In two earlier articles, we went over tax planning dos and don’ts, as well as basic tax-related terminology.
Part Three
In this final part of the series, we will be exploring business strategies, strategies for self-employed individuals, and real-estate strategies, as well as strategies for high-income individuals with W-2, K-1, 1099, or business income.
Tax Reduction Planning for Businesses
Tax Deductions
Whether through the purchase of a heavy vehicle, EV vehicles, expensing health insurance, depreciating assets, funding small life insurance policies for employees, or by creating an administrative home office, business owners have a vast range of deductions available to them.
Many aspects need to be considered before claiming a deduction, including industry, legal entity type, profitability, and business goals.
A good tax planning professional should look over the deductions you have been taking in order to make sure you are not overlooking tax savings, but also to make sure you are deducting expenses in compliance with IRS regulations!
Hiring Children
If you are a sole proprietor, own a single-member LLC, have a spousal partnership, or have an S Corporation or C Corporation, this strategy may apply to you.
Business owners with children under the age of 18 can deduct up to the standard tax deduction ($14,600 in 2024) per child, per year, by hiring their children to work for the business. Parents are not required to hand wages over to their children. The wages can be deposited into a separate account and these pre-tax earnings can be used to fund existing childcare-related expenses: school tuition, groceries, clothing, and schoolbooks (i.e. everyday costs incurred by the parents). They can also be used to fund a Roth IRA or college fund.
Business owners take a tax deduction for wages paid, while children do not pay federal or FICA taxes on their salary.
There are several caveats that go with the strategy—the most important of which are that children must actually perform age-appropriate tasks for the business and must be paid a fair market salary. It’s best to consult an experienced CPA to make sure the strategy gets implemented correctly, and tax savings are maximized in compliance with IRS regulations.
Want to read more about this strategy? Click here.
Hiring a Spouse
Spouses often help around the business in an informal way, as it might not make a difference which spouse is bringing in income when filing jointly. However, if your spouse is paying out of pocket for health insurance, wishes to fund their own retirement account or life insurance policy, it might be beneficial to formally bring them on payroll as an employee and have the business handle these expenses.
Retirement Planning
Many factors come into play when planning retirement strategies: business profitability, number of employees, age of employees, tax deferment goals, and cash flow goals.
Business owners who max out their 401(k) or other retirement vehicles may want to investigate setting up more complex retirement strategies, such as cash balance plans and profit-sharing plans.
Self-employed individuals may want to look into solo 401(k)s or SEP IRAs.
It is important to remember that most of these retirement strategies will defer, not reduce, your tax liability.
We discuss a wide range of retirement vehicles and retirement strategies in this article.
Advanced Tax Strategies for Profitable Businesses
There are many advanced tax reduction strategies available to qualifying businesses, such as Research and Development tax credits, Employee Retention Tax Credits, Work Opportunity Tax Credits, and more.
Certain businesses can also set up their own insurance company. If your profitable business activities come with a lot of liability that typical insurance policies do not cover (political unrest, war, “acts of god,” pandemic risk, acts of terrorism, loss of a key employee, etc.), you can set your mind at ease, save on taxes, and additionally insure your business by setting up your own insurance company. This is called micro-captive, captive insurance, or Section 831(b).
Premiums paid to a captive insurance company are federal tax free. If you use the funds inside your captive to pay for a claim, there is no tax to be paid at all.
Captive insurance companies have their risks if implemented incorrectly or for the wrong reasons, so you should always consult a tax planning professional before implementing this strategy.
Tax Reduction Planning for Self-Employed Individuals
Tax Deductions
Just like in the case of business owners, self-employed individuals receiving 1099s can deduct various expenses related to their self-employment, including a home office (if applicable), work-related purchases, travel expenses, necessary professional education, equipment, and PPE.
It’s important to make sure everything you are deducting is compliant with IRS regulations, and a good tax planning CPA will be able to help you.
Legal Entity Optimization
If you receive regular self-employment income and this will remain the case in the foreseeable future, it may make sense to set up a single-member LLC, or even make an S Corporation election.
Owning a legal entity may make it possible to implement additional tax reduction strategies that would otherwise be unavailable to you, including certain retirement strategies.
Making a so-called S Corp election should especially be considered very carefully, as apart from tax benefits, this choice comes with a few downsides – such as filing a separate S Corporation income tax return, maintaining formal and up to date accounting (no Excel or shoebox receipts), being on payroll and, in some cases, additional local or state filing or payment requirements.
S Corporation elections (also called Subchapter S elections) should never be made without careful tax reduction projections and knowledge of all the pros and cons.
Tax Reduction Planning for High-Income Individuals
High income individuals, regardless of their sources of income (i.e. W-2s, business income, 1099s, and K-1s) have access to a range of tax reduction strategies, below we list just a few.
Advanced Tax Reduction Strategies
While a high-income earner will not qualify for many common tax credits, such as the child tax credit or the earned income tax credit, they can get massive tax benefits in the form of Investment Tax Credits (ITC).
One way to receive Investment Tax Credits is by participating in commercial green energy projects, such as commercial solar energy projects. These projects are not on the residential level (you are not installing solar panels on your own roof!) but on a commercial level. The beneficiary of electricity provided by solar panels can be a non-profit, such as a school or place of worship, or a for-profit business.
High income earners can fund solar panels for the non-profit (or other business), and in return receive ITC, federal and state depreciation deductions, as well as residual passive income from the sale of electricity over a few years. The value of these benefits is greater than the initial purchase amount, which is not the case for residential solar projects.
This is a huge win-win for the buyer, the beneficiary of cheap green energy, and the environment. If you max out your allowable ITC for any given year, it can be carried forward for 22 years, or carried back up to three years. This means you can invest in green energy projects and lower last year’s taxes! We cover this strategy in an earlier article.
There are other advanced tax reduction strategies that a good Tax Reduction Strategist can help you with, and which will lower your individual income tax liability.
Donor Advised Funds
Many high earners make donations to charities, but do not always receive a full tax advantage for doing so (because of the standard deduction). A good CPA firm will help you become much more tax efficient by setting up 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.
You can make a charitable contribution to a DAF in the form of cash, appreciated stocks, mutual funds, real estate, or artwork, and immediately receive the maximum tax deduction for the year.
Additionally, your contributions in a DAF can be invested and grow tax-free.
Life Insurance as a Tax Planning Tool
Money in a 401(K), or equivalent (like a traditional IRA or SEP IRA), is not tax free, just tax deferred. This means you will pay taxes on 401(K) retirement funds as you take distributions upon retirement.
What will your federal and state tax rates be when you retire in 10, 20, or 30 years? No one can know for sure—but most experts expect tax rates to go up, way up! This is why retirement plans made in post-tax dollars, such as Roth IRAs, are becoming more and more popular, as distributions upon retirement will be tax free.
In addition, traditional retirement plans have contribution limits, income limits, and a minimum distribution age (i.e. how old you have to be before you can start taking money out without incurring penalties), or at what age you are forced to start taking distributions, whether you need to or not.
A whole life insurance policy can circumvent all these limitations, and your contributions (premiums) are made with post-tax dollars.
Though purchasing a whole life insurance policy to supplement retirement is definitely not for everyone, the strategy can offer:
- Tax preferred cash accumulation (funds grow tax free)
- No contribution limit, regardless of taxable income
- Baseline, guaranteed cash accumulation (available in some types of policies)
- Potential (not guaranteed!) dividends that add to your cash accumulation
- Ability to take tax-preferred withdrawals in retirement
- A custom policy to meet your needs
- An income tax free death benefit (if eligible)
You can also add bells and whistles to your policy, such as a disability waiver, a long-term care rider, or even a term life insurance policy.
Those interested must keep in mind that dividends are not guaranteed and that whole life insurance plans are medically underwritten, and thus, are not available to all applicants. It’s also important to see complete policy illustrations before making any decisions!
Live in a State with No Income Taxes or a Tax-Advantaged US territory
Nothing lowers taxable income like a 0% state income tax rate.
There are currently nine states with no state income taxes:
- Wyoming
- Washington
- Texas
- Tennessee
- South Dakota
- New Hampshire
- Nevada
- Florida
- Alaska
Want no state tax burden? Simply move to one of the states listed above! You do have to become a bona fide resident of a 0% income tax state in order to reap the benefits, meaning transferring your mail, driver’s license, voting registration, and primary residence to the state in question. You also have to spend at least 183 days out of the year residing in the state.
Certain US territories, such as Puerto Rico, offer even bigger incentives to business owners and high net worth individuals who move offshore – again, under the condition that you prove you are, by definition, residents of the territory.
Benefits might include receiving a 100% tax exemption from income taxes on all dividends and interest, tax exemptions on capital gains stemming from the sale or exchange of securities that appreciated in value, or reduced corporate taxes and exemptions from property taxes, municipal taxes, and taxes on dividend distributions for income generated and property used in exempt operations.
Tax Loss Harvesting
If your capital investments did well this year, you may be forced to pay short or long-term capital gains taxes. One strategy for reducing capital gains is to sell other investments at a loss and use those capital
losses to balance the gains for tax purposes. If you make a capital gain of $10 and a capital loss of $10, the net effect is zero, and no taxes are owed.
Using capital losses means you have to lose money on one stock in order to avoid paying income taxes on another. This method is often referred to as loss harvesting, where you sell shares at a loss on purpose to balance the gains on profitable sales.
Real Estate Strategies for Tax Reduction Planning
1031 Exchanges
Selling an appreciated investment property may lead to high capital gains tax liability. However, you will not have to pay tax on the sale of an appreciated property if you do a so-called 1031 exchange (Section 1031 is a provision of the tax code).
A 1031 exchange allows real estate investors a tax deferral on gains from the sale of an investment property if they “roll” the proceeds directly over into a similar property within 180 days. The provision was established in 1921 to promote economic activity.
Real estate professional status
Real estate investments are very popular among high income earners. You may be pondering the question: “How can I save on taxes with a rental real estate investment?”
The answer is very complex.
Investing in real estate is just that: an investment. Some investors make a lot of money buying, renting, and selling properties—and some lose quite a lot as well. This is because an ROI from an investment is never guaranteed, no matter what anyone tells you.
Rental income (unless you achieve professional real estate status) is considered passive income. If you have more expenses than revenue, this is called a passive loss. Many rental properties have passive losses as a result of depreciation, maintenance, property management fees, real estate taxes, insurance, and other operating costs.
With various business or self-employment income types, you can deduct losses on your annual income tax return. With passive losses this may not be possible, as passive losses can usually only be offset by passive gains (i.e. if your rental property becomes profitable, your passive losses will offset your passive gains, but usually not your active (ordinary) income, like from a W-2 job, a business, or a 1099).
Unless you have a passive gain or sell the property, your passive losses will be carried forward indefinitely, with no benefit to you.
There are exceptions to the above, but those with full-time jobs in a higher tax bracket often do not meet the requirements.
You may be able to deduct passive losses against your ordinary income if you obtain real estate professional status. This is not easy to do, as you must spend at least 750 hours annually in the real estate business, and more than half of your working hours must be dedicated to real estate. You must also fulfill a series of other requirements. This is almost impossible if you have a full-time job.
You should do a lot of due diligence on a company promising to slash your taxes in half through a rental property investment (especially if the aforementioned company wants you to set up a convoluted legal entity structure or employ complicated measures or loopholes).
So… what can you do if you are eager to invest in rental real estate or already own a property?
- View your purchase as an investment and not a tax reduction strategy.
- Understand that your rental property may not be profitable, and you may not see any of the passive income you strived to obtain with the investment.
- There are various ways to increase your passive losses to help offset passive gains (such as doing a cost segregation study, described below) or defer capital gains from the sale of your property (e.g., 1031 exchanges described above).
Cost Segregation
Cost segregation is a method utilized by real estate investors to expedite the deduction of property depreciation, encompassing a range of assets, from single-family homes to office complexes and retail spaces, against their taxable income.
Depreciation on investment real estate typically entails a gradual write-off over time, contingent on the specific property type. However, cost segregation offers an opportunity to accelerate this process, enabling a larger annual deduction.
As an example, your commercial property may depreciate over a standard period of 39 years. If the value of the commercial property is $1,000,000, this would give us approximately a deduction of $25,600 annually. However, the HVAC system (valued at $60,000) may depreciate over a ten-year period, and the flooring (valued at $50,000) over a seven-year period. This combined $110,000 value (HVAC and flooring), can be deducted at an accelerated rate, leading to a larger deduction year one through seven for the flooring, and one through ten for the HVAC.
To initiate the use of cost segregation, a cost segregation study is required.
Airbnb
While it is true that long-term rentals lead to passive income or passive losses that cannot usually be deducted against active income (such as business income or a W-2), income and losses from short-term rentals, such as Airbnb or Vrbo, are considered active income and active losses.
In this case, losses created by a cost segregation study, may lead to lower tax liability.
While not everyone will want to deal with short-term rentals, and some locations disallow them or impose a higher tax on these rentals, high income earners who wish to be “hands-on” with a residential rental property may be interested in exploring this strategy.
Getting Started with Tax Reduction Planning
We’ve explored business strategies, strategies for self-employed individuals, and whole life insurance strategies as well as strategies for high-income individuals with W-2, K-1, 1099, or business income. Based on your unique tax situation, different tax planning strategies can be leveraged to curate the optimal outcome. So how do you know which strategies are right for you?
The expert team at Ratio CPA can help you navigate the complex world of tax planning. We’ll take into consideration your income sources and long-term goals to formulate a comprehensive tax reduction plan just for you.
Contact us to connect with a Tax Reduction Adviser to see how we can help you lower your tax burden.