5 Tax Strategies for Small-Business Owners
Small-business owners are increasingly being congratulated for their contributions to the economy. They create jobs, provide much-needed services, promote diversity and put money back into their communities.
Yet, those same business owners often are so busy with their day-to-day pursuits that they neglect their own financial needs. In doing so, they miss opportunities to protect the revenue that can help them further grow their business and secure their retirement.
That particularly holds true when it comes to taxes. I can tell you from personal experience that paying taxes is easily the most frustrating part of owning a successful small business — and finance is what I do for a living. I know others face even bigger challenges — either because they don’t know what they don’t know or because they’re afraid they’ll do something to get the attention of the IRS and they’ll be audited. As far as audits go, there are two points to keep in mind:
- The IRS is not out to get you and in the case of an audit, as long as your return was honest and accurate, and you cooperate fully with the IRS’ requests, the process shouldn’t be too painful. Just make sure you are ALWAYS following the letter of the law.
- It’s unlikely you will be audited. For example, in 2016, 0.70% of individual tax returns overall, and only 1.7% of those making over $200,000, were audited.
Neither of those concerns should keep you from using available tax strategies to maximize the value of your company to the benefit of your employees, your customers and your own future. Here are five scenarios to consider when consulting with your financial adviser, CPA and/or tax attorney.
1. Start saving for your retirement.
Many of the entrepreneurs I meet seem to be constantly teetering on the brink of personal insolvency due to an isolated focus on their business. The most successful business owners I know are able to be more competitive because they feel financially fit themselves and thus more confident about the moves they make.
An easy first step is to establish a retirement plan that offers you financial security regardless of the long-term success of your business. These plans come in many shapes and sizes, and a trusted financial professional can help you decide which is best for you. The most popular is the defined contribution plan, most often implemented as a 401(k) or SEP IRA to which you can contribute up to $55,000 per year. (Contribution limits may be even higher for those over age 50.) You may want to also use a cash balance pension plan to stash away closer to $150,000 per year in total. If you can use these tools to get your taxable income below certain thresholds, you could qualify your business for the new 20% pass-through tax break.
If you’ve already taken this step, you may want to evaluate establishing what the founder of Wealth Factory, Garrett Gunderson, calls cash flow insurance, or properly structured cash value life insurance, providing you the ability to access these funds via policy loans before age 59½. What’s more, if the loans are used for your business, in most cases the interest you pay back to yourself is tax deductible.
2. Put your family members to work.
I find employing family members to be one of the most overlooked and yet resourceful ways to begin reducing the household tax burden. By employing my wife as the director of operations for our firm, for example, we’ve been able to double the amount of income that can be deferred into our 401(k) plan. My wife spends a great deal of time heavily involved in our regular business activities. Even if your spouse isn’t working with you full time, he or she may be more engaged in your business than you think and could have a place there.
If you have children, it may make sense to put them on the payroll, as well, as legitimate employees. Our family business has helped us teach our children about the value of a dollar and the importance of hard work. Our children have been employed nearly since they were born, initially under modeling contracts, as they have been utilized for advertising and promotional materials, then as they got older they were able to help with various menial tasks around the office justifying a higher, but still modest wage. Children typically will be in a lower tax bracket, but that doesn’t mean they aren’t spending plenty of the household money. Why not maximize the net income? Rather than taking your personal wages and paying for the children’s expenses, you can pay them their wages directly, so they can cover those expenses themselves at a lower tax rate and potentially no tax if their income doesn’t exceed their standard deduction. You could even have them open a Roth IRA to help them learn how to manage their investments and lay the foundation for their own tax-free retirement.
3. Rent your home when it’s used for business activities.
If you regularly host business-related events at your home or some other dwelling you own, you may be overlooking an extraordinary opportunity. The Internal Revenue Code allows dwelling unit owners to rent their property to other individuals or entities for 14 days or fewer in a calendar year and exempts the income received from taxation. Just be sure you’re executing a contract in which the rent is paid at fair market value and that it is an ordinary and necessary business expense of the entity.
4. Reduce self-employment tax with an S corporation.
Many people get so caught up in getting their business started that they forget to make the appropriate election to avoid paying excessive self-employment taxes. You have until the end of the year to elect to be taxed as an S corporation retroactively. You still must run your payroll and pay yourself a fair wage, but distributions can allow you to eliminate this 15.3% tax on a good chunk of your annual income. Keep in mind that avoiding self-employment taxes may ultimately reduce the amount of Social Security income you are supposed to receive in the future. My personal feeling on this is that I would rather save for my own retirement, rather than letting the government do so on my behalf, however if you feel the government can do a better job saving for your retirement than you it may make sense to pay a higher level of self-employment tax.
5. Evaluate the benefits of a C corporation.
There’s been a long-running debate regarding the benefits of establishing a C corporation over an S corporation. Generally, an S corporation allows you to avoid being taxed twice as earnings realized at the corporate level flow through to your personal return. For most businesses, this is probably the most advisable default. But for some, the C corporation structure may offer comparable advantages. A C corporation gives you the ability to make use of tax-free employee fringe benefits not offered to S corporations, such as meal expenses; medical, disability and long-term care insurance; and even tuition reimbursements. In some instances, it may even make sense to combine corporate structures for the biggest tax benefits.
Don’t be afraid to take legal measures to reduce your tax burden. Tax deductions, tax credits, tax-free reimbursements, corporate structures and more are all part of the tax code. As long as you follow the letter of the law, keep good records and have good counsel from a competent tax professional, as I do, you should be able to keep more of your money where it belongs: in your pocket.