1. Earned income: salary and bonuses reported on a W2 each year.
2. Unearned (investment) income: distribution of profits from the operation and/or sale of the business.
But there are other small business ownership advantages that I call “stealth benefits,” because they’re not as evident as operating opportunities. Arguably the most dramatic stealth benefit, which often has the most wealth creation potential, is for the business owner to also personally own the real estate in which that business operates.
Here’s the classic scenario: Every business is a tenant of some landlord, likely under the terms of a commercial lease. There are many financial and strategic reasons for a small business to lease property from an unrelated landlord. But that arrangement offers the business tenant only tax deductions of the lease payment and associated disbursements, and essentially no financial benefits for the owner of the tenant business.
Now let’s consider the stealth benefit mentioned earlier. As long as the business you own is legally structured as a tax reporting entity, like an S Corp or LLC, you can accrue stealth benefits by personally owning the real estate your business operates in and leases from you. For example: Smith Enterprises, Inc. (SEI), a small manufacturer, has one shareholder, Tom Smith. SEI enters into a long-term, formal lease of the improved real estate it operates in, and the landlord, the individual who owns that property, is the same Tom Smith. Several of the stealth benefits these two entities accrue from this legal arrangement include, but are not limited to:
SEI doesn’t have to worry about prohibitive rent increases, or getting kicked out because its landlord, Smith, won’t renew the lease.
As with any lease, SEI deducts lease payments and associated disbursements as operating expenses.
As owner and landlord, Smith personally deducts expenses necessary to deliver on the lease agreement, including mortgage interest, depreciation, maintenance, etc.
Profits arising from this venture are taxed as unearned (investment) income for Smith, calculated at his personal income tax rate, but – and this is important – not subject to payroll tax.
It’s possible that Smith could receive cash distributions from the property, even if the investment delivered a loss.
Over time, as inflation causes rents to rise against mortgage payments that may be fixed for that period, cash distribution will likely increase each year.
When the mortgage is paid off, the income-producing property becomes a cash-producing annuity for Smith.
Upon the ultimate sale of the property, basis-adjusted profit is taxed at the current capital gains rate, which is typically lower than Smith’s personal income tax rate.
In my long career, I’ve seen many family businesses that Mom and Pop founded and operated for decades. But at the end of their business careers, it turns out that the business itself had little or no value to a prospective buyer, and the founders just locked up the business one last time.
However, concurrent with operating their business, Mom and Pop also went about acquiring the property their business operated in, and leased it back to the company. Over those same decades, that corner of an intersection, in a once-sleepy section of town, became a valuable piece of commercial property.
In the end, Mom and Pop made a good living from operating their business, which ultimately was worth essentially nothing. But they retired well by selling the real estate they’d bought for thousands, for millions. Oh, and they actually have one other option that might be preferable: Just continue to lease the property to the next business.
And almost all of this, including years of rent distributions, was taking place under the marketplace radar, as a stealth benefit.
Write this on a rock … Take advantage of the benefit of owning the real estate your business operates in.