Deductions Protect Most Taxpayer’s Estates

Fortunately, the state provides a couple of big deductions and both are enlarged starting July 1, 2025: A standard $3,000,000 deduction that everyone gets. (Prior to the new law, the standard deduction was $2,193,000.) And that single deduction means most people’s estates don’t pay the state estate tax.

Further, a qualified family-owned business interest deduction that can technically shelter as much as another $3,000,000 starting July 1, 2025. (Before that date, the qualified family-owned business interest deduction equaled $2.5 million and wasn’t indexed for inflation.) That extra deduction potentially means small business owners’ families and heirs can sometimes avoid state estate taxes on as much as $6,000,000 of their estate in late 2025.

Someone who dies in the last half of 2025 with a $10,000,000 estate, for example, might shelter as much as $6,000,000 from estate taxes and then only have their estate pay estate taxes on the remaining $4,000,000.

But it’s tricky. So, let’s go over the details.

Qualifying for the Qualified Family-owned Business Interest Deduction

The “qualified family-owned business interest deduction,” or QFOBI deduction, burdens taxpayers with a handful of requirements.

First, the business must be an active trade or business. A passive business can’t use this deduction. Estates, for example, can’t use this deduction for real estate investments.

Second, the business must represent more than half of the estate and be worth $6,000,000 or less. (These twin requirements mean, practically, the estate needs to include a business interest that makes up more than half of an estate no larger than $12,000,000.)

Third, either the decedent or a family member must have materially participated in the business for five of the eight years before death by working 35 hours a week or in a hands-on managerial role.

Note: The QFOBI deduction doesn’t use the popular Section 469 material participation rules from Regulation 1.469-5T(a) but older estate-related rules from Section 2032A(e)(6). Those regulations treat ~35 hrs/week (or season-long full-time for seasonal operations) as a safe harbor, but a well-documented managerial role can also work.

Fourth, at least one family member or in a pinch a key-employee with ten years of employment needs to work full-time for the three years that follow the date of death. (Practically, this probably means any family member like an heir needs to be working in the business before the date of death.)

But meet these requirements and the estate probably slides another big chunk of estate out of the taxable category and into the non-taxable category. That move may save hundreds of thousands of dollars.

Examples of QFOBI Deduction Working

Let me provide a couple of examples of the qualified family-owned business interest deduction working. All examples will assume the taxpayer dies during the last half of 2025.

Example 1: Martha has an active business worth $5,000,000 while the remaining assets in the estate are worth $4,000,000. Thus, the total estate is $9,000,000. Her son materially participated in the operation for the five years prior to her death and will continue to operate the business for the three years following her death. The estate may deduct $3,000,000 of the $5,000,000 small business. The estate may also take another “standard” $3,000,000 deduction. That leaves $3,000,000 of leftover, taxable estate. And in the last half of 2025, that estate would trigger about $400,000 of Washington state estate tax. (Compare this example to example 3 below.)

Example 2: John has an active business worth $6,000,000 while the remaining assets in the estate are worth $5,999,999. Thus, the total estate is $11,999,999. His son, also named John, materially participated in the operation for the five years prior to his death and will continue to operate the business for the three years following his death. The estate may exclude $3,000,000 of the $6,000,000 small business. And the estate may also take another “standard” $3,000,000 deduction. That leaves $5,999,999 of leftover, taxable estate. And in the last half of 2025, that estate would trigger about $1,100,000 of Washington state estate tax. (Compare this example to example 4 below.)

Tip: We have a simple calculator you can use to estimate Washington state estate taxes: Washington State Estate Tax Calculator 2025 Version.

Examples of QFOBI Deduction Not Working

Let me provide a couple of examples of the qualified family-owned business interest deduction not working.

Example 3: Thomas has an active business worth $4,000,000 while the remaining assets in his estate equal $5,000,000. Thus, the total estate is $9,000,000, the same total as in Example 1. He materially participated in the operation for the five years prior to death and an adult child, already working in the operation, will continue to operate the business for the following three years. The estate may not exclude $3,000,000 of the $5,000,000 small business because the business does not represent 50 percent or more of the estate. The estate only will get to take the “standard” $3,000,000 deduction. That leaves $6,000,000 of leftover, taxable estate. And in the last half of 2025, that estate would trigger about $1,000,000 of Washington state estate tax. (Compare this example to example 1 above.)

Example 4: George has an active business worth $6,000,001 while the remaining assets in the estate are worth $5,999,999. Thus, the total estate is $12,000,000. His son, also named George, materially participated in the operation for the five years prior to his death and will continue to operate the business for the three years following his death. The estate may not exclude $3,000,000 of the $6,000,001 small business because the business value exceeds $6,000,000. The estate may however take the “standard” $3,000,000 deduction. That leaves $9,000,000 of leftover, taxable estate. And in the last half of 2025, that estate would trigger about $1,900,000 of Washington state estate tax. (Compare this example to example 2 above.)

Common Trip-wires

Easy-to-make mistakes can torpedo the qualified family-owned business interest deduction. Thus, let me quickly summarize these.

Day-1 Participation Gap

If no heir or other family member or ten-year key employee is already on the payroll when Mom or Dad dies, the three-year clock possibly can’t be met. (A ten-year key employee can stand in if no family member can.) Thus, families wanting to use this deduction need to plan now—and avoid post-mortem scrambling.

Tip: Probably material participants also want to document their work. Timesheets, management minutes, crop plans—anything that shows hands-on control—may make a difference.

Self-employment Tax Mismatch

The estate regulations presume material participation when the taxpayer paid SE tax. If past returns lack a Schedule SE, expect the Washington Department of Revenue to press hard on use of the deduction.

Business Worth > $6 million

One final trip-wire to mention. The new version of the Washington state estate tax (ESSB 5813) lifts the QFOBI deduction cap from $2.5 million to $3 million for deaths on or after July 1, 2025, and adds annual CPI indexing thereafter. Thus, the deduction grows with inflation starting in the calendar year 2026.

However, the business worth cap of $6 million is frozen. Thus, while the potential QFOBI deduction will get bigger each year, the number of firms eligible (because they’re worth $6 million or less) will shrink with inflation. Thus, keep this economic reality in mind for planning. Especially if the business valuation you’ll be using is one in a decade or two… or three

Gut-check on the Qualified Family-owned Business Interest Deduction

One final comment: The QFOBI deduction is tricky to use. As you now know if you didn’t before, the requirements an estate needs to meet are pretty limiting. Between you and me? What the state legislature cooked up here, about as absurd as it gets.

But that said, if you’re in a situation where your family or your clients operate a small business that represents the major share of their wealth? You want to at least think about using the QFOBI estate deduction. It’s often (as the examples above show) going to save hundreds of thousands of dollars. And even a million dollars in some cases.

The post Washington’s Qualified Family-Owned Business Interest Estate Tax Deduction: Updated for 2025 appeared first on Evergreen Small Business.

But Silver’s book? The risk management tactics and tricks he describes gamblers, casinos, venture capitalists, and artificial intelligence developers taking? That stuff is pretty applicable to small business owners, too. Thus, I’d recommend putting On The Edge on your reading list. And in case it takes you while to get to the book, let me spotlight a handful of interesting risk management ideas.

Idea #1: Most People Take Too Few Risks

A first idea backed up by a bunch of research: Most people take too little risk. Poker players, investment traders, entrepreneurs, and so on.

And why this matters: Unfortunately, avoiding or dodging risks? A destructive and unprofitable habit or practice.

The actionable insight here: Most of us (me included) take too few risks.

Idea #2: Testosterone Levels Affect and Are Affected by Risk

A second thought-provoking idea from the book: Testosterone levels are linked to risk-taking.

For example, people (yes, mostly men) with higher testosterone levels tend to take more risks. And because most of us take too little risk? That effect of higher testosterone might actually be a good thing.

But something else to note: According research Silver reviews and discusses, successful risk-taking boosts testosterone. So some people can experience a compounding here. Higher testosterone levels amp up risk-taking. (Initially good). That risk taking results in rewards. (Again, good.) Those rewards boost the testosterone. (So far, so good.) That triggers more risk taking. (Okay maybe good…but at some point not good.)

In any case, something to consider. Especially if you’ve just experienced a massive boost in your testosterone levels because you’re coming off of a giant success.

Idea #3: Cortisol Levels Affect Risk Tolerance

A related hormonal issue: Anxiety levels and cortisol stress hormone levels affect people’s risk tolerance.

So this actionable insight: Stresses and anxieties from stuff outside of work? That can obviously push down our ability or willingness to take risk. Which makes sense.

But if risk-taking and harvesting rewards from managing or bearing risk is one of the things entrepreneurs do? Maybe small business owners and entrepreneurs need to think more about the anxiety stuff.

Idea #4: Putting Money Down Often Problematic

An idea that jumps off into another area.

In talking with gamblers taking risks and also with venture capitalists, Silver talks about the challenge of actually finding opportunities to bear risk smartly.

A handful of times in the book, he talks about the challenge good poker players face trying to find good games or tournaments to play in. Or about sports betters struggling to find online gambling shops willing to take their bets.

I see a connection here to you and your small business. (I’m assuming your small business is or will become successful.) And the connnection is this: Yes, you should be earning great returns on your small business investment. Way better than you’ll earn if you “cash out your chips” and then invest in the public captial markets. Thus, you (and I) want to think very carefully about taking money off the table so to speak.

You and I may want to let our winner continue winning.

Example: Say your small business generates $200,000 a year in profits and that you could sell the firm for $500,000. (That would reflect a common valuation.) Viewed from one perspective, you’re earning a 40% return on your investment. If you cash out the $500,000 and invest in the stock market? Well right now, with the current valuations of US stocks US investors might earn $10,000 to $20,000 annually. You therefore may want to keep your money invested in your small business.

Idea #5: Kelly Criterion Suggests When to Sell?

A final risk-taking insight: A formula from the world of gambling and then (oddly) finance, the Kelly Criterion, suggests how much you or I should have invested in a small, high-risk business.

Assuming the entrepreneur is fully risk tolerant, more on this in a minute, the Kelly Criterion for fractional wealth allocation to a risky asset like a small business is:

(Expected return – Risk-free return)/(Volatilty²)

This formula looks complicated. But the math works more easily that you might expect.

Example: Say the return you expect from your small business equals 25%. Say the risk-free return you can earn from US treasury bonds equals 5%. Finally say the volatility, or standard deviation of your small business’s return, equals 50%. (These numbers are all pretty accurate guesses in many cases, by the way.)

With these inputs, the Kelly Criterion formula looks like this:

(25%-5%)/(50%²)

That 25%-5% numerator equals 20% obviously. Thus, the equity risk premium equals 20%

That 50%² denominator equals 25%.

And 20%/25% equals 80%.

Thus, risk tolerant small business owner might rationally choose to have 80% of her or his wealth invested in a small business that generating a 25% return with 50% volatility if riskless assets return 5%.

Note: We’ve got an earlier blog post about Merton shares which work identically to the Kelly Criterion in this situation. That blog post provides a calculator and additional background information on how you come up with the formula inputs.

The post Nate Silver On the Edge: Actionable Insights for Entrepreneurs appeared first on Evergreen Small Business.

Some folks can also prudently buy the home or apartment where they reside. But after those obvious options? I’m pretty agnostic. Except, that is, for the real estate investment every entrepreneur should consider: Self-rental property your business occupies.

Why Self-rental Property is So Attractive to Entrepreneurs

Self-rental property works great for entrepreneurs for a simple reason. As long as they follow the rules, they can pretty effectively unlock depreciation deductions that normally other real estate investors can’t unlock. Or unlock without spending tons of time or doing lots of fiddling.

A real estate professional by the way can unlock depreciation deductions. But to do that, she or he will need to spend more than 750 hours and more than 50 percent of their time working in a real estate trade or business. They will also need to materially participate in the properties they own if they want to deduct the depreciation—and this can be problematic.

And by the way? Short-term-rental investors? Yes, they can get giant deductions on their return too. And they may be able to materially participate with very modest hours. But they also need to manage the average rental interval of guests. Because in order to qualify as a short-term-rental investor? Your average rental interval needs to equal 7 days or less.

A self-rental property, however? Easy for entrepreneurs if they do it right.

The Self-rental Property Depreciation Deduction Estimator

Take a peek at the simple JavaScript Calculator below. It shows the depreciation deductions you can probably get from a owner-occupied commercial property that cost $1,000,000. The calculator defaults to 100% bonus depreciation (the right percentage for property placed into service on or after January 1, 2025), and it assumes a cost segregation engineer has broken down the price into real property and personal property.

To summarize, once you click the Calculate button, the Self-rental Property Depreciation Deduction Estimator calculates depreciation deductions for the first year through seventh years. These calculations assume a $1,000,000 price broken down into 25% land, 15% five -year property, 30% fifteen-year property, 0% 27.5-year property, and 55% 39-year property. But what’s unique here? As compared to most real etate investors who will not get to use those gian depreciation deductions? An entrepreneur very probably will.

Tip: Replace the percentages, or decimal values, for your potential real estate investment to estimate actual depreciation you might deduct on your return. And then click Calculate again.

Note: The seventh year’s depreciation is also roughly the depreciation deduction for years that follow the seventh year.

The Usual Problems with Real Estate Depreciation and Other Deductions

The problem with those big deductions however? In many, perhaps most cases, you can’t actually use them. Section 469 of the Internal Revenue Code limits your deductions on a passive investment like real estate to the income you earn from other passive investments. (This is the usual rule for real estate investments, by the way.)

Something special happens with self-rental property that the entrepreneur correctly sets up, however. First, if the entrepreneur groups the rental property with the operating trade or business? That grouping causes Section 469 rules to see the grouped rental property and active trade or business as not a real estate rental activity.

The second thing to happen? The entrepreneur looks at the hours she or she spends on both the rental property and the other active trade or business to determine whether they materially participate. If they spend more than 500 hours on the grouped activities? Bingo.

The First Requirement for Grouping the Rental with the Active Trade or Business

You have two requirements to get a grouping to work. First, the ownership of the rental property needs to perfectly match the ownership of the other operating trade or business. For example, if two shareholders own 60 percent and 40 percent of say an engineering firm? They would also need to own those same percentages—so 60 percent and 40 percent—of the building the engineering firm rents.

Note: You typically would put the real estate into one entity, like a limited liability company. And treat that entity as a partnership. And then the other operating trade or business might be a different partnership. Or a corporation.

The Second Requirement for Grouping

You need to make the grouping in the first year you own the property or operate the trade or business. For example, if this year, you buy a building to house the engineering firm you and your partner have operated for decades? You need to make the grouping election on this year’s tax return.

Note: Not all grouping and aggregation elections need to be made in the first year an activity or trade or business exists. With Section 469 grouping elections like a self-rental, however, the decision not to group the first year is treated as a default grouping. And then the problem that creates? You can’t regroup later on except in special circumstances. And then only with the Internal Revenue Service’s permission.

A Predictable Caveat

Let me end with a predictable caution. One you really don’t even need me to give. (Sorry. But accountants have pretty conservative, compulsive personalties.)

The tax deductions you generate by buying a building and renting it to your business? Very high impact. You may be able to in effect save hundreds of thousands of dollars pretax by using this gambit. (In comparison, remember something like a Section 401(k) plan in the absolutely best case scenario maybe lets you save $70,000-ish of pre-tax money.)

But the tax savings? Not so good an entrepreneur can ignore the return on investment. Thus, we want to treat a prospective real estate investment that same way we’d treat any other business investment. We probably want to calculate the anticipated return on investment. Consider whether and how we can safely use borrowed funds for some of the purchase price. Stuff like that.

The post The Real Estate Investment Every Entrepreneur Should Consider appeared first on Evergreen Small Business.

But that blog post got me thinking about the Section 183 Schedule C problem.  Which is similar.

But before we dig into the details, let’s discuss briefly what Schedule C is. And then I’ll move on to discussing the Section 183 connection to Schedule C.

What is Schedule C?

Schedule C is a profit and loss schedule that is filed on the individual level to report business income.  When you file Schedule C, you are telling the IRS you “engaged in an activity for profit.”  An activity must be “engaged in for profit” in order to be considered a business.

Positive net income from Schedule C is ordinary income subject to self-employment and income tax.  Negative net income from Schedule C offsets, or reduces, your other ordinary income.  It also reduces the income taxes you pay.

What is the Section 183 Schedule C problem?  Many of the Schedule C losses filed every year with the IRS do not rise to the level of an activity engaged in for profit. The activities, in other words, are hobbies.  You do not want to report a loss from a hobby, receive a tax benefit, and end up under examination with the IRS.

If you are unsure whether your activity is a hobby or a business, the IRS lays out nine factors to help you decide. These factors will help clarify whether you operate an “engaged in for profit” business or a hobby. Whether you have a Section 183 Schedule C problem.

Let’s take a closer look at each factor.

1. Manner in Which a Taxpayer Carries on the Activity

This is the first factor detailed in the Section 183 Audit Technique Guide, and unsurprisingly, is very important.  You want to operate your activity in a business like manner.  Here are several business-y things you ought to consider implementing if you are not doing so already:

• Separate personal and business finances.  Use a dedicated business checking account and credit cards.
• Use a real accounting system to track your income and expenses.
• Write a business plan to show, specifically, how your business will make a profit.
• If your business is not making a profit, change your operating methods to reach profitability.
• Register your business and pay appropriate state level taxes and file all appropriate forms.

Again, running your activity like a legitimate business is very important to support the engaged in for profit intent.  An activity run like a hobby, is probably a hobby.

2.  Expertise of the Taxpayer or Their Advisors

You want to be an expert in your activity or listen to or hire experts that are.  This doesn’t mean you need a Ph.D. or master’s degree, but you need to have knowledge of your activity and industry.

This makes intuitive sense.  It would be impossible (or nearly) to make a profit operating an activity, or operating in an industry, you know nothing about.

Substantiate the steps you took to acquire knowledge.  It might be reading books written by experts.  Or taking seminars or classes.  Maybe you really went to school and earned a Ph.D..

Relying on (and probably paying for) advice from experts like CPAs, attorneys, and consultants also help support your activity qualifying as an engaged in for profit business.

3. Time and Effort Expended in the Activity

The time expended in the activity should be consistent with an intent to make a profit.  This is vague because there is no bright-line “time” test.   And time doesn’t need to be exclusive or significant if competent management or employees are hired.

An examiner will look at the total time spent in the activity, plus time the taxpayer spends in other business activities and employment when weighing this factor.

The point is you want good documentation of time spent on the activity, whether it is you or someone else doing the work.  The more time spent, the greater chance of your activity qualifying as an engaged in for profit business.

4. Expectation Assets Used in Activity May Appreciate in Value

The title sounds self explanatory but there is a bit of nuance.  Appreciating assets, like property used in rental real estate, help to qualify an activity as an engaged in for profit business.

The nuance?  The IRS is okay with your activity realizing losses year after year, as long as there is the expectation that, eventually, the activity pays off and generates positive income.  The regulations even indicate a “reasonable expectation of profit is not required.”

I mentioned real estate earlier; this is also common in intellectual property.  The goal is to hold the asset long enough to realize substantial appreciation.

In an examination, you want to point to supporting documents like appraisals or comparables.  Something that helps substantiate the appreciation in value.

Note: Different rules apply for farming, as discussed a bit later

5. Success of Taxpayer in Carrying on Other Similar or Dissimilar Activities

A history of successful entrepreneurship helps to qualify your activity as an engaged for profit business.  I think a history of unsuccessful entrepreneurship helps support this too.  Not every business venture ends up being profitable.

If your activity isn’t doing well?  Course correct and change things up to try and make it successful.  And document the changes you make.

6. Taxpayer’s History of Income or Losses with Respect to the Activity

I’m going to paraphrase the regulations here.  They say, basically,  that losses during the start-up stage of an activity may not necessarily indicate the activity is not engaged in for profit.  But, continued losses beyond the start-up stage, if not explainable, may indicate the activity is not being engaged in for profit.

If your activity is losing money year after year, you want to explain why.  Market conditions, disease, theft, natural disaster, fire, etc. are all good explanations of why a business might not be profitable.

7.  Amount of any Occasional Profits that are Earned

Section 183 gives a taxpayer a presumption of profit intent if gross income from an activity exceeds the deductions from the activity for at least three out of five taxable years.  Most new activities will struggle to meet this.

As I said above, the expectation of profit is not required for your activity to be considered an engaged in for profit business.  And occasional profits, especially in highly speculative ventures, indicate the activity is engaged in for profit.

You absolutely should not manipulate income or expense numbers to artificially show a profit to meet the safe harbor (more on the safe harbor below).  An IRS examiner will almost surely catch this.

An IRS examiner will compare income and expenses between periods to find deviations.  They will also substantiate the income and expenses reported on the tax return.  Phantom income, or reduced or non-reported expenses, will be easy for an examiner to find.

8. Financial Status of the Taxpayer

A lack of income or capital from other sources indicates an activity is an engaged in for profit business.  If your Schedule C activity is your only source of income, most likely you have an engaged in for profit business and not a hobby.

If you have other major sources of ordinary income, you want to carefully go through each of these factors to determine how to accurately report your activity on your tax return.

9. Elements of Personal Pleasure

We have reached the final factor, and this one is quite subjective.  What is pleasurable to one person might be a chore for someone else.

You want to minimize the amount of personal pleasure in your activity as much as possible.  Let me explain.

An activity will not be treated as not engaged in for profit merely because the taxpayer has motivations other than solely making profits.  There will always be other activities which yield higher returns.  And those activities might make you miserable.  There should be a balance of enjoyment and financial success, not a narrow focus on one or the other.

There are a handful of other points I want to discuss before we wrap up.

Farming Activities

This blog post is tailored for Schedule C activities, but Section 183 is particularly consequential for farming activities that are reported on Schedule F.  Section 183’s intent is to prevent taxpayer’s engaged in farming activities from offsetting farming losses with land appreciation.

Remember factor 4?  It doesn’t apply here, at least with land.  The regulations say the farming and holding the land for appreciation constitute one activity, but only if the farming activity reduces the net cost of carrying the land.  In other words, the farming itself needs to be profitable.  Land appreciation has no weight in the determination of a farming activity being an engaged in for profit business.

Safe Harbor

Most of Section 183 is subjective, requiring taxpayers and examiners to look at the facts and circumstances of each activity.  But, fortunately, there is one quantitative way of determining if your activity rises to the level of an engaged in for profit business.

There is a presumption an activity is engaged in for profit if:

• The activity has net profits for three out of five consecutive tax years, or
• In the case of breeding, training, showing or racing horses, the activity has net profits for two out of seven consecutive tax years.

The IRS can still dispute your activity is really a hobby and not a business, but the burden rests on the IRS to prove it.

This safe harbor is difficult to meet for business that are still in their “start up” phase.  Fortunately, there is a an election to postpone the determination, which I cover next.

Election to Postpone Determination

Form 5213, Election to Postpone Determination, can be filed to delay an IRS determination as to whether an activity is engaged in for profit.  You can find the form here.

You want to file this form in the first year or two after beginning your activity if you expect to realize losses.  When filed, the IRS will postpone their determination until after the end of the 4th consecutive tax year, or 6th year if your activity is farming.

The form must be filed within three years of the due date of the first tax return.  If you receive a Statutory Notice of Deficiency from the IRS (the notice disallows hobby loss deductions) you must file within 60 days.

Final Thoughts on the Section 183 Schedule C Problem

The IRS estimates roughly 70-80% of Schedule C filers with losses are really hobbies.  This means Schedule C’s with losses are exceptionally vulnerable to IRS examinations.

You want to be confident your activity rises to the level of “engaged in for profit” before you claim a Schedule C loss.  And  be ready to defend your position with the IRS.  If you are unsure after reading this, you may consider reaching out to a tax professional for help.

The post The Section 183 Schedule C Problem appeared first on Evergreen Small Business.

Five million small businesses operate as S corporations. And surely most of those folks know the simple trick for saving money with an S corporation. You pay a low salary and avoid payroll taxes.

Too many S corporation owners, unfortunately, do not know about all the other more advanced S corporation tax planning tricks and tactics. Thus, this month’s blog post.

Basic S Corporation Trick: Avoid Payroll Taxes

To start, however, I want to review the standard, simple S corporation trick for saving taxes. Just to make sure we’re all on the same page.

And to do this, let me give a quick example where a business owner earns $100,000. I’m going to slightly round the numbers, by the way. That’ll keep this blog post more readable.

Tip: Use our free calculator to estimate S corporation tax savings for your situation: S Corporation Tax Savings Calculator

If the business operates as a sole proprietorship or a partnership and the owner realizes $100,000 of profit. He or she pays Social Security and Medicare payroll taxes on most of the $100,000. Those taxes run roughly 14%, which means about a $14,000 payroll tax. (The actual formula might work like this: a 15.3% tax on 92.35% of the $100,000. And now you see why I’m rounding numbers. And simplifying.)

If the business instead operates as an S corporation, however, tax law allows the business owner to split the $100,000 into regular employee wages and then a shareholder distributive share. The split, by the way, needs to be fair. The resulting shareholder-employee wages amount needs to be reasonable.

But if a business owner can reasonably split the $100,000 of profit into $50,000 of wages and $50,000 of distributive share, he or she halves the payroll taxes. The savings in this case run slightly more than $7,000 a year, which is great.

Too many S corporation shareholders stop there, however. Because a bunch of other powerful, more advanced S corporation tax planning tactics exist.

Trick #1: Optimize for Section 199A Deduction with Higher Wages

A first powerful technique: some business owners pay too little in W-2 wages by focusing just on the payroll tax savings. But if a business generates Section 199A qualified business income and earns its owners a high income, the owners need wages to support a full Section 199A deduction.

The Section 199A deduction, something we’ve talked about a lot through the years (see list here), allows a taxpayer to avoid paying income taxes on the last twenty percent of her or his taxable income. If a taxpayer’s income rises above a threshold amount—roughly $200,000 for a single filer and roughly $400,000 for a married filer in 2024—the Section 199A deduction can’t exceed more than 50 percent of the W-2 wages paid by the business.

Now to be clear, you can’t arbitrarily set your wages to some amount simply to optimize your 199A deduction. You need to pay yourself a reasonable salary. But in general, if you’re losing 199A deductions because you don’t have enough wages, you want to look at bumping your wages so you’re paying out 2/7ths of your profits as wages and 5/7ths as shareholder distributions.

Example: An S corporation makes $7,000,000 in profit for its owner. The owner pays herself $500,000 in W-2 wages, and those are the only wages. This approach limits her Section 199A to just $250,000. If she can reasonably bump her wages to $2,000,000, she increases her Section 199A deduction from $250,000 to $1,000,000. That bump should save her about $280,000 in income taxes.

Trick #2: Split a Specified Service Trade or Business to Requalify for Section 199A

Another 199A gambit: many high-income S corporations lose the Section 199A deduction because some part of the operation is a specified service trade or business (SSTB). These SSTBs include most of the traditional professions (but not all), performing artists, athletes, and celebrities.

But a tip? Many entrepreneurs operate multiple trades or businesses, some of which are SSTBs, and some of which are not. Often, the entrepreneurs hold these businesses in a single S corporation entity. The problem here: combining an SSTB and a non-SSTB disqualifies the entire business for purposes of Section 199A. This leads to an obvious idea: if the business owner can split one S corporation into two S corporations, that’ll often re-qualify some of the income for the Section 199A deduction.

Example: A physician owns a clinic and earns $400,000 practicing medicine. He also provides continuing medical education services in his specialty and earns $400,000 from that. If he combines those two activities in a single S corporation, he loses the 199A deduction on 100% of the $800,000 of income in all likelihood. Practicing medicine counts as an SSTB. And if half the taxpayer’s activity is SSTB-related, that taints everything. If, however, he separates the two activities into separate trades or businesses, probably using a couple of S corporations, he can get a big $80,000 199A deduction on the second non-SSTB business of providing continuing medical education. The savings here: close to $30,000 annually.

Trick #3: Elect to Pay Pass-through-entity Tax

A quick option for shareholders living in states with income taxes.

You can probably pay the state income taxes you individually owe on your S corporation profits directly from the S corporation. To do this, you make an election to pay a pass-through entity tax. And you want to do this.

Here’s why: if you personally pay the $30,000 in state income taxes on your S corporation profits, you almost surely don’t get a federal tax deduction for the payment. (Federal tax law limits the Schedule A tax deductions for state and local taxes to $10,000.) However, if your S corporation pays the $30,000 as a pass-through-entity tax, you almost surely will get a $30,000 federal tax deduction. If your federal tax rate is, say, 24%, that tweak to your tax accounting should save you about $7,200.

Trick #4: Use Tax-free Fringe Benefits

A simple gambit: you want to load as many tax-free fringe benefits onto your S corporation tax return as you can. These fringe benefits bump your shareholder-employee compensation without bumping your payroll taxes.

Example: Suppose an entrepreneur owns an S corporation that generates $100,000 of profit but wants to pay herself $50,000. That amount might be unreasonably low. But if she provides herself with $30,000 of health insurance (which counts as wages but isn’t subject to income or payroll taxes), that $80,000 of W-2 wages and fringe benefits might rise to the level of reasonable.

Trick #5: Set up a Generous Pension for Shareholder-employees

We think most small businesses want to set up good employee pension plans for rank-and-file employees. That step, especially when small firms compete for talent, makes good sense as a business practice in many situations.

But entrepreneurs also want to think about pensions as tax planning gambits they can use to not only save taxes but build wealth outside of their equity in the business.

Example: A Simplified Employee Pension (SEP) plan lets a business owner contribute up to 25 percent of their W-2 wages. Someone who pays herself $50,000 in base wages and then $30,000 in health insurance might be able to pay a $20,000 SEP contribution. This pension plan contribution in this situation probably saves payroll taxes. (With an S corporation, the SEP contribution saves both income taxes and payroll taxes.) And it also probably increases the reasonable compensation. Someone who receives $50,000 in base W-2 wages, $30,000 in health insurance benefits, and $20,000 of pension contributions arguably enjoys a $100,000 compensation package.

But higher-contribution options exist too. Inexpensive 401(k) plans in many cases not only allow for 25 percent employer contributions but let the shareholder-employee also add elective deferrals (from their W-2 wages) that in 2024 equal $23,000 for most individuals and $30,000 for folks aged 50 or older.

In special cases, an S corporation allows a shareholder-employee to set up a defined benefit plan that might allow an even larger employer contribution. Perhaps a low to mid six-figures deduction in some situations? Again, in this case, that pension benefit should count toward the reasonable compensation requirement. And as with SEP contributions and employer matching for 401(k) plans, a large defined benefit plan contribution saves not only income taxes but payroll taxes.

Trick #6: Own Partnership Interests Through an S Corporation

A partnership cannot own an interest in an S corporation. In essence, only U.S. citizens and permanent residents, and other taxpayers very similar to U.S. citizens and permanent residents can own interests in an S corporation. But this rule gets twisted and scrambled sometimes.

For example, the rule about eligible shareholders sometimes gets rephrased (incorrectly) as saying that an S corporation cannot own an interest in a partnership. But it can. Thus, if you own partnership interests in working trades or businesses and those partnerships generate self-employment income for you, you should explore with your tax advisor the possibility of setting up an S corporation and then having your S corporation own your partnership interests. That tiered structure—owning an S corporation that owns a partnership interest—will let you harvest many of the benefits of owning an S corporation already discussed on your partnership income.

A sidebar: Partnerships provide their own tax planning benefits including the ability flexibly allocate income and deductions. Thus, combining partnerships and S corporations in a tiered structure often lets you enjoy the best of both worlds.

Trick #7: Group Compatible Activities with an S Corporation

If you own an S corporation that operates an active trade or business generating strong profits and you start a new business, you need to consider making grouping elections that combine a loss-generating activity with the profitable S corporation’s activity.

Example: If you own two activities, materially participate in the one making $500,000 a year but don’t materially participate in the one losing $300,000 a year, you can’t use the $300,000 in losses to shelter any of the $500,000 of income. However, chances are good that you can find a way to group the two activities into a single activity. And that grouping will let you use your material participation in the one business for both businesses.

Predictably, the IRS requires your grouping to follow common-sense rules. We discuss those in another blog post here: Grouping Activities to Achieve Material Participation. But the general concept? The grouping needs to be timely and reflect common sense.

Trick #8: Use the Self-rental Rules to Harvest Big Real Estate Deductions

A related trick: in theory, real estate investments should allow entrepreneurs to shelter other income. Say someone owns a business that generates $200,000 of taxable income and owns a real estate property that loses $100,000 on paper due to depreciation.

A taxpayer might think he or she can use the $100,000 loss to shelter half of the $200,000 in income. However, in many cases, tax law prevents you from doing this. A specific chunk of the law, Section 469, prevents you from taking the easy obvious deduction in most cases.

A handful of ways exist to dodge the Section 469 limitations on real estate-related losses, however. And one of the most powerful ways works for profitable S corporations. If you elect to group a self-rental property with the other active trade or business using the property, the Section 469 loss limitation rules don’t apply if you set things up right.

This gambit is a little tricky. The ownership percentages of the rental property and the S corporation need to match. Also, you need to make the grouping election when you acquire the property. But done right, you can use depreciation deductions from real estate you own and use in your business to shelter that business’s income.

One other note: normally nonresidential property results in a tiny trickle of real estate depreciation deductions over basically four decades. That doesn’t do much to help with a profitable business you’re running today. You can, however, frontload your depreciation deductions using accelerated depreciation. In some cases, you might be able to immediately deduct ten, twenty, or even thirty percent of the purchase price in the year you invest.

Trick #9: Put a “Hobby” Inside Your S Corporation

Okay, I want to be very careful here. I am not saying you can operate a hobby inside your S corporation and thereby deduct hobby losses or hobby expenses. Again, not saying that…

Furthermore, for you to deduct expenses on a business tax return, you must be engaged in the activity in pursuit of profit. That’s a requirement of a little chunk of tax law called Section 183 and popularly referred to as the “hobby losses rule.”

However, some activities you engage in for profit may look like a “hobby” or an “activity not engaged in for profit” if you operate the activity outside of an S corporation. In a worst-case scenario, you lose the deductions these activities generate. Putting the income and expenses inside your S corporation may work, however.

Example: Say you do barn design and home interiors design that reflect an owner’s interest in and love of horses and all things equine. Maybe you sell your work to horse folk who can’t normally be approached or marketed to using telephone calls, email blasts, or direct mail. But you can effectively market through personal one-on-one selling if you’re riding your own horse at dressage competitions, cross country events, or hunter jumper shows.

In this case, you very likely might lose your deductions if you conduct your horsemanship activities outside your business. But if you do all this stuff “inside” an S corporation that does barn and home design work, the deduction will probably work. (For an example of how this might work, take a peek at this Tax Advisor article: Aggregating Activities to Avoid the Hobby Loss Rules.)

Trick #10: Section 1202 Qualified Small Business Stock Inside an S Corporation

A final trick to mention: some stock in C corporations qualifies as Section 1202 Qualified Small Business Stock. The attraction of this qualification? When the stock is sold, capital gain is either partially or wholly avoided as long as the requirements are met. For stock acquired after Sept 28, 2010, the exclusion equals 100% of the gain if held more than five years. (A handful of other requirements exist too.)

Stock in an S corporation can’t “be” Section 1202 stock. But some taxpayers who own S corporations have a workaround on this. A taxpayer who owns an S corporation with a valuable activity that can be spun off into a separate C corporation can often get Section 1202 for that corporation.

We’ve got a longer discussion of how Section 1202 works here: Section 1202 Qualified Small Business Stock Exclusion. But know for now that you might be able to use the Section 1202 tax planning strategy even for some activity you start up inside an S corporation.

Example: A taxpayer does contract programming as an S corporation. A few years after starting this venture, the S corporation owner working weekends also develops a software program. The S corporation then “incorporates” a new C corporation owned by the S corporation and contributes the software program to that new C corporation. Thus, the S corporation owns a C corporation that owns and sells the software program. Assume at the point the software program is contributed to that new C corporation the software program and therefore the C corporation is worth $1,000,000. Further assume the S corporation sells the C corporation for $11,000,000 five years later. In this situation, the S corporation will treat $10,000,000 of the $11,000,000 of gain as Section 1202 qualified small business stock gain and pay zero income taxes.

A Final Comment about Advanced S Corporation Tax Planning

Your existing tax advisor probably knows about all this stuff. So, if you’ve got questions or ideas you want to run by an expert, talk to her or him. (I mention this because I see too many advertisements on social media sites where someone advertising “tax strategy consulting” suggests they know something your regular tax advisor doesn’t.)

But if you don’t have access to someone expert you can easily ask about these sorts of ideas? Sure. Go ahead and reach out to our CPA firm. Here’s how to contact us: Click here. We’d be happy to discuss working with you.

The post Advanced S Corporation Tax Planning Secrets appeared first on Evergreen Small Business.

Ironically, much (most?) of the news coverage of the survey misses or ignores these insights. So, I want to talk about them here.

Wealth Building Insight #1: A College Degree

A first big insight from the survey: A college degree makes a huge difference to both your and my income and our net worth. I want to quote an actual statement from the survey:

…families in which the reference person had a college degree had twice the median income of those with some college but over three times the median net worth

The reference person by the way is the person in a family who the researchers guess is the primary breadwinner. And a college degree, according to the survey documentation, refers both to a two-year associate’s degree or a four-year bachelor’s degree.

But the big point here:  Obtaining and then selling higher-level skills into the labor market? A gamechanger in terms of both income and wealth building. (I know we all guessed a college degree probably made a difference… but a doubling of income and a tripling a wealth? Wow.)

Wealth Building Insight #2: Small Business Ownership

A second big insight from the survey: Small business ownership on average doubles your net worth—and that’s before counting the value of the business. Again, I want to quote an actual statement from the survey:

The mean net worth of families without a business was about $570,000 in 2022, while the mean net worth—excluding the value of businesses—of families that owned a nonemployer business was nearly $1.1 million.

Note that word “nonemployer” means a business without employees other than the owner. And most businesses are “nonemployer” firms.

But businesses with employees? Those families enjoy even higher mean net worths. Families owning a business employing from two to five employees? They average a net worth of $1.6 million before considering the business. Families owning a business employing more than five employees? They average a net worth of $4.1 million again before considering the business.

Again, I’m not surprised that entrepreneurs enjoy better balance sheets. But I am impressed with the size of difference.

Closing Comments

Two quick comments to close: First, I don’t think it has to matter much where you got your degree. An online degree works fine, for example. (Our small CPA firm has regularly paid for employees to get accounting degrees from online Western Governors University and those students have become good team members. Someone with some college credits can maybe finish their baccalaureate accounting degree in a year for $6,000 to $8,000.)

Second, I think you get a compounding effect if you combine a college degree with small business ownership. In other words, if a college degree triples wealth and a small business doubles wealth? I think someone who both gets a degree and establishes a small business ends up with six times the wealth. (Three times two equals six.). That’s a hunch. I admit it. But people should get synergies from a combination.

Additional Resources

The short summary I’m quoting from for this blog post appears here: 2023 Survey of Consumer Finances.

The actual Survey of Consumer Finances includes a bunch of publications and resources. You can get a list of those here: full list

We’ve talked before here at the blog about how to view college degrees as investments and how to maximize your return: What Lifetime Earnings Data Say About College Majors and Graduate Degrees.

Finally, we’ve also talked here at the blog before about the idea that we all (you, me, your kids, my kids and so on) ought to focus more on our human capital. If the latest Federal Reserve research makes you think the same thing, you might find this earlier blog post interesting: Human Capitalists in the Twenty-First Century

The post Wealth Building Insights from Latest Federal Reserve Study appeared first on Evergreen Small Business.

And here’s why: Washington state now levies a seven-percent capital gains tax on (1) the net long-term capital gains residents realize and (2) the Washington-state-y net long-term capital gains that nonresidents realize.

But if you’re a small business owner or entrepreneur? You can probably avoid the capital gains tax on the sale of a small business.  Because the law includes a qualified family-owned small business deduction.

A warning though: Washington state’s new capital gains tax is complicated. And the most complicated bit? The small business loophole you may want to use.

The Washington Capital Gains Tax in a Nutshell

But let me briefly explain how the Washington capital gains tax works. And then I’ll get into the gritty details of the qualified family-owned small business deduction (aka, the “QFOSB” deduction.)

So the big picture on this Washington capital gains tax. The state levies a seven percent tax on the net long-term capital gains an individual taxpayer realizes.

However two wrinkles here: First, the law exempts a bunch of special-case capital gains, including most capital gains on real estate, gains from selling depreciable property, and for specific industry situations. (For a complete list of the exemptions, you can refer to a blog post over at our CPA firm website: Washington State Capital Gains Tax Planning.)

And then the second wrinkle. The law provides three deductions: A standard $250,000 deduction (so the first $250,000 of gain is never taxed). A charitable contribution deduction of up to $350,000, which is an alternative to the $250,000 standard deduction. (You would use the alternative charitable deduction only if it exceeds the standard deduction.) And then a qualified family-owned small business deduction.

Note: Those amounts in the preceding paragraph get adjusted annually for changes in the Seattle-area consumer price index. The actual standard deduction for 2023, for example, should be eight or nine percent higher.

So, that’s the big picture. But you’ll need to understand the gritty details of the QFOSB deduction.

Deduction Detail #1: Gross Revenues $10 Million or Less

A first thing to know about the QFOSB deduction: To be a small business, a firm’s worldwide revenues for the twelve-month period prior to the sale or exchange need to equal $10,000,000 or less. (This value also gets adjusted for inflation. So if you’re looking at a sale in 2023? The value might be closer to $11,000,000.)

But note that the tax doesn’t look at the capital gain, as the following two examples highlight:

Example 1: George developed and patented artificial intelligence software. After several years of development, annual revenues average less than $1,000,000 a year. But a large technology company buys his business for $100,000,000. He should qualify for the full qualified family-owned small business deduction on the $100,000,000.

Example 2: George’s wife Martha starts an ecommerce business and slowly grows the business to $12 million in revenues. After George sells his business, she sells her firm in 2022 for $500,000 based on the firm’s annual profits. (Profits roughly run $200,000 a year.) Probably half of her $500,000 of capital gains, or $250,000, gets taxed. Her business? Too big to use the QFOSB deduction on her tax return.

Deduction Detail #2: Three Families or Fewer Control

The next thing to know. The QFOSB deduction only works for an interest in a family-owned business that meets, and here I use the language of the statute, one of the following characteristics:

• An interest as a proprietor in a business carried on as a sole proprietorship
• An interest in a business if at least 50 percent of the business is owned, directly or indirectly, by any combination of the taxpayer or members of the taxpayer’s family.
• An interest in a business if at least 30 percent of the business is owned, directly or indirectly, by any combination of the taxpayer or members of the taxpayer’s family and at least 70 percent of the business is owned, directly or indirectly, by the members of two families or at least 90 percent of the business is owned, directly or indirectly, by the members of three families.

The Washington capital gains tax law, by the way, says a taxpayer’s family members include ancestors (so parents and grandparents of the taxpayer, for example), spouses and state registered domestic partners, lineal descendants, lineal descendants of a taxpayer’s spouse or state registered domestic partner, and finally, the spouse or state registered domestic partner of a lineal descendant. (These definitions come from Revised Code of Washington Section 83.100.046.)

Example 3: George and his wife Martha along with their good friends John and his state registered domestic partner Abigail start a small business. Initially they each own half. Later on they sell a third of the company to a venture capital fund. If they subsequently sell the business, because their two families together own less than 70 percent, they won’t get to use the QFOSB deduction. Note that had they sold the firm before raising venture capital? Yeah, they would have qualified.

One thing to note here: The new law doesn’t define what a business is. But a reasonable guess is that the definition used for federal income taxes works. For example, the Section 162 standard established in a famous U.S. Supreme Court case, Commissioner v Groetzinger, says a business is an activity conducted in pursuit of profit and carried on with regularity and continuity. (Groetzinger was a professional gambler, by the way.)

One would think that all the common business forms “qualify” for the qualified small business interest deduction: sole proprietorships, partnerships, regular “C” corporations, S corporations, LLCs operating as a proprietorship, partnership or corporation, and so forth.

But an awkward reality: We don’t at this point know for sure how the state defines a “business.” (For example, federal income tax laws say a real estate rental activity may rise to the level of a trade or business. Yet who knows how the state sees this issue.)

Deduction Detail #3: Sell Substantially All of the Business or the Interest

Another detail you need to know to assure the deduction: The business owner needs to sell at least 90 percent of her or his interest or the owners need to sell at least 90 percent of the business’s real property, taxable personal property, and intangible personal property.

Example 4:  Washington and Adams, a land surveying partnership with two owners, sells all of the assets of their business for a $1,000,000 capital gain. The two owners share the $1,000,000 equally. Assuming all the other requirements are met, each owner shelters their proportional $500,000 gains with the QFOSB deduction because they’ve sold 100 percent of the consulting business.

Example 5: Jefferson and Burr operate a law firm as equal partners. Burr wants to sell his 50 percent interest in the law firm to a young new partner, Clinton, and then retire. When Burr sells his 50 percent interest to Clinton, he realizes a $500,000 capital gains tax and he also avoids the Washington capital gains tax on  the $500,000 gain. The reason? He sells 100% (so more than 90%) of his interest in the business.

Note: The statutory and administrative guidance available from Washington state provide no guidance on whether an existing business might be split into two or more separate businesses. For example, in Example 4, could Washington and Adams split the land survey firm into two businesses—say a Virginia operation and a Massachusetts operation—prior to the sale? And then they could possibly sell substantially all of one of those businesses? I would guess this does work. And here’s why: In  the July 2023 administrative rules’ Example 11, the Department of Revenue describes how a real estate gain potentially subject to capital gains tax can be “moved” into another entity and so escape the tax.

Deduction Detail #4: Hold Interest for Five Years

The usual time frame required to receive long-term capital gain treatment on a federal and most other state income tax returns is more than one year. But to enjoy the qualified family-owned small business deduction, a taxpayer needs to have held her or his interest in the business, either directly or beneficially, for at least five years immediately preceding the sale.  And while a mere change in the form of the business doesn’t necessarily restart the five year countdown, the change in form needs to not change the proportions of any beneficial ownership interest. (This last requirement comes from page 12 of the July 2023 administrative rules.)

Example 6:  James starts a restaurant on January 1, 2020 and operates as a sole proprietor for two years. He then incorporates the restaurant and elects Subchapter S status two years later on January 1, 2022. He sells the restaurant on December 30, 2024 and realizes a $1,000,000 capital gain. Because he sells the business one day short of five years? He will pay the capital gains tax on a portion of the $1,000,000. (Partial days count as full days per the statute. So if he’d sold on December 31, 2024 or later, he could have taken the deduction.) Note that the change in the form of the business ownership—a sole proprietorship for two years and then an S corporation for almost three years—doesn’t matter because James’ ownership percentage doesn’t change when the form of the business changes.

Example 7: John, James’s brother, also started a restaurant on January 1, 2020 and then owned and operated it for a full five years, selling the restaurant on January 1, 2025. John operated the restaurant as a sole proprietorship for the first two years and then as an S corporation the remaining three years. When he elected Subchapter S status, however, he allowed his key employee to acquire a five percent interest in the S corporation. Unfortunately, he fails to qualify for the qualified family-owned small business deduction. Why? Because his changed ownership percentage in the S corporation “form” of the business restarts the five-year holding period.

Deduction Detail #5: Taxpayer or Family Materially Participates

A material participation rule exists for the QFOSB deduction: Either the individual or a family member owning the business needs to materially participate in the business for five of the ten years immediately preceding the sale unless the sale is to another member of your family.

To determine material participation, the Washington statute basically regurgitates Section 469 of the Internal Revenue Code, which says material participation means a taxpayer needs to be involved in the operations of the activity on a regular, continuous and substantial basis. And then the statute says material participation has the roughly same meaning as the Section 469 statute and its regulations. (The actual statute says, “materially participated must be interpreted consistently with the applicable treasury regulations for Title 26 U.S.C. Section 469 of the internal revenue code…” The administrative rules then soften the “consistently” requirement with a rule to “generally” apply the 469 regulations.)

But a note: The Section 469 temporary regulations provide seven methods of achieving material participation. And only the first three methods, which set time-spent thresholds (more than 500 hours a year or more than 100 hours when no one works more or substantially all of hours), appear to work well. The regulations’ other material participation methods appear not to work. Or not to work cleanly. (Two methods, for example, say a taxpayer has materially participated for federal income tax purposes even when she or he hasn’t spent any time working in the preceding five years.)

Deduction Detail #6: Document Material Participation

A related material participation thing. Material participation from any member of the family of the taxpayer apparently counts for the entire family. But surely many family-owned small business owners have not been documenting their participation.

And for a good reason: They haven’t needed to.

Internal Revenue Code Section 469 and the companion Treasury regulations use material participation to determine when individual taxpayers claim passive activity losses and use passive activity tax credits. That’s exactly the opposite of what Washington state wants. The state uses the passive loss material participation regulations to determine if individual taxpayers report taxable income.

The practical problem in this misapplication? Profitable “qualified family-owned small business” businesses probably won’t have been tracking their material participation at least before now. Because they didn’t need to. But now they should. Probably. So they can later prove material participation.

Deduction Detail #7: Consider (Reconsider?) Activity Groupings

One other wrinkle related to Section 469 material participation rules bears mentioning.

Section 469 and its companion regulations provide a way for taxpayers to aggregate their trade or business activities into larger grouped trades or businesses.

As a generalization, trades or businesses (which is what the Washington state statute appears to talk about) might qualify for the family-owned small business deduction if they meet the requirements and follow the rules described here.

But one probably needs to stay alert to the possibility that the state says activity groupings create trades or businesses for purposes of the Washington state capital gains tax.

Example 8: Years ago, for purposes of filing his federal income tax return, Andrew appropriately grouped a warehouse he owns (held in an LLC) with a distribution business he owns (in an S corporation) based on self-rental grouping rules embedded in the Section 469 regulations. Because the IRS sees these two activities as a single activity, one wonders if the Washington Department of Revenue would see them as a single trade or business. That unintended consequence would mean that Andrew would not get a qualified family-owned small-business deduction unless he sells both the warehouse and the distribution business to the same buyer.

A related thought: Even if Andrew sold both the warehouse and distribution business simultaneously, would two sales to different buyers count as a sale or exchange that disposes of substantially all of the assets? The language of the statue talks about the “sale of substantially all of the taxpayer’s interest in a qualified family-owned small business.” Not “sales” plural, then. But a singular “sale.”

And another related thought: If the Washington Department of Revenue would see an activity grouping consisting of a warehouse and  a distribution business as a single trade or business, could the business owner first sell the warehouse? (That would presumably not trigger Washington capital gains because real estate gains are exempt from the tax.) Then later, but perhaps even in the same year, the business owner could sell substantially all of the remainder of the previously grouped activities—so just the distribution business. I would guess this works. For what it’s worth.

Deduction Detail #8: Use Smart Purchase Price Allocations

Some small businesses get sold as a collection of assets: the inventory, furniture and fixtures, maybe the real estate and then the intangible personal property like the goodwill. Because some of the assets fall into exempt income categories, a seller might want to sell assets rather than the entity.

Example 9: Martin owns a small business, Van Buren Inc., that he can sell his stock in for a $750,000 gain. However, he worries he will fail to qualify for the QFOSB deduction because he can’t confidently prove his material participation. Thus, by selling this stock, he might pay the seven percent tax on $500,000 of the gain (assuming the 2022 $250,000 standard deduction). Alternatively, in an asset sale, he can sell the inventory for a $100,000 gain (not taxed because inventory is not a capital asset), sell the depreciated furniture and fixtures for a $200,000 gain (statutorily exempt from the Washington capital gains tax), sell the real estate for a $200,000 again (again, statutorily exempt), and thus completely avoid the Washington capital gains tax.

Note: Some practitioners wondered how the Department of Revenue would handle purchase price allocations. And the July 2023 rule proposals provide helpful guidance. The proposed rules say that taxpayers can use full appraisal reports, assessor valuation if the assessment date closely matches the sale or exchange date, or the purchase price allocation the seller and buyer use to comply with IRC Section 1060. Predictably, the Department of Revenue reserves the right to change or modify what it views as an inappropriate allocation.

Deduction Detail #9: Consider Domicile of Owners

A Washington state domiciliary (basically what tax law usually thinks of as a resident) pays taxes on essentially all of her or his net long-term capital gains. (I’m ignoring the credit for taxes paid to another state if some net long-term capital gains get sourced outside Washington.)

For nonresidents, however, only tangible personal property sold or exchanged from a location in the state gets hit with the Washington capital gains tax.

Tangible personal property, per the administrative rules means “personal property that can be seen, weighed, measured, felt or touched”. Tangible personal property, then, does not include an interest in a partnership or shares of a corporation. Thus, an out-of-state small business owner might optimize by selling her or his interest in the partnership or the corporation instead of having the partnership or corporation sell its assets.

Example 10: Martin’s wife Hanna, also owns a small business, Hannah Hoes Corporation. After Martin sells his business, he and his wife move to Nevada. And then, after establishing residency there, Hannah sells her interest in her Washington corporation for a $1,000,000 gain. She avoids Washington capital gains tax.

Deduction Detail #10: Avoid Section 338(h)(10) Treatment

The modest guidance from the Department of Revenue, at least at the time we’re writing this, suggests to us that taxpayers might want to avoid common but more complex transaction structures.

As one example of this, I’d think a taxpayer wants to avoid applying Section 338(h)(10) to a qualified stock purchase transaction. Section 338(h)(10), by the way, treats a sale of stock as a sale of assets. The issue with Section 338(h)(10) is, one might not know how to handle the transaction on a Washington capital gains tax return.

Deduction Detail #11: Reconsider Section 754 Elections

A technical point.

I’m not necessarily a fan of making Section 754 elections. (The work required to make the election and then the resulting annual tax return adjustments often exceeds the tax savings.) However, taxpayers and their tax advisors probably want to reconsider Section 754 elections for appreciated property held inside a partnership at the time when a partner dies and receives a Section 1014 step-up in basis.

The reason? The step-up in basis may eliminate, or at least minimize, a taxpayer’s long-term capital gains. And that will probably eliminate or minimize Washington state’s taxation of long-term capital gains.

Deduction Detail #12: Consider Using Trust or Estate Ownership

A final, weird tangential comment: The list of pass-through entities which confer beneficial ownership for an individual excludes estates as well as trusts other than grantor trusts. That means if a nongrantor trust or estate realizes a long-term capital gain, the individuals who are beneficiaries of the estate or trust don’t pay the seven percent tax.

Thus, some small business owners may want to move an interest in a small business into a trust or sell an interest held in an estate before realizing the gain. (This gambit also works for capital assets other than interests in small businesses.)

Additional Resources for Qualified Family-Owned Small Business Deductions:

As noted earlier, we’ve got a “general” blog post over at the CPA firm website that discusses the mechanics of the Washington state capital gains tax including some common tax planning tactics: Washington State Capital Gains Tax Planning

The actual statute appears here: https://lawfilesext.leg.wa.gov/biennium/2021-22/Pdf/Bills/Senate%20Passed%20Legislature/5096-S.PL.pdf?q=20210426052154

The most recent July 2023 draft of the administrative regulation appears here: https://dor.wa.gov/sites/default/files/2023-06/20-XXXcr1frmdraftjune23.pdf?uid=64aac2f8dc5d9

The post The Qualified Family-Owned Small Business Deduction appeared first on Evergreen Small Business.

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.

Tax law (and especially Section 469 of the Internal Revenue Code) mostly eliminates your ability to save big on taxes using real estate. That said, you do have a bunch of clever tricks available to deduct real estate losses on your tax return.

You just need to to plan ahead. And carefully structure your investing. But with little effort? You’d be surprised at the results.

Quick Review of Why Real Estate Produces Big Deductions

Let’s quickly review, though, how you can use real estate to generate big tax deductions.

Say you own a $1,000,000 property that generates $50,000 in rent. Further, suppose the property expenses, including the interest on the mortgage used to fund a part of the purchase, run $50,000.

You might assume such an investment breaks even for tax return purposes.

However, tax accounting rules will typically show a property like that described as losing money. Why? Because the investor depreciates the property.

Tax laws say investors can depreciate, or write off, the purchase price of a residential building over 27.5 years. And those same laws say a taxpayer can depreciate the purchase price of a commercial building over 39 years. (You only get to depreciate the building, not the land, by the way.)

And then the other wrinkle: Some of the bits and pieces of a residential property or commercial property can be written off much faster. Maybe in the year of your purchase.

A $1,000,000 rental property that breaks even, for example, might result in you putting a $100,000 or $200,000 deduction on the tax return you file the first year of ownership.

Which is why tax law includes the Section 469 passive loss limitation rules. In most situations, these rules say you don’t get to use big real estate deductions to shelter other income.

Exceptions exist for all rules, however. And more than a dozen exceptions allow you to deduct real estate losses or use real estate to shelter your other taxable income.

Real Estate Deduction Trick #1: Active Real Estate Participant

The first and easiest to use exception: The active participant exception (provided by Section 469(i)).

Specifically, if your modified adjusted gross income equals $100,000 or less, you can deduct real estate losses of up to $25,000 each year. The only two rules to make this deduction work are:

1. You or your spouse need to own at least ten percent of the property.
2. You or your spouse need to be actively participating in managing the property by doing things like picking the property manager, approving tenants and expenditures, and making rental agreement decisions.

By the way, if your modified adjusted gross income exceeds $100,000 but falls below $150,000, tax law proportionally phases out the $25,000 allowance. Someone with a modified adjusted gross income halfway between $100,000 and $150,000, for example, loses half of the $25,000 allowance.

The active real estate participant exception works for middle class taxpayers and for most upper-class taxpayers.

Note: Modified adjusted gross income equals a taxpayer’s adjusted gross income plus retirement deductions, passive losses such as on real estate, deductions for self-employment taxes, student loan interest, tuition deductions, and some foreign income deductions.

Real Estate Deduction Trick #2: The Section 280A(g) Exception

A weird trick works for property owners who also own a business structured as a corporation or a partnership.

A taxpayer in this situation can sometimes direct the corporation or partnership they own to pay rent to them for the use of a personally-owned real property.

If the rent counts as an ordinary and necessary expense, the rent payments get deducted on the corporation or partnership return. Which makes sense.

But here’s what’s weird. If the property owner rents the property for fourteen days or less, and then the property owner also personally uses the property for more than two weeks, the rent payments the taxpayer receives from their business don’t count as income.

An example shows how this works. You own a condo in Florida. When you attend a two-week industry conference in Orlando, rather than pay some hotel for lodging, your corporation pays you for using the condo for two weeks. (Say the corporation pays you $10,000.)

On the corporation’s tax return, the corporation counts the $10,000 as a valid deduction.

But on your individual tax return, the $10,000 rent received doesn’t count as income. Because of the Section 280A(g) rule.

By the way, the rental rate needs to be the market rate. (Accordingly, if the market rate is high, the rent amount can and must also be high.)

Real Estate Deduction Trick #3: Self-Rental

A related gambit works to deduct real estate losses, too.

If you buy property to rent to another trade or business you own, you can group the rental property trade or business with the operating trade or business on your tax return. That self-rental grouping lets you sidestep the passive loss limitation.

For example, if you run a professional practice (perhaps as an S corporation) and then you personally buy the building you use for the business, you get to deduct the real estate losses from the building on your personal return.

The one key bit of this rule to be alert to: The ownership of the rental property and the ownership of the operating trade or business need to match. Perfectly.

Note: We’ve got a longer and rather detailed discussion of how the self-rental trick works here: The Self-Rental Loophole.

Real Estate Deduction Trick #4: Real Estate Professional

Here’s a really powerful strategy to deduct real estate losses.

A real estate professional gets to deduct real estate losses if she or he materially participates in the rental operation.

To be a real estate professional, someone needs to spend more than 750 hours and more than 50% of their work day in a real estate trade or business they own (Section 469(c)(7)). Real estate trades or businesses include property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, property management, learning, or brokerage.

And then, as noted, either the taxpayer or the spouse needs to materially participate in the rental business by spending enough time. (The standard, clean way to materially participate is to spend more than 500 hours on the investment property or properties in a year. But you can achieve material participation in other ways, too. Like by spending more than 100 hours a year if no one spends more time.)

An example shows the power of this strategy. Say a high income professional or executive earns $400,000 annually. Suppose his or her spouse manages a family real estate portfolio and in that role as a property manager qualifies as a real estate professional. Further suppose that the real estate portfolio produces real estate losses equal to $150,000. This married couple pays taxes on the net $250,000 in this situation. In other words, $150,000 of the household’s $400,000 annual income gets sheltered by the paper real estate losses.

Note: A longer discussion of how the real estate professional strategy appears here: How the Real Estate Professional Tax Strategy Works  Also note that California prevents a taxpayer from using the real estate professional strategy for its state income tax returns. (A Californian still can use the real estate professional loophole to shelter federal income taxes.)

Real Estate Deduction Trick #5: Short-term Weekly-or-less Rentals

Here’s another strategy to deduct giant real estate losses.

If your average rental interval equals seven days or less, tax law (specifically Reg. Sec. 1.469-1T(e)(ii)(A)) says you’re not in the real estate rental business. Rather, you’re in a non-real-estate business. That means you get to deduct any of the non-real-estate losses if you materially participate.

Note: A longer discussion of how this real estate deduction exception works appears here: How the Vacation Rental Tax Strategy Works.  But know that short-term rentals work really well as long as you carefully follow the rules.

Real Estate Deduction Trick #6: Short-term More-than-a-Week Rentals

Another similar, but less well-known, short-term rental exception applies, too.

If a taxpayer rents property for, on average, thirty days or less but more than a week and she or he provides significant personal services, tax law (in this case, Reg. Sec. 1.469-1T(e)(ii)(B)), says they’re also not in the real estate rental business. Rather, they’re in a non-real-estate business. If a taxpayer materially participates in the non-real-estate business? Bingo. They get to deduct real estate losses.

So for example, if someone operates a hotel and the hotel provides daily maid service, a front desk with bellhops, and then maybe a concierge, that’s not a real estate business. And the taxpayer gets to deduct any of the non-real-estate losses if she or he materially participates.

Sidebar: The IRS Definition of “Significant”

One caution here: The IRS says “significant personal services” means really significant. Here’s the example the Treasury regulations give for when personal services provided by a residential apartment hotel fail to reach the level of “significant:”

Example 4:

The taxpayer is engaged in an activity of owning and operating a residential apartment hotel. For the taxable year, the average period of customer use for apartments exceeds seven days but does not exceed 30 days. In addition to cleaning public entrances, exists (sic), stairways, and lobbies, and collecting and removing trash, the taxpayer provides a daily maid and linen service at no additional charge. All of the services other than maid and linen service are excluded services (within the meaning of paragraph (e)(3)(iv)(B) of this section), because such services are similar to those commonly provided in connection with long-term rentals of high-grade residential real property.

The value of the maid and linen services (measured by the cost to the taxpayer of employees performing such services) is less than 10 percent of the amount charged to tenants for occupancy of apartments. Under these facts, neither significant personal services (within the meaning of paragraph (e)(3)(iv) of this section) nor extraordinary personal services (within the meaning of paragraph (e)(3)(v) of this section) are provided in connection with making apartments available for use by customers. Accordingly, the activity is a rental activity.

So, daily maid service isn’t enough. A taxpayer needs more than that.

Real Estate Deduction Trick #7: Rental Incidental to Extraordinary Personal Services

Sometimes, the owner of a residential property or commercial building lets customers use the residential facilities or commercial property just as part the customer receiving some other service.

For example, a hospital or nursing home may in effect “rent” hospital rooms to patients. But the rental activity pales in comparison to the medical or nursing care the people receive.

Another example: A college or boarding school provides (so in effect “rents”) rooms in on-campus dormitories to students attending classes. But the real activity is education.

In these settings where extraordinary personal services are provided, tax law (specifically Reg. Sec. 1.469-1T(e)(ii)(C)) considers the activity a non-real-estate activity. And the taxpayer may deduct the non-real-estate deductions and losses if they materially participate.

Probably not an idea many people will use. But you never know.

Real Estate Deduction Trick #8: Rental Activity Incidental to Nonrental Activity

Another way exists to deduct real estate losses based on the incidental nature of the real estate, too.

Specifically, if a trade or business owns and rents property, but that rental activity is only incidental relative to the main trade or business? The losses connected to the rental property don’t get limited by the Section 469 passive loss limitation rules.

The current Section 469 regulations (at Reg Sec. 1.469-1T(e)(vi)) provide three examples of this sort of incidental rental activity. One example says that if the taxpayer holds the property for appreciation and the gross rental income is less than the lesser of two percent of either the unadjusted basis or the fair market value of the property, that counts as incidental. Another example says that renting property to an employee counts as incidental. Finally, a third example says that if a property is used in a trade or business the taxpayer owns an interest in and the gross rental income falls less than two percent of the lesser of property’s unadjusted basis or fair market value, that minuscule rental income counts as incidental.

This approach to deducting real estate losses probably won’t result in giant tax savings. But might produce some.

Real Estate Deduction Trick #9: Nonexclusive Rental Activity

Nonexclusive use of property doesn’t count as a real estate rental activity (per Reg. Sec. 1.469-1T(e)(ii)(E)).

Examples of this situation? The Treasury’s regulations talk about a golf course where, in one sense, the property owner rents the use of the course to golfers. But not exclusive use. So that works.

And then a crazy idea which I also think works. Suppose you decide to get into the amusement park business. And you set up a haunted house attraction that charges people an admission fee. Again in this example, the property owner in effect rents the use of the house through an admission fee. But again not exclusive use. So that should work.

In these nonexclusive-use situations, as long as the owner materially participates in the activity, she or he can deduct real-estate-y losses.

Real Estate Deduction Trick #10: Insubstantial Rental Activity

The Regulations for Section 469 describe rules taxpayers can use to group activities. For example, a barber with two barber shops might treat the two shops as two activities. Or he might group the two barber shops into a single activity.

Normally, though, taxpayers can’t group rental activities with a nonrental activity.

But except for that special rule, most grouping rules apply common sense. Stuff a taxpayer would logically think of as one trade or business can be grouped. (The specific rules appear at Reg. Sec 1.469-4 but talk about similarities and differences in the businesses, the extent of common control and ownership, geographical locations, and then interdependencies between the activities.)

However, these grouping rules also flag a couple of other interesting possibilities that effectively allow a taxpayer to deduct real estate losses by clever grouping. For example, a taxpayer might (per Reg. Sec. 1.469-4(d)(1)(i)(A)) group an insubstantial rental activity with another trade or business. And then in effect deduct real estate losses.

The now-expired former Reg. Sec 1.469-4T provided a less than “20 percent of the activity’s income” threshold for determining insubstantial-ness. In an example the regulations provided, a law firm earned 90 percent of its gross income from practicing law and 10 percent from renting out two floors in the ten-story office building it owned and operated out of. That example said the two floors of rental activity counted as insubstantial.

But note what happens in this case: The taxpayer probably does get to deduct real estate losses in situations where an insubstantial rental occurs.

Tip: If you need to explore this possibility in more detail, read the Technical Advice Memorandum 200014010. It describes why the less than 20 percent approach shouldn’t be considered a “bright line” test.

Real Estate Deduction Trick #11: Insubstantial Nonrental Activity

The other example of insubstantial-ness occurs when an insubstantial non-rental activity gets grouped with a rental activity. In that situation, income from the insubstantial non-rental activity might allow a taxpayer to deduct real estate losses equal to the income from the insubstantial non-real-estate activity.

For example, a building owner starts a small coffee shop in the lobby of an apartment house she owns. Those two activities might be group-able based on georgraphy, common ownership and control, and then interdependencies. Further, if they are group-able and the coffee shop activity is insubstantial, it’s income may be netted with the apartment house losses. That means the taxpayer shelters active trade or busienss income using real estate losses.

Tip: Another tip for taxpayers or tax accountants who want to explore in more detail grouping real estate with insubstantial non-real estate activities: look at the Glick v. United States federal district court case.

Real Estate Deduction Trick #12: Other Passive Income

A twelfth way to deduct real estate losses: You get to deduct the passive losses you incur on an investment property to the extent you have passive income. And you may unlock past suspended passive losses.

For example, if your tax return will report a large $1,000,000 passive gain on the sale of one rental property, Section 469(d), so the actual law, essentially says that gain can be sheltered by $1,000,000 of suspended passive losses you’ve incurred in the past. And it can be sheltered by large passive losses you intentionally orchestrate for the current year. So that’s another way to deduct real estate losses on your return.

Real Estate Deduction Trick #13: Disposition of the Activity Generating Passive Losses

A final way to deduct real estate losses exists: You do get to deduct passive losses generated in some activity when you dispose of the activity.

For example, if over the years your tax returns have shown passive losses accumulating on a rental property, selling the property will typically unlock those losses.

Say you bought a property for $1,000,000, for example, wrote off $500,000 of the purchase price through depreciation deductions, and will now sell the property for $500,000. And say the rental income and rental expenses equaled each other. So, the property essentially broke even before considering the depreciation deductions.

A sale in this situation will unlock the previously suspended losses.

Closing Thought

As always, taxpayers want to discuss a strategy like this with their tax advisor.

But this plug for our CPA firm: If you don’t have a tax advisor who can help? Please consider contacting us: Nelson CPA.

The post A Dozen Ways to Deduct Real Estate Losses appeared first on Evergreen Small Business.

After mulling over the authors’ ideas for the last several weeks, a conclusion: What these guys report? It matters to small business owners and entrepreneurs. A lot.

Capitalists in the Twenty-First Century Research

The economists’ research makes a fascinating observation: The largest share of the income earned by the top one percent and the top one-tenth of the top one percent? Non-wage business income earned by partners and S corporation shareholders. And more specifically, typically business owners working in a high-skill, “human capital” business.

Definitely not trust fund babies anxiously awaiting their next distribution. Or passive investors fueling high living with dividends and capital gains. Something much, much different than these stereotypes.

Let me quote from the research to give you their insight about just who makes up the top one percent and top one-tenth of one percent:

The data reveal a striking world of business owners who prevail at the top of the income distribution. Most top earners are pass-through business owners. In 2014, over 69% of the top 1% and over 84% of the top 0.1% earn some pass-through business income.

The research also describes the sorts of firms that top one percenters typically own:

Typical firms owned by the top 1-0.1% are single-establishment firms in professional services (e.g., consultants, lawyers, specialty tradespeople) or health services (e.g., physicians, dentists).

And also the sorts of firms that the top one tenth of the top one percent own:

A typical firm owned by the top 0.1% is a regional business with $20M in sales and 100 employees, such as an auto dealer, beverage distributor, or a large law firm.

This observation challenges the hypothesis presented by French economist and author Thomas Piketty in his bestseller “Capital in the Twenty-First Century.” (You see where Smith, Yagan, Zidar and Zwick got their paper’s name.) And it also challenges the work of Emmanuel Saez and Gabriel Zucman who have employed Piketty’s ideas to develop wealth tax proposals for the United States.

But does the paper from Smith, Yagan, Zidar and Zwick also point out new rules for twenty-first century entrepreneurs? And new rules for today’s investors? I think so. In fact, I see at least three big insights that drop out of their research.

Twenty-First Century Entrepreneurs are Human Capitalists

The first big obvious insight from the research? Simply this: If you want to work as an entrepreneur or own your own business, probably you want to start a human capital business.

You don’t want to be a financial capitalist.

You want to be a human capitalist. A skilled expert who provides an in-demand service. And then you want to work your way into an ownership role in a firm that delivers that service.

So, probably not a real estate thing. Probably not something that uses a factory. And probably not a deal where you raise financial capital from angel investors or venture capitalists or banks.

Rather what you want to think about are business ventures you can only do because you went to medical or law school. Or because you went to college and got a technical degree. Or because you have spent years learning some high-skills trade or craft. And as a result, you personally have acquired a lot of human capital in the form of knowledge, maybe credentials and then also experience.

For example, the top three S corporation categories of top one percent earners? A doctor’s office, a technical services firm, and a dentist’s office.

And the top three partnership categories of top one percent earners? A law firm, a doctor’s office, and an accounting firm.

The list of top earning categories appears at the very end of the 60-page research paper (see link at end of this blog post). But just so you know. All sorts of high skill categories appear on the list, including specialty contractors, restaurants, and you name it. Not just white-collar-y professions. Human capital comes in many colors and sizes.

Wealth Building Works Differently for Human Capitalists

Another actionable insight from the research: People don’t automatically get rich from running a super-successful human-capital business. Or at least not rich as rich gets depicted in movies or books. Or depicted in the research from Piketty, Saez and Zucman.

The Smith, Yagan, Zidar and Zwick research results highlight this reality. They point out that when top one-percent-ers retire or die, the income earned by their human capital business drops by eighty percent or more.

The researchers logically conclude, then, that the business income earned by these firms mostly reflects the labor provided by the firms’ owners.

And then here is another take-away for entrepreneurs: Most owners of successful small businesses need to build wealth outside their businesses. By saving a big chunk of the business owner’s income.

In other words, the way to build net worth is not by selling the firm and exiting with a giant windfall. That is not a likely outcome even for super-successful small business owners. Why? Because these firms rely on human capital that evaporates when the owners die or retire.

Rather, the reasonable best-case outcome is probably two or three decades of great income from the business you own. Which small business owners and entrepreneurs should use to fund two or three decades of aggressive saving.

We pointed out in a blog post a couple of years ago, Lifetime Earnings of the Top One Percent, that someone would need to earn a top one percent income and make the maximum 401(k) contribution for three decades to accumulate a couple of million dollars. Which is great, don’t get me wrong.

But there’s a big difference between earning a $300,000 year (which if earned over thirty years might put you in the top one percent) and then drawing $80,000 annually from your $2 million retirement (which would reflect an average rate of return while accumulating and then use of the well-known 4 percent safe withdrawal rate in retirement.)

Is Everyone a Human Capitalist?

Finally, a quick last comment. And this isn’t something Smith, Yagan, Zidar and Zwick say. But I think their research supports the conclusion.

Individuals need to think more about investing in their human capital. Even when they aren’t interested in entrepreneurship or small business ownership.

All the time and energy people spend trying to juice portfolio returns or tweak their asset allocation? (Investing books, time spent in online forums and so on.)

And all the time people spend thinking about and then building and managing a portfolio of rental properties? (Seminars and workshops, books and again online forums.)

I mean, that’s all good. But probably the big money opportunity? Finding a way to grow your or my human capital: a new skill, more knowledge or experience, a credential the economy financially rewards, and other stuff like that.

Related Resources You Might Find Useful

Here’s a link to the paper from Matthew Smith, Danny Yagan, Owen M. Zidar and Eric Zwick: Capitalists in the Twenty-First Century. This obvious comment you don’t need me to make: If you’re an attorney, accountant or investment advisor, you want to read this research paper. Probably more than once. It describes who your (and my) clients are.

Smith, Zidar and Zwick published another research paper that builds on the “Capitalists” paper and provides some updated information: Top Wealth in America: New Estimates under Heterogeneous Returns

Finally, it’s not specifically about twenty-first century entrepreneurs or investing. But we did a blog post on the That Nearly Secret IRS Wealth Study which further discusses the research of Zwick.

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