easier—and this is rough—I figured about $20 a customer. So $80 from the lunch hour. If the business owner saw similar numbers for the dinner hour–so another four customers and $80 of revenue–the total daily revenue equaled $160.

To keep the numbers simple, I figured a 25% “Cost of Food,” $200 a day for the server and chef, and then $100 for the overhead (rent, utilities and so forth).

Rearranging this information into a little profit and loss statement, I guessed the first day’s results looked bleak:

Revenues (8 customers at $20 each):	$160
Less: 25% for Food	$40
Less: Waiter and Cook	$200
Less: Overhead:	$100
The Day’s Loss:	($180)

I honestly wondered how many days the owner would last.

He not only needed enough cash to lose nearly $200 a day, he surely also needed money to pay things like his personal rent and groceries.

Heartbreaking…

Fast Forward A Week

I went back a week later. And the situation seemed almost as dire.

This visit, I counted only eight customers enjoying lunch.

Re-running the same formulas for the daily profit loss only with 16 customers—8 for lunch and 8 for dinner—I estimated this great little restaurant still struggled, sadly:

Revenues (16 customers at $20 each):	$320
Less: 25% for Food	$80
Less: Waiter and Cook	$200
Less: Overhead:	$100
The Day’s Loss:	($60)

True, the numbers showed a smaller loss. But people don’t start a business to “only lose a little bit of money.”

And this restaurateur was maybe a couple of weeks into his venture. Ugh.

Fast Forward Another Week

I went back for the third time a week later. Partly because I wondered if the restaurant still operated. Partly for the excellent food.

That visit, the customer counts had slightly grown again. I counted 12 lunchtime customers. Assuming a similar dinnertime crowd of 12 diners, I guessed the daily totals might look like this:

Revenues (24 customers at $20 each):	$480
Less: 25% for Food	$120
Less: Waiter and Cook	$200
Less: Overhead:	$100
The Day’s Profit:	$60

But that level of daily profit still looked bleak. Nobody starts a business where they lose thousands during the startup phase only to get a job that pays $60 a day.

Then, finally, it dawned on me. This guy’s business worked just fine, thank you.

He only needed to hold out long enough. And the reason? He enjoyed good arithmetic growth rates.

The Secret of Arithmetic Growth Rates

You probably quickly saw what happened here: Each week the customer counts grew arithmetically.

When I first visited his excellent little restaurant, he served maybe 8 customers a day. A week later, he served 16 customers a day. A week after that, he served 24 customers a day. And he continued growing this customer base.

One might also say that the business grew by roughly a customer each day: Eight customers added in a week equals roughly one new customer added each day on average.

Note: If a business adds 8 customers in 7 days, the precise arithmetic growth equals 1.14 customers a day. I rounded down to 1.

By the way? The restaurant now serves maybe 40 customers for lunch? A similar number for dinner.

Even with a larger waitstaff and extra help in the kitchen, the profit surely looks good.

I’m not going to guess at their daily profits… That seems a little intrusive. But with maybe $1600 a day in revenues, the business surely works well for the owner. Kudos to him and his family for a well-executed new venture.

But here’s the reason for the story: The business nicely demonstrates the power of steady arithmetic growth.

The story also spotlights some actionable insights…

Arithmetic Growth Matters When You Have Returning Customers

A first insight, for example: The arithmetic growth rate thing shows up in businesses with returning customers.

A restaurant that serves “regulars.” An accounting firm with clients who come back each tax season. A piano teacher who gives weekly music lessons to the same group of students.

Not every small business enjoys returning customers. But many do. And so for many, arithmetic growth matters. A lot.

Arithmetic Growth Rate Drives Forecasted Future Revenues

A second insight: For businesses with returning customers or clients, the owner may be able to forecast revenues at various points in the future using the arithmetic growth rate.

A piano teacher can start his or her business with zero students, for example. But if the teacher adds a student a week, 52 weeks later, he or she may be teaching 52 students. (The arithmetic growth formula is 52 weeks times a student a week.)

An accounting firm may start from scratch but if it adds 2 clients a month, three years later, it may have 72 clients. (The arithmetic growth formula is 2 clients a month times 36 months.)

A restaurant that grows daily customer counts by a patron a day may serve roughly 30 customers after a month in business.

Arithmetic Growth Rate Helps Owner Plan Startup Losses

A related third insight: An entrepreneur may be able to use an estimate of the arithmetic growth rate to plan for those days, weeks and months of startup losses.

The business owner needs to build a detailed spreadsheet to do this. But that isn’t too tricky.

Hopefully the restaurateur I observed did this. And if he did and his estimates were close to reality, he probably worked his way through those first lean weeks with comfort and confidence.

Note: You can download a free profit volume analysis Excel workbook from our CPA firm website. That workbook comes from an old book of mine, the MBA’s Guide to Microsoft Excel, and it lets you determine how revenues, expenses and profit change over a range of sales revenues. The workbook also lets you estimate a venture’s break-even point.

Arithmetic Growth Rate Not Only Input to Revenue Growth

A quick clarification about something obvious once you think about all this a bit.

The arithmetic growth rate explains much of the growth in revenue a new firm experiences. But it doesn’t explain all of the growth.

You can also grow revenues by increasing prices, for example. And you grow revenues by adding products or services.

Finally, some growth a new business experiences looks more like geometric growth than arithmetic growth. Perhaps customer demand for your product or service grows five percent annually because of demographic changes. Or maybe two percent of your customers refer you new customers.

In the case of a new business just starting, however, arithmetic growth probably explains most of the new revenue.

A Closing Comment

Regularly, new business owners don’t think about and watch their arithmetic growth closely enough. (Me included.)

But we all want to do a better job at this when we start new ventures.

Steady arithmetic growth, often hidden at first, may relentlessly push a new business toward profitability and financial success.

Some Related “Grow Your Small Business” Articles

If you’re planning for small business growth, you might find some of the following posts useful or interesting:

In How to Grow a Small Business, I share comments from established small business owners about how they’ve grown their ventures steadily over time.

In Has Your Small Business Stopped Growing?, I discuss a common reason some small businesses see their growth stall–and then a way you can try to fix this problem.

In the slightly theoretical post, Small Business Monte Carlo Simulation, I describe how to simulate small business ownership returns.

Finally, if you’re thinking about all this sort of stuff, you might find the Millionaire Next Door Business Plan blog post useful.

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Maximize Depreciation Deductions under the Tax Cuts and Job Act of 2017

Christian Block CPA — Mon, 22 Jul 2019 12:59:23 +0000

The Tax Cuts and Jobs Act (TCJA) of 2017 created new depreciation rules. And both business owners and real estate investors want to learn the new rules in order to maximize depreciation deductions.

In the paragraphs that follow, accordingly, I briefly describe the three big depreciation changes in the new law.

A Little Background

But before you step into the details, however, let me explain a few basic depreciation concepts.

Tax laws and the IRS require business owners to capitalize fixed assets and real property. Essentially, capitalization means a business or investor deducts costs of long lived assets not at the time of purchase but as depreciation deductions over time.

Not every long-lived asset matters, though. Typically, taxpayers capitalize and then depreciate only assets costing more than $2,500.

What gets capitalized and depreciated then? Lots of items. Common fixed assets include furniture and fixtures, machinery and equipment, computer hardware and software, buildings, and even some intangible assets such as loan fees and organizational expenses.

Furthermore, a bunch of rules govern how the cost of these assets get deducted, or “depreciated,” over time.

Bonus Depreciation: Often the Right Way to Maximize Deduction

Bonus depreciation perhaps counts as the easiest way to maximize depreciation deductions.

Historically, bonus depreciation allowed businesses to expense 50% of the cost of qualifying fixed assets immediately in the year placed in service.

But prior to the TCJA rules, a catch existed. Qualifying property only included brand new property. Bonus depreciation, then, excluded used property.

Under the new current rules, bonus depreciation now includes used property as well. Not only that, but the deduction increased from 50% to 100% of the cost.

Example: You buy two trucks for your business, one brand new for $50,000 and one slightly used for $25,000. Under the new tax law, bonus depreciation works for both trucks. The first truck creates $50,000 of bonus depreciation. The second truck creates $25,000 of bonus depreciation.

Two other important bonus depreciation features to consider. First, no phase out limitation exists. In other words, a business or investor may “bonus depreciate” any dollar amount spent on fixed assets (assuming the assets qualify).

Example: A small business which buys $100,000 of qualified assets deducts $100,000 of bonus depreciation. A much larger business which buys $100,000,000 of qualified assets deducts $100,000,000 of business depreciation.

And one other important feature of bonus depreciation to consider: Bonus depreciation ignores a taxpayer’s taxable income.

The “no taxable income limitation” means bonus depreciation can eliminate taxable net income and can even create losses that can be carried forward to future years.

Example: A taxpayer earns $50,000 in dividend and interest income and $100,000 in a sole proprietorship. If the business puts $150,000 of bonus depreciation on the taxpayer’s tax return, the bonus depreciation zeroes out taxable income and the taxpayer’s tax bill.

Section 179 Expense: Another Powerful Depreciation Approach

Section 179 expensing of qualifying fixed assets represents another method to maximize depreciation deductions.

Resembling bonus depreciation, Section 179 expensing allows businesses to deduct 100% of the cost of qualifying fixed assets. However, Section 179 burdens taxpayers with more limitations.

First, the taxpayer’s total income from her or his active trades or businesses sets the upper limit on the taxpayer’s Section 179 income.

Example: A taxpayer earns $100,000 in an active trade or business and another $50,000 in interest on bonds. Tax law limits the taxpayer’s Section 179 deduction to $100,000.

A second limitation? Tax law limits the maximum Section 179 expense allowed on a taxpayer’s return to $1,000,000.

Note: Prior to the TCJA, Section 179 allowed businesses to deduct up to a maximum of $510,000.

Furthermore, fixed assets placed in service over $2.5 million begin to phase out dollar for dollar, meaning that if a business places in service $3.5 million in a single year that firm loses its ability to take the deduction.

These limitations may allow a taxpayer to maximize the depreciation deduction or its tax savings, however.

For example, Section 179 allows you to pick and choose which assets you want to apply the deduction to. Bonus depreciation represents an “all or nothing” choice for each class of property. Sometimes Section 179 provides flexibility that allows taxpayers to “schedule” depreciation deductions when they generate the most savings.

And as another example, Section 179’s taxable income limitation sometimes extends the life of net operating loss (NOL) deductions because it delays when NOLs first appear. That delay benefits taxpayers because NOLs can only be carried forward for 20 years and could potentially expire with no future benefit to the business. A smaller or even Section 179 deduction instead of a larger bonus deduction preserves future depreciation deductions.

Understand Qualified Improvement Property to Maximize Savings

One last depreciation change to discuss: Qualified Improvement Property (QIP).

I won’t get into the long history of this class of depreciable property. Nobody cares about that except tax practitioners.

However, I do want to point out some new changes and opportunities within this unique class of depreciable property.

First, let’s define what it is though… QIP refers generally to any improvement to an interior portion of a nonresidential building placed in service after the building itself has been placed in service.

And then the exceptions to the general rule? Some sort of obvious items if you think about the fact that Congress and the Treasury’s tax attorneys possess considerable experience writing our tax laws. QIP excludes expenditures attributable to the enlargement of the building, elevators and escalators, or the buildings internal structural framework.

Prior the TJCA, most qualified real property was subject to a 15-year life and was eligible for bonus depreciation. Post TJCA, property that falls into QIP is now, unfortunately, subject to a 39-year life. Fortunately, QIP is now eligible for Section 179 and can be 100% expensed in the year it is placed into service.

Another benefit resulting from TJCA is that QIP can be placed into service any time after the building is. In contrast, the old rules made you wait 3 years or else it was ineligible. Furthermore, the IRS also expanded the 179 deduction to include roofs, HVAC systems, fire and protection alarms, and security systems.

Final Thoughts

This final thought. Savvy taxpayers enjoy some wonderful new opportunities to maximize depreciation deductions.

Accordingly, take the time to strategize about these with your CPA. You may potentially save thousands of dollars in income taxes.

The post Maximize Depreciation Deductions under the Tax Cuts and Job Act of 2017 appeared first on Evergreen Small Business.

IRS Audit Prevention Tips

Stephen Nelson CPA — Mon, 26 Mar 2018 12:51:51 +0000

Your tax return is due sometime in the next couple of weeks—unless you extend. And given that, I thought it’d make sense to talk about IRS audit prevention.

Don’t worry. We’re not going to dig down into the details of tax accounting or tax law. The discussion that follows focuses on the big picture stuff.

IRS Audit Prevention Tip #1: Don’t Rush to File Your Return

My first tip? Don’t rush to file a return. Rushing a return jacks your mistakes. And those errors will tend to increase your risk of an audit.

Note: You can extend your tax return for free as described here: how to extend your tax return.

IRS Audit Prevention Tip #2: Don’t Do Your Return by Hand

A second easy tip: Oh my gosh, please, please, don’t do your tax return by hand.

I know, I know. Some people proudly do prepare their tax returns by hand. But you don’t want to go “manual.”

Preparing your return by hand invariably means you make more errors. Again, more errors probably jacks up the “hey this return looks suspicious” score the IRS computers assign to your return.

Use a computer and tax preparation software to prepare your return. That’s the way to go.

IRS Audit Prevention Tip #3: Do E-file Your Return

By the way? You can file your tax return by mailing in a paper return or electronically.

But file electronically. Your return goes through extra error diagnostics when you file electronically. And those diagnostics also dial down errors and presumably the risks of the IRS contacting you about goofy stuff in your return.

IRS Audit Prevention Tip #4: Upgrade Your Preparer

Based on this assumption that return errors do increase your IRS audit risk, you may want to upgrade your preparer if you’re concerned about an audit.

A volunteer preparer will probably do a better job than you do (if only because this person will prepare many more returns than you do and probably will have an on-site expert he or she can consult).

A paid preparer will probably do a better job than an unpaid preparer. (This person earns a living preparing taxes, afterall.)

Finally, an enrolled agent or CPA who specializes in taxes will probably do a better job than an unenrolled preparer. (These people get lots of training and must continue to maintain their skills through professional education.)

Note: Good granular data on preparer errors is harder to come by than you might guess. But the IRS provides an interesting study here.

IRS Audit Prevention Tip #5: Use the Organizer

If you do outsource your tax return preparation to a paid preparer, she or he will surely provide you with either a paper or electronic organizer. This organizer includes checklists and simple worksheets you fill in to describe your financial year.

You really want to use the organizer. If you don’t, you’ll force the preparer to spend time teasing out the information in phone calls, emails and telephone conversations. (That wastes the preparer’s time organizing your data when the time should instead be spent preparing the actual tax return.)

Further, if you blow off the organizer, you’re very likely to omit some disclosure or bit of tax return information that’s really dangerous to omit. (The big example here? Omitting to tell IRS about foreign bank accounts and business holdings.)

IRS Audit Prevention Tip #6: Religiously Match 1099s, K-1s and W-2s

Another tip: Be sure your return matches the 1099 information returns that you and the IRS and state tax agencies receive.

For example, if you receive a 1099-MISC form reporting $10,000 of independent contractor income, be sure that income appears on your return.

Ditto for W-2s, of course! And ditto for K-1s you receive from partnerships, trusts, estates and S corporations.

By the way? Be particularly careful about 1099-Ks which show credit card payments you’ve received if you’re a small business. These 1099s can include amounts that you would not think to include as income like state sales tax, restaurant employee tips, and the credit card service fee collected by the bank before you even see any money.

IRS Audit Prevention Tip #7: Use a Real Accounting System

If your tax return includes rental property or a small business, you want to use a real accounting system. Something like QuickBooks or Xero or Quicken.

You don’t want to use a shoe box. Or Microsoft Excel. Or rely only on bank statements.

Without an accounting system, your income and expense data will end up sketchy. If you end up throwing rough estimates onto your return, for example, the numbers themselves will look suspicious. And the IRS computers seem to do a pretty good job identifying returns with sketchy or suspicious numbers.

IRS Audit Prevention Tip #8: Minimize your Multi-state Footprint

Each state in which you earn income probably expects a tax return from you.

And, in general, the only time you won’t owe that other state a tax return and income taxes is when that state doesn’t have an income tax.

But think about what this means. Each state in which you file a tax return has its own version of the Internal Revenue Service, of course. And in a sense, every tax return you file works like a lottery ticket where the “prize” is an audit.

Note: You “lose” the audit lottery by having your tax return selected for an audit because of errors or suspicious data or just because of random bad luck.

Accordingly, you may want to try to dial down the number of states in which you file tax returns and inadvertently “play” the audit lottery.

Furthermore, avoid investments (like partnerships) that mean you find yourself subject to taxes in scads of other states. (An investment in a pipeline partnership where the pipeline goes through ten states may saddle you with ten nonresident state tax returns.)

And don’t carelessly trigger filing requirements in other states by having a business presence in that other state: an employee of your small business, rental property, business operations and so forth.

IRS Audit Prevention Tip #9: Don’t Operate as a Sole Proprietorship

One final tip comes from the blog post the FiveThirtyEight news blog did a couple of weeks ago: Everyone Tries to Dodge the Tax Man.

That article provides lots of interesting bits of tax trivia—mostly about how people cheat on their taxes.

But something else interesting are the under-reported income statistics highlighted. It turns out that partnerships and S corporations under-report their income far less often than sole proprietorships.

That would suggest to me that operating as a partnership or S corporation very possibly dials down your audit risks… if only because you’re probably more likely to be considered “innocent by association.”

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Unreliability of Long Run Stock Market Returns

Stephen Nelson CPA — Mon, 11 Sep 2017 12:19:36 +0000

A myth about long run stock market returns exists. A powerful, but maybe dangerous, myth.

That myth goes like this: Over the long run, because much of the up and down choppiness evens out, you can count on a pretty good, average-ish outcome if you’re investing for decades.

Restated another way, the myth says that if you or I can stay in the market for decades, we can probably get that nice average long run stock market return everybody seems to know about. That 6% or 7% figure. Or whatever.

Unfortunately, this myth about the reliability of long run stock market returns misleads. Long run stock market returns absolutely are not reliable. And you and I need to plan accordingly.

My Crude Line Chart of Long Run Stock Returns

Let me show you a simple line chart that visually depicts this reality. (If the image doesn’t render well, click it to display a larger version.)

The crude little line chart shown above depicts the worst case, average, and best case returns someone saving $10,000 annually enjoyed if they saved over 5, 10, 15, 20, 25 or 30 years using a typical 75% stocks and 25% bonds portfolio.

The average return, for the record, quickly converges to around 6%. The orange line shows this value.

But here’s the thing to note: Though the range from worst to best narrows over time, results still vary widely even when you look at long run stock market returns.

At year 30, for example, the best case scenario (shown as a blue line) delivers a 10% real rate of return on your savings. And the worst case scenario (shown as a gray line) delivers no real rate of return–so zero percent–on your savings.

You see the reality, right? Sure. Maybe long run stock market returns average out to a healthy number. A typical retirement savings portfolio that emphasizes stocks maybe averages out to 6%.

But wide, wide variability in results occurs.

So here’s the point of of the post: Yes, the myth whispers you can count on average-like long run stock market returns if you just show enough patience. But history says something different. History says you better not.

How I Calculated Long Run Stock Market Returns

Let me quickly explain how I got the numbers plotted in the line chart. (If you don’t care about the math or numbers are not your friend, skip ahead to the next section.)

The data comes out of the cFIREsim online calculator, which uses a data set that starts in 1872.

The asset allocation equals 75 percent stocks and 25 percent bonds. So not 100% stocks but rather a more typical stocks and bonds blend.

The scenarios I modeled say some investor saves $10,000 annually for a given number of years: 5 years, 10 years, 15 years and so on at five year increments right up to 30 years.

I used the cFIREsim default .18% expense ratio and default annual rebalancing.

Finally, I calculated the average annual return using Microsoft Excel’s RATE function using as the function inputs that $10,000 annual savings amount, the number of years of saving, and then the cFIREsim-calculated future value for the average, best case and worst case scenarios.

And now back to the message from the chart…

Why My Tail is Fatter than Other Charts

The line chart above (and others like it) show you bear more risk than you realize.

Now I can guess you’re slightly disoriented by this statement and by the way it contrasts with what you thought. So let me try to explain the apparent differences between my cFIREsim-derived results and the information you’ve seen elsewhere.

Four factors probably explain most or all of the apparent disconnect.

First, and very frankly, you possibly just missed the reality discussed here. Regularly, authors don’t highlight the variability. Instead, they focus on the fact that the range of possible returns (that “tail”) narrows over time. This is true as the chart above shows. But the range doesn’t compress to a single value like 6%.

Note: If you’ve read and still own books written by John Bogle or Burton Malkiel, look for their charts that shown the range of returns on stocks over time. You’ll now spot the 3% or 4% or more difference between the worst case and best case returns.

Second, I’m calculating the future value of an annuity, $10,000 a year for up to 30 years. I’m not calculating the future value of an initial one-time deposit. This change from a one-time deposit to an annuity fattens the tail by nearly 70%. You do want, however, to calculate returns using an annuity since you save for retirement by making regular contributions and not a one-time deposit.

Third, some of the data people use to make the calculations and create the charts you’ve seen before don’t go back very far. To name just two examples, both the PortfolioCharts.com website and the PortfolioVisualizer’s back test asset allocation tool start their data in 1970s. That start date means they miss some really bad and some really good patches in investing. This change seems to fatten the tail by another 25% or so.

Note: Please don’t construe my statements as criticisms of the Portfolio Charts or Portfolio Visualizer websites or tools. I love both of them for what they do. But their data sets aren’t big enough to highlight what I’m talking about here.

A fourth explanation for a disconnect–at least visually: Some of line charts that show the range of long run stock market returns scrub the data of the extreme results. (Portfolio Visualizer does this, for example, showing not the worst and best cases but the 25th percentile and 75th percentile cases.) Scrubbing the data makes the line charts more usable and readable. (I’d do the same thing if I was them.) But in this particular comparison, that scrubbing hides the variability in returns.

Closing Comment

If the stuff discussed here is all new to you, you’ve got enough new stuff in your head for now. No reason to drag this on further.

Let me, though, close with this point: If this wide variability in returns is new to you, you probably have misunderstood the financial risks you’re bearing in your retirement savings program. And given that, you probably want to do some thinking about that risk and how you want to deal with it.

I’ve got some other blog posts that may help you do this:

Retirement Plan B: Why You Need One

Average Retirement Savings Return

Bogleheads Investment Philosophy Flaws: Problems with a Popular Approach

The post Unreliability of Long Run Stock Market Returns appeared first on Evergreen Small Business.

FIRECalc Retirement Plan B Calculations

Stephen Nelson CPA — Tue, 23 May 2017 12:09:24 +0000

Yesterday’s blog post talked about why you and I both need to have a retirement plan b.

To recap, that suggestion flows from a simple reality—that reality being that you and I don’t really know how much we’ll end up with for retirement—even if we know exactly how long we’ll save, exactly how much we’ll save, and exactly where we’ll save.

This blog post continues the discussion, explaining how to use the popular FIRECalc tool to make “retirement plan b” Calculations.

Note: Over the next couple of days, follow-up blog posts will explain in detail how to use cFIREsim and Portfolio Visualizer to make the same calculations.

But let’s get down to the details.

Describing Your Retirement Savings Program

FIRECalc, as you probably know if you’re reading this, is a wonderful online calculator you can use to plan your retirement—and especially how to safely draw down your retirement savings.

You can also use FIRECalc to estimate likely future values for your retirement savings at the start of your retirement. But you need to, well, sort of trick the program.

Your first step in using FIRECalc for retirement plan b calculations is describing your savings program. To do this, follow these steps:

1. Open the FIRECalc home page using this link firecalc.com. Figure 1 shows this web page (which doesn’t render well, frankly). You can click the image open a larger copy of the screen shot.
  Figure 1
2. Enter the value 0 into the Start Here box’s Spending text box.
3. Enter your current savings into the Start Here box’s Portfolio text box. (This amount might also be zero, too.)
4. Enter the number of years you’ll save money for retirement into the Start Here box’s Years text box. (For example, if you’ll save money for 35 years, enter the value 35.)
5. Click the Not Retired tab near the top of the FIRECalc window to display the optional settings used for modeling a future retirement.
6. Enter the year you’ll retire into the What Year Will You Retire box. (This year should probably be the current year plus the value you entered in step 4.) Figure 2 shows this webpage. Again note that you can click the image open a larger copy of the image.
  Figure 2
7. Enter the amount you’ll annually save into the How Much Will You Add To Your Portfolio Until Then, Per Year box. (For example, if you’ll save $5,500 a year–the maximum amount allowed using a traditional IRA–enter 5500.)
8. Click Submit to have FIRECalc model your savings.
Reviewing Expected Retirement Plan Outcomes

After you click Submit, FIRECalc calculates the historical results your plan would have produced had you run the plan during any period after 1872.

The FIRECalc website displays the calculations results in a new FIRECalc Results page that gives you the low, high, and median result using the following language (and here I quote):

Here is how your portfolio would have fared in each of the 111 cycles. The lowest and highest portfolio balance at the end of your retirement was $0 to $1,032,376, with an average at the end of $608,045 (Note: this is looking at all the possible periods; values are in terms of the dollars as of the beginning of the retirement period for each cycle.)

The above language describes the outcome when someone runs a 35 year retirement savings program saving $5500 annually and starting with no savings.

And some notes: First, the worst case scenario isn’t actually zero. The FIRECalc website gives zero as the low point because that’s the starting balance in the scenario modeled.

Second, note that the FIRECalc website does give you the average (median) outcome—which is $608,045 with the inputs I provided. But the point of this whole “retirement plan b” discussion is that value would probably not be what you end up with. Half the time people will end up with less than that value. Half the time, more.

A third comment: FIRECalc says the very best case scenario equals $1,032,376, which hints at the great variability you may experience. (This might be your “retirement plan c” scenario, something I’ll briefly talk about on Friday.)

The FIRECalc Results page also produces a line chart that graphically displays the outcomes someone running the modeled retirement plan in the past would have encountered. Figure 3 shows this image which graphically depicts retirement plan outcomes for the scenario described in the earlier paragraphs. Again, and sorry, the line chart doesn’t render well on a blog page, but you can click the image to get a bigger copy of it.

Figure 3

By eyeballing the chart—and this will be easier on your monitor using the actual FIRECalc web pages—you can see that the worst case outcome in the example case described here is slightly over $200,000 in retirement savings at the start of retirement. Further, a large number of outcomes fall under $412,952.

And there you have it: FIRECalc’s assessment as to the range of outcomes possible if the future looks like the past.

Your “retirement plan b”, given the numbers discussed in this blog post, might go something like this:

“While I’m counting on and hoping for a $600,000-ish balance in the retirement savings account when I start retirement, I need to be prepared on some level for the outcome where I end up with maybe $400,000-ish since a large number of outcomes fall even lower than that.”

Tweaking Your Retirement Portfolio Asset Allocation

The outcomes provided in the preceding paragraphs assume your retirement savings allocate 75% of your funds to equities and 25% to bonds delivering the long-term interest rate. But you can tweak these percentages, and should, if you’re using some different asset allocation.

An observation: If you tweak the percentage allocated to equities, you’ll notice the range from worst case outcome to best case outcome shrinks and grows.

To maybe state the obvious, you absolutely do forecast higher future value balances if you allocate a larger percentage of your portfolio to equities. But you also end up with a larger range of outcomes. The higher the equities allocation, therefore, the more important your retirement plan b becomes.

You can tweak FIRECalc’s asset allocation formula using the Your Portfolio webpage. You get to this website by clicking on the Your Portfolio tab at the top of the FIRECalc webpage. To reset the allocation to equities, replace the value in the Percentage Of Your Portfolio That Is In Equities box.

Tip: Lots of people (me included) often don’t do a good job of internalizing the risk embedded in their portfolios. But you may find your FIRECalc retirement plan b calculations very useful for sizing up the risks of your asset allocation, too.

Other Resources about Retirement Plan B Calculations

Each day this week at the Evergreen Small Business blog, I’m discussing the idea that you probably want a “plan b” for your retirement. Those other posts are probably going to be interesting to you if you’ve just finished reading this.

You might also find these other related blog posts useful:

$10,000,000 Individual Retirement Accounts and 401(k)s Really Possible?

Absurdly Good Retirement Outcomes: What Small Business Owners Can Learn From Public Employee Plans

Why You Don’t Need to Worry About Income Taxes During Retirement

Finally, on the off chance you need a retirement plan “a”, go ahead and grab a free copy of my “Thirteen Word Retirement Plan” available here.

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