This is why working with a financial planner that has a tax background is critical. Lionshare Partners LLC was registered to do business on December 12th, 2017 and less than two months later one of my blogs is already obsolete. I recently wrote about the decisions behind choosing a S Corp or C Corp as the entity for your operation. Well with the new tax law dropping the top corporate rate to 21% and shuffling the deck on tax strategies it is critical you meet with your tax advisor soon to discuss the best situation for your ongoing enterprise. After all, as your business grows and evolves, what is the likelihood that the same choice of entity that worked for you five years ago still works today?
And what’s funny is for the last 31 years, the choice of entity for the majority of entrepreneurs has been a binary one: they will be an S corporation, or they will be a partnership (LLC). Why? Think about the pre-2018 corporate landscape: corporate-level income was taxed at 35% (compared to top tax rate of 39.6% for individuals). A subsequent distribution of cash was taxed to the shareholder at a top rate of 23.8%. And a distribution of appreciated assets by a corporation to a shareholder was treated as if the corporation sold those assets for fair market value.
So, the question you need to ask when meeting with your tax advisor is “Should my business be a C Corp?” There are several reasons to consider the move besides the lower tax rate on profits. For example, the cash method of accounting is now available until average gross receipts exceed $25 million. Tack on the benefits of the new 100% asset expensing rules, a top corporate rate of 21% on personal service businesses, the doubling of the estate tax exemption, and the pre-existing benefits afforded only to C corporations that tax reform did nothing to dilute: For example, the ability to provide tax-free fringe benefits to shareholder/employees, and an exclusion from gain on the sale of stock held longer than five years under the recently-expanded Section 1202. Add all these things up, and C corporations can no longer be an afterthought.
Yes, ask your tax advisor about the Section 1202. This is one of those crazy capital gains exclusions exploited by Private Equity firms and often missed out by ordinary small business owners. But the Section 1202 allows the potential to sell your C corporation stock after five years without paying tax. Yeah, you heard me!
Make sure you run some long-term (10 year) projections with an exit (liquidation event) to truly see which entity works best for you. Because a C corporation might “lose the battle” each year relative to flow-through entities by paying slightly more in tax, the owner of that C corporation can sell their stock (Section 1202) and exclude the gain under Section 1202 (not available to S corporations or partnerships). That large tax savings at the exit could be ultimately matters in terms of overall tax savings.
Generally speaking, the two levels of tax would still make a corporate operation less advantageous than a flow-through entity. However, if you do not pay out dividends–and are rather planning to re-invest a majority of profits back into the business as part of a long-term strategy (like a manufacturer) –then the C corporation is a solid option. If you have multiple business lines under one entity, it could make sense to break them into separate businesses to take advantage of the reduced corporate rate and other aspects of the new law. Consequently, corporations with shareholders taking significant bonuses at year-end will not necessarily benefit by a move to a C corp because some of those bonuses will have to be treated as dividends.
Other items to consider before changing your business taxing structure include:
- Owners’ ability to deduct losses at personal level with pass-through treatment versus having the losses trapped inside the C-Corporation structure.
- Lack of step-up on sale for buyer.
- Accumulating appreciable assets C-Corporation, double taxation structure.
Be mindful if you are on the “I got screwed list” under the new tax code that do not qualify for the pass-through deduction. This list is corporation that are professional services — which could encompass legal counsel, financial consulting, athletes, doctors, or freelance design work. If this applies, you should consider taking the time to re-organize, and there are workarounds to avoiding being double taxed.
Lastly, for those who wish to move quickly, the process of converting to a C corporation could theoretically take less than a week. California is one of the states that allows for “statutory,” or streamlined, conversions. Briefly, to convert a California LLC to a California corporation, you need to: adopt a plan of conversion; and file Articles of Incorporation containing a statement of conversion with the Secretary of State.
This is an important distinction and should be understood prior to getting your revocable living trust reviewed by an Estate Attorney. A Trust Amendment is a legal document that changes specific provisions of your trust but leaves all of the other provisions unchanged. This is useful for minimal changes – adding or deleting specific bequests (property you think you kids want but can careless about), changing successor trustee, updating beneficiaries/successor trustee’s legal name due to marriage.
Contrast that with a Trust Amendment and Restatement, which completely replaces and supersedes all of the provisions of the original Revocable Living Trust. The closest analogy I have for a restatement is when your grandpa loses his cool playing Monopoly and flips over the board. So the restatement is useful for significant changes – adding a new spouse as a beneficiary, completely cutting out a beneficiary, changing from distributions to children to distributions to charity (or vice versa). Also if you have already made 3-4 simple trust amendments over the last decade and you’re going to make another change then consider consolidating all of the changes with a complete amendment and restatement. This will make it easier for the successor trustee (generally you kids) by having a single document rather than a bunch of separate amendments.
A couple of housekeeping items. You don’t change the original name of date of the trust with either an Amendment or Restatement. This is so you don’t have to re-fund (title property to the trust) the trust. Don’t make the changes yourself and slip it back into the drawer. Work with an estate attorney to prepare the Trust Amendment because the it must be signed with the same formalities as the original trust agreement. So let’s not potentially void or have your trust ignored.
This is an interesting question and depending on who you talk to will probably result in dramatically different answers. Attorneys tend to push for the Limited Liability Company (LLC) more than necessary, and insurance brokers tend to push for more insurance coverage than necessary. Therefore, some people will advocate for a “belt and suspenders” approach of having both a high amount of liability insurance and an LLC. Well, the cost of both insurance and an LLC ($800/yr in CA) plus the cost of a property management firm (8 – 12% of the monthly rental value of the property, plus expenses) will significantly decrease the profitability of your properties. A lot of investors form an LLC as a magic solution. A few clicks of the mouse on Legal Zoom, pick a cool sounding name, get some business cards and website, and suddenly you have your foolproof LLC. This is the reason most estate investors want an LLC. Limited Liability means that owners of an LLC cannot be held liable for acts or debts of the LLC. If the LLC is sued, the plaintiff could potentially win a judgment for the value of everything owned by the LLC, but the plaintiff can’t go after the financial assets of the owners of the LLC.
So, let’s take a step back and explain what an umbrella policy is. An umbrella policy is an additional layer of protection on top of your existing insurance policies. It provides protection against a wide variety of perils across all your assets. Let me give you an example:
Chad owns a rental property with $250,000 of equity and has a landlord policy with $500,000 of liability coverage and an umbrella policy with an additional $1,000,000 of coverage ($10k deductible). The current tenant has a party with people on the upstairs balcony. The balcony collapses, causing serious injury to 7 people. Chad gets sued for $1,650,000. The first layer of protection is the rental dwelling insurance covering the first $500,000. After paying the $10k deductible, your second layer of defense, the umbrella policy, pays the next $1,000,000. Chad would then be left with a total out-of-pocket liability of $150,000.
When reviewing my client’s insurance policies, this is a risk exposure that tends to be underfunded and tends to be the least understood. Not all umbrella policies are the same, and these are insurance companies and not charities. So, they are also in the business of risk, so they will exempt and/or exclude items that you assumed were covered. It’s best not to wait until a claim is filed before figuring out if it is covered. With that said, there are (3) great advantages to having an umbrella policy:
- Protection that travels with you – An umbrella policy provides a very comprehensive layer of protection against threats you might not have any protection from today. It provides insurance against incidents that happen away from home (your dog bites somebody in a park), libel and slander, and a variety of threats to your finances that aren’t protected through other mechanisms.
- It is cheap and simple – I’ve found coverage for a $1,000,000 umbrella policy for as low as $250/year, and the cost goes down the more coverage you seek. Coverage for a $10,000,000 umbrella policy is available around $1,000/year. It is also really simple to manage. One check, one company, for covering both your personal and business (rental properties) liabilities.
- Covers all your properties, regardless of location – An umbrella policy will cover all your rental properties throughout the U.S., regardless of what state they are in. An LLC is specific to the state it’s formed in. If you have an LLC formed in California and you want it to operate in Texas, you’ll need to file paperwork (and pay fees) to register the LLC in Texas. If you’re going to file paperwork to allow your California LLC to operate in Texas, you might as well just create a new LLC in Texas and have a bit more protection.
Remember the first layer of protection as a landlord is through your rental dwelling insurance policy (landlord policy). Note that a rental dwelling insurance policy is a different policy from the homeowner’s policy that you have on your primary residence. A homeowner’s policy insures not just your house, but also your furniture, clothing, etc. The rental dwelling insurance policy only covers the actual structure, but it does provide higher liability insurance. It’s also important to note that your insurance company provides legal representation in addition to the stated coverage and your insurance company has no incentive to negotiate a settlement at any amount over their stated coverage. This means that you’ll still need to hire a lawyer if you’re sued for an amount greater than your landlord policy + umbrella policy. I recommend my clients require that their tenants carry renter’s insurance. A renter’s insurance policy will cover their possessions as well as provide some liability insurance for incidents that happen on the property that they are responsible for. If the renter has insurance, there is less reason to go after you and their insurance means you’re less likely to be sued.
Since the most likely scenario is one where there are no issues and no claim, the vast majority of individual investors are better off with an umbrella policy. If you have lots of individual rental properties, then the LLC fees could eat into your profits if you have a separate LLC per property. The fees vary from state to state, and some are more expensive upfront, some are more expensive each year, etc. There is an initial filing fee to set up the LLC, an LLC formation fee ($200-$1,000), and a licensing fee for each year the LLC is active.
- Arizona – Both low initial cost & low yearly cost
- Texas – High initial cost ($300), No yearly cost (assuming revenue <$300k)
- California – Low initial cost, high yearly cost ($800)
But you can’t be cheap and try to cram multiple properties into a single LLC because you are losing much on the protection of having an LLC in the first place.
If you have a small number of large or valuable properties (significant equity), then an LLC doesn’t help much because most of your net worth is probably already tied up in the property. If you have a mortgage-free $5,000,000 duplex in Santa Monica and get sued, even though you had an LLC you can still lose the property in a judgment and be effectively wiped out financially.
A scenario where having an LLC makes sense is if you have lots of expensive properties. Putting each property in an LLC prevents a single large liability from wiping out your entire net worth. This is for the real estate investor who has 15 San Diego rental properties that were purchased decades ago and each property is currently worth $1,500,000. This is a net worth of $22,500,000, so you don’t want an incident at one rental property to allow a judgment beyond $1,500,000.
However, if you choose to go the LLC route there are (3) major considerations to understand:
- Transferring property into an LLC – Before the LLC will offer you any protection, you first have to move your properties into an LLC. This is a major inconvenience to a lot of investors. Especially if you have a mortgage and have to get the lender to agree to transfer to avoid triggering due-on-sale clause (balance of your loan is immediately due), which rarely happens. When transferring real estate, too many real estate investors opt for Quit Claim option most likely due to its common parlance amongst investors when discussing the transfer of real estate. A Quit Claim Deed transfers bare legal title to the grantee without any warranties of any sort. Think of it like the “AS IS” clause in a real estate purchase and sale agreement. A Warranty Deed on the other hand guarantees free and clear title of any defects. This is important because you want the guarantee that the transfer of property is valid to ensure you have the LLC protection. So go with the warranty deed.
- Outside Liability – An LLC will protect assets from a lawsuit against your LLC, but it will not protect you if you get sued personally (car accident for texting/driving). If you act as the property manager, there’s liability from that as well. Maybe you didn’t warn the new tenant about an issue with the property when they moved in – you’ll be sued as the property manager AND your LLC will be sued as the owner. Most importantly, an LLC is a business entity. So, function like one or a plaintiff attorney can try to “pierce the corporate veil” and flow a lawsuit directly to a personal judgment. This means having separate books, LLC bank accounts, annual compliance (holding yearly meetings, documenting them with contemporaneous meeting notes, formally passing new bylaws, etc.). There are paralegals who will do this for $200.
- Anonymity – Some landlords don’t like the idea of tenants knowing who they are or where they live. Especially when dealing with the prospects of raising rents and evictions. So the LLC can be used to provide an initial layer of anonymity. Real estate ownership is public record, so it’s not too complicated to find out who owns a given parcel. You can go down to the county recorder’s office or pay for third-party online search services. So by transferring ownership of the property to the LLC, a property search will reveal the LLC as owner. So don’t use your name for your LLC. Make it abstract like Red Leaf Development. If a potential Plaintiff does some additional digging, it is not hard to find out who the owner of the LLC is. This is common when you’re the registered agent and/or the LLC address is your home address and has completely blown your anonymity efforts. You’d need to set up a third-party to be the registered agent and rent a PO Box to use as the mailing address for your LLC. Lastly, if you’re also acting as the property manager (or otherwise involved with the property) and/or have a mortgage lien in your name, then any anonymity measures will be trivial.
I’ve been in the personal finance field for about a decade, and I continue to see asset protection strategies for prospects as a significantly overlooked part of the comprehensive financial planning process. If you have rental properties or any corporate entity, it is important to understand your exposures, layers of protection, & have them reviewed.
I’m always on the lookout for proposed policies that impact pensions. There are two considerations for both federal and private pension beneficiaries. The explosion of private pension transfers in 2017 and the president’s fiscal 2019 budget includes a few proposals to reduce retirement benefits for federal civilian workers. The president’s budget proposes four changes to the Federal Employees Retirement System (FERS): 1) increase the employee’s contribution so that employers and employees each pay half of the normal cost; 2) eliminate the cost-of-living adjustment for FERS retirees; 3) calculate FERS benefits based on high-5 rather than high-3 years of earnings; and 4) eliminate a special benefit available to those who retire prior to 62. The eliminating of the cost of living adjustment will significantly affect retirees.
With pension liabilities becoming extremely expensive to maintain, increased longevity, low-interest rates, and the popularity of the 401(k), many companies are looking for de-risking avenues. Pension risk transfers have generally become more popular for employers who have to make annual payments to the Pension Benefit Guaranty Corp., a federal agency, to insure against their future inability to pay plan participants. Employers pay both a flat rate (per-participant) and variable rate (on underfunded amount), which have respectively doubled and tripled since 2013. According to Millman, a consulting firm, corporate pension plans were 84% funded on average at the end of 2017.
Single-premium pension buyouts are the most popular type of pension risk transfer. Employers transfer their pension obligations to an insurance company by purchasing a group annuity contract for all or a portion of the plan participants. The insurer then makes monthly payments to participants and relieves the employer of their associated pension liabilities. Funding for the block of liabilities must be at 100% to do a transaction. According to the LIMRA Secure Retirement Institute, which tracks insurance data, single-premium pension buyout sales ballooned 68% in 2017 compared to the prior year.
Employers will look to two major tailwinds to position themselves to a funding position for a pension risk transfer. Economists are predicting that Jerome Powell and the Feds will raise interest rates three or four times this year. Rising interest rates will likely improve pension funding ratios in the coming years. Further, a lower corporate tax rate could provide a boost to pension transfer deals by making funding a pension to 100% sooner more appealing. The Republican tax measure, signed into law in December, lowers the corporate tax rate to 21% from 35%. Many employers have until Sept. 15 (if they are calendar-year tax year) to make a pension contribution and have that contribution be tax deductible at the higher 35% tax rate. If they wait longer, their contributions would be deductible at the lower 21%. This 14% rate differential is very important to funding up the pension plan because those savings create additional funding which makes de-risking easier to do.
With low-interest rates, it is easier for companies to borrow to get their plans to a status of being fully-funded. According to Scott Kaplan, head of Prudential’s pension risk transfer business, an employer doing a pension risk transfer for a retiree population can typically expect to pay between 101%-105% of the associated liabilities. Large employers can do these pension risk transfer to certain blocks of participants, such as active employees, retirees receiving benefits, and terminated vested participants.
There are risks that participants need to be aware of if their pension is being offloaded. MetLife Inc., for example, has been in the spotlight recently for failing to pay benefits to thousands of pension clients after MetLife had lost track of those pensioners. This isn’t the first time insurers have been admonished for not doing enough to reach clients. In recent years, Metlife and others came under scrutiny from regulators who accused them of holding on to benefits people hadn’t claimed, rather than turning them over to states or policyholders. Many insurers now use a government database known as the “Death Master File” to double-check whether clients are still alive.
Risks are building in the markets but so is bearishness. Though markets are going to do what they are going to do in short-term, we have learned there are still not a lot of natural sellers, and if the market gets too offside, you can bet the other side for a trade.The fast money is now so short-term focused, especially the growing number of HFTs that don’t hold overnight risk, they have no patience and must cover quickly especially if the market begins to move against them. I do believe investors are going to get a chance to buy stocks and much lower levels, however.
The stock market went stock market in February. After closing January at 2,823.81, the S&P 500 ended February down 3.89% at 2,713.83. Prior to the normal and much-needed correction, the S&P 500 was at its most expensive level in 14 years. While stock valuations remain an issue, I believe these high valuations are justified if corporate earnings continue to rise, the economy remains strong, no imbalances or surprises emerge, and interest rates stay relatively low. I talked about this last month in avoiding naïve extrapolation. With February finishing the month down, the U.S. stock market experienced its first monthly drop in fifteen months. So, RIP to the positive feedback loop that markets are a one-way trade to easy money because of ______. Add the weak hands that jumped in late and panicked at the first sight of red in their portfolio and the environment was ripe for a selloff.
The closest analogy I have is akin to dating in Los Angeles. Person A (apparently harmless Stock Market) spends the first 8-12 months pretending to be someone else in a full Daniel Day-Lewis effort to convince Person B (the suddenly risk friendly investor), who is also pretending to be someone else, that they are the perfect match and strangely have everything in common, “What!? You also think Tyler Perry’s Boo 2! A Madea Halloween is the greatest movie of all-time?” Things are going well. Both parties are sticking to their false narrative with only minor slippage. The relationship gets too comfortable, reality creeps in as the false personages sheds, and finally someone throws their soup at the waiter and claims 9/11 was an inside job.
The point is. There is volatility in all aspects of life. With work, with your children, with your partner, with your business and dreams, and definitely with your investments. Accept it and expect it. Don’t let the confidence nor doomsayers’ rhetoric change a sound strategy. Wallstreet needs Mainstreet to buy their products and churn their accounts. Financial media needs ad revenues via clicks or viewers so they can never run segment that is, “Hey folks, markets are acting normal, the best action is to do nothing and focus on the personal finance at-risk items you can control. Check back in this summer for a quick update.”
If you’re truly worried and notice how the anxiety/angst has made you a Debbie Downer, then it’s time to re-evaluate your portfolio and assess your bear market strategy. This is important. There needs to be a tangible game plan that you refer to when things get rough and they will at some point. I know some investors have jettison components of their asset allocation due to recency bias and the lack of performance relative to U.S. Growth stocks. That herd mentality becomes dangerous as investors reduce the amount and degree of hedging and risk management components in their portfolio. When everyone rushes to the exit at the same time prices collapse and it takes a while for the market to catch a bid.
Investors who used the cheaper online advisory platforms have learned the hard way during the 1,000-point Dow sell off on February 5th when they were unable to login to place trades. Those that use robo-advisory services – from the likes of Vanguard and Charles Schwab to pure players Betterment and Wealthfront – suffered from spotty access and being shut out of their trading platforms altogether.
I’m a big fan of the “Rocky” movies. Duke, played by Tony Burton, is famous for playing both Apollo Creed’s and Rocky’s corner man in the “Rocky” movies. In Rocky IV, Rocky heads to Russia to avenge the death of Apollo Creed and fight Ivan Drago. Sadly, Tony Burton passed away two years ago, but what I remember most from him in the films is the overly simplistic & succinct advice he would yell at Rocky between rounds after he just took 2,453 unanswered blows to the face. I would love to create a mobile app that is just a pop up of Duke’s intense face followed by random quotes from Rocky IV anytime an investor without a plan tries to panic sell. So the next time the President starts a trade war or the market opens down 2% for no reason and your portfolio takes a shot to the face…This pops up followed by one of these lines:
“Be a rock for me!”
“Be strong! No Pain!”
“Brace Yourself. It’s All-right”
“You’re doing fine. You’re doing great.”
“Don’t go down. Don’t go down.”
At this point, I expect volatility to continue in both the equities and fixed income markets as the Federal Reserve, European Central Bank, and other central banks pursue a tightening monetary policy. New Fed chairman, Jerome Powell, declined to raise the Federal Funds target rate at its February meeting, but the board has indicated that at least three – and possibly four – small rate hikes could be in store for 2018. The Fed is expected to raise rates by 0.25% in March. Historically, it is not the raising of rates by the Fed that has been the downfall of stocks but rather the rate of increases and after they have finished raising rates.
In addition to a gradual rate increase, the Fed began a long-term effort to trim its $4.5 trillion balance sheet in October 2017 by ending its policy of purchasing Treasury issues and mortgage-backed securities. With liquidity marginally diminishing, interest rates could rise, affecting stock and bond prices. These mandates will be tough with the federal budget deficit on track to blow through $1 trillion in 2019, along with a weak U.S. dollar, and threats of trade wars.
Know what you own. The cost, the risk, & the bear market strategy. When you wake up to the S&P 500 down 2-3% remember the words of the late Tony Burton, “Be a rock for me. Be strong. No Pain.”