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.

This new bit of red tape stems from Congress’s concern about money laundering and other financial crimes. And it’ll cause some small business entrepreneurs and investors to go nuts.

Essentially a BOI report identifies the individuals who own 25 percent or larger chunks of the corporation or LLC and then also individuals who have substantial control (like corporate officers and directors, LLC members, LLC managers, and so on) over a corporation or LLC.

This information gets stored in a federal database so it’s available to law enforcement agencies. And also to financial institutions who need or want to check on their customers.

Why It’s Important to Handle this BOI Report Stuff

Yes, this is all a bit of a headache. I feel pretty sure both the politicians who cooked this up and the bureaucrats who designed the system haven’t thought through the compliance costs for you and your small business. But all of that? Pretty irrelevant. You (and I) want to get ahead of this BOI report stuff for a couple of reasons.

First reason? You may need to file the report yourself. We understand that many accountants and attorneys simply do not want to do this risky, random, hard-to-schedule work.

A second reason to learn and handle this new reporting requirement quickly and correctly? The penalties for failing to file? Pretty brutal. The daily penalty equals $500 (with a $10,000 maximum). And in a worst-case scenario? Willfully failing to file a report can lead to imprisonment.

Note: Presumably, the worst case scenarios should only occur when people willfully break the law. But innocent folks can find themselves targets of aggressive regulators and prosecutors too, as our office has personally observed.

Beneficial Ownership Information (BOI) Report Disclosures

FinCEN requires pretty basic information about corporations, LLCs and similar entities entrepreneurs and investors set up. Which is maybe the only good news here.

Reporting companies (so corporations, LLCs and similar entities) must provide their:

• Full legal name
• Trade names and “doing business as” (DBA) names
• Complete current U.S. address
• State, tribal or foreign jurisdiction where formed
• Internal Revenue Service taxpayer ID number (so probably your EIN)

Tip: If you now need to get an EIN, such as for a family LLC, refer to this blog post: Step-by-step Instructions for Applying for an EIN

Then for each beneficial owner owning 25 percent or more of the company or exercising substantial control, reporting entities must provide an individual’s:

• Full legal name
• Date of birth
• Complete current address
• Unique identification number and jurisdiction from an unexpired U.S. passport, unexpired state driver’s license, or unexpired identification card issued by a state, local or tribal government (Note that if none of these identification documents exist, an individual must use a foreign passport.)
• Image of identification document for the person

By the way, for corporations, limited liability companies and similar entities formed on or after January 1, 2024, the company must also name the applicant or applicants who filed the formation documents with the state, local or tribal government. (This might be the name of the attorney or paralegal who prepared and filed the articles of incorporation or formation.)

Some Organizations Exempt from BOI Reporting

Most small businesses need to file BOI reports, as noted earlier. The Corporate Transparency Act hits small businesses hard. Plan to file the report.

However, a list of about two dozen exempt entities exist. As a generalization, if some federal or state agency already regulates and monitors a firm (so like the Securities & Exchange Commission, the Federal Deposit Insurance Corporation, a state’s insurance commissioner, a public utilities regulator, and so on), the entity doesn’t need to file a BOI report.

Entities employing more than 20 full-time employees in the U.S., generating more than $5 million of revenue in the U.S., and maintaining a physical office don’t need to file. (So big small businesses dodge the bullet.)

Finally, inactive entities with less than a $1,000 of transactions and which own no assets don’t need to file.

Every other corporation, limited liability company or similar entity? Their ownership or management needs to file and provide the information listed in those earlier two sets of bulleted points.

Timing of BOI Reports

So the timing thing is sort of confusing.

You’ll file your BOI report online at www.fincen.gov sometime on or after January 1, 2024.

If your entity existed before January 1, 2024, you have until January 1, 2025.

If your entity formed on or after January 1, 2024 but during 2024, you need to file within ninety days of the date you receive confirmation of the filing or the date the information is publicly available. (Whichever date occurs first triggers the ninety-day countdown.) Thus, if you setup a new corporation, limited liability company, or some other entity from this point forward, be sure you plan to file the BOI report at the very start. (If you’re an attorney or accountant or incorporation service who files articles of incorporation or formation? Please do this. Please.)

If your entity formed after 2024, you need to file with thirty-days of the date you receive confirmation of the filing or the date the information is publicly available. (Again, use whichever trigger occurs first.)

Also note this: If any of the information that goes on a report changes? (See those bulleted lists provided earlier.) You need to file an updated report within thirty days. Almost any change in the information reported on the BOI report triggers a requirement to update the BOI report within thirty days. For example, a new driver’s license triggers a new countdown. The two exceptions we’ve spotted: If a beneficial owner dies, you have until thirty days after the estate is settled. And then if a company dissolves, you don’t have to report that.

Next BOI Report Steps

First, if you want to yourself file the report, get and carefully read the Small Entity Compliance Guide the U.S. Treasury and Financial Crimes Enforcement Network have provided. It’s available here.  And, fortunately, the guide is well-written and thorough. Figure a two to three hour read.

Second, both individuals and reporting companies may apply for and, according to FinCEN, immediately get a FinCEN identifier, or identification number. An individual applies for a FinCEN identifier by supplying the same information as goes onto the BOI report. A reporting company applies by checking a box on the BOI report form. And the advantage of using a FinCEN identifier? Rather than enter all individual bits of information, the individual or company just provides the FinCEN identifier. Note too that using a FinCEN identifier should mean an individual needs to only make one update if some bit of information (like an address) changes. (The instructions don’t say this. But surely the FinCEN system will do this.)

Third, finally, if you get into this subject matter, and realize you just don’t feel comfortable and have too many questions about details? Go ahead and reach out to your accounting firm or attorney. Hopefully one of them will be able to help you. (We are, for example, providing this service to our corporation and partnership tax return clients. We plan to do this work in the spring after tax season ends)

The post BOI reports and Your Small Business appeared first on Evergreen Small Business.

That misconception? That distributions from partnerships, S corporations and other pass-through entities get taxed. (They usually don’t, by the way.)

The misconception regularly leads to a minor financial tragedy. Because often times a business owner sits on a huge cash balance in their business checking account. That money, they actually need to use on, you know, life things like rent or mortgage payments, insurance, taxes, day care, food, clothing, vacations and so forth.

But the business owner doesn’t want to distribute the profits. Because she or he fears paying tax on the money. Which is ironic. And wrong.

So this article explains what’s going on here. I’ll discuss what you get taxed on. When you get taxed. I’ll explain how the mysterious thing the accountants call “basis”works. And then I’ll end with a warning about a common error you want to avoid because it unnecessarily triggers additional taxes.

To start, a quick discussion about taxable income and basis…

Taxable Income from Your Business

Each business entity type calculates taxable income in basically the same way. Taxable income equals taxable revenues minus deductible expenses. This number gets reported in box 1 of the K-1 form you receive from the business, which in turn gets plugged into and taxed on your individual 1040.

For example, you start a business at the beginning of the year and collect $100,000 of revenues and pay $50,000 of deductible expenses.  Your business’s taxable net income at the end of the year equals $50,000. Suppose you only used the revenue you collected to pay the business expenses and now have $50,000 in your business checking account.

Money left over in the bank is the confusing part. Because you might think you avoid taxes on this money if you leave it in the business. And that you only pay taxes on the money when you take it out of the partnership or S corporation or sole proprietorship.

But that’s not the way the accounting works. You pay taxes on the business profit. Not, usually, on the distributions of profit paid to an owner.

Now let’s have a quick chat about basis.

Basis and Why It Matters

I want this discussion to remain as simple as possible. (If you would like to dive deeper, you can read the statute for S Corporations here and the statute for Partnerships here.) But to generalize, a business owner’s basis consists of the cash and adjusted-for-depreciation cost of property contributed to a business, adjusted for certain items that increase and decrease said basis.

Let’s look at the common increases and decreases…

Increases to Basis:

• Contributions of cash and property into the business
• Taxable income from the business
• Sale of appreciated property the business owns
• Non-taxable income (think PPP and EIDL grants)
• Recourse and qualified non-recourse debt for partnerships
• Partner loans to the business
• Credit cards used for business issued personally to the shareholder for S Corporations

Decreases to Basis:

• Distribution of cash and property from the business
• Loss from the sale of property the business owns
• Non-deductible expenses (meals, entertainment, etc.)
• Decreases in partner loans and decreases in recourse and qualified recourse debt
• Payments made by the business to pay off S Corporation owner owned credit cards

The general rule: As long as you have basis, you pay no taxes on distributions. Which is why basis matters.

Examples Show How Mechanics Work

But the problem here? Basis constantly fluctuates from year to year. That reality means you or your accountant need to carefully track the basis each tax year in order to know whether distributions trigger tax.

Let me show you some examples so you see how this works.

Example 1

Let’s circle back to our example where you earned $50,000. Pretend you spent no money funding the startup for this business because there is little to no overhead.

Your basis at the beginning of the year is $0.00. The $50,000 of net income increases your basis by $50,000. Now what?

You can take the total $50,000 as a distribution and pay $0.00 in taxes. In this case, your basis at the beginning of year 2 is $0.00. Remember, your basis increased by the net income of $50,000 (what you paid tax on), and decreased by the distribution of $50,000.

Alternatively, you decide to leave the whole $50,000 in the business in year 1.  Maybe you are living off of savings.

But remember, you are still taxed on $50,000 of income, regardless of where the money goes.

By the way? If in year 2 the business loses $25,000 and you never extracted any profits from year 1? You can still distribute $25,000 to yourself tax free at the end of the year, so year two, ending year 2 with $0.00 basis.

Example 2

Another example. You start your business with a personal contribution of $100,000.  You use the money to buy some equipment, lease an office space, and hire an employee.  Year 1 net income equals $200,000, and you distribute $100,000 to yourself to pay your personal expenses.  Your basis looks like this:

Year 1

You pay tax on $200,000 of income, the distribution is tax free, and you end the year with $200,000 of basis.

Year 2 profits are down a bit, and net income equals $50,000 for the year. You took the same distribution of $100,000, and your basis at the end of the year is $150,000.

Year 2

Year 3 you try to aggressively expand and require more capital to do so. Your business secures a $500,000 loan to pay for more equipment, employees, advertising and general overhead. This year you are also purchasing an investment property to take advantage of the deductions offered by a short term rental.

The aggressive expansion is a success, and you end the year with $200,000 of net income. But you had to distribute $400,000 to yourself to put a down payment on your rental property and pay the same living expenses. Whoops, now part of your distribution is taxable. Lets break it down:

Year 3

You probably noticed that doesn’t foot out. And it’s because basis can’t dip below $0.00.

In this third year, you are taxed on $200,000 of net income (taxed at ordinary income tax rates) and are left with $350,000 that can be distributed tax free.

But the additional $50,000 of distribution?  This is called “a distribution in excess of basis.” The $50,000 of distribution which you do not have basis for becomes a capital gain and gets taxed at capital gains rates.

Guaranteed Payments or Distributions?

One final important point. I want to discuss a mistake we often see on partnership returns.

Distributions to partners are commonly but incorrectly coded as guaranteed payments.  And this can have negative income tax consequences.

But first, a little background on guaranteed payments. A company uses guaranteed payments to incentivize a potential partner to join a partnership, most often in professional service firms. The partnership pays a specified amount to the partner each year, regardless of how the company performs. Their payment is “guaranteed,” kind of like a salary.

However, a majority of partnership agreements I read have no clause for guaranteed payments. And still, tax preparers frequently incorrectly code distributions as guaranteed payments.  Why does this matter?

Reason #1

Guaranteed payment income is not eligible income for the Section 199A, Qualified Business Income Deduction (QBID).  The partner forfeits a 20% deduction because their distribution is coded incorrectly.

Reason #2

Limited partners are not subject to self-employment taxes.  But guaranteed payments are subject to self-employment taxes.  A limited partner unnecessarily pays an additional 15.3% in taxes when their distribution is incorrectly coded as a guaranteed payment.

Pretend a tax preparer codes a $50,000 distribution as a guaranteed payment.  The partner pays income tax on $50,000 instead of $40,000 by missing out on QBID.  Assume a 25% tax rate and that’s an additional $2,500 they pay in income taxes.

Additionally, the partner pays $7,065 ((92.35% x 50,000) x 15.3%) of self employment tax on the $50,000!

The point I’m trying to make is you want to get this right for partners.

Final Thoughts

I hope this clears up some confusion on what actually gets taxed when a flow-through business generates profits.  And also that the discussion not only eases your anxiety about taking distributions–but allows you to avoid the one or two bookkeeping blunders that trigger tax.

The post Why Profit Distributions Usually Don’t Get Taxed appeared first on Evergreen Small Business.

So even if our costs rose? We sort of ignored that. We were more concerned with helping people get through the last couple of years. Helping readers of our blog and then our clients get PPP loans, for example. And helping folks maximize employee retention credits.

And when the pandemic or regulatory changes pushed up costs? Okay. Keep this under your hat. It’s a little embarassing. Because we’re accountants. But we also pretty much ignored that. We were doing tax returns.

And so now after a couple of years of mostly flat prices, we need to get serious about repricing for inflation. And why I’m talking about this openly in a blog post?

Well, I am very sorry to suggest yet another task for your crowded to-do list. But I suspect you too may need to think about how to raise your prices for the effects of inflation.

But let’s go over the arithmetic and the accounting.

Why You Need to Raise Your Prices

The rationale for raising your prices? Well, if you haven’t yet experienced it in a big way, inflation is coming.

But probably? You’ve already been experiencing inflation. Stuff costs more now. People, Technology. Insurance. Rent.

And then the other issue that you may be confronting? The way you may have compensated for inflation in past? You know, just making it up on volume? So by selling more?

Supply and capacity constraints maybe won’t work in this environment. At least for a while. (See this article from Forbes.)

Accordingly, to stay economically viable? You may have to rise prices. Regularly. Diligently.

A Really Simple Example: What Not to Do

Let me construct a really simple example of what you don’t want to happen.

Let’s assume your revenues run $1,000,000, your cost of goods sold runs $500,000, and your overhead (rent, salaries, advertising and so on) run $300,000.

That means you make $200,000 a year if things work as you want. Now probably you use a chunk that $200,000 of profit to grow your business. We both know that’s the way small business works.

But let’s ignore that complexity. And with that simplification, your baseline year looks like this:

That’s pretty good, right? I agree.. But danger lurks.

What Inflation Does to your Profitability

The problem you face now is how to respond to inflation. Probably your costs of goods sold is inflating. Maybe even sharply.

And then your overhead costs—salaries, rent, advertising and so on–are surely coasting up, too.

If cost of goods sold increases by five percent and overhead costs increase by four percent for each of the next couple of years—and you don’t adjust your prices—things might be pretty bleak, as shown below.

Just to point out the obvious: For the baseline year, cash profits equal $200,000.

But after two years of steady inflation, cash profits shrink to $125,000 if you can’t raise your prices.

That’s brutal.

And this sidebar because some business owners and most non-business owners miss this point: Those cash profits do not equate to owner wages.

Some of the  money represents owner wages. But some of it represents payroll taxes. Some of it represents the fringe benefits like the employees get. And much of it goes to grow the business (by investing in inventory, fixtures and equipment.)

How Price Bumps Fix Profitability Problems

You can see what you need to do: You need to raise your prices so you don’t continually experience shrinking profits

Suppose you increase your prices by four percent, across the board.

In that situation, even if cost of goods sold increase by five percent and overhead costs increase by four percent for each of the next couple of years, things look way better.

Which probably shows you what you need to do. And what we need to do. And for the record? I agree regularly raising your prices to deal with inflation isn’t very pleasant.

But the pandemic changed a lot of stuff. And getting used to dealing with the impact of inflation on your profit margins and bottomline profits? Yeah, probably just another new task you need to deal with. Sorry.

Related Blog Posts

How to Grow Your Small Business

Hidden Magic of Arithmetic Growth

Pricing Small Business Services Profitably

The Small Business Long Game: Compound Growth

Has Your Business Stopping Growing?

The post Psst. Time to Raise Your Prices. appeared first on Evergreen Small Business.

You want to learn about this bit of federal government largesse. If you’re an entrepreneur. Or if you’re a small business owner. Because it’s nearly unbelievable.

But in a nutshell? The federal government will give you up to $100,000 for paying your employees if you’ve started a new trade or business.

The Actual Statute

Let’s look at the actual Section 3134(c)(5) language. Because that rather clearly gives you the lay of the land.

Here’s the law Congress wrote and passed and which the President signed:

(5) Recovery startup business

The term “recovery startup business” means any employer-

(A) which began carrying on any trade or business after February 15, 2020,

(B) for which the average annual gross receipts of such employer (as determined under rules similar to the rules under section 448(c)(3)) for the 3-taxable-year period ending with the taxable year which precedes the calendar quarter for which the credit is determined under subsection (a) does not exceed $1,000,000, and

(C) which, with respect to such calendar quarter, is not described in subclause (I) or (II) of paragraph (2)(A)(ii).

That’s it.

So, to summarize? A trade or business you start after February 15, 2020.

A situation where the employer’s average annual gross receipts do not exceed $1,000,000.

Finally, a situation where the employer would not qualify for employee retention credits under the usual rules. Those usual rules? Revenues less than 80 percent as compared to the same quarter of 2019. Or government orders closing the business either fully or partially.

Note: We most recently discussed the “usual” qualification rules for employee retention credits here: Solving the Employee Retention Credit Partial Suspension Puzzle. And for the record, you would want to use the usual rules if you could, because they’re even more generous if you qualify.

Example of Trade or Business Started After February 15, 2020

Let me give you a couple of examples of trades or businesses started after February 15, 2020.

Example 1: You open a restaurant on February 16, 2020. In this case you qualify. Note that had you opened one day earlier? You would not qualify.

Example 2: You operate an accounting firm and prepare people’s taxes. So that’s one trade or business. But on August 15, 2021, you open an equestrian center. Which represents another trade or business. You do qualify for the credit potentially because you began carrying on a trade or business (the new equestrian center) after February 15, 2020.

Example of Gross Receipts Limitation

The statute limits the recovery startup business employee retention credit. Only businesses with average annual gross receipts of $1,000,000 or less for the three previous years qualify.

If you have less than three years of operation, you look only at the years you operated.  (This is why the law quoted above references Section 448(c)(3).)

Some examples show how this works.

Example 3: The fictional restauranteur from Example 1 generated zero revenue in 2018 and 2019 but $300,000 of revenue in 2020. His three-year average, therefore, equals $300,000 . Because ($300,000)/1 year equals $300,000. And, obviously, $300,000 “does not exceed $1,000,000.” Accordingly, he qualifies.

Example 4: The fictional tax accountant faces a more complicated situation. Following a rule specified in Section 3134(d), she needs to aggregate the gross receipts from the businesses she operates. But say the tax accounting firm generated $400,000 in 2018, $800,000 in 2019, and $1,200,000 in 2020. Further suppose the equestrian center generated zero revenue in 2018, 2019 and 2020. Because it only starts in 2021. In this case, the average gross receipts for the three years equals $800,000 because ($400,000+$800,000+$1,200,000+$0+$0+$0)/3 years equals $800,000. And because $800,000 “does not exceed $1,000,000,” she qualifies.

The Recovery Business Startup Employee Retention Credit Limit

One final thing to mention.

The usual employee retention credit in 2021 equals seventy percent of up to the first $10,000 an employer pays employees.

Example 5: An employer with ten employees who each earn $10,000 a quarter might receive $70,000 of employee retention credits, assuming she, he or they qualify. Note that if the employer paid each of these ten employees $15,000 for the quarter, the credit doesn’t increase in size. The formula only looks at the first $10,000 in wages an employee earns, giving the employer a credit equal to seventy percent of this amount.

The recovery business startup employee retention credit formula limits the benefit, however.

Quoting the statute, the credit “for any quarter, shall not exceed $50,000.”

Example 6: If the employer described in Example 5 doesn’t qualify for the usual employee retention credits but does qualify for a recovery startup business credit, the credit equals $50,000.

Note, too, that the credit only works for the third and fourth quarter of 2021—so two quarters.

But still, think about that. $100,000 is lot of money. You want to keep your eyes open for new trades or businesses you can start…

Other Resources

Here’s the full statute that creates the recovery startup business employee retention credit: 26 USC 3134: Employee retention credit for employers subject to closure due to COVID-19

IRS Notice 21-49 provides the only additional guidance on the recovery startup business credit (see pages 6 through 11) and it’s available here.

If you realize some of your staff need more training about how the employee retention credits work, no problem. We’ve got economical $14.95 paperback book that represents a great way for staff, managers and partners to learn how employee retention credits work: Maximizing Employee Retention Credits.

Finally, we’ve also got a number of related articles and blog posts about the employee retention credit and many may be useful for folks still getting up to speed.

The post Recovery Startup Business Employee Retention Credit appeared first on Evergreen Small Business.

The good news embedded in Mr. Biden’s proposals? Most S corporation shareholders avoid a tax increase. But let’s dig into the details…

Biden Proposes to Levy Obamacare Tax on S Corporations

The major piece of Mr. Biden’s S corporation tax proposals? To levy the 3.8 percent Obamacare tax on some S corporation shareholders with adjusted gross incomes more than $400,000.

But some quick backstory so everybody starts on the same page…

Two flavors of the Obamacare tax exist: “net investment income tax,” or what we’ll called here the “NIIT” and then “self-employed contributions act tax,” or what we call here and what the Biden proposal calls the “SECA”.

If an S corporation shareholder holds a passive interest in an S corporation, she or he may already pay one flavor of the 3.8 percent tax, the net-investment-income-tax (or NIIT), on the S corporation’s profit. In this case, the 3.8 percent Obamacare tax kicks typically when a taxpayer’s total income equals $250,000 if married or $200,000 if single.

Currently, however, if an S corporation shareholder holds a nonpassive interest, she or he avoids the other flavor of the 3.8 percent Obamacare tax: the 3.8 percent SECA on up to 92.35 percent of the S corporation’s profit. Mr. Biden proposes these shareholders also now pay the Obamacare tax.

Just to be clear, then, a passive “investor” shareholder might currently pay a 3.8 % tax on a $100,000 S corporation profit. And Mr. Biden proposes a working shareholder-employee should pay a 3.8% tax on $92,350 of a $100,000 S corporation distributive share of the profit.

And one other thing to mention because date confusion exists. The proposal suggests an effective date of January 1, 2022.

Average S Corporation Shareholder Continues to Enjoy Benefits

Perhaps the most important point to make here: The average S corporation should continue to enjoy significant tax benefits from an S corporation. And, the same benefits enjoyed in the past.

The most recent IRS data available (from 2017) suggest that S corporations roughly pay their shareholders about $40,000 of wages and then also generate another $50,000 of profits, or distributive share.

If this small business owner operated as a sole proprietor or a partner, she or he would pay the 15.3 percent SECA tax on 92.35 of the $90,000 of business income, or roughly $12,000.

When the owner instead operates as an S corporation and pays $40,000 in wages and then the other $50,000 in distributions, she or he instead pays the 15.3 percent tax on the $40,000 of wages, or roughly $6,000.

In 2017, then, the average S corporation shareholder-employer maybe saved about $6,000. Probably that savings amount has increased since then. Or at least it increased before the effects of the Covid-19 pandemic.

But the main point: Mr. Biden leaves S corporation tax saving in place for most S corporations.

High Income S Corporation Shareholder-employees Lose Savings

High income S corporation shareholders, however, face a different situation.

Say an S corporation shareholder enjoys $1 million of income from an S corporation she or he works in. Further assume the shareholder earns $250,000 in wages and then receives the remaining $750,000 as a distributive share of the profits.

Under current law, the shareholder employee pays roughly $25,000 in payroll taxes on the $250,000. But the shareholder avoids paying any payroll taxes on the other $750,000.

Mr. Biden proposes this shareholder-employee pay the 3.8 percent tax on $600,000 of the $750,000. So, roughly $23,000 of new taxes.

In this example, the shareholder-employee still saves roughly $6,000 of taxes. The taxpayer avoids paying the 3.8 percent Obamacare tax on $150,000. But the pre-Biden tax rules let this same person save nearly $30,000 annually. Under those rules, the taxpayer avoids paying the Obamacare tax on $750,000.

And now I want to say something for the tax accountants…

This Next Part Only for the Tax Accountants

The May General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals document, known as the “Green Book,” gives a detailed description of how the calculations work:

In order to determine the amount of partnership income and S corporation income that would be subject to SECA tax under the proposal, the taxpayer would sum (a) ordinary business income derived from S corporations for which the owner materially participates in the trade or business, and (b) ordinary business income derived from either limited partnership interests or interests in LLCs that are classified as partnerships to the extent a limited partner or LLC member materially participates in its partnership’s or LLC’s trade or business (this sum referred to as the “potential SECA income”).

Beginning in 2022, the additional income that would be subject to SECA tax would be the lesser of (i) the potential SECA income, and (ii) the excess over $400,000 of the sum of the potential SECA income, wage income subject to FICA under current law, and 92.35 percent of self-employment income subject to SECA tax under current law. The $400,000 threshold amount would not be indexed for inflation.

The thing to notice: Mr. Biden calculates someone’s “potential SECA income” by adding up their S corporation profits and then the similar profits from partnerships and LLCs that have not been subjected to an Obamacare tax. And then he applies the 3.8 percent SECA tax to the lesser of the SECA income or the amount by which the business-y part of the taxpayer’s adjusted gross income exceeds $400,000.

As a result? High income taxpayers do not pay as much tax as one might expect from reading the news reports.

Some High-Income Folks Avoid Losing Out

An example shows why this occurs…

Consider this situation. A taxpayer earns $500,000 in investment income (which would already be subject to the 3.8 percent NIIT). Further, say she or he also earns another $500,000 from an S corporation in which she or he materially participates. (Perhaps the shareholder recently retired so earns no wages but still per the regulations counts as materially participating.)

How much S corporation income does Mr. Biden propose taxing at 3.8 percent? I think $100,000. And here’s my accounting…

This fictitious taxpayer’s “potential SECA” income equals $500,000.

The sum of the potential SECA income (so $500,000), wage income subject to FICA (so zero), and 92.35 percent of self-employment earnings (so, again, zero) also equals $500,000.

The tax applies to the amount by which this $500,000 exceeds $400,000. So only the last $100,000. And thus the tax equals $3800.

Four Final Things to Note

Four other points to make a quick note of here…

A first thing to note: Back-of-the-envelope calculations suggest the most a working shareholder saves with an S corporation runs about $15,000 annually under the Biden plan. The most a non-working shareholder who still materially participates (perhaps using the rule in Regulation 1.469-5T(a)(5) or 1.469-5T(a)(6)) saves with an S corporation runs about $30,000.

These savings amounts sound good. But some high-income taxpayers may prudently decide the costs of operating as an S corporation don’t make sense given limited benefits. (I’d think about lower Social Security benefits, lower retirement contributions, stricter ownership rules, reduced flexibility in allocating profits among owners, and then potentially extra costs to liquidate.)

Second, this quick but really important note. Keep in mind that Mr. Biden proposes bumping the top tax rate from 37 percent to 39.6 percent. S corporations and their shareholders need to plan for this. For example, their S corporations may need to adjust upward the tax distributions they make.

Third, and I’ll try to keep this nonpolitical, but this proposal to subject S corporations to the Obamacare tax diverges from the promise that former President Obama and Congressional Democrats made when they worked to sell the Affordable Care Act (also known as Obamacare) to voters–including voters who owned small businesses. Accordingly, while for decades S corporations avoided payroll taxes on some their profits, this proposal if it passes may signal the end is in sight for the S corporation loophole. However…

A fourth final point: Because the S corporation loophole has survived attacks for decades, and regularly been defended by both Democrats and Republicans, many knowledgeable tax practitioners we talk with think Congress won’t in the end make this change.

Other Resources

We wrote a blog post about how Mr. Biden proposes bumping up taxes on Small C corporations at our Nelson.CPA website: Avoiding Biden Tax Increases on Small Corporations. Small business owners who want to consider all their options may want to skim that.

The Treasury Green Book referenced above is available here. It is well worth a careful read if you’re a tax accountant.

The post Biden S Corporation Tax Proposals Cap Savings appeared first on Evergreen Small Business.

The experience was a fun walk down memory lane. I hadn’t eaten there for decades. (Over the meal, the owner mentioned they started the restaurant 55 years ago. Wow.)

Because earlier in the day, by coincidence, I’d been reading Daniel Kahneman’s thoughts about entrepreneurship and business failure statistics, the experience prompted me to reflect on the small business failure rate. Especially the general public’s perception of the failure rate.

And my key thought? I am pretty darn sure conventional wisdom exaggerates the true risks of entrepreneurship.

But hear me out… and see if you agree.

The Conventional Wisdom about Small Business Failures

The conventional wisdom goes like this: Most small businesses fail. Twenty percent for example close in the first year. Most don’t last more than five years.

That’s the conventional wisdom…

And if you don’t believe me? Yeah, go ahead and Google on the phrase “small business failure rate.” The search results pages will link to a long list of webpages that repeat this assertion. And many of these sources? Highly credible.

Big newspapers. Popular blogs. Well-known business publications.

Small Business Failure Definition

The source for the small business failure rate varies.

But these days, writers often directly or indirectly reference the Bureau of Labor Statistic’s Business Employment Dynamics statistics study. Or the Census Bureau’s Business Dynamics Statistics database.

Those statistical studies mostly track employment by quarter and employer.

And what the studies report as a business failure? When a business stops employing people.

For example, the Bureau of Labor Statistics reports on when some business paid employees the third month of the previous quarter but paid no wages in the current quarter based on unemployment insurance claims. (Here’s an example table of data that provides this sort of information.)

The Census Bureau sort of does the same thing—only with an adjustment that doesn’t count mergers as failures if the new combined firm continues.

But to be nitpicky—and we should—these definitions arguably fail to accurately describe reality. Maybe even badly fail.

Which I found myself thinking about over the Mongolian beef lunch special.

How the Conventional Small Business Failure Definition Fails

You’ve maybe already spotted the logic error in the definition. Some employer who stops paying wages may not have failed.

If an entrepreneur sells a business for a big windfall? That may show up as a failure.

If a small business owner with a profitable operation gets an irresistible job offer and so takes the job? That may show up as a failure.

If a small business person retires—maybe after making a good living for decades? That may show up as a failure.

In all of these cases, and more as well, the employer may stop paying wages. Or the business activity may stop. And that meets the Bureau of Labor Statistics’ or the Census Bureau’s definition of failure.

However, the business owner or entrepreneur may in fact see the change in status as a success.

My blog posts sometimes get way too long. That’s probably because most of my writing? Books.

But let humor me for a few more paragraphs… because I want to share a handful of related comments.

Daniel Kahneman is a Nobel Laureate But…

A first tangential comment. Daniel Kahneman in his classic, Thinking Fast and Slow, uses entrepreneurship as a perfect example of a common flaw in our thinking: being optimistic. (He calls this an optimism bias. And in that discussion, he quotes the statistic discussed in this blog post.)

But while I love Kahneman’s book—you really want to read it if you’ve not yet done so—I respectfully submit he gets this bit about entrepreneurship wrong.

With great irony, Professor Kahneman actually makes two other cognitive mistakes he warns readers about in the chapters before the chapter where he warns people about entrepreneurship and optimism bias.

He (like many others) uses the answer to a different easier question. He doesn’t know how many entrepreneurs fail, so he looks at how many employers stop paying wages.

Further, he falls into the trap of relying on a popular easy-to-understand story—what his book calls a “narrative fallacy.” That story? Well, that we all know most small businesses fail.

We want to avoid making the same errors.

Anyway, that’s my first comment.

A little sidebar may be appropriate here: Professor Kahneman received a Nobel prize in economics for the work he an Amos Tversky did on prospect theory. I want to acknowledge that.

Ask Your CPA About Small Business Failures

Another tangential comment. If you work with a CPA, ask her or him if most of their small business clients quickly fail.

My hunch? She or he won’t say that’s the case. She or he won’t say, “Oh, heavens yes… it’s a bloodbath. Every year. I don’t know why people keep trying it…”

Rather, she or he will say, “Well, you need to be careful… thoughtful… but yeah, some folks do really well.”

Your accountant may then go on and talk about having a business plan. Maybe about needing to be adequately capitalized. And other stuff along these lines.

That commentary represents only anecdotal information of course. But it also hints that the conventional wisdom about small business failure rates may be wrong.

A Last Comment About Small Business Failure Rates

And this final comment about small business failure rates.

Not much data exists about the number of business closures that count as clear-cut entrepreneurial failures.

But some does. And the picture that data paints looks very different from the conventional wisdom.

As one example, Australian business school professors Jim Everett and John Watson looked closely at failures of mall-based retailers about two decades ago in a paper entitled Small Business Failure and External Risk Factors.

What they found? Nearly half the closures were voluntary. So, not economic. Rather, business owners closed stores due to retirement, health reasons, or simply to exit at a profit.

Those researchers were careful to say their small study shouldn’t be generalized. But one can’t ignore their data. If Everett and Watson were right, maybe half the failures the popular statistical studies report should be reclassified as entrepreneurial successes.

Which changes the situation a lot…

Other Resources

The Bureau of Labor Statistics entrepreneur information including the Business Employment Dynamics survey appears here.

The Census Bureau’s Business Dynamics Statistics overview appears here.

A few years ago, we blogged about the odds of entrepreneurial success and shared some real-life anecdotes. If you’re thinking about whether or not you want to become self-employed, that discussion may be useful.

Finally, we rebut some of the academic arguments against entrepreneurship here: The Illusions of Entrepreneurship Professors.

The post Small Business Failure Rate Grossly Exaggerated? appeared first on Evergreen Small Business.

Cases, hospitalizations and fatalities have collapsed in the U.S. since the beginning of the year.

In the U.S., we no longer look for a light at the end of the tunnel. We are moving out of the tunnel.

But the pandemic ending—or more accurately, the end of local and regional epidemics across much of the U.S.—isn’t just good medical news.

The pandemic ending means small businesses need to quickly adapt to a new post-pandemic economy.

This blog post shares thoughts about this post-pandemic economy and small businesses.

Tip #1: Understand Competitors May Be Ahead

A first comment—which isn’t something to freak out about—but rather something to know: Competitors may be ahead of you on this. But let me explain.

The collapse in cases, hospitalizations and fatalities? That’s been apparent to some owners and managers for weeks or even months.

The line chart below—which comes from the CDC data tracker—shows Covid-19 cases in the U.S. since the beginning of 2020. And many scientists and mathematicians were saying even before the peak in cases at the year end that infections would or were collapsing. (See our earlier blog posts here and here for the names of those folks.)

Now obviously people disagreed. One could often read news coverage earlier this year that suggested the pandemic was worsening. In February 2021, for example, one particularly popular pessimistic prognosticator said we still faced a “category 5 hurricane.”

But the point isn’t that the collapse was 100% certain. Even if the collapse looked mathematically likely.

Rather, the point is smart executives and savvy entrepreneurs included that “pandemic ends soon” scenario in their planning.

At this point, those foresighted managers and leaders have already responded. And you and I don’t want to get left behind.

Tip #2: Stay on Top of Local Guidance

A first concrete step you can take? And starting right now? Get disciplined about staying on top of state and local guidance.

Public health policies will change as things get better. Restrictions will end in your markets if they haven’t already. You want to be ready to respond quickly.

Already in online social media networks, you can see people talking about businesses quickly adapting to and recognizing the newest guidelines.

Example: You can find people saying they will shop someplace like Costco or Wal-Mart (which nearly immediately updated in-store policies for new CDC guidance related to vaccinated customers). And those customers will in effect indirectly penalize Costco and Wal-Mart competitors who delay.

By the way? I think you might choose to lose vaccinated customers to quick moving competitors. Maybe you serve customers who often can’t get vaccinated, for example. But you’d want to consciously make this decision. Ideally for strategic reasons.

Tip #3: Watch Your Supply Chains

A quick caution: you want to stay alert to the possibility your supply chains break or get stuck as the economy restarts.

CPA firms, for example, buy lots of technology products. So tons of hardware and software.

And one of the things we’ve noticed? You can’t quickly buy computers right now. (The order wait time runs months.)

And then the bigger point: Other stuff you and we need? We may experience the same supply chain problems.

Even things like retailers changing hours or consolidating outlets can really change the way we all need to operate going forward.

Tip #4: An Awkward Comment About Quality

So something internal to be aware of… and gosh this is awkward…

Quality problems  with both services and products seems to be growing. That’s based on largely anecdotal evidence. (Which, yes, you should suspect…)

But working from home, burdened by restrictions, struggling through supply chain glitches? Yeah, this sort of stuff seems to push down product and service quality.

Probably customers and clients will just need to accept this. At least for a little while.

But you and I need to work diligently to prepare customers or clients for quality reductions. And then work diligently to return to earlier quality standards.

Example: An area where professional service firms have unfortunately reduced quality? Turn-around times. Many of us have struggled mightily to deliver in our usual timeframes. We need to get better, soon as we can. And we need to keep customers and clients informed in meantime.

Tip #5: Plan for Possible Labor Shortages

You would think workers are widely available. Nearly a third of small businesses appear to have closed according to Opportunity Insights’ Track the Recovery website.

The ten million small businesses who possibly closed presumably employed workers who should now need employment.

But one reads news reports that suggest regional labor shortages are stalling small businesses reopening or are pausing growth.

Example: Prior to the pandemic, we were often able to advertise a job opening online and get dozens of applicants within a few hours. The last time we did this, however? Four applications.

Tip #6: Keep Eye Out for Inflation

Former Treasury Secretary and Harvard Economist Lawrence Summers warns significant inflation is underway.

Whether Secretary Summers is right or wrong? Who knows. (I would bet he is, in case you’re interested.) But maybe the actionable point is, we want to consider the possibility that inflation unlike anything we’ve recently seen may become a “thing” over the next few years.

You and I therefore don’t want to be in a situation where we lock in flat or even just stable prices for customers but then need to buy production inputs that continually increase due to inflation.

Tip #7: Consider Sustainable Growth

A final caution: In many business categories (for example, food, accommodation, some brick and mortar retailing) firms got really beat up by the pandemic.

Overall, small business revenues declined by about 30 percent according to Opportunity Insights.

If you’re in the group that got beat up, you need to assess if you have enough working capital on your balance sheet to resume normal operations.

You may need to secure new funding. Or start slow and re-build your working capital by reinvesting profits.

Tip: If you were right-sized in terms of working capital before the pandemic, in the post-pandemic economy, you’ll probably need to have that same working capital to operate comfortably.

Two Final Comments about Post-pandemic Economy

The pandemic is over many places in the U.S. That’s really good news!

But that means for many small businesses, a big new challenge appears. Restarting operations and returning to a normal.

The post The Post-Pandemic Economy and Your Small Business appeared first on Evergreen Small Business.

I want to talk about this research. Because while you might think Covid-19 scientific research a strange topic for a small business blog? It’s really not.

What researchers Alex Washburne, Justin Silverman, Jose Lourenco and Nathaniel Hupert have done? They’ve identified a rule of thumb that suggests when Covid-19 cases peak and then decline.

That should help you plan. But let’s talk about the research first.

The Natural Epidemic Endpoint

If you like science, you want to read the paper (see link at end of this post). The math gets pretty dense. But the charts the paper includes? Many readers will find them understandable—and extremely useful.

And what they show? Through the time period the scientists examined, the Covid-19 epidemic in an area peaked when the fatalities hit the grim milestone of one in a thousand.

For example, when the United States Covid-19 fatalities rose to 330,000—that’s the one in a thousand threshold—these scientists’ work suggests the epidemic probably peaked.

Two notes about this. First, if you look at any of the graphs that plot Covid-19 cases in the US, cases did peak at one fatality per thousand.

Second, the researchers’ work is not them simply “looking into the rearview mirror.”

This weird coincidence. I happened to exchange emails with Alex Washburne over Christmas 2020. And he shared then that their research suggested Covid-19 cases were peaking or had already peaked in many areas.

In comparison, at that time, other scientists like Michael Osterholm of the Center for Infectious Disease Research and Policy, were suggesting the opposite. (From Osterholm’s podcast at same time, “terrible trajectory continues!…)

The Actionable Planning Insight

You want to read the paper probably. And pay attention to the charts since those are easiest for nonscientists to process.

But here’s the planning insight you can glean from this research.

While covid-19 cases peaking and then collapsing doesn’t mean everything instantly gets better?

That peak and collapse signal the point at which you need to plan how to return to normal operations.

You won’t know the exact when.

For that, you need to wait until state and local public health officials come to the same conclusion and “unlock” your state or county.

You may also need customers, clients, and employees to emerge from their hibernation.

Finally, uncertainty still exists as the world moves forward.

But at the point cases peak and then collapse? You want to be getting ready.

And this last comment? In many areas, as hinted above, Covid-19 cases may have already peaked and collapsed.

Other Resources

A current draft of the research paper from Washburne, Silverman, Lourenco and Hupert appears here: Analysis and visualization of epidemics on the timescale of burden: derivation and application of Epidemic Resistance Lines (ERLs) to COVID-19 outbreaks in the US

Silverman, Hupert and Washburne’s earlier paper that spotted way more Covid-19 infections were occurring than case statistics suggested appears here and is interesting: Using influenza surveillance networks to estimate state-specific prevalence of SARS-CoV-2 in the United States. (This paper was widely covered in the press.)

The post The Covid-19 Epidemic Endpoint: New Research Gives Hope appeared first on Evergreen Small Business.

One example? The paper from Lawrence Summers and Jason Furman about ultralow long-term interest rates and the way those rates should impact fiscal policy in the Biden administration (available here:  A Reconsideration of Fiscal Policy in the Era of Low Interest Rates.)

Another example? The recent paper from Robert Shiller, Lawrence Black and Farouk Jivraj about expected equity portfolio returns in a low-interest-rate world (available here: CAPE and the Covid-19 Pandemic Effect.)

The theme you see in these papers and a few others they reference? People need to update their thinking for the pervasive impact of ultra-low long-term interest rates.

I personally find this argument extremely compelling. And if these guys get it right? Yeah, a game changer.

But the good news here? You and I enjoy actionable insights for investing and entrepreneurship if we consider how low interest rates and low equity returns impact our financial game plans. So, let me share some of the insights I think I spot.

Good Time for Borrowing

First quick observation: Now seems like a good time to borrow long.

For example, if your family plans to buy a home? Or your business needs new machinery or equipment? Or an extra educational credential would pay off handsomely but would need to be paid for with a loan?

Sober, well-planned, thoughtful borrowing makes a lot of sense if you get an economical loan and smartly deploy the funds.

Rethinking Financial Leverage

A second thing to ponder about low long-term interest rates.

If you’re a small business owner with investment opportunities that generate high returns relative to borrowing costs, you want to consider making those investments.

You know how financial leverage works. You borrow $100,000 maybe paying 5 percent interest. So, a few thousand bucks a year.

If you can earn 25 percent, or, $25,000, on your investment? Bingo. You earn big profits.

Obviously, you need to borrow at a rate that’s well below the rate you earn on the investment.

Further, you want to match the term of your borrowing and your investment. If an investment pays off over 10 years, you want to fund that investment with a 10 year loan.

Always, business risks exist with these sorts of opportunities. As you well know.

But you want to think about this idea. And if you’re comfortable with the risk-reward trade-offs, you want to keep your eyes open for opportunities.

Note: If the Covid-19 pandemic beat up your business’s balance sheet, as it beat up many business owners’ balance sheets, consider the possibility that more low-interest-rate debt provides a way to rebuild.

We Need to Save More

A third impact to consider? Low long term interest rates and equity returns probably mean you and I need to save more to get to the number we want for our retirements.

You see why we need to do this. If you and I invest in bonds paying 1 or 2 percent interest for the next decade–or next three decades–we can’t plan that these bonds will average 5 percent return over those same years.

And then the returns on other traditional asset classes also look very low in the future, at least according to the aforementioned macroeconomists. Which makes sense. Expected low returns from equity connect to the nearly zero percent long-term interest rate bonds pay.

In a recent New York Times article discussing low interest rates, another Harvard economics professor Gregory Mankiw suggests the long-run return on a balanced portfolio has dropped from a real return of 5 percent to 3 percent, roughly in line with what’s happened to interest rates. Which also makes sense.

So, if your or my old plan assumed a balanced portfolio of stocks and bonds averaging maybe five percent after adjusting for inflation?

That assumption now may mostly reflect quaint financial nostalgia.

Once you or I recalculate an appropriate savings rate using lower expected returns? We very probably need to save more or save for longer.

For example, if you planned to save $5,000 a year to get to half a million in savings in 35 years, you may need to bump that annual savings amount up to nearly $7,500 a year.

Or if you planned to save for 35 years to hit your “number,” you may now want to think in terms of working longer. Maybe (sorry) an extra ten years?

And maybe what’s really most practical? Probably we all just need to save a chunk more and work a bit longer.

Delaying Your Exit from Entrepreneurship

A related point. Always entrepreneurs face a harsh financial reality when they sell a successful business. The return on a small business investment usually greatly exceeds the return a balanced investment portfolio generates.

To use numbers that make the math easy, suppose an entrepreneur builds a business that generates $250,000 of profits after paying the owner a fair wage. If the owner sells out for $1,000,000—that might be a good guess—she or he may net after taxes $800,000.

In the past, this owner might have been able to reinvest the $800,000 of proceeds into a stock-heavy portfolio and then hoped for a generous real rate of return. Probably in the past, she or he even received that generous rate of return.

But now? Now the owner may be reinvesting the proceeds into a balanced portfolio earning a 3 percent real rate of return. So, about $24,000?

That giant reduction in return suggests some business owners may want to delay a sale. At least until they’ve adjusted their financial game plan for lower interest rates and equity returns.

Adjusting Your Safe Withdrawal Calculations

A related thing to mention. Investors planning safe withdrawal amounts from a retirement nest egg probably want to plan on a lower withdrawal rate.

In other words, say your current plan reflects the idea that you can draw 4 percent from, say, a $500,000 portfolio. That would mean $20,000 a year to start.

In this case, you should adjust that planning formula. You might want to assume a 3 percent withdrawal rate. The math of a Monte Carlo simulation suggests 3 percent works pretty well in this low return environment.

That would mean with $500,000, you plan to draw $15,000. Because .03 times $500,000 equals $15,000. Or to draw $20,000, that you plan to need $666,666. Because $20,000 divided by .03 equals $666,666.

Note: I use numbers here that keep the math simple. But most people don’t save anywhere close to $500,000 for retirement. That amount of savings at retirement, in fact, puts you at roughly the 90th percentile.

Two other notes about adjusting safe withdrawals for low returns. First, remember that the safe withdrawal rate or amount reflects a value that works if we both live a long time and encounter a bad patch of investment returns at the start of our retirement. If we don’t both live a long time and encounter an early bad patch? Low interest rates and low equity returns may not matter. Or matter much.

Second, you and I probably won’t use a crude inflexible spending percentage in our retirement. We’re going to show flexibility. And if we do that? If we use what people call a “variable withdrawal rate?” That variable withdrawal rate should work well and let us nudge our withdrawal amounts up and down. (See this useful Bogleheads resource for more information:  Variable Percentage Withdrawal Rate.)

Re-evaluate Tax Strategies

Two final quick thoughts. First, I think you and I need to re-evaluate any tax gambits or strategies that implicitly assume historical, good returns.

One obvious example? Roth IRA and Roth 401(k) account conversions. Especially when someone uses these to “solve” a future required minimum distribution problem.

If investment returns run low through someone’s retirement, drawing 3 to 4 percent each year may on its own prevent problematically large required minimum distributions.

Rethink Inheritances and Bequests

And then this last thought: Lower investment returns may also dial down the bequests you and I leave heirs. And the inheritances we receive from parents and grandparents.

To provide for a legacy for heirs in this low-interest-rate and low-equity-return environment? One may want to be slightly more proactive. Maybe that means spending less. Or gifting more. Or  better planning for our estates.

Other Resources You May Find Useful

The draft paper from Jason Furman and Lawrence Summers referenced earlier was the centerpiece of an online web conference in early December. You can view the entire two-hour conference here: Fiscal Policy Advice for Joe Biden and Congress. And the presentation is well worth watching. Even if only to see how rational, collegial and calm experts with different viewpoints discuss a tricky set of political issues. Plus, it’s fun to see some beautiful minds at work.

If you’re not used to capital budgeting (which is the math that lets you calculate returns on business investments and real estate), you might want to peek at these blog posts: Small Business Net Present Value Analysis and Small Business Investment Returns Astronomical. You might also want to peek at how one does capital budgeting for something like buying a home, which I describe in this post: Are Houses Investments?

For more information about how expected stock market returns impact safe withdrawal rates, I like the earlier thoughtful research from Michael Kitces which looks at using cyclically adjusted price earnings ratios. (See for example Michael Kitces’ discussion of using CAPE 10 to calculate safe withdrawal amounts  and the Boglehead Siamond’s update on this idea: CAPE 10 and Safe Withdrawal Rates.  Also my discussion of Siamond’s discussion: Siamond Withdrawal Rate.)

To get an idea of what investment experts think about the prospect for long-run returns, you might find it useful to review this recent article from Morningstar’s Christine Benz: Experts Forecast Stock and Bond Returns. (I would say the views of the experts mesh with what I describe here.)

Finally, if this business about lower returns in the future blindsides you and now you’re bummed out, don’t be! Rather check out our blog post series on “retirement plan b”. You have a bunch of steps you can take to address the issue of lower returns:

Why You Need a Retirement Plan B

FireCalc Retirement Plan B Calculations

cFireSim Retirement Plan B Calculations

Monte Carlo Simulation Retirement Plan B Calculations

Tips for Building a Retirement Plan B

The post Updating your Financial Game Plan for Low Interest Rates and Equity Returns appeared first on Evergreen Small Business.