Consider Joe. Joe is a consultant. He operates his business as a sole proprietorship. Joe does not have any employees. Joe makes a good living, taking home $300,000 per year. Joe files a joint return with his wife, a stay at home mother. For purposes of simplicity, Joe takes a standard (non-itemized deduction).
Let’s consider Joe’s tax situation. As a sole proprietor, Joe has to pay federal income taxes, state income taxes and payroll taxes. As a sole proprietor, all of Joe’s income is subject to payroll tax. In addition, because Joe has no employees he is unable to take advantage of the new tax rules which allow up to a 20% deduction against the income of sole proprietorships and other “pass through entities.” How does this play out for Joe? Joe pays $24,658 in payroll taxes since all of his $300,000 income is subject to payroll tax. Joe pays $54,819 in federal income taxes and $21,597 in California income taxes. All totaled, Joe pays $101,075 in taxes – more than 1/3rd of his total income. What can Joe doe? Under the above facts, Joe can save approximately $21,358 in taxes by incorporating and hiring himself. How does this work? First, Joe creates a statutory “close” corporation called Joe, Inc. Close corporations can be run more like a partnership or sole proprietorship without the need for messy corporate formalities, such as shareholder meetings, board meetings, officers, and the keeping of minutes. Second, Joe elects S-Corp status for Joe, Inc. This avoids the double layer of taxation for C-Corporations. Third, Joe, Inc. employs Joe for a reasonable salary of $100,000. What are the results? First, Joe saves a considerable amount on payroll taxes. Because Joe is now a W-2 employee, only $100,000 is subject to payroll tax. The delta between Joe’s income and Joe Inc.’s net income is passed through as profit to Joe and is not subject to payroll tax. Total payroll taxes are just $15,300, saving $9,358 right off the bat. Second, under the 2018 federal tax reform bill, the IRS (not California, unfortunately) allows qualified businesses (including S-Corps, limited liability companies and sole proprietorships) to deduct the lesser of 20% of their income or 50% of all W-2 wages. Here, Joe, Inc. is paying Joe $100,000 per year. The lesser of the two amounts is $50,000 (50% of $100,000, as opposed to $60,000 which is 20% of $300,000). This deduction lowers Joe’s taxable income to $250,000. The net result is $42,819 in federal income taxes, a savings of $12,000. By incorporating and paying himself a reasonable salary, Joe pays just $79,716 in taxes, a savings of $21,358. Costs of Running an S-Corp. Against these savings, there are some added costs. California imposes a $800 per year tax on S-Corps. In addition, California imposes a 1.5% tax on the net income of an S-Corp, which in Joe, Inc.’s case would be 1.5% of $200,000, or $3,000. After accounting for the increased cost of $3,800, Joe’s net tax savings by incorporating is $17,558 or $1,463 per month. Why can’t Joe set up an LLC? Certain professionals (including real estate brokers) can only be organized as a corporation, not a limited liability company. However, even for those professions which allow limited liability companies, the above strategy only works with a corporation. This is because members of LLC’s cannot, by definition, be employees of the same LLC. The only entity which can employ its owner is a corporation (including an S-Corp). Employing Joe is the only way to reduce payroll taxes and get an entitlement to the new deduction for pass-through entities. Caveats. The payroll tax savings in this analysis can be achieved by incorporating and hiring the owner as an employee for a reasonable salary. What is “reasonable” depends on the facts and circumstances. However, for purposes of federal income taxes, for most “service providers” (i.e., accountants, lawyers, brokers, advisers, consultants, etc.) the ability to deduct upwards of 20% of income under the new tax law gets limited and then eliminated as one’s income rises. The current limit for joint filers is $315,000 (and $157,500 for single filers). Between $315,001 and $415,000 (for joint filers) and $157,501 and $207,500 (for single filers) the deduction gets reduced under a very complex calculus. Over those amounts, the deduction, unfortunately, goes away entirely. How to do this? Below is a step by step guide to taking advantage of these potential tax savings: 1. Create close corporation by filing articles of incorporation with the Secretary of State; 2. Draft bylaws and initial corporate resolutions; 3. Draft shareholder agreement between the shareholder and the company; 4. File election to be taxed as an S-Corp; 5. Apply for and obtain a federal tax identification number; 6. Set up a payroll account and pay yourself a "reasonable" salary.
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Corporations are generally thought of as being less flexible than partnerships or limited liability companies. For example, all corporations are run by a board of directors who have regular meetings. The board is elected by the shareholders at an annual meeting. The board then appoints officers who run the day to day operations of the corporation under the board’s direction and supervision. Corporate minutes of the shareholder and board meetings are required. The failure to follow these “corporate formalities” can lead to “piercing the veil” – i.e., exposing the shareholders to personal liability.
These corporate formalities pose challenges, especially in smaller corporations (and especially in corporations with a single shareholder). For example, the sole shareholder is forced to go through the farce of holding a “shareholder meeting” to elect himself or herself to the board. The same person then holds a “board meeting” and appoints himself or herself as the president, treasurer and secretary of the corporation. And all the while, minutes of the “meetings” must be kept. Incorporating as a partnership or a limited liability company is not always the answer. In some cases, choosing a corporation over a partnership or limited liability company makes good tax sense. In other cases, certain professions are required to be corporations. Real estate brokers in California, for example, cannot operate as a limited liability company, only a corporation. One solution to this problem may be a statutory “close” corporation. Close corporations are not new in California, but they are used less than one might imagine. If a corporation becomes (or converts to) a close corporation, the failure to follow the above corporate formalities cannot be used as a basis to “pierce the veil” and go after the shareholder(s) personally. In addition, a close corporation may enter into a “shareholder agreement” which vests management and control of the company in a “manager” (or managers) – thus virtually eliminating the need for a board of directors and corporate officers. The manager(s) takes total control of the corporation, thus allowing the close corporation to be run more like a partnership or limited liability company, as opposed to a publicly traded corporation. Becoming a close corporation (or converting an existing corporation into a close corporation) is a fairly easy process. A close corporation does have some limitations – namely, the corporation cannot have more than 35 shareholders. For most small corporations, this is not an issue (and even if it became one, you can covert back to a regular corporation). Two other items are worth noting. First, a close corporation is – for all intents and purposes – the same as a “regular” corporation. The only difference is the fact corporate formalities need not be observed and the corporation can enter into agreements with its shareholders which alter how the company is operated and managed. Second, a close corporation is not the same as an S-corp (although many close corporations will elect to be taxed as an S-corp). If you incorporate as a close corporation, you will still need to elect to be taxed as an S-Corp. If you convert to a close corporation and are already an S-corp, you do not need to do anything. Many are aware that the Tax Cuts and Jobs Act of 2017 (TCJA) significantly reduced corporate tax rates. To achieve some degree of parity for pass-through entities (like limited liability companies, S-corps and sole proprietorships), the TCJA also includes a “qualified business income deduction” (the QBID) which can, in some cases, equate to a 20% deduction against income from pass-through entities.
The Basics. The QBID is incredibly complex, but understanding the new deduction is not as complex from a 10,000-foot level. Under the TCJA, a deduction is allowed against “qualified business income” (meaning income from a pass-through entity or sole proprietorship) in an amount equal to the lesser of: · 20% of the taxpayer’s qualified business income; or · 50% of the W-2 wages with respect to the qualified trade or business. An Example. Let’s take a simple example to show how this works. Suppose John runs a widget company known a Widgets, LLC. John is unmarried and is the sold member of Widgets, LLC. John has one employee whom he pays $50,000 per year. The net income from Widgets, LLC is $100,000 which passes through to John on his personal return. Under the TCJA, John is entitled to a deduction equal to the lesser of 20% of the net income from Widgets, LLC, or 50% of the W-2 wages paid by Widgets, LLC. Here, the lesser amount is $20,000 (20% of $100,000 net income) as opposed to $25,000 (50% of $50,000 W-2 wages). The deduction would reduce John’s taxable income from $100,000 to $80,000 and would result in a federal tax savings of $4,750. Service Entities. The situation is a bit different for certain for certain “service” entities. This includes professionals such as lawyers, accountants, brokers, financial planners and others whose income is derived primarily from the provision of services (as opposed to selling things). (Apparently the architects and engineers have a powerful lobby since they have been expressly excluded from the definition of “service” entities.) For service entities, the ability to claim the QBID deduction is capped at certain income levels -- $157,500 for single filers and $315,000 for joint filers. If the service partner’s income is below these amounts, he or she may claim the deduction in full. The deduction is phased at incomes between $157,500 and $207,500 (for single filers) and $315,000 and $415,000 (for joint filers). Above that, no deduction is allowed at all. Planning Opportunities. As can be seen, the ability to claim any deduction requires the existence of W-2 wages. This may present problems for sole proprietors and single member LLC’s. One way to solve this is to create (or convert into) an S-corp. The S-corp could then pay the owner a “reasonable salary” and that can be used as a basis for getting the needed W-2 wages to claim the deduction. What happens when grapes under contract are damaged (but not totally destroyed) by fire or smoke?10/18/2017 The Napa and Sonoma fires have destroyed thousands of properties. This post addresses the obligations of the buyer and seller when grapes are damaged (but not destroyed) by the fire. Even for those vineyards not destroyed by the fire, the smoke from the wine county fires may cause “smoke taint” which can seriously affect the quality of the grapes. Many of these grapes and wines are under existing contracts of sale.
As in the case of a complete destruction of the grape crop, the seller should notify the buyer when the seller first becomes aware of the problem. Under the California Commercial Code, anything less than “perfect tender” (i.e., grapes meeting the exact specifications of the parties) is a breach of contract. In the event of a breach, the buyer may recover damages, generally the difference between the contract price and either the price at which the buyer bought substitute grapes or the fair market value of the grapes. The buyer is also entitled to consequential damages to the extent they were foreseeable. This might include lost profits suffered on the buyer’s end as a result of the defective grapes. In order to recover damages, the buyer must mitigate its damages. This means attempting to purchase substitute grapes. It may also mean selling the damaged grapes if they are in the buyer’s possession and at risk of perishing or further deteriorating in quality. Section 2613 of the California Commercial Code may also apply and has slightly different rules. Where goods are identified (e.g., grapes from a certain vineyard), the buyer has a right to demand an inspection. Thereafter, the buyer can cancel the contract or accept delivery. This can be done either in whole or in part. If the buyer cancels the contract, neither party has any additional liability. If the buyer accepts the grapes in their non-conforming/damaged state, the buyer is entitled to an adjustment in purchase price, basically the difference between the price of the grapes as promised and the price of the grapes as delivered (in their damaged state). The buyer in this case would not be entitled to consequential damages (as the buyer might be in a case where Section 2613 does not apply). In addition to grape purchase contracts, the above rules also apply to a custom wine making agreement whereby the seller agrees to sell finished wine to the buyer under the buyer’s label. These agreements can sometimes be more detailed than a grape purchase agreement (especially with respect to the quality and specifications of the finished product). In all cases, reference must first be made to the terms of the written agreement itself which may expressly or implicitly allocate the risk of loss in a different manner. Many of these agreements have detailed dispute resolution procedures and (sometimes) limitations of liability (e.g., disclaiming consequential damages and the like). Most grape purchase and custom winemaking agreements have force majeure clauses. It is important to review this language. For example, clauses only apply if the seller’s operations are suspended for things like fire and would not cover things like smoke damage to the grapes or the wine. The Napa and Sonoma fires have destroyed thousands of properties. This post addresses the obligations of the buyer and seller when grapes or vineyards are destroyed by fire.
The wine country fires destroyed many vineyards. In many cases, the grapes had not yet been harvested, resulting in a total loss of the 2017 crop. Many of these grapes were under contracts of sale. The seller/vineyard owner (obviously) cannot perform. The first thing which should be done is for the seller to notify the buyer as soon as possible of the destruction of the grapes. Upon receipt of such notice, the buyer has a duty to mitigate damages. Generally, this will mean attempting to purchase grapes from another source. Unless the grape purchase contract allocates losses in a different manner, in most cases, the seller’s performance should be excused. There are a number of ways to reach this result. First, under Section 2613 of the California Commercial Code, where goods are identified (e.g., grapes from a certain vineyard), the total loss of such grapes results in the termination of the contract without any further liability. If, however, the loss is partial (e.g., half of the vineyard is destroyed), the buyer may demand an inspection, and thereafter, either cancel the agreement, or accept the undamaged grapes with an allowance in the purchase price for the decreased quantity. Second, under Section 2615 of the California Commercial Code, if the seller is unable to perform due to the occurrence of a contingency (i.e. a fire) the non-occurrence of which was a basic assumption on which the contract was made, the contract may be avoided. This is the defense of “impracticability.” Third, many grape purchase agreements have a force majeure clause which can likewise excuse performance. A typical force majeure clause can read something like the following: “If either Seller or Purchaser is unable to carry on its normal operations or is compelled to reduce or suspend its operations because of forces beyond its immediate control, including but not by way of limitation, laws, regulations, court orders, labor disputes, breakdown of machinery, lack of transportation, interruption of power, fire, catastrophe, earthquake, war, civil commotion, quarantine, weather, drought, frost, and other action of the elements, crop failure or shortage, Act of God, or other matters beyond its immediate control, then the party so affected shall, while so affected, be relieved to the extent it is prevented from performing its obligations hereunder, but in such event, said party shall take reasonable measure to remove the disability and resume full performance at the earliest possible date.” In the event a part of a vineyard was destroyed, and more than one buyer had contract to purchase grapes from that vineyard, the seller is required to allocate between the multiple buyers in a reasonable manner. The seller is also required to notify the buyers of their respective expected quotas. The Napa and Sonoma fires have destroyed thousands of properties. This post addresses the obligations of the insured following a loss.
Immediately a loss occurs, the insured has a duty to mitigate further damage. Stated differently, the insured has an obligation to take steps to prevent further damage to the property. The failure to mitigate further loss is a ground for denying coverage. As soon as possible after a loss, the insured must notify the insurer or the insurance agent of the loss. This is called a “notice of claim.” Typically, the policy does not prescribe a specific time-period for providing the notice of claim (e.g., 15 days after the loss). Rather the policies usually require notice “without delay”, “immediately” or “promptly” after the loss. The failure to promptly provide notice of claim is not a ground for denying coverage unless the insurer was actually and substantively prejudiced by the late notice. Note, however, that Insurance Code Section 550 provides that in cases of fire insurance, an “unnecessary delay” in providing notice will exonerate the insurer (although courts have found ways around this). After the notice of claim is made, the insurer must commence an investigation of the claim. The insurer is also required to provide receipt of the notice of claim within fifteen days. After the notice of claim is made, the insured is required to submit a “proof of loss.” This must generally be submitted “without unnecessary delay” or within a set time period (e.g. 60 days). The proof of loss must include a complete inventory showing in detail the quantities, costs, actual cash value and amount of loss claimed. In addition, the insured must submit a sworn statement providing the time and origin of the loss, the interest of the insured in the lost property, and the actual cash value of each item and amount of loss. The proof of loss must be made on the best evidence available to the claimant at the time it is submitted. This does not mean you need proof like what you would provide at a trial. Nevertheless, substantial compliance with the proof of loss provisions is required. A proof of loss which fails to provide the basic information and required documentation has been held to be a material breach of the insurance policy and negates the insurers obligation to indemnify for the loss. The insurer is not obligated to indemnify if no proof of loss is filed. The insurer may object to a proof of loss on the basis of incomplete descriptions or omissions. The claimant has a reasonable time to provide a supplemental response. Any defects not objected to by the insurer are waived. The insurer may not object to a proof of loss based on issues of credibility. The insurer will sometime prepare its own proof of loss based on the information provided to it by the claimant. They will then send this to the claimant asking them to sign it. Unless you believe the insurer is so generous that it is trying to maximize your recovery, instead of minimizing their own exposure, do not sign the insurer-provided proof of loss. You have the right to submit your own estimates. In the event your estimates are higher than the insurers, the insurer must either: (i) pay the higher amount, (ii) provide the claimant with the name of a person or entity who agrees to perform such repairs at the insurer’s cost estimate, or (iii) make written adjustments to the claimant’s estimates and provide a copy of such adjustments to the claimant. Throughout the process, the insured has a duty to cooperate with the insurer. The insurer is entitled to review your books, records and other documents. It is entitled to talk to you and your employees and others with knowledge of the loss. Upon demand, you are also required to submit to an examination under oath (similar to a deposition). There are reasonable limits to what the insurer can and cannot demand (e.g., they must have some relevance), but typically, the insured is advised to cooperate to the extent possible. The failure to cooperate with the insurer will void coverage if the insurer can establish it was substantially prejudiced by the failure to cooperate. In any event, the insurer’s duty to pay is suspended until such time as the claimant adequately cooperates. The claimant has the right to see all claim related documents. Upon demand, the insurer must provide, within 15 days, all bids and estimates, appraisals, third party findings, all reports and drawings and all valuation and loss adjustment calculations. Almost all policies have statutes of limitation saying when a lawsuit must be filed against the insurer. Homeowners’ policies generally have a two-year statue of limitations; other property insurance policies often have a one year statue of limitation. The limitations period typically runs from the date of loss. The limitations period is tolled (i.e. suspended) during the time period from when the notice of claim is made and when the insurer unequivocally denies coverage. In the event there is a dispute as to the valuation of the property (as opposed to the existence of coverage or another policy related dispute), both the insurer and insured have the right to commence an appraisal process to determine the amount of loss. The Napa and Sonoma fires have destroyed thousands of properties. This post addresses the obligations of insurers under California’s Fair Claims Settlement Practices regulations (the “Regulations”).
The Regulations prohibit an insurer from doing a number of things, including: (i) discriminating on the basis of sex, race, religion, property location and additional factors, (ii) failing to notify a claimant of the benefits under a policy, the coverage under a policy and applicable time limits for acting, (iii) requiring the claimant to submit a notice of claim or proof of loss within a specific time (unless the policy itself contains such a time limit), (iv) making a partial payment accompanied by language releasing the insurer unless the policy limits have been paid or the parties have entered into a mutual settlement of the claim, and (v) requiring the claimant to submit to a lie detector test. The Regulations also provide specific notice requirements and time periods for acting. For example: · The insurer must acknowledge receipt of a notice of claim within 15 days of receipt; · The insurer must respond to any correspondence from the claimant within 15 days (if the correspondence seeks a response); · The insurer must commence investigation of the claim within 15 days after receiving the notice of claim; · The insurer must accept or reject a claim no later than 40 days after the claimant submits a proof of loss (although the insurer may extend this time period by giving written notice every 30 days in the event the insured has not submitted sufficient information); · The insurer must tender payment of the undisputed portion of a settlement payment within 30 days. The Regulations impose additional substantive requirements on insurers. An insurer is prohibited from making an “unreasonably low” settlement offer. The insurer is prohibited from requiring the claimant to use a particular person or entity to perform the repairs (although they may make recommendations). If the insured submits a higher repair estimate than the estimate prepared by the insurer, the insurer must either: (i) pay the higher amount, (ii) provide the claimant with the name of a person or entity who agrees to perform such repairs at the insurer’s cost estimate, or (iii) make written adjustments to the claimant’s estimates and provide a copy of such adjustments to the claimant. The insurer is also required to notify the claimant of the benefits under the policy, the coverage under the policy and any applicable time limits for action. The failure to do so is a prohibited act under the Regulations. With respect to actual cash value policies (as opposed to replacement cost policies), the carrier has the burden of justifying any depreciation in an itemized and explicit manner. This must be explained to the claimant. The cost of labor is not included in any depreciation deduction. If a claim is denied or rejected, either in full or in part, the insurer is required to, amongst other things, provide a factual and legal basis for the denial, including citations to applicable statutes and/or the policy language itself. The Napa and Sonoma fires have destroyed thousands of properties. Most homeowners’ insurance policies include coverage for living expenses, such as rent and food. This post addresses the tax ramifications of such payments.
Unless the loss occurred in a federally declared disaster area, if the living expense insurance payments are more than the temporary increase in your living expenses, the excess is taxable as ordinary income. This rule can best be explained by means of an example. Assume your normal living expenses (rent and food) are $1,000 per month. As a result of a fire, you are forced to move into a hotel and your living expenses (hotel and food out) are $2,500. The difference between your normal living expenses and your actual living expenses is $1,500. This is called your temporary increase in living expenses. If you receive $2,000 from your insurer for living expense, you would have $500 in income. This is the difference between the insurance proceeds received ($2,000) and the temporary increase in living expenses ($1,500). The Napa and Sonoma fires have destroyed thousands of properties, including many businesses and commercial properties. This post addresses standard “business interruption” coverage in commercial property insurance policies.
The standard policy language indemnifies the insured for business interruption “during the suspension of operations during the period of restoration.” The suspension of operations must be caused by covered physical loss to property of the insured at the insured premises. Stated differently, the business interruption must be caused by damage to your property. In addition, the coverage is only triggered if there is a complete suspension of operations. There is no coverage for a business slowdown or for the interruption of a specific project or contract. For example, in one case, a law firm’s building was flooded, but since the lawyers were able to generate billable hours during that period (albeit at much lower hours than normal), no coverage was allowed. Business interruption generally indemnifies the insured for net income lost and ordinary operating expenses until such time as the property is restored. Some policies limit the time period, for example, only covering the first twelve months, even if the premises are not restored and business has not commenced again. Occasionally, the policy itself will set the amount recoverable (e.g., $1,000 per day), although usually amount of the insured loss is determined after the loss. In this case, the insured has the burden of proving its lost net income and operating expenses. Because the insured has the burden of proof, it is imperative to have an accurate accounting to prove the net profits of the business when submitting a proof of loss. It is also imperative to understand the different coverages, endorsements, limitations and exclusions so the proof of loss can be drafted to account for these issues. Additional coverages include extra expense coverage (such as the cost of relocating or hiring additional labor). Rental coverage may also indemnify landlord form lost rental income (even, in some cases, if the property was not leased at the time of the loss). The Napa and Sonoma fires have destroyed thousands of properties. This post addresses the loss settlement provisions in property insurance policies. Loss settlement refers to the valuation method used to compensate the insured for a covered loss.
The statutory default rule provides that the insured will be indemnified for the “actual cash value” of the lost property. In the case of a total loss, this means the fair market value of the lost property. In the case of a partial loss, this means the cost to repair, replace or rebuild the lost property, less depreciation. The insured has the burden of proving the fair market value or cost of repair. The insurer has the burden of proving the amount attributable to depreciation. Some policies alter this rule by providing for replacement cost coverage, which does not include any deduction for depreciation. There are three types of replacement cost coverage. Standard coverage covers the replacement cost, up to the policy limits. Extended replacement cost covers the replacement cost, plus either a fixed dollar amount or percentage amount above the policy limits (e.g., 150% of the policy limits). Guaranteed replacement cost covers the full cost of the repair or replacement irrespective of the policy limits. Although the insured is not required to rebuild the lost property, many policies allow the carrier to withhold the difference between the lower actual cash value of the property and the higher replacement cost until such time as the repairs or replacement is complete. In effect, if the insured does not repair or replace the damage property, they may be limited to the lower actual cash value. In addition, many policies impose time limits. For example, some policies require that the insured enter into a contract to perform the repairs within a fixed amount of time. Other policies require the insured to complete the repairs within a fixed time (at least 12 months, or 24 months in the case of a state declared emergency). The failure to meet these conditions could result in a waiver of the increased replacement cost. Another issue with replacement cost involves the cost to comply with new building codes and laws. Most policies (through different provisions) do not cover the increased cost of complying with new building codes. Stated differently, they will pay to replace to repair the property as it was built (not at today’s cost which would reflect additional building code requirements). Some policies have an “ordinance or law” endorsement which does indemnify the insured for the increased cost of rebuilding to current code. Before preparing a proof of loss, it is imperative to understand the coverages and possible limitations or exclusions so these issues can be addressed from the outset with the carrier. |
blogHi. I'm Stephen Flynn. Attorney and founder of the Law Offices of Stephen M. Flynn. This is my blog. Enjoy! Archives
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