Learn What The Rich Know: Pillar 3 - The Fundamentals of Taxes

“In this world nothing can be said to be certain, except death and taxes.”

— Benjamin Franklin

“That the institution of the income tax will tend to silence all boasting about wealth may ... be regarded as one blessing associated with it; we know at present of no others.”

—The New York Times in 1913, the year income tax was introduced

“This is too difficult for a mathematician. It takes a philosopher.”

—Albert Einstein, on preparing his income tax return

• It’s important to know the laws, and it can be very expensive if you don’t.

• It’s never a good idea to invest in something just to avoid paying taxes or in something that’s losing money. The idea is to make money, not lose it.

• The law is always changing, and the best way to reduce your tax burden is to keep abreast of developments. How? By watching the financial news on television, reading the financial section of your newspaper, or consulting your tax attorney or accountant.

Employees of Corporations: Earn >> Pay taxes >> Spend

The Rich who have Corporations: Earn >> Spend >> Pay taxes

• “You can’t beat the IRS. Concentrate instead on earning as much as you can, knowing that you can reduce, but not eliminate, your tax burden.”

• First by learning what business entities are available to you and what the advantages and disadvantages are of each. These entities include the sole proprietorship, the partnership, the corporation, and the limited-liability company, which is a hybrid partnership/corporation.

“It’s a game. We (tax lawyers) teach the rich how to play it so they can stay rich—and the IRS keeps changing the rules so we can keep getting rich teaching them.”

—John Grisham

• Sole Proprietorship

Pros • Owner in complete control • Flexible decision making • Business expenses deductible • Owner earns all profits • Easy and inexpensive to set up

Cons • Owner completely liable for debts and suits • Business terminates with owner’s death • Tax rate may be higher than other entities

• Partnership

• General Partnership: the partners have full rights to control all the day-to-day affairs of the business.

Pros •  Combined assets and expertise • Flexible decision making • Partners, not partnership, taxed at the individual level • Business expenses deductible • Ease of formation

Cons • Partnership terminates on death or withdrawal of any partner • Partners totally liable • Each partner can enter into other business agreements, so control is difficult • Each partner is individually liable for agreements made by any partner

• Limited Partnership: has both general partners, who run the daily business and make all the decisions, and limited or silent partners, who generally put up the money in hopes of profit.

Pros • Limited partners are not personally liable for the partnership’s debts and obligations • Partnership does not dissolve with death of limited partner • Number of partners/owners unlimited

Cons • Transfer of interest usually requires general partner approval • Complete and separate paperwork filings • Limited partners have little, if any, control over daily operations

• Corporation

• A corporation is really nothing more than a way of doing business.
• The owner control what happens in the corporation, but the corporation owns its own assets and pays its own debts. This is one of the secrets of the rich: Own nothing, but control everything.
• Types of corporation
• C Corporations (Subchapter C)
1. offers all the legal protection just mentioned but is taxed as a separate entity.
2. In general, income tax rates for a corporation are lower than rates for individuals.

Pros • Liability limited in case of lawsuit • Shareholders risk only their investment • Corporation can survive the death of owner, officer, or shareholder • Easy to sell small portions of stock to raise capital • Tax rate may be lower • Corporation can elect different year-ends than shareholders— helpful for tax planning • Corporation can provide certain benefits not available to other entities

Cons • Double taxation occurs when dividends are paid to shareholders • Corporations must comply with recordkeeping and other government regulations • State laws can limit operating flexibility

• S Corporations

Pros • No double taxation • Changing from C to S and from S to C is possible

Cons • Company must be registered as a domestic corporation • Corporation can issue only one class of stock • Limited number of shareholders can own stock • Limitations on who qualifies for shareholder status

Double Taxation - when a corporation pays a dividend to its shareholders, the dividends are taxable to the shareholders but not deductible by the corporation

• Limited-Liability Company (LLC) - An LLC gives its shareholders, or members, all the legal protection that a corporation offers, but an LLC may elect how it is to be taxed, whether as a corporation or as a partnership.

Pros • Owners or members have management authority • Allows an unlimited number of shareholders • Can elect to have income or loss pass through to members’ returns • Liability protection of a corporation with no responsibility for debts

Cons • More expensive to open than a partnership • Rules may vary by state • Must have consent of members to transfer interest to another person