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.

You wondered at the time whether it was a scam, right? And now you regularly see news reports about ERC scams. Employee retention credit scams, that is.

And so two questions. Did you get scammed? And if so, what should you do at this point? Fortunately, you can probably answer these two questions pretty easily.

Note: This blog post has been updated for the additional guidance the IRS provided on October 19, 2023.

Did You Get Conned or Scammed?

You or your business qualifies for an employee retention credit in one of three ways:

First way: You’re a small business and you started another, new business sometime after February 15, 2020 and before the end of 2021. (That’s easy, right? You know if you did this.)

Second way: Quarterly revenues, as compared to 2019, collapsed. To qualify for 2020, the collapse needs to exceed 50 percent. To qualify for 2021, the collapse needs to exceed 20 percent. (Your accounting system lets you make these determinations with roughly three or four clicks of a mouse.)

And then the third way you qualify: If a government order triggered either a full or partial suspension in your business. And this method? Where the nonsense seems to occur. The place where ERC scams show up.

Fortunately, you can easily determine your eligibility for an ERC based on a government order. You just need to pull out the actual government order that either fully closed your business for some period of time. Or you need to pull out the actual government order that partially closed your business for a period of time—and then show that the partial closure reduced the hours of service or revenues by at least 10 percent.

And now here’s the cold reality. Too often? We see situations where no government order actually exists. I kid you not. And when that’s case? Yeah, sorry. No easy way to say this. But I think you’ve very possibly gotten caught in an ERC scam.

Note: Here’s an example of an actual government order from Washington state: Proclamation by the governor: Stay Health Stay Home.

Real-life Example of ERC Scams

You see all sorts of sloppy thinking regarding government orders.

For example, in one case, a business owner prominent in his industry circulated an email that talked about a government order hitting a major supplier of his firm and similar firms. We understand numerous employers filed millions of dollars of ERC refund claims based on this email.

But when we checked? No government order existed. In fact the supplier, helpfully, said so on their website. Explicitly.

Note: A clarification: A government order “counts” for purposes of employee retention credits if it affects your business… or vendors you get supplies from… or vendors of vendors you get supplies from. A government order that affects your customers does not matter for purposes of your ERC eligibility however. (It might negatively impact your revenues of course–which is another way to qualify.)

Double-check You Got Caught in ERC Scam

So your first step is obvious, right? Find or see if the ERC consultant worked from a real government order. Get a copy. Read the copy and make sure it either closed your operation down. Or it closed down the operation of a vendor in your supply chain and the impact was more than nominal.

And if you can find this document? Count yourself lucky. Because many of your small-business-owning brothers and sisters appear to have claimed employee retention credits when no government order existed. You however should be fine. Not so for people who don’t have a government order.

Take These Steps If You Actually Were Scammed

If you did claim ERC refunds you were not entitled to? You need to take several steps to dial down the damage.

First, if the federal quarterly payroll tax returns—which is where an employer claims employee retention credits—have not yet been filed? I think you stop that process. This may mean instructing the “consultant” preparing the amended returns to stop. You probably want to tell them explicitly that you now believe no government order exists if that is case.

Second, if the federal quarterly payroll tax returns have been filed? But you haven’t received a refund? I think you withdraw your refund request using the procedure desrcibed here:  Withdraw an Employee Retention Credit Claim. Note that the process works very simply in most cases: You make a copy of the 941-X form used to file the ERC refund claim, write “Withdrawn” into the left margin and then have an authorized person sign, give a title, and date the withdrawal using the right margin. You then, quoting from the IRS instructions, “Fax the signed copy of your return using your computer or mobile device to  the IRS’s ERC claim withdrawal fax line at 855-738-7609.”

Third, if the IRS has already processed ERC refunds and you now know your firm was not eligible? You want to amend any tax returns that reflect the erroneous ERC refunds. For example, you want to amend the 941 quarterly payroll tax returns again and then repay the tax refund. That will get you square with the Internal Revenue Service and stop the compounding of penalties and interest.

Another example: If you amended your 2020 and 2021 income tax returns to report the refunds as income (which is required), you want to amend your income tax returns and remove that income. This will reduce your income tax liability for 2020 and 2021 and get you a refund while you still can.

Other Resources

We’ve got a bunch of blog posts about how employee retention credits work here. If you’re concerned you didn’t know enough or still don’t know enough about employee retention credits, check these out to provide yourself with the information you’ll need to get out of this mess.

If you’re a tax practitioner who now needs to do a deep dive into the law, pick up a copy of Maximizing Employee Retention Credits from Amazon.com. (You will have a number of clients who need help with this if your firm is anything like ours. Sorry.)

If you’re an employer who got into trouble on this area? Check first with your CPA to see if he or she can help you get out of the mess. If that doesn’t work, we do have an ability to help a limited number of taxpayers. You can make contact with our firm here:  Nelson CPA PLLC.

The post If You Got Conned in ERC Scam 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.

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.

The post Human Capitalists in the Twenty-First Century 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.

Unfortunately, this method of qualifying for credits is murky. At least for small businesses that operate in a single location. But you want to look at the rule. Learn it. And then see if it applies to your situation.

If you can’t otherwise get employee retention credits? The partial suspension eligibility method provides a backdoor way for some firms who wouldn’t otherwise qualify to get credits.

Quick Review of the Easy Eligible Employer Rules

But first a quick review of what employee retentions are and how they usually work…

Employers who experience a greater than fifty reduction in gross receipts in some quarter of 2020 or a greater than twenty reduction in gross receipts in some quarter in 2021, get an employee retention credit.  (The comparisons typically look at the same quarter of 2019.)

For 2020, that credit equals fifty percent of the qualified wages paid. But not more than $5,000 per employee for the calendar year.

For 2021, that credit equals seventy percent of the qualified wages paid. But not more than $7,000 for a quarter.

Note: The 2021 credit—potentially $28,000 per employee—is huge. Take notice of that.

If a federal, state or local government order fully suspends operations, that order also qualifies an employer for employee retention credits.

For example, if a government order causes a restaurant to close from May 15 through August 15, the wages paid for that interval plug into the employee retention credit formula. The employer does not, in other words, need to compare quarterly gross receipts.

But then there’s also one other route to qualifying for employee retention credits: partial suspension. And here the waters get muddy in many settings.

Partial Suspension Rule

Let’s start by quoting official language that describes how the partial suspension rules work. IRS Notice 2021-20 says this about which employers have eligibility to claim employee retention credits:

Section 2301(c)(2)(A) of the CARES Act defines the term “eligible employer” as any employer carrying on a trade or business during calendar year 2020, and, with respect to any calendar quarter, for which (1) the operation of the trade or business carried on during calendar year 2020 is fully or partially suspended due to orders from an appropriate governmental authority limiting commerce, travel, or group meetings (for commercial, social, religious, or other purposes) due to COVID-19.

Note: The same rule applies for 2021. But you need to read IRS Notice 2021-23 to get the official instruction for that.

IRS Notice 2021-20 Question 11:

On page 27 of that IRS Notice 2021-20, the IRS then asks and answers the key question about when a business is “partially suspended” in what I’ll call a blurry-picture situation.

Here’s the actual question asked which you want to look at and consider:

If a governmental order requires non-essential businesses to suspend operations but allows essential businesses to continue operations, is an essential business considered to have a full or partial suspension of operations due to a governmental order?

 IRS Notice 2021-20 Answer 11:

And here’s the official answer to this question:

An employer that operates an essential business is not considered to have a full or partial suspension of operations if the governmental order allows all of the employer’s operations to remain open. However, an employer that operates an essential business may be considered to have a partial suspension of operations if, under the facts and circumstances, more than a nominal portion of its business operations are suspended by a governmental order.

For example, an employer that maintains both essential and non-essential business operations, each of which are more than nominal portions of the business operations, may be considered to have a partial suspension of its operations if a governmental order restricts the operations of the non-essential portion of the business, even if the essential portion of the business is unaffected. In addition, an essential business that is permitted to continue its operations may, nonetheless, be considered to have a partial suspension of its operations if a governmental order requires the business to close for a period of time during normal working hours.

The notice then elaborates. A “more than nominal” portion of an employer’s business operations would have generated ten percent or more of the firm’s gross receipts in the same quarter of 2019. Or it would have amounted to ten percent or more of the firm’s hours of service in the same quarter of 2019. (This information appears in the “Question 12” discussion.)

If a employer operates in multiple locations and government orders close one of those locations, that closure counts, plain and simple, as a partial suspension. (This information appears in the “Question 20” discussion.)

Finally, the notice adds a little twist and complexity to all of this. A reduction in consumer demand doesn’t matter for purposes of determining partial suspension. (This information appears in the “Question 13” discussion.)

You may want to read the roughly 15 pages of discussion about what counts and what doesn’t count if it matters to your clients. Or for your own firm’s employee retention credits. But let me spotlight some of the issues that I think may help you determine whether you qualify or might qualify for partial suspension for less than obvious situations.

Nominal Matters

A first obvious observation. You probably need to be able to show a reduction of ten percent or more in gross receipts or hours in order to take the position that an employer’s operations have been partially suspended.

In other words, any reduction in gross receipts or hours of service less than ten percent probably fails to support the position that a non-nominal chunk of the business stopped due to a government order.

Consumer Demand

And then something else. The bit about not looking at consumer demand connects to this, I think.

For example, the available data I’ve looked at and talked about elsewhere at this blog suggests that reduced consumer demand and government orders work hand in hand to push down business revenues. (Er, if you’ve read any of my complaints about the media exaggerating infection, hospitalization and fatality rates, you know I beat that drum because I worry it damages your business.)

But if we maybe think about this? Maybe you and I want to see considerably more than a ten percent reduction in gross receipts or hours worked so we’re also formally recognizing some dampening in consumer demand?

In other words, you need some ten-percent-or-greater chunk of the business to have been suspended, obviously, to just meet the “more than nominal” operations threshold. That’s maybe the first ten percent.

And then don’t we probably need some chunk of additional reduction in revenue or hours to reflect the drop in consumer demand?

The Twenty Percent Test May Be Relevant

Another percentage to anchor your analysis and thinking? Twenty percent. And here’s why I say this.

For 2020, the gross receipts eligibility test qualifies an employer for employee retention credits when the gross receipts drop to less than fifty percent of the same quarter in 2019. But the employer maintains its eligibility for the credits as long as the gross receipts stay at least twenty percent off as compared to 2019.

That twenty percent value pops up again for 2021. For that year, the gross receipts eligibility test qualifies an employer for employee retention credits when gross receipts drop by more than twenty percent as compared to 2019.

Again, we’re just talking here. Trying to bring this partial suspension rule into sharper focus… but I propose this: If a twenty percent decline in gross receipts often works as the hard number that maintains or creates eligibility for credits based on gross receipts? That reduction in revenues may really suggest a firm suffers from non-essential operations or activities closing.

Fixtures and Equipment and Comparability

One final thing to mention here. The IRS Notice mentions (Question 14) the issue of whether a firm can continue operations comparable to those prior to closure due to a government order.

The Notice discussion then gives a couple of examples. One example describes a software development firm. It reconfigures its operations to run comparably even after a local government order closes its offices. That firm, the IRS concludes, fails to qualify as partially suspended.

Another example in that same discussion describes a physical therapy facility. This firm also reconfigures operations. But reconfigured, it can’t provide the full range of therapies. Why? The facility provides equipment and tools that the physical therapists often need in hand to treat patients. That firm, the IRS concludes, qualifies as partially suspended.

The takeaway here? Maybe two things. First, if a business operation uses physical assets located in the closed offices, that suggests a partial suspension occurs when the offices close. Second, if a service must sometimes be provided in the presence of a customer or patient, that suggests a partial suspension occurs when the offices close.

Summing Up Partial Suspension Rule

Putting everything mentioned above together?

Here are my current impressions. I think separating essential not-suspended business operations from non-essential suspended businesses gets tricky. Especially for single-location and really small businesses. Accordingly, I think these small businesses want to see some overall reduction in revenues or hours significantly greater than ten percent. To me, that seems in line with non-nominal operations stopping due to a government order.

I don’t think however, that you need to go much above that ten percent reduction threshold for blurry-picture situations. Maybe a fifteen percent reduction signals a firm suffers from partially suspended operations? Or maybe twenty percent sends that signal? At least the way I’m thinking.

Finally, as just a matter of common sense? In any blurry-picture situation, I think a firm arguing for partial suspension wants to be able to point to equipment or fixtures required for the services but that could not be used due to an office closing. Or a firm wants to be able to point to in-office, face-to-face services that could not occur due to a government order closing the offices used for such meetings.

But I’d welcome your comments…

Need More Information or ERC Training for Staff?

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.

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 Solving the Employee Retention Credit Partial Suspension Puzzle appeared first on Evergreen Small Business.

The only problem? You need to move quickly. Thus, this blog post where I’ll talk about boosting the size of the credits you calculate.

But let’s make sure you’re up to speed on how the employee retention credit works. And then we’ll talk about how you can increase the size of the employee retention credits you calculate.

And by the way, one other note: These credits? They nearly instantly become refunds. Starting next time you do payroll. And in some cases, gigantic refunds.

Employee Retention Credits in a Nutshell

In effect, the federal government will pay an employer, such as a small business, up to a $5,000 credit for wages paid and group health insurance provided to each employee in 2020.

In 2021, the deal gets even better. The federal government will pay up to a $28,000 credit for wages paid and group health insurance provided to each employee in 2021.

Example 1: A small business employs ten workers who each earn $40,000 annually and it qualifies for employee retention credits for both 2020 and 2021. In 2020, the firm receives $50,000 of credits ($5,000 for each employee). In 2021, the firm receives $280,000 of credits ($28,000 for each employee).

The credit formula, by the way, works differently in 2020 and 2021.

In 2020, the employee retention credit formula equals fifty percent of the wages and group health insurance paid but not more than $5,000 per employee. (The 2020 credit formula looks only at the first $10,000 of wages and group health insurance paid for the year.)

In 2021, the employee retention credit formula equals seventy percent of the wages and group health insurance paid but not more than $7,000 a quarter. (The 2021 credit formula looks at the first $10,000 of wages and group health insurance paid during each quarter.)

Unbelievable, right? I agree. The numbers, especially for 2021, get huge. Even for a small business.

Five Basic Employee Retention Credit Rules

Five basic rules apply to the employee retention credit.

The first rule? The credit works, potentially, for wages and group health insurance paid after March 12, 2020 and through December 31, 2021.

The second rule: A firm needs its operations either fully or partially suspended by federal, state or local government restrictions… or a firm needs to suffer a significant contraction in quarterly revenues as compared to 2019. (I’ll talk more about this in a minute, but a firm only gets the credit on wages and group health insurance paid during a full or partial suspension or during a down quarter.)

A third rule says that you can’t “double dip” and thereby get a credit and refund if some other federal government program already provided you money to pay the wages. For example, you don’t get employee retention credits for wages you paid using Paycheck Protection Program funds. Or using an EIDL grant. Or if you received other payroll tax credits that, in effect, funded employee wages.

The fourth rule? Large eligible employers only take the credit only on wages paid to employees for not working. For 2020 employee retention credits, a large eligible employer is a firm employing more than 100 full-time employees in 2019. For 2021 employee retention credits, a large eligible employer is a firm employing more than 500 full-time employees in 2019. For small eligible employers, in comparison, the employer takes the full credit, potentially, on all their workers’ wages (subject to the third rule just mentioned).

The fifth rule: A business owner aggregates the businesses she or he or they own. For example, if you own a restaurant (maybe operated as a sole proprietorship), 100 percent of a consulting business (maybe operated as an S corporation), and a majority interest in a partnership, you aggregate all of these businesses to determine whether your operations qualify (according to rule #2 above), what the wages total and so forth.

And now let’s look at the three big opportunities to maximize employee retention credits. Because for two of these opportunities, time may be running out.

Bigger Employee Retention Credit Tip #1: Savvy PPP Forgiveness Application

Here’s the first technique you may be able to use to maximize your employee retention credits: How you complete the PPP forgiveness application. But let me explain.

Whatever wages you report on your PPP loan forgiveness application? The employee retention credit formula ignores those wages, as mentioned earlier, for purposes of the employee retention credit.

Example 2: Say a small business potentially qualifies for $50,000 of employee retention credits on $100,000 of wages and qualified health expenses due to partial suspension. If this small business received a $100,000 PPP loan, the borrower might get full forgiveness for using the funds for $100,000 of W-2 wages. And it might, just to be efficient, show that same $100,000 of W-2 wages on its PPP forgiveness application. But in that case, it receives no employee retention tax credit on those wages. The business can’t use the same wages for PPP forgiveness and employee tax credits.

Example 3: Say another nearly identical, partially suspended small business also potentially qualifies for up to $50,000 of employee retention credits on some portion of a $100,000 of wages and qualified health expenses. Further, say this PPP borrower also received a $100,000 PPP loan and could have gotten full forgiveness simply by claiming that full $100,000 of W-2 wages and health expenses. But say it instead applied for forgiveness by showing it used the PPP money for $50,000 of W-2 wages and health expenses, $10,000 of other payroll costs including payroll taxes and pension contributions, and then $40,000 of rent, utilities and mortgage interest. In this case, the business should still get employee retention credits on half of the wages. So roughly $25,000 of employee retention credits.

You see the big point here: How you complete the PPP loan forgiveness application affects the leftover wages and qualified health insurance you or your accountant plug into the employee retention credit formula. (The basic trick is, try to get forgiveness for spending other than wages and group health insurance, if that approach protects your ability to get employee retention credits.)

Finally, this bit of bad news: If you already applied for forgiveness, you can’t undo your application. But some first-round PPP borrowers haven’t yet applied for forgiveness. Some borrowers also received a second-round PPP loan. Many of these firms still have the opportunity to apply for forgiveness in a way that maximizes employee retention credits.

Bigger Employee Retention Credit Tip #2: Look at Every Qualification Possibility

A firm qualifies for employee retention credits in two basic ways.

Maybe the most talked about way? Suffering a significant contraction in revenues. Specifically, a greater-than-fifty-percent contraction in 2020 or a greater-than-twenty-percent contraction in 2021.

Note: If a firm suffers a greater-than-fifty-percent contraction in 2020, it continues to qualify for employee retention credits until the quarter after the first quarter its revenues equal eighty percent or more of the same quarter’s revenues from 2019.

Example 4: Say a firm generated exactly $100,000 in revenue each quarter of 2019. If its revenues in 2020 equaled $80,000 in quarter 1, $40,000 in quarter 2, $80,000 in quarter 3, and $100,000 in quarter 4, it qualifies for employee retention credits in quarters 2 and 3.

Example 5: Say the firm from example 4 experienced another contraction in 2021. If revenues for quarter 1 and quarter 2 of 2021 equal $75,000—so seventy-five percent of what the firm experienced in 2019—it qualifies for employee retention credits in quarters 1 and 2 of 2021.

A firm may also qualify if federal, state or local government mandates, directives or proclamations fully or partially suspend its operations.

Example 6: On April 1, 2020, a restaurant reduces the number of tables for diners by fifty percent due to a state government public health directive that stays in effect for the rest of 2020. Say the firm usually generates $100,000 a month of revenues but through the closure generates $70,000 a month of revenues. The restaurant fails to qualify for employee retention credits based on reduced revenues. Revenues “only” decline by thirty percent. However, the restaurant does qualify for employee retention credits based on state public health restrictions that partially suspend operations.

The obvious trick here to maximize the employee retention credit: Look at both qualification rules: the one based on the reduction revenues… and the one based on the federal, state or local government restrictions on activity.

And then the less obvious trick for maximizing the credit and the resulting refund. Be sure to explore whether a firm can stretch out the time frame it qualifies for employee retention credits by looking both at restrictions and revenue reductions.

Example 7: Say a firm that enjoyed $100,000 a quarter of revenues throughout 2019 sees operations restricted on March 15 due to local government directives that continued through June 30. Assume that revenues “only” sag in the second quarter to $60,000 as compared to 2019, then sag in the third and fourth quarters to $40,000. The firm qualifies as partially suspended from March 15 through June based on local government directives. The firm qualifies due to substantial revenue declines for the third and fourth quarter. Accordingly, wages and group health expenses paid between March 15, 2020 and December 31, 2020 potentially produce an employee retention credit.

Bigger Employee Retention Credit Tip #3: Acquiring to Aggregate

One other powerful tax planning opportunity bears mentioning. As noted earlier, the rules for employee retention credits require employers to aggregate businesses. An entrepreneur who owns, for example, two or three (or more) separate businesses aggregates those businesses into a single employer for the purposes of the employer retention credit.

Example 8: An entrepreneur owns a restaurant, an online ecommerce website, and a consultancy. All three businesses generated a $100,000 quarter of revenues in 2019. The employee retention credit formula combines these three businesses. If the aggregated firm experienced a full or partial suspension in any one of the three businesses through the entire second quarter, the entire consolidated operation potentially qualifies for employee retention credits for the second quarter. For example, if local public health officials directed the restaurant to close from April 1 through June 30, but the other two businesses continued to chug along? The entire three-business aggregation counts as partially suspended from April 1 through June 30. That “partially suspended” status means all three businesses qualify potentially for employee retention credits.

And then here’s the planning opportunity related to aggregation. If a business acquires a firm, it can aggregate that firm’s data from before the acquisition date if the acquirer possesses the information needed to calculate the formulas. A couple of examples show how this technique might work.

Example 9: A consultant operates a firm that generates $100,000 a quarter in 2019 but due to Covid-19 only $80,000 a quarter in 2020. Because no government restriction fully or partially suspends the consultancy operation, the consultancy fails to qualify for employee retention credits due to government restrictions. Further with a twenty-percent reduction in revenues, the firm fails to qualify for employee retention credits due to a significant decline in revenues.

However, if the consultant acquires another business, that may result in qualification for employee retention credits.

Example 10:  The consultant from example 9 acquires a restaurant on April 1, 2021. If that restaurant enjoyed $100,000 a quarter of revenues in 2019 but only books $70,000 a quarter of revenue in 2020 and 2021, then the consultant’s aggregated businesses qualify for the employee retention credit for the quarter that starts on April 1, 2021. For that quarter, the combined revenues, $80,000 for the consultancy and $70,000 for the restaurant, equal seventy-five percent of the aggregated 2019 revenues. Seventy-five percent falls under that eighty-percent threshold therefore qualifying the aggregated businesses for employee retention credits in the second quarter.

Show Me the Money

A quick comment in case you’re new to this employee retention credit topic. You get the refund created by the employee retention credit using the quarterly 941 payroll tax form.

If you should have claimed a credit on some past 941 forms from 2020? Or on the first or second quarter 941 for 2021? You need to go back and amend those. Or maybe better yet, have your tax accountant do the calculations and prepare the form. (If you didn’t know to include the credit in the first place, maybe you ought to have the accountant take care of this for you.)

Note: Our CPA firm will amend 941 forms for small businesses if you use a outside payroll service (like ADP, Paychex, or Gusto) and if you have an accounting system that supplies quarterly revenue data (so like QuickBooks Online, Xero Accounting, or QuickBooks Desktop). Use our CPA firm’s contact form to reach out.

If you can claim a credit on your original second, third or fourth quarter 941, you just calculate the amount and enter it on the 941 form. (You do need to have workpapers which backup and explain your calculations.) Further, if you know for a fact you’re getting a credit, you can and should reduce your payroll tax deposits immediately so you don’t have to wait a month or two or three for the refund.)

Closing Comments

Three quick comments in closing. First, you may unfortunately find you’re too late to boost your employee retention credits by more thoughtfully preparing the PPP loan forgiveness application. Don’t beat yourself up for that. Initially you could not qualify for employee retention credits if you also borrowed PPP money. So probably you or your accountant prioritized getting the PPP loan money. And then prioritized getting that loan forgiven. All that made sense. You want to remember all that if you inadvertently missed that opportunity.

And a second comment: As mentioned earlier, time is running out your ability to maximize your credits. If you want to use aggregation, for example, you need to finish an acquisition as soon as possible. Further, with regard to the PPP loan forgiveness, you probably need to apply soon for forgiveness if you haven’t already. The bottom-line in all this? You probably need to move fast to maximize employee retention credits.

A third comment which may be helpful to some readers trying to make sense of this crazy, new tidal wave of free money supplied by the federal government. Accept the free money element of this. Don’t try to make sense of what may not, once the dust settles, make much sense. The Congressional rationale here? Well, the Covid-19 pandemic restrictions coupled with reductions in consumer demand destroyed millions of small businesses. As I write this in July 2021, one source is reporting that nearly fifty percent of small businesses open in January of 2020 have now closed. And so what Congress did with programs like the Paycheck Protection Program and employee retention credits is shower small businesses with money to keep people on the payroll.

Need More Information or ERC Training for Staff?

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.

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 Three Tips for Bigger Employee Retention Credits 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.

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