Strategic Tax Planning
The Internal Revenue Code is set up to provide numerous tax breaks to individuals and businesses alike. Even the IRS acknowledges that you must keep some money to live on and with which to run your enterprise.
Some small business tax savings strategies, like timing income and expenses, must be accomplished before the end of the tax year. But others, such as funding a retirement plan, can be done at any time before you file your tax return.
The Qualified Business Income Deduction
The Tax Cuts and Jobs Act (TCJA) created the Qualified Business Income (QBI) deduction when the law went into effect in 2018. You might be able to deduct 20% from your qualifying business income if your business is a pass-through entity—a sole proprietorship, an S corporation, or a partnership, passing its income and deductions down to its shareholders, partners, or owners to report on their personal returns.
This deduction is in addition to claiming your ordinary business expense deductions. You should qualify if your taxable income is below $157,500, or $315,000 if you’re married and filing a joint return. Special rules apply if you earn more than these amounts, so you might still qualify depending on the nature of your business
Fund a Retirement Plan
Setting up and funding a retirement plan for yourself and/or your employees can save you money on taxes. Make sure it’s a qualified plan so you can take advantage of those tax savings. It must be one that’s recognized by the IRS to allow deferment of taxes on earnings until the earnings are withdrawn. They include IRAs and defined contribution plans such as a 401(k) or 403(b).
Many options are available depending on your business, your goals, and your needs. Consider talking with a financial professional to figure out which is best for you.
Take Tax Credits to Lower Your Business Income
Tax credits are the federal government’s way of encouraging businesses and individuals to do things—or not do things—that affect the greater good. For example, you can take tax credits for hiring employees, going green, providing access to disabled employees and the public, and providing health coverage for employees. Most are part of the General Business Credit, which is quite extensive so it’s quite possible that you qualify under some of its terms. Check with your accountant.
Reduce Your Taxable Income
Your first tax planning strategy should be to reduce your taxable income. This does not mean changing your work schedule. Instead, you should be changing your approach to your finances. You can restructure your income and your contributions to bring down the taxable amount of your income.
An incredibly helpful way to do this is to make pre-tax contributions to your retirement accounts, such as a 401k plan. This means that you get a massive tax break on this year’s taxes while growing your money responsibly. Similarly, you can use a backdoor Roth IRA strategy, where you contribute to your IRA and then switch it to a Roth IRA. This strategy does not save your taxes this year, but it can also never be taxed again.
Diversify Your Investments
A significant part of tax planning is managing and strategizing your investment portfolio. Optimizing your investments can allow for greater tax efficiency and less investment risk. There is not a standard rule for investments when it comes to diversity, but most experts recommend the 5/25 rule of thumb. Ideally, you want to stick to five different asset classes and have no more than 25% of your finances in one asset.
Strategic Tax Planning for Business
Buying Or Selling A Business
Many factors influence the decision to purchase or sell a business. Among those, the tax implications should be one of the most important. Under the current tax structure, adopting a multi-year purchase strategy can typically go a long way in reducing the tax burden for both those looking to purchase a business and those looking to sell one. By receiving all of the proceeds of at closing, a buyer is likely to push his taxable income into higher brackets than if he or she had adopted a deferred compensation or installment strategy for the purchase.
Forming A Business
When deciding to form a business, an important part of strategic tax planning is entity selection. In addition to concerns about personal liability, certain entities may be subject to double-taxation or certain tax deductions.
Here are the most popular forms of corporate entities, and a brief breakdown of their advantages and disadvantages:
C-Corporations.
A C-Corporation is a popular business entity, especially for large businesses. Corporations listed on stock markets are typically C-Corporations. While they separate business and personal assets and thus prevent personal liability on business assets, they typically have unfavorable tax treatment compared to other forms. This is because C-Corporations are subject to “double taxation” where the company’s profits are taxed when they are earned, and then taxed again when they are distributed to shareholders. In addition to its unfavorable tax treatment, federal and state law also impose a slew of requirements for these businesses – including mandatory annual meetings.
S-Corporations.
Similar, to a C-Corporation, an S-Corporation separates business and personal assets, meaning the owners of an S-Corporation will not have to worry that creditors may attack their personal assets. However, unlike a C-Corporation, an S-Corporation does not have double-taxation. Instead, this corporate entity utilizes “pass-through taxation” where the business profits are allocated and taxed to the individual shareholders. There are several requirements for a business to qualify as an S-Corporation, which include limits on the number of shareholders and a requirement that all shareholders be American citizens.
Limited Liability Companies.
Limited liability companies have become increasingly popular in recent decades because of their combination of favorable tax treatment and reduced personal liability. Similar to the previous two business entities, limited liability companies separate business and personal assets allowing the owner to avoid personal liability for the business debts. Limited liability companies are similar to an S-Corporation in that limited liability companies utilize “pass-through taxation” meaning the profits from the business are only taxed once. Unlike an S-Corporation, though, limited liability companies do not have the onerous shareholding requirements.
Sole Proprietorships and Partnerships.
Sole Proprietorships and Partnerships are both the easiest business entity to create–and usually the worst option. While there is no state filing required – the law assumes a sole proprietorship or partnership has been created merely when someone starts operating a business without filing any other entity documentation with the state – these two business forms both impose personal liability on the business owners. This unnecessary exposure to liability is easily avoided by using an LLC or S-Corporation, which also have the same “pass-through” taxation benefits. Partnerships are especially problematic because a partner will be liable for the business debts, even when they are incurred by the other partner, and sometimes even without his or her permission.
Time Your Business Income and Expenses
Timing your income involves moving it from one year to another. You first have to determine the year in which you expect to pay the most in taxes. Review your current expenses before the end of each year and prepay some of those amounts if you want to reduce your income for the current year. You can also increase your expenses and decrease income by making expenditures such as stocking up on supplies.
Write Off Bad Debts to Reduce Income
The end of the year is also the time to review your customer accounts if your business operates on the accrual accounting method. First, find those customers who aren’t likely to pay you. You can write off the amounts they owe as “bad debts” and deduct these amounts from your business income to save on taxes. Bad debts can also include loans made to clients, vendors, or employees who don’t pay you back.
