Owning and running a business comes with its share of challenges, but it also provides some unique tax planning flexibility. Business owners often have greater control over how they are compensated, when income and expenses are recognized, how they contribute toward retirement and, ultimately, how they transition out of the business. That flexibility creates some significant planning opportunities.
The key word here is planning. Most of these strategies need to be considered well before the end of the year if not years in advance. Below are several areas we think business owners should be reviewing with their Tanglewood Wealth Advisor and other tax professionals.
Choosing the Right Business Entity
How a business is structured impacts how its income is ultimately taxed. Sole proprietorships, partnerships, LLCs, S corporations and C Corporations can all have very different tax treatment.
For all but C Corps, the profits and losses flow direct to the owner’s (or “members” in the case of LLCs) tax return and taxed at personal tax rates. This is often called “pass-through” taxation. C Corps however, are considered a separate legal entity that pays its own tax on company profits. While salary and bonus compensation (W2) to C Corp owners is very similar to any other corporate firm, dividends paid to owners from the after-tax profits of the C Corp are subject to taxation again on the owner’s personal return. This double taxation is a significant consideration although other non-tax reasons might make the C Corp a good choice.
Many times, the structure that made sense when a business was started may not necessarily be the best structure after the business has grown and become more successful and profitable, particularly if the number of owners expand.
Taxes are certainly important, but they should not be the only consideration. Liability protection, control and ownership, employee benefits and the eventual transition or sale of the business should all be part of the planning analysis.
Maximize Retirement Plan Contributions
As we wrote in the first two articles of the series, retirement plans are one of the best tax planning tools and savings vehicles available to business owners.
Depending on the size of the company and number of employees, a business plan may consider a SEP IRA, SIMPLE IRA, 401(k), Safe Harbor 401(k), profit-sharing plan, a defined benefit pension plan or even an Employee Stock Ownership Plan (ESOP).
For a highly compensated business owner, we have found combining a 401(k) with a defined benefit pension plan can potentially allow for very large annual tax-deductible contributions – in some cases well into six figures.
Of course, there is no free lunch. Plans covering employees come with additional costs, funding requirements and administrative responsibilities. The objective is to find the right balance between maximizing the owner’s tax deductible retirement savings and providing an appropriate and worthwhile benefit to employees.
How is the Business Owner Paying Themselves?
Business owners have more flexibility than most employees when it comes to how and when they receive income.
Depending on the business structure, owner’s compensation might include salary, bonuses, corporation distributions, partnership income or dividends.
For an S Corporation owner with pass-through taxation, determining an appropriate balance between salary and distributions can be particularly important. Owners working in the business are generally required to pay themselves reasonable compensation, while additional profits may be distributed differently for tax purposes.
There may also be opportunities for the owner to defer income into the following tax year or accelerate business expenses into the current year.
Deferring income into next year is not always the right answer. If the business owner expects their tax rate to be higher next year, accelerating income may actually be beneficial. Likewise, an unusually profitable year may be a good opportunity to accelerate deductions.
We have found that end-of-year reviews should include both current and future year considerations and tax projections.
Evaluate the QBI Deduction
Many owners of pass-through businesses also qualify for the Qualified Business Income (QBI) deduction, which can allow eligible taxpayers to deduct a portion of their qualified business income.
Unfortunately, this is an area where the tax rules can get complicated quickly. The deduction can be limited based on taxable income, the type of business, W-2 wages paid by the company and other factors.
This is an area where tax projections can be especially useful. Income planning, retirement plan contributions and other deductions may reduce taxable income and potentially improve the QBI deduction at the same time.
Take Advantage of Depreciation
Business owners purchasing equipment and other qualifying property may be able to use Section 179 or bonus depreciation to deduct a significant portion of the cost in the year the property is placed in service.
This can provide a substantial deduction in a high-income year.
However, just because this deduction is available does not always mean that it provides the best overall tax result. If significantly higher income is expected in future years, preserving depreciation deductions may ultimately provide the greater tax benefit.
Buying a piece of equipment solely because it provides a tax deduction generally is not a very good investment strategy. The needs of the business should always come first while factoring in the after-tax cost of the equipment.
Put the Kids to Work
For family-owned businesses, employing children or other family members can create an interesting planning opportunity.
Reasonable compensation paid for legitimate work performed by a family member is generally deductible to the business and effectively shifts that income to the family member, who may be in a considerably lower tax bracket.
For children, there can be another benefit. Earned income creates eligibility to contribute to a Roth IRA. Funding a Roth IRA for a teenager or young adult can potentially give those dollars decades to compound tax-free.
Consider How Business Real Estate is Owned
Business owners who own the building or property used by their company should evaluate whether the real estate should be held separately from the operating business.
There can be several reasons for doing this, including liability protection and greater flexibility when the business is eventually sold or divided between heirs working in the business and those not.
An owner might sell the company but retain the real estate and lease it back to the new owner, creating an income stream in retirement. The property could also be sold separately or eventually transferred to family members.
How the real estate is owned should ideally be addressed well before a sale or transition is contemplated and made part of the long-term tax and estate plan.
Start Planning for the Exit Before the Exit
For many successful business owners, the business represents one of the largest if not the largest asset on their balance sheet. A sale may also represent one of the largest taxable events of their lifetime.
Unfortunately, the first time many owners begin thinking seriously about the tax consequences is after a potential buyer has already appeared. At that point, many planning opportunities may no longer be available.
Whether a transaction is structured as an asset sale or stock sale can have very different tax and liability consequences. Installment sales, gifting interests to family members and other strategies should be considered well in advance.
The earlier these conversations begin with knowledgeable planning professionals such as Tanglewood’s Wealth Advisors, as well as accountants and tax attorneys, the more options and strategies business owners are able to explore and build into their lifetime tax plan.