Given all the hardships business owners experience, a bit of financial TLC seems to be in order. Here are our top 8 tips for lowering your tax burden.
Tip #1: Do ongoing tax planning for your business
All the hard work you put into your business might be meaningless if the IRS is taking up to 50% of your income. Every business, large and small, should invest in tax planning once every few years at the very least, as it may lead to considerable tax savings.
What does tax planning provide? In a nutshell, it provides a comprehensive analysis of your business taxes and personal income taxes, to find ways to lower income taxes. This includes but is not limited to:
- Making sure you have selected the correct legal entity for your business
- Making sure you are claiming all available deductions and tax benefits
- Ensuring your retirement plan is optimal
- Ensuring your insurance structures are optimal
- Making sure you are taking advantage of more advanced tax saving strategies, such as tax credits available to you
- Making sure you are taking advantage of recent regulatory changes – such as forgivable loans offered to business owners impacted by the pandemic
- Any custom tax questions you may have – relating to the sale or purchase of a business, investments, capital gains, vehicle purchases, rental properties and more.
You can see by the above list what incredible value tax planning can have – and how your money may be needlessly going to taxes, when it could be reinvested in your business or retirement!
Tip #2: Find the right professional
Now that you know that tax reduction planning can lead to amazing benefits for you and your business, how do you go about claiming these advantages? By working with the right professional, of course!
We cannot stress this enough. Unless you yourself are a CPA with years of tax reduction planning experience, you probably have no business implementing tax reduction planning strategies on your own. No matter how much you read, google, watch YouTube gurus, research and dig – you will most likely get something wrong. And getting something wrong when taxes are concerned can lead to a huge nightmare of IRS notices, audits, penalties, interest and fees. We see this every day.
So, who is the “right” professional to help you reduce your tax liability?
Look for a professional with tax planning experience in your industry, preferably a licensed tax professional, such as a Certified Public Accountant, or CPA. Many people call themselves “planners”, “optimizers”, “tax reduction specialists”, but CPAs have a (state certified) in-depth understanding of tax law as it relates to you and your business.
Not all CPAs, however, specialize in reducing your income tax liability – just like not every doctor specializes in neurosurgery. It’s not enough to be a CPA – your tax planning professional should have years of experience reducing their clients’ tax liability.
Most tax planning professionals offer free initial consultations – don’t be afraid to ask about education, experience, and certification.
In 2021 we had a call from a doctor who was, seemingly, using every tax reduction strategy in the book. Once we did a deeper dive, however, it turned out the doctor did not qualify for most of the strategies he was implementing (as he was a W-2 earner and the strategies were meant for S-Corps). He told us he read about and implemented the strategies himself. He had to spend over $15,000 amending several income tax returns, in order to avoid penalties from the IRS.
Tip #3: Plan for future events as far in advance as possible
Imagine inviting your entire family for a Thanksgiving dinner and not doing any planning until the day of. Sounds like a recipe for disaster! Why do we plan for weddings, family dinners, parties or vacations weeks (sometimes months or years!) in advance, but leave important financial or tax planning decisions until the last minute?
Although vacation planning is, admittedly, a lot more fun than speaking with a CPA, the latter can have a much larger impact on your life, especially in the long-term.
We recommend contacting your accountant or CPA as soon as you become aware of future events that will affect your taxes (e.g. the sale of a business, purchase of investment real estate, a larger injection of income, a capital gain that could lead to capital gains tax, or an inheritance).
This will give your CPA ample time to analyze the financial consequences of a future event, and recommend ways to reduce your tax bill, if possible.
Many tax credits, deductions and other goodies offered to business owners by the IRS or States are deadline-driven, which means that business owners who procrastinate are leaving thousands of dollars on the table. Once you receive that state or federal income tax bill, it is usually too late to do anything about it.
Tip #4: Optimize your retirement
Business owners have a wide variety of retirement accounts to choose from – including a 401(k), SEP IRA, profit sharing plans, cash balance plans… Additionally, many business owners wish to make Roth IRA contributions to further boost retirement savings.
Which plan is right for you? Is the plan you are contributing to now the most tax efficient? Is it helping you reduce your taxable income while ensuring your golden years are stress-free?
What kind of tax savings could be available for you? In 2019 we met with a business owner who was contributing to a SEP IRA. We recommended that she contributes to a profit sharing plan with a cash balance component instead, and created a multi-layered retirement plan for the client. Her savings? Approximately $90,000 in taxes annually, with just this ONE strategy!
Tip #5: Optimize your insurance structures
With tax hikes on the horizon, including increased taxes on inheritance, taxpayers are looking for new financial vehicles that will help them, and their heirs, avoid hefty tax bills.
Tax planning, and estate planning, experts say that life insurance could be one of those vehicles.
Why?
- Life insurance policies can offer heirs tax-free proceeds upon death.
- These proceeds can be used to cover any final expenses (including funeral expenses and final taxes owed by the insured), debts, inheritance or capital gains taxes incurred by heirs, as well as estate taxes.
- More importantly, these proceeds can be accessed relatively quickly – much faster than it would take to liquidate real estate or other assets.
- Life insurance payouts (if a beneficiary or beneficiaries are named) are also not subject to probate – which can be a lengthy and public process.
In addition, cash accumulation within a policy can be accessed tax-free by the insured, via loans against the policy.
Tip #6: Reduce your individual income tax liability
Business owners are not the only ones who can put a dent into their tax liability with tax planning. If you are a high-income earner, or received a larger cash injection, there are quite a few things you can do to decrease your liability to the IRS and state.
- Open a Health Savings Account (HSA). This account can used to pay for qualified medical expenses tax free, as long as you meet other requirements (e.g. you must have an HSA-eligible, high deductible health insurance plan). Apart from tax-free spending on qualified expenses, funds in an HSA can be invested and grow tax deferred. Funds also roll over to future years if you do not spend your entire annual contribution. In addition, you can open this account yourself at your financial institution (no need for an employer to set it up for you).
- See if your employer offers a Flexible Spending Account (FSA). Here funds do not roll over, so make sure you spend your entire contribution amount by the end of December each year!
- Charitable contributions are tax deductible, but in many cases they do not actually lower your tax liability, due to the hefty standard deduction individuals and married couples filing jointly get to claim on their tax return. Optimize your deductions by starting a Donor Advised Fund (DAF). A DAF allows donors to make a larger charitable contribution, receive an immediate tax deduction, and then recommend grants to charities from the fund over time. Donors can contribute to the fund as frequently as they like, and recommend grants whenever it makes sense for them.
- Make sure you are deducting everything you can on your income tax return, such as mortgage interest. A CPA should be able to help you with that!
- Claim any tax credit available to you – such as the Child Tax Credit.
- Ask your CPA to make sure the standard deduction makes sense in your situation. At times, an itemized deductions offer more benefits.
- Explore state and federal benefits of saving for educational expenses and college for your children – such as 529 plans.
- Have self-employment income? There are many strategies and deductions you could be taking advantage of – including claiming a home office deduction (if you work from home and meet other IRS requirements). Receiving a 1099 may have other benefits – such as deducting expenses and mileage (if applicable!).
- Did great on the stock market and want to avoid capital gains tax? Ask your CPA about loss harvesting or Qualified Opportunity Zones.
- Finally, if you make the big bucks, there are quite a few advanced tax reduction strategies you should be taking advantage of – ask your CPA about Investment Tax Credits.
Tip #7: Compliance, compliance, compliance
The IRS (or State Departments of Revenue) never gives anything out for free – there are always hurdles to jump through. Want to claim a tax credit or tax deduction to lower your state or federal income taxes? Don’t forget about the paperwork!
No matter what type of tax reduction strategy you implement, it’s not enough to just claim it on your income tax return. You need to make sure you are keeping all the receipts, filling out all the forms, have proof of all the transactions, etc.
Always investigate whether your tax planning professional will also help you with tax strategy implementation compliance.
Tip #8: Avoid gray areas and red flags
No one can promise you they’ll wipe out 100% of your state or federal income tax liability. At Ratio CPA, although we understand that you want to lower your tax burden as much as possible, we make sure to ONLY use ethical tax reduction strategies.
We also make sure to only offer tax credits and deductions that our clients are qualified for, and always warn clients about possible risks.
In summary, tax planning, just like retirement planning or financial planning, is a very important tool in your toolkit. We recommend working with a certified and experience tax reduction planning professional (this is not the time to DIY!!) and focusing on both your business and your individual taxes. We recommend taking advantage of tax credits, tax deductions, retirement and insurance planning, and absolutely avoiding gray areas of the tax code!