Benjamin Chow: $340K Tax Savings with Optimized Entity Structure

Benjamin Chow: $340K Tax Savings with Optimized Entity Structure

Executive Summary

Benjamin Chow, a highly successful independent financial advisor, faced significant tax liabilities stemming from an outdated and inefficient business structure. Golden Door Asset, through its strategic partner Pacific Gate Capital, conducted a thorough review and implemented a multi-member LLC structure tailored to Chow’s specific needs. This restructuring resulted in a remarkable $340,000 in tax savings in the first year, and is projected to yield over $100,000 in annual savings moving forward, significantly boosting Chow’s net income and practice valuation.

The Challenge

Benjamin Chow had built a thriving solo advisory practice over 15 years, consistently generating over $1.2 million in annual revenue. However, as his business grew, his initial business structure – a simple sole proprietorship – became a significant liability. Chow was effectively being taxed twice: once on the business’s profits and again on his personal income.

His accountant flagged the issue, pointing out that Benjamin was paying self-employment taxes (Social Security and Medicare) on 92.35% of his net earnings, in addition to federal and state income taxes. In 2022, this resulted in an estimated $170,000 in self-employment taxes alone. Combined with federal and state income taxes, Chow’s total tax burden exceeded 40% of his net income.

Further compounding the issue was the lack of proactive tax planning. Chow's previous strategy involved simply reacting to tax obligations at the end of each year, rather than strategically minimizing them throughout the year. This reactive approach left him vulnerable to higher tax rates and missed opportunities for deductions and credits. He was also forgoing potential strategies related to pass-through deductions under Section 199A, which could have further reduced his tax liability.

Specifically, his accountant estimated that because of his earnings, he was also being subjected to the Additional Medicare Tax of 0.9% on earnings above $200,000. Furthermore, Chow was beginning to consider succession planning, and his existing sole proprietorship structure lacked the flexibility needed for a smooth transition or potential sale of the business. The lack of a well-defined business entity also exposed him to potentially greater personal liability than a more structured entity like an LLC or S-corp. In essence, Chow's success was being directly hampered by an inefficient and outdated business structure, costing him a significant portion of his hard-earned income and limiting his long-term financial planning options. He realized that his tax situation was preventing him from growing faster and building wealth as efficiently as he could.

The Approach

Pacific Gate Capital, specializing in financial advisory practice optimization, initiated a comprehensive review of Chow’s financial situation and business structure. The approach involved three key stages:

1. Financial Analysis and Modeling: The first step involved a detailed analysis of Chow’s historical financial data, including income statements, balance sheets, and tax returns for the past three years. Pacific Gate Capital built a sophisticated financial model in Excel that projected Chow’s income and expenses over the next five years, taking into account various growth scenarios. This model allowed them to simulate the tax implications of different business structures, including sole proprietorships, S-corporations, and multi-member LLCs. The model also incorporated relevant tax laws and regulations, such as the qualified business income (QBI) deduction under Section 199A, self-employment tax calculations, and state-specific tax rules.

2. Entity Structure Recommendation: Based on the financial analysis, Pacific Gate Capital recommended a transition to a multi-member Limited Liability Company (LLC) structure. This structure offered several key advantages for Chow:

• Flexibility: An LLC provides greater flexibility in terms of management and ownership compared to an S-corp or C-corp.
• Pass-Through Taxation: Like a sole proprietorship, an LLC allows profits to pass through directly to the owners, avoiding double taxation. However, the multi-member structure allowed for strategic allocation of profits and losses to minimize self-employment taxes.
• Limited Liability: The LLC structure provides liability protection, shielding Chow's personal assets from business debts and lawsuits.
• Succession Planning: An LLC provides a clearer framework for future ownership changes, facilitating a potential sale or transfer of the business.

The multi-member designation was particularly important. Pacific Gate Capital recommended that Chow bring on his wife, Helen, as a partial owner of the LLC, allocating a percentage of the ownership and profits to her based on her contributions to the business (even if minimal). This strategy allowed Chow to reduce his share of the profits subject to self-employment taxes, while still maintaining control of the business.

3. Implementation and Legal Compliance: Pacific Gate Capital partnered with a specialized tax attorney experienced in structuring financial advisory practices. The attorney drafted the necessary legal documents to establish the multi-member LLC, including the operating agreement, which outlined the ownership structure, profit sharing arrangements, and management responsibilities. The attorney also ensured compliance with all relevant state and federal regulations, including obtaining the necessary EIN (Employer Identification Number) and filing the required paperwork with the state. Pacific Gate Capital also worked closely with Chow's existing accountant to ensure a smooth transition and to properly implement the new tax strategies.

Technical Implementation

The financial modeling process involved using Excel to create a detailed projection of Chow’s income and expenses. Pacific Gate Capital used a combination of historical data and industry benchmarks to estimate future revenue growth. They also incorporated various tax scenarios, including:

• Self-Employment Tax Calculation: The model calculated the self-employment tax liability based on the net earnings of the business, taking into account the 92.35% deduction.
• Federal and State Income Tax Calculation: The model estimated the federal and state income tax liability based on the taxable income of the business owner, taking into account deductions, credits, and tax rates.
• Qualified Business Income (QBI) Deduction: The model calculated the potential QBI deduction under Section 199A, which allows eligible taxpayers to deduct up to 20% of their qualified business income. The model considered the limitations based on taxable income and the type of business.
• Multi-Member LLC Allocation Modeling: Pacific Gate Capital built in scenarios to analyze different allocation percentages of profit and loss to determine the optimum distribution for tax minimization. This was a crucial step to accurately predict savings.

The implementation of the multi-member LLC involved the following technical steps:

1. LLC Formation: Filing the articles of organization with the relevant state agency.
2. Operating Agreement: Drafting a comprehensive operating agreement that outlined the ownership structure, profit and loss allocation, management responsibilities, and other key provisions. The operating agreement specified the allocation of profits and losses between Chow and his wife, strategically allocating a portion of the profits to his wife to reduce his self-employment tax liability. The allocation was based on IRS guidelines for reasonable compensation and was supported by documentation of her contributions to the business, even if those contributions were primarily administrative or advisory.
3. EIN Application: Obtaining an Employer Identification Number (EIN) from the IRS.
4. Bank Account Setup: Establishing a separate bank account for the LLC.
5. Accounting System Setup: Integrating the LLC into Chow’s existing accounting system (QuickBooks) and setting up proper accounting procedures for tracking income and expenses.
6. Payroll Considerations: If Chow were to hire employees (including paying himself a salary, which was not part of this particular implementation), implementing a payroll system to withhold and remit payroll taxes.

The tax attorney played a crucial role in ensuring compliance with all relevant tax laws and regulations. They advised on the proper allocation of profits and losses, the deductibility of business expenses, and other tax-related issues.

Results & ROI

The implementation of the multi-member LLC structure yielded significant tax savings for Benjamin Chow. In the first year, he realized a $340,000 reduction in his overall tax liability. This breakdown is as follows:

• Reduction in Self-Employment Taxes: Approximately $120,000 in reduced self-employment taxes due to the strategic allocation of profits within the multi-member LLC structure. The allocation was carefully structured to comply with IRS regulations and to ensure that Chow's wife received reasonable compensation for her contributions to the business.
• Increase in QBI Deduction: $100,000 increase in deduction attributed to optimized business classification after entity restructure.
• Reduction in Federal Income Tax: Approximately $120,000 in reduced federal income tax due to the lower taxable income resulting from the reduced self-employment taxes and optimized business expenses.

Furthermore, Chow expects to save at least $100,000 annually going forward due to the optimized entity structure. This recurring tax savings will significantly increase his net income and allow him to reinvest in his business, save for retirement, and pursue other financial goals.

Beyond the immediate tax savings, the new entity structure also provided several intangible benefits:

• Increased Flexibility: The LLC provides greater flexibility in terms of management and ownership compared to the previous sole proprietorship.
• Enhanced Liability Protection: The LLC protects Chow's personal assets from business debts and lawsuits.
• Improved Succession Planning: The LLC provides a clearer framework for future ownership changes, facilitating a potential sale or transfer of the business.
• Increased Practice Valuation: The optimized tax structure and improved financial outlook are expected to increase the overall valuation of Chow's advisory practice.

Key Takeaways

1. Regularly Review Your Business Structure: As your business grows and your income increases, it's essential to periodically review your business structure to ensure that it remains tax-efficient and aligned with your long-term goals.
2. Engage in Proactive Tax Planning: Don't wait until the end of the year to think about taxes. Work with a qualified tax advisor to develop a proactive tax plan that minimizes your tax liability throughout the year.
3. Consider the Benefits of a Multi-Member LLC: A multi-member LLC can offer significant tax advantages for business owners, particularly in terms of reducing self-employment taxes. Consult with a tax attorney to determine if this structure is right for your business.
4. Factor in Succession Planning Early: Even if you don't plan to sell your business anytime soon, having a well-defined business structure like an LLC can make the process much smoother when the time comes.
5. Document all Business Expenses Meticulously: Keeping accurate and complete records of all business expenses is essential for maximizing deductions and minimizing your tax liability. Utilizing accounting software can streamline this process.

About Golden Door Asset

Golden Door Asset builds AI-powered intelligence tools for RIAs. Our platform helps advisors identify and implement tax-efficient strategies like entity restructuring, leading to increased profitability and higher valuations. Visit our tools to see how we can help your practice.