The dream of owning your own business is a lot like owning your own home. Once you have
done all of your searching, decided on the size, style, color, neighborhood, local amenities and the price, you are ready to make the plunge. Homebuyers who do some up-front planning and seek advice on a myriad of financial and non-financial matters that occur during the homeownership period reap huge benefits down the road.
Likewise, when owning your own business, the tax planning you do up-front pays huge dividends in the future. An age-old axiom among tax professionals is “never let the tax tale wag the dog." In other words, an owner needs to understand his or her business as thoroughly as possible. He needs to know the industry, the market, the customers, the drivers and business strategies for that business before making an investment in it. Once he has done that, it’s time to think about the major tax strategies to help him maximize the return on his investment.
Here are my top 5 tax strategies:
#1: Choice of Entity
A business owner can operate in these structures: a sole proprietorship, regular C corporation, a subchapter S corporation, limited liability company (LLC), a general partnership or limited partnership. Under current tax rules, all of these except a C corporation offer the business owner one level of taxation; that is, the earnings of the business are taxed only once and then the owner is permitted to distribute those earnings to herself without further taxation. In a C corporation setting, the business profits are taxed at the corporate level (first level of tax) and again when the owner distributes the after-tax earnings to herself (second level of tax).
#2: Selection of a tax year
There is considerable flexibility under the tax code to choose the tax year that best fits the business. With a C corporation, any calendar month end is permissible, so picking a month that coincides with a low point in the business cycle, allows a certain amount of income and tax deferral benefits. The other type of entities listed in #1 offer less flexibility and will generally permit a tax year ending with any month from September through December. While there are some tax deferral savings to be had, it typically will be much less than with a C corporation.
#3: Selection of tax accounting methods
The tax law allows numerous ways to defer income or accelerate deductions which are primary strategies. Anytime a business or its owner can push off into the future paying a dollar of tax, it allows a greater retention of cash in the business to fuel its growth. Common elections include whether to use an overall cash or accrual method of accounting for tax purposes. Heck, a business may even qualify to have its cake and eat it too by keeping its regular books and records on an accrual method, but electing to use the cash method for filing its tax returns.
#4: Keep current with all tax reporting and filing deadlines
Nothing causes a business owner to lose sleep more than to have the IRS “knock on the door” because of missed tax filings, failure to properly report transactions or make tax payments. Especially with payroll deposits involving trust fund taxes, such as employee withholding taxes and Social Security and Medicare taxes, failure to withhold and pay over these taxes can make the owner personally responsible to pay them if the business fails to do so.
#5: Convert “ordinary income” to “capital gain” income
With businesses operating as “flow-through” entities (e.g. sole proprietorship, S corporations, LLC’s or partnerships), there is a 17% to 20% tax savings with having income characterized as long-term capital gains instead of as ordinary income. The tax savings from one transaction where income gets converted to L-T capital gains can be huge.
My final advice is for business owners to seek competent counsel and advice from an attorney and outside CPA on these strategies before the business opens its doors. Like the homeowner who finds it hard to leave his dream house, investing some time and money in good, solid tax planning upfront will make the business ownership experience a memorable one. If you would like more information on the strategies discussed above, click here.