About a month ago I discovered Mark Kohler on YouTube [1] who runs a little channel talking about wealth management. Once you watch a couple of videos you quickly see the pattern - the biggest cheat code to the US tax system is entrepreneurship and business ownership. But aside from that, it's shocking and eye-opening how many schemes (aka "legal structures") you can employ to preserve your wealth and reduce taxation which are available to everyone regardless of their social status. It's just that... most of us mere mortals don't know anything about them. In fact, some of this stuff seems borderline illegal, but it's not and it's been used by the wealthy to transfer wealth for generations. I think this just demonstrates yet another failure of the education system in the US.
> it's shocking and eye-opening how many schemes (aka "legal structures") you can employ to preserve your wealth and reduce taxation which are available to everyone regardless of their social status. It's just that... most of us mere mortals don't know anything about them. In fact, some of this stuff seems borderline illegal
Be careful. There are a lot of creative interpretations of the tax code out there that genuinely are illegal. People who employ them often assume they’re fine because they haven’t been audited or caught yet, but that doesn’t make them legal.
Always, always refer to a qualified accountant to review any tax strategies that seem too good to be true. YouTube is a fun place to learn about things, but the goal of YouTube producers is to get more clicks, not necessarily give the most accurate legal advice.
> People who employ them often assume they’re fine because they haven’t been audited or caught yet, but that doesn’t make them legal.
There's also the pack effect. Kind of like how few folks taking the EITC actively trade stock, it looks 'normal' for rich people to do these things, whereas the same device when used by someone of more modest means is more likely to attract attention.
Not to mention having fewer resources to fight if you are audited.
> Not to mention having fewer resources to fight if you are audited.
Can't find the link now, but I read somewhere that the IRS avoids audits if the risk of losing is higher (i.e. the person in question has more resources to fight it $). So their enforcement is heavily skewed towards average people.
Which corroborates this statement.
> more modest means is more likely to attract attention
The reason the IRS takes this tactic is it is literally underfunded. It does not have enough money to go after every millionaire and fight those court battles, even though there's a near certainty that it was in the legal right and enforcement of that type would bring back multiple dollars for every dollar spent on enforcement. The IRS does this calculus every single year, submits it as a report to the legislature, and then often has it's budget cut
I would argue that the failing is not in the education system, but instead that the tax structure of a country should not be built in such a way that those with the time and resources to spend can effectively game the system to pay significantly less of a percentage of their total wealth than those who are less wealthy.
Notice that the current infrastructure bill before the U.S. Congress includes a provision to increase enforcement resources for the IRS. Those resources have been cut considerably in recent years, and restoring them is expected to pay for itself several times over, by catching people cheating on their taxes.
Conservative groups are mobilizing to oppose increasing the funding:
"Fat cat" is a relative term. You might be surprised to know how many people of modest means think that every small business owner is a fat cat.
Hell, I used to own a single family house that I rented out and I had to listen to snarky comments from tenants who assumed I was rich. Newsflash: I'm not!
You can start an s-Corp, and as an employee of the Corp, you pay yourself a reasonable salary. Say 40% of gross (you'll pay social security, unemployment, etc as an employee drawing a salary).
Then as the owner of the Corp, your compensation gets distributed as a dividend. With a dividend, you don't pay taxes on FICA.
You'll save ~15% in taxes.
You could do this with a simple s-Corp created with LegalZoom. $400.
> You can start an s-Corp, as an employee of the Corp, pay yourself a “reasonable” salary on say 40% of the gross (pay social security, unemployment, etc).
> As the owner of the Corp, pay the rest of the comp as a dividend. Thus avoiding fica taxes.
Sounds good in theory, but if you're operating as a consultant, charging clients one rate, and then only claiming 40% of that is your "reasonable salary" then the IRS is likely to see right through your scheme. They can, and will, send the S-Corp a bill for unpaid taxes when they recharacterize those "dividend payments" as salary for you.
> You could do this with a simple s-Corp created with LegalZoom. $400.
Starting an S-Corp is only the beginning. S-Corps are legally required to do a lot of record keeping, paperwork, filing, and even hold shareholder meetings with recorded minutes. Yes, even if you're the only shareholder and you're meeting with yourself.
Some number of people do abuse the S-Corp status to dodge taxes by paying themselves in dividends with a token salary, but it's not an easy or risk-free tax dodge. The IRS may be understaffed for audits (for now) but they're not dumb when they actually start looking into these things.
> The IRS may be understaffed for audits (for now) but they're not dumb when they actually start looking into these things.
People don't get this. I have a family friend was was an IRS agent specializing in a few niche frauds. His personal caseloads pulled in 9-figure recoveries and a few criminal prosecutions a year. When he started in the late 80s, there were about 100 agents working those cases. When he retired a few years ago, it had attrited down to 4, and was doing half of the cases he had been due to the travel requirements for audit and court appearances, which could take him as far away as Guam or as close as in his backyard.
Definitely a super-smart dude, I remember going to parties with some of his work buddies and they were a unique group of really passionate nerds about tax and accounting issues.
You're both an employee and an owner of the Corp. And are entitled to benefits on each side.
Dividend distributions are a common means of compensation to share holders. You are an investor in the company.
Your usage of "scheme" is interesting and probably one of the many reasons why people like Bezos bring up so much vitriol when discussing taxes.
I see this approach as a perfectly legitimate, thoughtful structure to the issue of division between employee and ownership compensation. You see it as a "scheme".
Generally, if your S-Corps income exceeds the FICA threshold (currently $142,800), you must first pay yourself $142,800 as FICA-taxable salary before you can pay yourself a dividend.
If your one-person S-Corp doesn't reach that level of income, all of its earnings should be paid as a salary subject to FICA.
Also...S-corps don't pay dividends. I don't know who told you that. S-Corps are pass-through entities, so the portion of income paid to an owner other than as a salary retains the character it had when the S-corp received it, meaning that ordinary income to the S-Corp...is also taxable ordinary income to the owner.
Importantly, this taxation applies whether the S-Corp actually send the earnings onward to its owners. S-Corps, like partnerships, may then distribute this already-taxed income to its owners then or at any point in the future, and it will be tax free, because the owners have already paid taxes on it.
>Generally, if your S-Corps income exceeds the FICA threshold (currently $142,800), you must first pay yourself $142,800 as FICA-taxable salary before you can pay yourself a dividend
This isn't supported by Sean McAlary LTD, Inc. v. Commissioner, T.C. Summary Opinion 2013-62.
"The IRS, as it’s wont to do, argued that McAlary was not reasonably compensated, and once again, the Service took a scientific approach. Utilizing the same engineer employed by the IRS in JD & Associates and Watson, the IRS determined that $100,000 of the $240,000 distribution represented McAlary’s “reasonable” compensation."
>Generally, if your S-Corps income exceeds the FICA threshold (currently $142,800), you must first pay yourself $142,800 as FICA-taxable salary before you can pay yourself a dividend.
Source?
>If your one-person S-Corp doesn't reach that level of income, all of its earnings should be paid as a salary subject to FICA.
> if you're operating as a consultant, charging clients one rate, and then only claiming 40% of that is your "reasonable salary"
Why would that be off? 40% sounds exactly right; large consultancies pay their consultants 40% (or less!) of what they’re charging clients for said consultants’ time.
Maybe what you’re more concerned about here would be giving giving a 40%-of-revenue salary plus a 60%-of-revenue dividend. But the dividend wouldn’t be 60%. You, as the S-Corp, would be paying into all the regular withholding stuff companies have to pay into on behalf of their employees (social security, etc.). Ever heard the phrase “employing someone at a given salary, costs ≥200% of that salary”? It’s not far off.
My accountant working for respected accounting firm in my state literally told me to do this. I've spoken with others, and this is the exact advice they give to S-Corp clients.
I pay myself a "salary" of $60k and the rest (~$240k) is dividends. I pay my taxes quarterly too.
The FICA net benefit window for s-corps is pretty narrow in the face of the 199A deduction. I haven't run the numbers recently but s-corp doesn't make sense until you hit something like $100k gross income to start with because of the tax prep fees and then social security tax stops at $160k-ish of W2 income.
The 199A deduction lets most sole proprietorships deduct 20% of net income. S-corps can only deduct 20% of payroll.
There are certainly other benefits to operating as an S-Corp (using an HRA and HSA in the same tax year is a particular favorite) but the income/fica benefits are overstated these days.
An HRA lets you deduct 100% of qualified medical expenses by paying for them through your company. An HSA lets you deduct up to $7200 for future medical expenses.
In 2016 we deducted something like $40k off of our income between premiums, deductibles and copays (HRA) and maxing our HSA.
When I worked in a firm (doing tax law), I loved seeing posts like this online, because the idiots that followed this advice provided a steady stream of clients needing help with their IRS audits.
If someone actually does follow your advice they will be audited, they will owe penalties and back taxes to the IRS. This is also known as a "false tax return", and so the statute of limitations never expires and the IRS has until the end of time to audit the understated returns.
75% of households earn under $120k per year. With max 401k, HSA, IRA, standard deduction, and a couple other easy to use deductions, is it worth it for them to go through all that trouble?
It is also more work though. An S-Corp needs to have shareholder meetings, corporate bylaws, keep meetings minutes, final annual reports, requires a board of directors, and you have to be a US citizen/resident. These are all doable of course, but you have to make sure it's worth the tradeoff. The richer you are, the easier it is to hire someone to do all of this extra stuff for you.
Here's one - a Charitable Remainder Trust (CRT) allows you to donate your wealth, get a tax deduction on it and setup an income stream from it for as long as you're alive before the funds go to charity. This is highly simplified, but it's a way to avoid capital gains on your wealth and costs ~$3K to setup and doesn't require much "wealth" to begin with. How many people know about this? Probably very few. And that's my point.
> Here's one - a Charitable Remainder Trust (CRT) allows you to donate your wealth, get a tax deduction on it and setup an income stream from it for as long as you're alive before the funds go to charity.
The catch, of course, is that the funds actually get donated to charity in the end.
It's not so much that people are unaware that this exists. It's that it's not actually an attractive option for most people who wish to leave their inheritance to their children.
There is definitely a catch and the catch is that you still pay taxes on that stream of income, but not as much as you would have if you paid the tax on capital gains and yes, some funds still go to charity in the end. Like I said, my description was simplified for brevity. Here's the full video [1] about this as it pertains to crypto (but it doesn't have to). He goes into explaining how to actually distribute the wealth to your family after your death (via Irrevocable Life Insurance Trust) at the end of the video.
In all my years, anytime someone says there’s this easy way to avoid taxes that no one is taking advantage of, it is because there is a catch or downside that does not make it worth it to be popular.
In the internet era, information spreads pretty quickly, so I imagine a tax benefit will be quickly disseminated so either it is brand new or you should take it with a boulder of salt.
In this case, this seems like a pretty big drawback. And I assume sure you cannot just set yourself up as beneficiary.
> Charitable remainder trusts are irrevocable. This means that they cannot be modified or terminated without the beneficiary's permission. The grantor or trustor, having transferred assets into the trust, effectively removes all of her rights of ownership to the assets and the trust upon creation of its irrevocable status.
A tax haven LLC with one employee is going to be exposed as a sham by an audit. The wealthy need staff to run their operations and can credibly claim that they are a legitimate business.
This isn't entirely true, but it really depends on how you read OPs point. I know people who have LLC setup to buy rental property. At a very minimum they write off depreciation cost of the properties against their taxes. I wouldn't call it a tax haven LLC though.
You can write off rental property depreciation even if you don't have an LLC. Per my extremely limited understanding, the LLC provides a liability shield for your personal assets against litigious tenants (though it won't save you if there was genuine negligence). It can also hide your identity from people trolling property rolls to find wealthy people to sue.
Depends on state of incorporation. It's usually a low one-time fee -- Texas is $300. There's also no need to incorporate in a state you are physically present in, but it makes taxes simpler if the state you're in requires state income tax.
Setting up an LLC varies by state, but to pay someone else to do this for you (like LegalZoom) it's about $350 + $50 for an EIN. Then there's a filing you have to make every so-many years (like 10 years. I don't know how much that costs).
Others might simply refuse to take advantage of a loophole they don't consider right. People rallying under the "avoidance is not evasion" flag rarely seem to be terribly far from not minding a little taxdodging if they knew they wouldn't get caught, despite all their claims to never go beyond avoidance, but there are many who are not in that camp.
Has there ever been a state in recent history that simply refused to start the deduction game?
I agree - practical financial education is a huge, glaring omission from most curriculums. However, even if it wasn't, universal availability isn't a good argument for the societal benefit, morality, or legality of these practices, since to say they would still disproportionately benefit the wealthy would be an understatement.
Schemes that get more widely used are removed from the tax code and something else is put in their place. The fact their only used by a small percentage of the population is a feature not a bug. Governments spend mind boggling amounts of money, most people need to hand over a large fraction of their earnings or the system fails.
Apologies if the below comes across as inflammatory. It's not the intention, however it's largely the same as what you're saying, only how things actually play out in reality today. It doesn't need to be this way. It shouldn't be this way. Unfortunately, it is this way.
> Schemes that get more widely used are removed from the tax code and something else is put in their place.
Schemes that benefit the income-class are removed from the tax code
> The fact their only used by a small percentage of the population is a feature not a bug.
The fact they're only used by the very wealthy is a feature, not a bug.
> Governments spend mind boggling amounts of money, most people need to hand over a large fraction of their earnings or the system fails.
Governments are paid by the ultra weathly to siphon more money their way, most non-ultra-wealthy people need to hand over a large fraction of their earnings or the system fails.
Well, sure but I try and avoid inflammatory language when it comes to taxes etc. People get really uptight that of course X, when you bring up say ‘business shield their owners from liability’ like whatever is being discussed is some inherent property or the universe rather than simply a social contract subject to change.
People pretend anything that is currently benefiting them is simply a forgone conclusion in part to avoid having to defend it. Nobody wants to admit that say “companies should pay taxes” because incorporation brings benefits and those benefits should have an associated cost.
I use the liability thing because it’s such an old social contract. Plenty of more recent exceptions evoke similar responses from those who benefit.
The problem is you are trying to base a tax code on "should," which is why it's broken in the first place. The problem with taxing corporations is that it isn't clear cut what their income is. Individual income is much more easily defined, (even if it comes from distributions from corporations) so taxes that target individuals tend to be more successful.
I don’t mean should as in an ethical argument. Forcing people to do paperwork to get shielded from liability is simply less efficient than shielding everyone from liability. Yes the second option seems silly, but if there is zero costs to forming a cooperation then why would anyone refrain?
The only way such a system is a good idea is if there is some reason for people not to incorporate.
It is actually quite interesting what you can find on youtube these days. There are people that have instead purchased very cheap property and are living debt free. Those people are talking about society as still having slavery - in effect - because they realize, after their freedom, what it actually was the entire time. So it's not just about tax evasion or what have you, there are all sorts of ways to restructure one's life. We don't all need what we think we need.
> Those people are talking about society as still having slavery - in effect - because they realize, after their freedom, what it actually was the entire time.
Comparing a mortgage to slavery is wildly out of touch with the horrors of actual slavery. Let’s pick a different word to discuss the relative inconvenience of having to have a job in modern society.
Technically available to everyone. The issue is that > 90% of people have an income that is majority W-2 wages, and there isn't really a good way to avoid that.
Many people avoid a lot of taxes on their w-2 wages by not earning much money. They never develop much personal human capital. They don’t acquire specialized job skills. As a country the US should be more concerned about the fact that sixty percent of households don’t earn enough to sustain their lifestyle and receive large amounts of government aid in the form of services and transfers.
Alot of the "entrepreneurship" stuff is grey-area stuff that doesn't get enforced well due to complexity and de-funding of IRS enforcement. It's all good until it isn't.
The real "cheat" for US taxes is real property. At the small scale, you buy one of more multi-family properties and use cash rents and improvements to get rid of taxable income. At the larger scale, there are many different schemes to defer or eliminate tax liability. Looking at the business model for franchised hotels (Hampton Inns, Holiday Inn, Courtyards, etc) provides alot of perspective.
> It's just that... most of us mere mortals don't know anything about them.
It’s less that than that they’re not worth the trouble without a fair amount of capital at stake. It’s not worth hiring accountants and lawyers, setting up trusts, etc. if you don’t have enough tax savings to balance out those upfront costs – for many people, it’d be easier and a better return to put the same money in an index fund.
how many schemes (aka "legal structures") you can employ to preserve your wealth and reduce taxation which are available to everyone regardless of their social status.
It's not a massive news by any means. I know plenty of low income folks who use 1 member corporations to minimize their taxes. I mean, it's a pretty common knowledge.
Thanks for the link, I've been thinking a lot about this lately. Like:
- Why can Trump write off a $70k haircut but I can't write off a $35 haircut?
- Why can my employer buy my laptop, and I can use it in my off time for video games but if I buy a laptop, even to help with say an LLC I might own, I can only write off the 'portion' used for work?
- Why can my employer buy us lunch but if I work on my own I can't write off a meal except under specific circumstances?
At what point is a corporation able to do the above? Can other normal citizens also do it or is the system kinda rigged against us (even if unintentionally)?
>- Why can Trump write off a $70k haircut but I can't write off a $35 haircut?
Probably claims it as a necessary expense for being on TV.
>Why can my employer buy my laptop, and I can use it in my off time for video games but if I buy a laptop, even to help with say an LLC I might own, I can only write off the 'portion' used for work?
Stuff provided to employees for personal use is supposed to be taxed as a benefit. It's just likely that this hasn't been investigated by the IRS.
> - Why can my employer buy us lunch but if I work on my own I can't write off a meal except under specific circumstances?
That one's a can of worms and I know the rules have changed a number of times on this. You might consider inviting potential client to lunch. Then he or she might invite you next time as a potential vendor to lunch.
Similarly: company retreats, teambuilding exercises, and gifts to clients. Consult your tax professional.
[1] https://www.youtube.com/channel/UCHYeaAH3D-wzQyDiXndSfMA