As business owners, you possess a unique advantage when it comes to taxes — you have the power to strategically plan both your personal and business taxes, leading to significant long-term impacts on your overall lifetime tax burden. While many focus solely on short term tax savings, the true essence of strategic tax planning lies in its ability to reduce your total lifetime taxes. It’s a shift from short-term thinking to a long-term mindset.
It is crucial for business owners to spend the time, build a team of trusted professionals, etc. to mitigate their tax liabilities. The more you save on tax, the more you can be paid and the better your business can grow.
Let’s dive right into them:
Business retirement accounts serve as a valuable financial tool that enables individuals to optimize their tax strategy, taking advantage of either immediate tax savings through a Roth account or deferring taxes from higher-earning years. These accounts offer a spectrum of options tailored to different business structures and objectives. Three notable options include:
These retirement accounts not only facilitate individual retirement preparedness and tax planning but also serve as an effective employee retention strategy. By offering retirement benefits, businesses can attract and retain talent, contributing to a loyal and motivated workforce.
Additionally, it is worth noting that there are currently tax credits available to assist businesses in covering the expenses associated with establishing these retirement plans. These incentives further underscore the advantages of incorporating retirement accounts into a comprehensive financial strategy, benefiting both business owners and their employees alike.
This is one of the more complicated junctures small business owners come across. Depending on your situation, the difference between an LLC, an S-Corporation, and a C-Corporation can be the difference between saving or paying huge amounts of taxes every year. This is going to be unique for everyone, so certainly work with your financial advisor and tax professional to determine the correct path for you, as having a suboptimal entity structure can and will have immediate and lasting consequences to you as the owner.
The good news is that you can elect to change your entity classification after you’ve opened your business. The elections vary in complexity, but it is generally easier to have your LLC elect into corporate status or make a subchapter S election than it is to go from a corporation to an LLC. Keep that in mind when weighing your options. Let’s discuss some of the primary benefits that you can expect from each entity.
Single member LLCs offer the most simplicity and flexibility. From the IRS’ perspective, this entity is considered disregarded, and you, as the owner, are responsible for the tax responsibility for the business. Because the LLC is not a separate legal entity, the business’ net profits are reported directly on your tax return through the Schedule C. Those profits are then subject to self-employment tax (15.3% on the profit of the business). You’ll be able to deduct half of that tax (7.65%) on that same return. This is all done to align your income with those working traditional W-2 wage based jobs, where employment taxes are withheld for them. As owner you cannot take payroll and the avenues to save on these employment taxes are very limited. However, the good news here is that you save on service costs that are essentially required by corporate structures.
Again, speaking in generalities, an S-Corporation is going to save significantly on payroll taxes. Once you elect into this structure, the business is an independent entity. It files its own tax return (Form 1120S) and you, as the shareholder, must take a reasonable salary. What qualifies as reasonable is left intentionally vague by the IRS. Work with your tax professional to make sure that you’re in compliance. Because your net profit is no longer subject to self employment taxes, you only pay payroll taxes throughout the year on your salary. The remaining profit passes through to your personal return and is taxed as ordinary income.
A few things to keep in mind when determining if this is right for you are the added costs and time commitments. For those small business owners that are used to a more laissez faire approach to bookkeeping, this can necessitate a large shift in your record retention and preparation. You’ll need to ensure that you are accounting for every dollar in and out of the business, which assets remain, log any liabilities, and track your equity. Furthermore, you have the consideration of shareholder basis. If you don’t have accounting experience, you will likely need to outsource this and bookkeeping can be expensive. On top of that, you’ll need to either run your own payroll and understand the complexities that come along with it, or you’ll need to outsource that, as well. The last main added cost is that S-Corporation tax returns are usually much more expensive to have prepared than personal returns. If the tax savings don’t usurp those costs by a considerable amount, it might make more sense to simply remain an LLC.
Finally, we come to the C-Corporation. There are more similarities than differences with the S-Corporation. The main difference is that the C-Corporation is not a passthrough entity. This means it pays its own corporate taxes (21%). The owner does not recognize the profits of the C-Corp. They still are required to take a reasonable salary and will likely still incur the same real costs that an S-Corp would (bookkeeping, payroll, separate return preparation etc...). One of the main benefits that a lot of small business owners try to realize is the QSBS exclusion (Qualified Small Business Stock). This exclusion is very complicated and deserves a post of its own to come in the future. The important thing to note is that if you scale your business and sell for a profit, this exclusion can wipe out up to $10 million of gains on your sale. There will always be AMT to consider here, so most people will not get out scot-free, but it’s still vital to take this into consideration.
QBI, or Qualified Business Income, represents a vital tax benefit designed to support self-employed individuals and small business owners. Specifically, this deduction enables qualified business owners to deduct either 20% of their qualified business income or 50% of their wages when computing their tax obligations. There are limitations to QBI and certain thresholds that will determine if you take the flat 20% or 50% of wages (link to that blog is posted below) The impact of this deduction on reducing income tax payments cannot be overstated, making it a pivotal element of tax planning and financial management for eligible entrepreneurs and small business entities.
Check out more on this from my last post and how you can maximize it. This can be a complex topic, but again, it is extremely important to plan around.
Yes, it is true that children usually can receive wages and not file a tax return. The threshold for 2023 is $13,850 (their standard deduction). The devil is in the details, though. People overplay this one and try to hire their babies which the IRS generally frowns upon. An exception could be you’re a photographer and you need your baby to be photographed in marketing material, but keep in mind, under scrutiny, it is unlikely that baby’s modeling was worth $13,850 during the year. To make the point, it’s even more unlikely that the baby was able to provide services worth that amount to a construction company. Make sure your child is able to actually do something of value before putting them on your payroll.
Furthermore, you can hire your spouse or older children and have them do different jobs you need around the business. Hiring your spouse will give them wages for the year, but it will also be a deduction to your business. The larger upside here is that, now they have the ability to use your retirement account at work and defer the income, putting more away for retirement.
The same is true for the kiddos. Remember that if you end up paying them more than the standard deduction threshold, they’ll need to file a payroll tax return. In some instances, they may even get a nice refund from the state they work in.
Check on my podcast where we go more into this.
This is one not many people think about but is a great end of year tax planning move if it applies to you. If you have a down year, maybe you can have clients pay earlier to accelerate that income. Or maybe it's the opposite, and this has been an abnormally good year, you could have them wait to pay you until next year where you expect income to be lower. This balancing act can smooth out your tax consequences and provide you with some additional capital in the short term. Depending on your relationship with the client and the contracts in place, sometimes this is impossible, but it’s definitely a worthy consideration. It might end up working out best for both parties!
This is another one of the more ‘creative’ ways to defer some capital gains after you have sold your business, or maybe you liquidated a large capital investment and the tax bill isn’t looking ideal - you can always invest into a qualified opportunity zone. This will defer taxes until 2026. If you are confident that the investment will increase in value, the growth will be tax free if you hold your investment for 10 years. Keep in mind, you probably don’t want to take any random opportunity zone, you want to find one that you believe in.
Learn more about this on one of my recent podcast episodes.
One of the simplest ways to reduce your taxes is through charitable contribution. This can be a great way to reduce your tax burden if you’re charitably inclined. Donor advised funds or charitable remainder trusts can be used for large donors. Additionally, you can donate highly appreciated securities to avoid capital gains tax and still claim a deduction. Remember to donate before you sell. If you don’t, you’ll still get the deduction, but you’ll be subject to capital gains tax on those securities.
On this same note, some consider bunching charitable donations every other year to pass the itemization threshold to maximize the utility on the tax side of things. ‘Bunching’ is making two or more years worth of contributions in one year. This has become increasingly popular after the Tax Cuts and Jobs Act in 2017. This is because the standard deduction was nearly doubled. Your itemized deductions must usurp the standard deduction to gain any tax deduction value from your contributions.
The HSA (Health Savings Account) is not available to everyone. However, they are often a no-brainer when you’re in a high income bracket. They reduce taxable income and grow tax free while invested. In addition, expenditure on qualifying healthcare costs or long term care insurance premiums can be paid out the account tax free. This makes the account one of the most tax advantaged available. For high income earners, allowing it to grow while not using it can really pay off when you need it.
A great alternative if the HSA is not available to you is the FSA (Flexible Spending Account). Contributing toward it will also reduce your taxable income, it just can’t be invested and used later on. It’s typically a use it or lose it fund - some do offer the ability to have a small amount rolled over into the following year.
Allocating your accounts between post-tax dollars and pre-tax dollars is an essential element in tax planning. This can be the difference between paying thousands or tens of thousands of unnecessary taxes during retirement and not. Perhaps you’re having an uncharacteristically light year in terms of net income, you can utilize this time period to convert your pre-tax holdings to post-tax. You’ll pay slightly more in taxes, now, to save yourself from paying more taxes in the future. Consider a Roth conversion to accomplish this. Again, a key element to tax planning is subjecting as much of your income to the lower brackets as possible. Another thing to note is that this consideration can take place when the market is down and your holdings have depreciated in value.
Real estate is one of the most tax advantaged asset classes - offering a huge variety of strategies, it is important to understand your opportunities in this realm. It’s actually too much to get into all of it here, but I’ll leave you with some topics to research and I’ll post some other more in depth posts/podcasts of mine for your convenience below.
To name a few: bonus depreciation, cost segregation studies, 1031 exchanges can allow you to offset/defer gains or income that you would otherwise have no way of avoiding.
An increasingly popular method of tax avoidance for small business owners is the short term rental loophole. If you or your spouse has Real Estate Professional Status (REPS) or you have an interest in attaining it, you may be able to take advantage of the short term rental loophole. This strategy will allow you to use, what would otherwise be considered passive activity losses, to offset other active income. This is a very rare benefit and I’m sure you’d agree it sounds wonderful. With all things in life, it’s almost never as easy as it seems. To achieve a qualifying status, there are some very difficult hurdles to overcome. Again, I’m not going to get into all of it here, but I’ve linked a deep dive into the topic below.
Deferred compensation plans are a great way to defer income from the current tax year to later years. While taxes will certainly be paid on the withdrawn funds, these plans allow you to potentially withdraw those funds while in a lower tax bracket. This is particularly useful in states where income taxes are particularly high, think California or New York.
Be aware, the main drawback from deferred compensation is that they’re not guaranteed. Meaning, if your company goes bankrupt, you as the employee may never see any of that income, ever. This is less of an issue for the business owners themselves.
These strategies are just the tip of the iceberg in the world of tax planning, but all of these are useful to understand, even if they don’t apply to your current situation. The main takeaway that people should have reading this is that tax planning is complex and often tedious to analyze. Surrounding yourself with a competent team that shares your vision for your tax goals is of paramount importance.
Disclaimer: This is just for informational purposes. None of this should be seen as tax advice. Work with your financial planner and tax professional to evaluate which strategies would be the best for your situation.
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