The Importance of Converting Equity to Capital

Guy Baker By
Guy Baker

MBA, MSFS

 

  1. Introduction
  2. The Beginning
  3. Why have a business entity
  4. To Pass Through or not
  5. Closed Entities and Pass through entities
  6. The benefits of owning a closed entity
  7. The Three Circles of Wealth – The Common Denominator
  8. The Three Big Questions
  9. I. Creating and Retaining Value
  10. II. Keeping Superkeepers
  11. III. Exit Strategies
  12. Additional strategies to build and retain wealth
  13. Conclusion

 

The Benefits Of Owning A Closed Entity

Years ago, one of the main benefits to a C Corp was the ability to put significant contributions into a retirement benefit. In recent years, the IRS leveled the playing field. All contributions are the same regardless of the form of doing business. So a sole proprietor can put in the same contribution or have the same benefit as a corporation. The same is true of an LLC or a partnership. So this difference has narrowed significantly. There are only two remaining benefits but they are not significant enough to dictate one best entity. One is for executives of C Corps, who can deduct 100% of their medical costs, unlike a pass through which has no limitations. As the cost of health insurance benefits increase for older shareholder/employees, the ability to deduct 100% of the cost may be a valuable reason. But in the future, it is likely there will be a cap placed on these deductions just as the IRS has capped entertainment expenses at 50%.

One significant benefit of having a closed entity is the ability to use separate tax brackets to manage your tax liability. This allows you to move money from one year to the next through purchases and income timing. But in the final analysis, this is only a delaying tactic. The tax will ultimately be paid, the only question is when.

The Benefits Of Owning A Pass Through Entity

As we just discussed, with a pass through entity, there is no threat of being challenged on unreasonable compensation. But because it is possible to underpay yourself, the IRS could come in and actually cause you to increase your payroll compensation. This would be costly. S Corp compensation is an anomaly and will likely be rectified as the government seeks new sources of income. It is probable that dividends from a closely-held business could have the Medicare tax attributed to even the dividends. The theory would be all closely-held income is a form of compensation even if it is classified as a return on capital.

Building wealth in the corporate AAA account tax free ultimately becomes a benefit when you want to exit the entity. AAA is much better than facing a deferred tax liability when you liquidate a C Corp in an asset sale. If the sale is structured as an asset sale, the C Corp has to pay tax on the gain over basis and then you have to pay tax on the liquidation value. An asset sale in an S Corp eliminates this problem. Here the tax on any gain in the value of assets (such as land) will avoid tax at the entity level, but because the income passes through to the shareholder, the proceeds would be taxable at the personal level.

There is much written on the tax treatment of these entities and the pros and cons of pass through entities and closed entities. This little booklet was NEVER meant to be comprehensive. I just wanted to give you the highlights of the tax principles. The following pages will describe wealth building strategies and these basic tax strategies are important elements in that discussion.

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