SECTION 125: IGNORE IT AND YOU PAY TOO MUCH IN TAXES: CORPORATE STRUCTURE FOR MAXIMUM OPTIMIZATION

SECTION 125: IGNORE IT AND YOU PAY TOO MUCH IN TAXES:
CORPORATE STRUCTURE FOR MAXIMUM OPTIMIZATION

Note: This memorandum is extracted and modified from a certified public accountant (CPA) continuing professional education course (CPE) on Internal Code Section 125 (fringe benefits cafeteria plans) offered by Taxes Mastered, Inc. (TMI). Please see our website at www.TaxesMastered.com to access the complete course. TMI’s core message is 85%+ of all small business owners (entrepreneurs) pay too much in tax. The results of paying too much in tax hurts small business owners because they are left with:

✓ Sub-optimal cash flow.
✓ Sub-optimal equity value.
✓ Sub-optimal debt structure.
✓ Sub-optimal exit strategies.
✓ Sub-optimal liability protection.
✓ Struggling to achieve their vision\goals on-time, on-budget, and with the highest probability of success.

TMI’s mission is to change the results of paying too much in tax…one person at a time. Section 125 is a tremendous tool to change the results of overpaying taxes. Summary of Section 125: Internal Revenue Code Section 125 shifts a vast array of personal, after-tax expenditures made by the small business owner to pre-tax business deductions. This is a powerful tool in not paying too much in tax and only paying your fair share.

This article summarizes why most small business owners are blocked from using Section 125 because of self-inflicted wounds and how to heal those wounds and eliminate that blockage.
Historical longevity: 1978 is the generally accepted launch date of Section 125 by the tax code.
Benefit for you: Section 125, given a historical perspective since 1978, usually provides a powerful reduction in income taxes paid. Your Section 125 benefit is unique to you and the results of others might not be applicable. TMI can perform a tax strategy analysis and closely estimate your savings if Section 125 was fully implemented. TMI’s knows a big reason for the blocks preventing the entrepreneur from using Section 125 are self-inflicted.

These self-inflicted wounds follow a course:
• The entrepreneur owns businesses.
• How the businesses are owned (structure) prevents the entrepreneur from using Section 125.

TMI knows these self-inflicted wounds can be instantly healed by changing how the entrepreneur owns their businesses. Background research: The tax code is based on the superstructure of social engineering and four cornerstones.

Copy this link into your browser to see short video on the four cornerstones of the tax code. (https://youtu.be/CrrRAkcDCtc)

Expanded discussion: An expanded discussion follows. Section 125 covers businesses large and small
Section 125 applies to very large corporations and to the small business owner (entrepreneur).

Generally, Section 125 defines the entrepreneur as:
• Under 100 employee count.
• Business owner is an employee.
• Non-business owner employees receive minimum coverage.
• Business owner employee receives maximum coverage.

This is the definition used in this article. Section 125 is a violation of the matching concept.
There is a concept in tax accounting called the matching concept. Under the general application of the matching concept, if one taxpayer takes a deduction for a cash outlay, then another taxpayer must report that cash outlay as income. While violated by the definition for a cash basis reporting taxpayer and other specifically defined tax transactions, the purpose of accrual accounting is to match income and expenses in the correct year.

As a practical example, if the employer paid for health care for a non-owner employee, the non-owner employee would add to their compensation income the amount of the health insurance premiums paid by the employer; the employer would have a deduction in the same amount.

The purpose of Section 125 was to nullify the matching concept for very specially defined benefits offered to the non-owner employee. Using our practical example, if the business owner paid for health insurance for a non-owner employee, the non-owner employee would not need to report those premiums as income.

While the philosophy behind Section 125 was predominately to benefit the non-employee owner, the owner employee wants to also receive these benefits. Problems for the owner-employee To prevent or severely reduce such benefits, in a surprising large number of benefit definitions, certain classes of owner-employees were statutorily exempt from Section 125 benefits.

For a cafeteria\Section 125 plan, the term employee does not include the following:
• Self-employed individuals.
• Sole proprietors.
• Partners.
• Members (subject to self-employment tax) of LLC's electing partnership tax treatment.
• Directors solely serving on a corporation’s board of directors (and not otherwise providing services to the corporation as an employee).
• More than 2% shareholders of S corporations (attribution rules may apply)2,4.

Therefore, a person defined by the rules above cannot participate in a Cafeteria\Section 125 plan 2,4.
However, the rules cited above are a self-inflicted wound as all the entrepreneur needs to do is change the ownership structure to associate the Section 125 plan with a C-corporation. Businesses owned by a C-corporation are not restricted in any meaningful degree as to excluding owner-employees from cafeteria plan benefits regardless of ownership percentage.

Practical solution to the self-inflicted wound.
Can Section 125 benefits be provided, at all, to owner-employees? The answer is YES but it depends upon the organizational structure of the entity providing the benefits.
The key to a practical solution is a C-corporation properly integrated into the overall tax strategy for the business owner. Another huge benefit of using the C-corporation is moving tax planning from the Form 1040 (personal income tax return) an onto Form 1120 (filed by the C-corporation).

Since the 1986 Tax Reform Act, tax planning on the Form 1040 became ineffective and inefficient for the small business owner. Since the 1986 Act, tax planning on the Form 1120 became effective and efficient; Form 1120 is the first place to do tax planning.
Why? Form 1120 (C-corporation) has a very large toolbox of strategic tax planning options. Form 1040 has a very, very small box of strategic tax planning tools.

Boogeyman: Double taxation using a C-corporation
The tired boogeyman of a C-corporation having double taxation is not a valid response to an effective and efficient tax strategy. Due to the expanded and enhanced benefits for the owner-employee, most of the “amount subject to double taxation” is eliminated by proper strategic planning. If there is an amount of taxable income left in the C-corporation, it should be immaterial and passed onto the personal return subject to tax rate arbitrage between the Form 1040 and the Form 1120. Comment In the following section, an example of a properly constructed ownership flow is presented. This flow is presented for educational purposes only and needs to be adopted to any unique and specific circumstances.

Strategic tax planning is not an isolated process where bits and pieces do not need to fit together. Strategic tax planning is a very integrated process where all elements need to be balanced against the vision of the client and balanced against each other for the greatest synergistic effect. In TMI’s quest to help you not pay too much in taxes, solving\addressing one problem often presents a solution for a completely and seemingly unrelated problem. Such it is with the following example.
The following example solves many more problems than the adaptation of a Section 125.

As this is an extract from a larger course, and as the course content is extracted from a large field of strategic tax options, please contact Taxes Mastered, Inc. for a unique analysis of your personal situation to see how our overall strategic tax planning can benefit you.
TMI’s mission is to change the results of paying too much in taxes…one person at a time. Why don’t we start with you?

An example of a properly constructed ownership flow is primary tax planning is not on the Form 1040 (personal income tax return) but on the C-corporation’s Form 1120 tax return. This has many possible benefits:

1. Maximum availability of strategic tax planning options including Section 125.
2. Highest probability of paying only your fair share of taxes.
3. Optimal cash flow.
4. Optimal equity value.
5. Optimal debt structure.
6. Optimal exit strategies.
7. Optimal liability protection.
8. Achieve your vision\goals on-time, on-budget, and with the highest probability of success.

Conclusions
✓ Section 125 is a tremendous tool to ensure you do not pay too much in tax.
✓ The rules for Section 125 are not complicated; they are exact.
✓ Exactness starts with the proper ownership flow. This proper Section 125 ownership flow can provide
material benefits in other areas of your tax world.

Please contact me with your comments, questions, or requests for additional information.
1 A proprietary and copyrighted large-sample size mathematical study maintained by John C. Brooke since the mid- 1980s. The initial base for this study were his CPA clients. The study later expanded to include other small businesses either of his CPA firm or based on his other entrepreneurial activities.

2 IRS Publication 15-B (2019) Employer’s Tax Guide to Fringe Benefits either by direct quote or discussion of its internal methodology.

3 Publication 538 (2019), Accounting Periods and Methods (Accounting Methods>Accrual Method) published by the Internal Revenue Service. 4 Prop.Reg 1.125-1(g)(2), IRS Secs. 401(c), and IRS Secs. 1372) Representations: Nothing in this memorandum and attachments (if any) rises to the level of a representation.

Circular 230 Disclosure. The IRS requires us to advise you that any federal tax advice contained in this memorandum and attachments (if any) is not intended to be used and cannot be used for the purpose of avoiding penalties under the Internal Revenue Code, or for promoting, marketing or recommending to another party any transaction or matter addressed herein.

This memorandum and attachments (if any) may contain numeric, graphic or narrative presentations that are theoretical in nature and provided only for educational and exploratory purposes. Only third parties to Taxes Mastered, Inc. provide non-theoretical presentations and representations.

This memorandum and attachments, if any, are considered © copyrighted and proprietary material by JC Brooke, Inc. and licensed to Taxes Mastered, Inc. This memorandum and attachments, if any, is restricted solely for the use of the parties addressed above. Therefore, use of this memorandum and attachments, if any, for any other situation or party is prohibited.

Last updated 25 July 2019.
The views expressed in this memorandum, and attachments (if any) are the opinion of John C. Brooke. This presentation is a fractural picture of one aspect of a comprehensive strategic tax plan and should not be implemented without careful study and analysis by a qualified tax professional.

Concluded…