I get asked this a lot lately. Here is what I think has happened. Back in Olden Times when I was working for a CPA firm and the Earth was cooling, earned income tax rates were 50% and unearned income rates were a whopping 70%! I’d ask successful clients whether they were considering expanding. Most said it wasn’t worth expanding because the risks were great and they wouldn’t be able to keep much of their money; most would go to the government.
These were also the days of tax shelters. Most tax shelters were either oil and gas deals or related to developing real estate. Tax shelters in those days provided write-offs far in excess of the amount invested, so they sheltered income that would otherwise be taxed at 70%.
During the Reagan administration, the tax code got the most extensive rewrite in my lifetime. Two big things happened. First, the tax rates for individuals were dropped to 15% and 28%, the latter being the maximum tax rate for an individual on any type of income. The second thing was the elimination of tax shelters. The ‘at risk’ rules reduced tax write-offs to the amount that was truly ‘at risk’ of being lost.
These changes incentivized business owners to expand and take chances. Deals were done for sound economic reasons rather than shams to shelter taxes. What followed was a period of prosperity in America.
I think people felt that at a 28% tax rate, it felt like a quarter for the government and three-quarters for me. The government took 28% and they kept 72% and that was perceived as fair.
Unfortunately, tax rates have crept back up. The marginal rate for individuals is 39.6% currently. And while 28% felt like a quarter, almost 40% feels like a half. For most people, half is too much for the government. And this is just the income tax. There is also self-employment or FICA taxes to pay, adding another 13 to 15% to the burden, and making the overall tax load over half.
In addition, if one is trying to grow a business, paying 40 to 50% to the government and then reinvesting the balance in the business is an awfully slow way to grow. The perception of most people is that this rate of taxation, with almost all tax shelters gone, is unfair. At least that is the impression I get from clients and other business owners.
What to do about this? Unfortunately, there aren’t a lot of other options. People are certainly getting more aggressive in the tax positions they are taking. Of course, it is a fine line between an aggressive position and tax evasion or cheating. Of course, I would never recommend cheating.
My first recommendation is to take care of the basics. Make sure you’ve got a flow-through entity to avoid double taxation. In most cases, you want to pay taxes as an S Corporation and to set the owner’s salary at the low end of the range that can be justified. This minimizes payroll taxes.
Real estate is still attractive, although not as good as in the old days. For many businesses, having the owner own real estate through an LLC and rent the property to the business they own makes sense.
There are also some very attractive retirement funding opportunities available with careful planning. There are some R&D tax credits and things like that, but they are relatively minor compared to the typical tax burden.
Sorry, I wish there were more.
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