Editor’s note: Since publication of this update, our Scoreboard feature has undergone a change, and we now call it the Dashboard.
Tax season has come and gone, but the main takeaway from our recent webinar on tax planning for small businesses is that the key to saving money on your taxes is to think ahead and plan. It’s never too early to start thinking about how to prepare for your business taxes.
One of the first things you’ll have to consider is what type of legal entity you would like your business to be. It’s a decision that too often gets made by new business owners based on whatever’s easiest to file for, but it’s a decision that really should be motivated by tax planning. Who owns your business, and how often would they like to be paid? How would they like to be paid, and how much? Well, the answers to those questions will determine which business entity is most appropriate for you: a partnership, a sole proprietorship, a C Corp, or an S Corp.
Another important thing to know about your business taxes is that you can only claim tax deductions for expenses that occurred during the tax year. For example, if you spent $2,000 on marketing services in December 2013 that weren’t actually delivered to your company until January 2014, you probably couldn’t claim those marketing services as an expense for the 2013 tax year. This is important because it means you should be tracking your sales and profitability all year long, and determining that your business has extra cash to spend as early in the year as possible, so you can plan for how to spend it in the most tax-efficient way possible.
Earlier this month I hosted Ryan Clower, a CPA from the accounting firm M. White and Associates, for a webinar on tax planning for small businesses that we called “5 Critical Tips to Reduce Your Business Taxes This Year.” Ryan is extremely knowledgeable on this topic, and I was really pleased with how much information we were able to cover in only an hour.
I’ve included the full audio and slide deck above, and the full transcript below:
5 Critical Tips to Reduce Your Business Taxes This Year
Sabrina: I want to welcome everybody to our webinar this morning. I’m really excited to have Ryan Clower from M. White and Associates—based out of Plano, Texas—joining us, to help give some advice about taxes and small businesses, and obviously, ’tis the season right now. We’re getting near that April 15th deadline, and oftentimes, businesses get different deadlines, but if your business is a pass-through organization or depending on the legal entity, then April 15th is a deadline, but is important to all of us, so very timely.
M. White and Associates is a firm that is passionate about small business owners, and really focused on helping them achieve their financial goals. They work with business owners nationwide to get a better handle on their financial performance through financial consulting and proactive planning, which we at Palo Alto Software, the makers of LivePlan, love to hear. One of our favorite things to do is work with accountants who are helping small businesses and really teaching them all about what proactive planning is.
The more that you do some of this proactive planning, the better your business will do. It’ll help you understand and plan for taxes that will be better off for your business, so it really kind of all goes hand-in-hand. They love to educate their clients, and that’s why we have Ryan with us here today to provide some education into the often complicated world of business taxes. With that, I’m going to hand it over to Ryan.
You can see that on the screen here, I’ve got my @MommyCEO Twitter handle. When I’m not running Palo Alto Software, I’m pretending to be the boss of my three children, although apparently, very often I’m not supposed to be the boss of them. That’s why @MommyCEO, and I’d love to hear any questions you have.
Of course, throughout this webinar, Ryan will be focusing on a lot of in-depth information, and we will have questions come through in the question section in the GoToWebinar panel that you see, so please ask them. If we don’t get a chance to answer your question, we’ve got everybody who’s registered for this webinar. We’ve got your email addresses, and we will go ahead and field some of those questions and send out an email with the recorded webinar, as well as with some answers and maybe link some resources after this webinar.
We’re going to have some help fielding the questions, and we will save the questions to the end, but please go ahead and ahead and ask them while we go through. So with that very lengthy intro, Ryan, I’m going to pass it over to you.
Ryan: Yeah, Sabrina, I really appreciate that. I’m excited to be able to be here with you guys today. We’ve been working with our firm—we’ve been working with LivePlan, and the folks back there, to really kind of help business owners get a better handle on from a consulting and a business financial performance and get a better handle on their business, and really achieve their long term goals. I’m excited to be here. I am a CPA, down here certified in the great state of Texas and really just stoked to be here.
I’m one of those people who, I geek out in a tax sense, and few and far between in this world, but I’m one of them, so I think this presentation is right up my alley.
We’re a firm that prides ourselves in education with our clients, and that’s really because we want them to have a handle on their business financials and their personal financials. Today, we’re going to go into five critical tax tips to reduce your business taxes this year. A lengthy title. We couldn’t figure out what to call it, but it’s about taxes. It’s that time a year, so bear with me as we get going here.
These are your five tax tips for the day. Write these down and we can end the presentation here shortly after. Just kidding. You don’t have to write those down.
[LAUGHTER]
Here’s the problem, and I’m not going to go back to them. Here’s the reason why. People in tax season will jump out there, go to Google, they get their tax bill, they hear from their CPA, and they kind of run around and do it on TurboTax or something. They jump onto Google, say, “How can I save on my taxes?” The problem is, just like in that previous slide you see, five generic tax tips, and many times you see 50 or 100, and they’re not necessarily applicable to you or your business.
Applying tax tips and tax advice really has to come through a holistic approach to knowing your situation on a personal side and your situation on the business side. As business owners, it’s a complicated world out there. I realize taxes are one of the most complicated of the things that you have to deal with in your life. If you have solid tax advice and you have solid guidance in all areas, you won’t have to use Google to try to meet your goals.
As I mentioned, asking why, all of our business owners, I really work with them in a month-in, month-out basis. They call me all the time, not only talk about their business financial performance, but to talk more about why we’re making the decisions we’re making and how those decisions affect their long term goals. Everybody who has a business has a goal of selling that business at some point in time or transitioning that business to another individual at a point in time. That is really how you achieve your long-term well planning goals.
If we all want to be a non-profit, that’s what we’d be doing, but the truth of it is, we’re all in a business to make a little money and to build wealth. So asking why we’re doing certain things is the most important to us, and really what we’re try to educate people on.
Sabrina: I love that Ryan is telling you guys to think about your long-term financial goals and planning, because I totally echo what he’s saying. If you have those goals in mind and you understand where you’re going with your business, you have so much more power to plan for them, both on the tax side as well as on the revenue and expense side for your business and cash flow management.
I think it’s one of the reasons we work so well with M. White and Associates. They get that long-term planning and really see how it’s beneficial to small businesses on all angles, so I just wanted to jump in there and say, it’s what businesses should be doing, and oftentimes, I know you guys are all sitting there as small businesses going, “I’m overwhelmed! I have too much to do!” It’s so well worth your time.
Ryan: That’s exactly right. All professionals in our arena that help business owners should be educating along the way. You don’t all have to be tax people. You don’t all have to be accountants. You have to be good at running your business, but you do need to know why.
It kind of starts with the legal arena, right? That’s one of the areas that most people just, start a business. Everybody knows you have to incorporate or build an entity structure. It’s part of the business planning that the folks over at LivePlan help you with. This is not ever what you want to see, however. A lot of attorneys get out there in the same room with CPAs and they all start geeking out on the whole entity structure and tax planning and all that stuff, and this is what you end up with.
This is not what you want, and I’m going into what you do need, but then go into what corporation this structure is for. Alright?
You all guessed that it is Enron. Accountants make jokes at Enron’s expense all the time. They crushed an accounting firm, so we just do it. It’s fun.
The real question behind entity structuring falls into two buckets. There’s the legal side and there’s the tax side. On the legal side, why do we have entities? Well, we have entities for two reasons, to protect your business assets from your personal risk and your personal assets from your business risk. Oftentimes, the example is, in your business you have an employee. They get injured on the job. Yes, you have insurance. Yes, you have all this other protection that can be in place, but the legal entity is kind of the end-all, be-all to make sure that your personal assets that you’ve accumulated from the business are not at risk from any lawsuits that happen in and of the business. The same thing holds true on a personal side.
Then on the tax side, which you have to understand is when we start talking tax planning, what we’re really talking about is being efficient with the way in which we run transactions. Now as a business owner, you take two hats and put both on sometimes simultaneously, one as the investor and owner of the business, and the other area is as the employee of the business.
Let’s be honest here. Every business owner, if the job’s not getting done by the rest of the employees, the job falls to you. Though tax efficiency is one of the areas we jump into when we’re talking legal structure, Sabrina, I wanted to ask you a question here. In your experience in helping these businesses get up and operational, what type of entity structures are you seeing most of your customers kind of get into or set up at?
Sabrina: You know, that’s a great question, Ryan. The answer is a good number of them are sole proprietorships. We definitely see a lot of partnerships, and then kind of split between C Corps and S Corps, but most of the entities that we see are pass-through entities for small businesses, and I’ll let you describe a little bit more what the big picture of that means. But basically, your personal finances and business finances are little more intermixed when it’s pass-through entity.
The bigger thing, though, is too often we see small businesses that start up, and they are an entity but they haven’t really created the best legal documents between the people who have founded the business. If it’s two partners who maybe were friends, a lot of times, let’s say siblings or cousins, some sort of family aspect, and what we see that, we think it’s freely about idea, and we try to get people to understand, if these entities being formed without a clear idea of very specifically who owns what, how is that owned, documenting who has invested how much money, and also documenting what happens if someone wants to walk away from the business, and how does that all work.
A lot of the times I hear small businesses say, “Oh, those are awkward conversations, and we don’t want to talk about the negatives.” You know, we look at it like, wow, this is, like, besides maybe a marriage from a personal perspective with a spouse or a significant other, this is a marriage, and you need to think of all scenarios, including if somebody has some life reason why they want to walk away from the business. If you don’t think about it, you’re going to spend money on lawyers and legal fees, and things are going to happen that both parties are going to not be happy about.
That’s sort of the big thing that we see, is people will pick an entity type but then won’t go the next step and really think about all the pieces of, what does that mean, especially when they’re doing things in partnership.
Ryan: Sabrina, I’ve seen the same thing. Like you said, in a partnership, when there’s two or more people involved, it can get ugly. It is a marriage. It is a financial business marriage, and oftentimes, I’ve seen personal marriages end in a less harmful way than I’ve seen a lot of business marriages end.
You’re exactly right. Following through on the documents and following through with a partnership agreement that is well stated and clearly explains the duties, roles, and everything about that business, that really needs to be the guiding light behind the managerial decisions and the long-term business decisions that are made. What’s commonly referred to as a push-pull or a buy-sell type of agreement should be included in there. It’s all legal jargon, and a good attorney could help you out with that. But going out and setting up a partnership without a partnership agreement may have some tax benefits, but from a legal protection sense, it really kind of hurts you.
Sole proprietorships, C corps, S corps, and partnerships—those are the four business types that the IRS recognizes. An LLC is a state-based registration classification.
So kind of go back to the slide, I’m in total agreement with that. You see four types of entity types here. Sabrina mentioned the sole proprietor. That’s on your 1040, Schedule C. She mentioned a partnership down there at the bottom, the two in the middle, C Corp and S Corp. When she was talking about flow-through—and many of you already know this, your sole proprietor flows through, your S Corp flows through and your partnership flows through. But some of you may be sitting there right now and questioning, “Why, I don’t have any of these entities. My documents don’t say any of these. I don’t really understand. Where am I? Where’s my entity?”
If you see here in the graphic, the LLC, which is a limited liability company, many of you are probably set up in that format. These are state designations. You form or incorporate an entity type in a particular state. Then on the left hand side, the sole proprietor, C corp, S corp, partnership—those would be four that the IRS recognizes. So you could be an LLC and then from a federal tax standpoint, you have to then elect or make the decision to be one of those four, depending on your circumstances.
Getting into the advantages and disadvantages, this is kind of the meat of the legal and entity side of things, there are advantages and disadvantages and there’s more than just two advantages or two disadvantages for each entity type, but we thought we’d try to get it all on one slide and not make it look too nasty.
From a sole proprietor standpoint, again, this is on your Schedule C on your 1040. It’s pretty much an administrative ease, because there’s no board meetings or minutes that have to happen like there are in C Corps. There’s not necessarily a partnership agreement, because a sole proprietor is only one individual. You don’t necessarily have to keep up with a federal tax return or the entity.
Now on the disadvantages side, I spent a couple of years with the IRS under the self employment small business division, and yeah, I was an auditor. I had no friends, right, so that’s why I jumped back into public accounting. But it’s one of the most highly-audited areas of the Internal Revenue. It’s the Schedule C, or sole proprietor, business. The reason is just the way that they benchmark some of the statistical data that you put on a tax return. It can end up coming out in the wash where a number looks funny to them. It’s not necessarily that it comes in front of a person. It’s a mathematical equation that they put into a software program.
The way in which that folds out, there’s more fraud and so it is more highly audited. Your partnerships, your C Corps, your S Corps, have less of a risk of audit. Does that mean they have no risk? No, not at all, but they do have less of a risk of audits.
The big disadvantage, however, is the self employment tax. Self employment tax, think about it this way. It’s payroll tax. Payroll tax is Social Security, Medicare. You think back to the days when you had a W2. You had your Social Security and Medicare that came out of your check. That was 7.65 percent of what you got paid, but keep in mind, your employer also paid the other half. Those of you that are employers now, you know exactly what I’m talking about, and it’s that 15.3 percent, Social Security and Medicare. On all sole proprietor income, you do have that self employment tax.
I’m going to move on to C Corps. C Corps, there are some benefits and deductions, mainly under what’s called section 125, or what’s known as a cafeteria plan. There’s some different things that can go in there. A lot of times, we use C Corps in conjunction with heavy tax planning. There’s a $50,000 threshold whereby your tax rate can’t be less than it can be or it could be on your individual return. It’s also something that you’ll see whenever we start talking about some different types of deferred retirements or insurance type of models, and so C Corps are used in that respect most often.
The disadvantage to C Corp, and this is very important, is the problem of double taxation. I’m going through a quick example, so bear with me. $100,000 of C Corp income, 35 percent tax rate, the C Corp owes $35,000. How you get that money out of the corp, where you have to give to yourself either as owner wages, or you have to give to yourself as dividend income. Either way, we’ve already paid the tax once at the C Corp level, and now when it comes under our individual return, we’re going to be taxed again, therefore double taxation. So the effective rate on that one source of income can literally double or thereabout. The other disadvantage of C Corps is there’s a great deal more of administrative burden than on some of the other entity types.
Moving onto S Corps, this is the most common that I see. I do more S Corp returns than anything else, and a lot of the reason is because individual single owners benefit most from an S Corp entity model. The advantage there is that we can designate part of their net profit that they can distribute to the owner as either tax-free distributions, or as owner salary.
Now the problem is the tax-free distributions are tax-free, but like Sabrina mentioned, flow-through entities, if the net profit, the distribution amount, does flow through to your individual return. The good thing is, different than a C Corp, it’s not taxed at the corporate level. It’s only taxed once at the individual level.
Well, then you could probably look at me and say, “Hey, Ryan, why don’t we send it all through distributions? Then we don’t have to pay payroll tax.” But Congress, despite what some may think, is smarter than that and they figured out that they should add a clause in there for anybody who’s an S Corp, that states that you have to have reasonable compensation. That pretty much closes the hole that allows us to be able to send it all through distribution, so there is some that has to go through as owner wages. I could talk offline more about the percentage there, and how much I feel in a case-by-case basis should go through, but that’s where you pick up the biggest tax advantage in an S Corporation.
Sabrina: Hey, Ryan, there was a question from someone, but I think it gets into some specifics, so it’s one of these that I think we will follow up in an email with more resources on C Corps and S Corps and partnerships and pass-throughs, because Sara asked, how does—she and her husband formed an S Corp, and wanted to know how business finance separates from personal finance. That question, Sara, we’ll make sure we follow up with a section all on the advantages and disadvantages of entities from a tax perspective, giving you some links and resources to check out after the webinar, so that we can keep moving along.
Ryan: That’s perfect. That’s perfect, and that is a very important question to understand, especially in a flow-through environment.
The disadvantage, the primary disadvantage on the S Corp side is whatever you give into a multi-owner situation like that, S Corp law requires that everything get split according to ownership. So if you have two owners in an S Corp that are 50 percent owners each and yet you want to give a distribution to one person more than the other, same $100,000 we had in a C Corp, say you’re in an S Corp and you want to give $60,000 to one person and $40,000 to the other, S Corp law keeps you from doing that. Everything has to be equal ownership. Same thing with net profits or net losses.
Now on a partnership, one of the biggest advantages is that we can split that profit and distribution and things like that unequally. I didn’t put that one in there. I probably should have, but that’s one of the bigger advantages and differences between partnerships and S Corporations.
Another big advantage of partnerships over S Corporations is that any debt that you incur or personally guarantee that’s from a bank or a third party source, you get what’s called “debt basis” for that. Basis is a very complicated thing. I’m not going to go into debt here, but just know that when you have a basis, you’re allowed to take net losses up to the amount of basis you have.
Disadvantage, going back to an S Corp, the difference between S Corps and partnerships, is it that third party debt basis is not there and is not allowed, so when you have multiple owners, that could be an advantage to go with a partnership versus an S Corporation.
The disadvantage to an S Corporation, the biggest thing is some of it has to be subject to self employment, the active participation and your active generation of that income per the IRS, which theoretically has to be subject to self employment. There’s some real gray areas there, so I don’t want to go too deep, but just know that that’s what it is.
I do want to pause for just a moment here, because, just because you have an entity, and many people come to me, “Ryan, I set up an business. I have an entity! How can I save on taxes?” Well, they’re equivocating the business set-up and the new legal entity structure with the ability to be able to take bigger deductions, and that doesn’t work. Planning, knowing what you can deduct, knowing what you do have in revenue and knowing what your long term goal is from a holistic approach is the biggest key to success in trying to be tax efficient.
Planning, knowing what you can deduct, knowing your revenue, and knowing your long-term goals are the biggest keys to success in trying to be tax efficient.
So now we’ve gone through entities, let’s kind of get into some of those deductions. From your deduction standpoint, in a business, it really falls into two categories. It falls under the employee benefits category, what’s known as section 125 in the Internal Revenue code, or it falls into your regular business deduction. We can talk all day about specifics, what-if scenarios on the business deductions, meaning, “Should I run the car through the business as an auto expense? How much is too much for meals and entertainment?” Or, “Hey, the Church of Puerto Rico or wherever you want to go—is that a legitimate business expense? Can I run that through the business?”
The answer to that is, and you’re not going to like this, but it’s a case-by-case answer. It depends on the business purpose. Also, you don’t really want to, if you’re going to incur the expense and it’s on your personal side, that doesn’t necessarily mean, “Well, I really want to take a tax deduction for this. I’m going to run it through the business.” We think about everything on our side from two perspectives: 1) being efficient with our tax dollars, and 2) looking at the long-term, overall objective. So just putting money through the business for a tax deduction isn’t necessarily achieving what we want to achieve.
Now on the employee benefit side, a lot of people, especially with the Affordable Care Act, and I don’t necessarily want to get into that topic, because that’ll open up a whole can of worms, but the health insurance, life insurance, auto allowance, continuing ed, tuition reimbursement, this is stuff that you typically see in any big corporation in America, provided to their employees. On a small business level, the purpose of running through the business instead of outside of the business, is to be able to pick up the business deduction for it if you’re going to spend it anyway.
Now the difficulty is in employee benefits, what you offer to one person, meaning you as the owner, you have to then also offer to all your employees at the same level, meaning the offer has to be made; it doesn’t have to necessarily be made at the exact same dollar amount. It’s on a contractual basis.
But like I said, with the planning, before we really start talking about how to be tax efficient and getting deep into those deductions, you have to know where your money is coming from. This is again where we look at a holistic picture of things. There’s really three main sources of income: payroll, business income—that’s your flow through profit—or your investments. That’s a little more complicated, because there can be dividends, interest or capital gains, and there’s different tax rates for those.
But there’s three main income sources, and planning and knowing where that money’s going to come from helps us in tax efficiency. Or to say that in reverse, to be tax efficient, we need to plan which way we want the money to get to us. There’s four types of taxes on those three types of income. Individual income tax, payroll tax—that’s the same thing as self employment tax—capital gains tax, and then this new one for this year, or not this year, but last year, 2013. It’s the Medicare tax.
Let’s take a look at what type of income sources we want. What’s the worst and what’s the best? Well, if we’re planning for tax efficiency, the worst type of income to have from an effective tax rate perspective, would be payroll income, your wages that come from your business, because that’s subject to your individual income rates, which can be between 10 percent to 39.6 percent. Plus, you’re going to have payroll taxes, which is around 15.3 percent. Now there is a Social Security pay out but we don’t want to go there. So a total, the payroll is somewhere under 54.9 percent. That would kind of be the max.
Then we move to income from passive investment. This would be dividend. This would be interest. This would be kind of some flow-through income from a passive investment you made from an equity perspective. That’s going to be tax and income tax rate, the individual side, 10 to 39 percent, plus this new Medicare tax, which is on passive investment income. That tax rate is 3.8 percent. So from your passive investments, you’re looking at just under 43.4.
Now the business income, this is from the flow-through side. Not talking sole proprietor Schedule C here, because that would fall back to category number one, the payroll. But from the business flow-through side, this is only taxed at the individual income tax rate, between 10 and 39.6 percent.
The last one here is your long-term capital gain. The reason this is most beneficial is because of the favorable long term cap gain tax rate of 15 to 20 percent, depending on your income threshold, plus the Medicare, because this is a passive ownership investment, of 3.8 percent, so totaling somewhere around 23.8 percent. Most people, when they build this wealth in this business, take the money out through payroll and business income as they move forward over the years, and then when you go to sell it, you get long-term capital gain.
What you have to know is, during that process of earning your wages and your flow-through business income, how should that break down? At the end of the day, if I run more deductions through the business, keep my wages the same, I have less business income. Well, so now should I divert some of my wages to business flow-through income instead of having it in payroll? That’s a discussion that needs to happen.
Working with a company like LivePlan and using this Scoreboard feature that I love so much about that software, we’re able to actively plan with our client, in knowing in a real-time basis where we are from a financial performance perspective and moving to making decisions that help us on a tax efficiency front.
I kind of wanted to pass this onto you from a LivePlan standpoint, because planning for the income, planning for the tax efficiency, really has to come down to business planning.
Sabrina: Exactly.
Ryan: What type of planning or usage are you seeing by your customers in that Scoreboard feature, or with a business plan software?
Sabrina: You know what, really, it’s exactly what you’re saying. What we see is the people who are using, say, the LivePlan tool to do a budget and a forecast and then bring in their accounting data and see the actual… Other people who are most aware of all the different variables that are affecting their business, so they’re watching these financials. They’re going to have a couple of key pieces of information before they would have it if they’re not watching them, so if you all of a sudden realize, “Oh my God, I’m way more profitable than I thought I was going to be,” it’s a lot better to realize that in, say, July rather than in December, assuming you’re on a calendar year in terms of your fiscal year. Let’s just pretend, because that’s easier. Everybody’s on a calendar year.
To find out that you’re way more profitable than you thought you were going to be in December gives you a lot less time to plan your approaches to that profitability. In our business, I’d rather think about ways to spend that money smartly and reinvest in the business, rather than to pay Uncle Sam taxes, so some of it will be tax planning that we do with profits, where we start to look at our profit a good six months before the end of the year and say, “Hey, looks like things are going really well. Let’s really look at employee bonuses. Let’s look at things that we can legally spend this year to bring those profits down, and then we finish off the year with minimum taxation on our profits.”
When you plan and when you look at what’s happening versus what you plan to do, it allows you to do that, because a lot of the time, business is going so fast and business owners are just happy that things are profitable and there’s cash in the bank, and they’re not stopping to really think through, “Wait a minute! Things are going so well that I need to rethink things.” It might be time to think about giving some raises and some bonuses and maybe there’s some marketing programs that you never thought you could afford, and this is the time to do that. But you can’t book a bunch of marketing programs in December that aren’t going to happen til January and legally claim that. You have to do things in the year that you have the profit. That’s where the planning and really comparing to your actual comes into play.
Ryan: That’s perfect. That’s how we use it with our clients. The benefit of that Scoreboard feature in LivePlan, I can’t even explain it. We have clients hooked up on it right now, and they call me all the time, “Hey, did you see how well I did last month, or this last couple of days,” because we have it in a real-time fashion. We do the accounting in a back office every single day so that they can go in and pull the P&L or pull the dashboard every day and get a good handle on where they are, and mid-month, be able to make managerial decisions that will help them achieve their goal for the month. If they’re ahead or behind, it really helps them long term.
The other thing, and this is what we’re about to get into, it’s the biggest tax saving tax tip. I’m about to show it to you, but the real thing you have to understand before we get into it is planning. You have to know if you’re going to have the money to do this, because if you don’t and you get to the end of the year…I had a client who called me up yesterday and he said, “Hey, Ryan, can I not make that investment, because we didn’t plan well enough.” He’s a client who I don’t have set up a live button, because he elected not to be there, and now we’re having problems trying to figure out how to scramble and get the money to build to make the contribution.
What I’m talking about is deferred retirement. These are the things that really help to increase efficiency from a tax standpoint. The reason is because we earn the money today, we save it until tomorrow, or in most cases it’s many years from now, and then you pay the tax when you’re in a lower tax bracket. A deferred retirement vehicle, think back to 401Ks you have when you were an employee at one point in time, or an IRA. The thought process or the theory is here, I want to drink from a water hose, a garden hose, rather than from a fire hydrant. The reason is because I can take that garden hose and turn it off and turn it on and turn it off and turn it on. It’s much less of a flow, and I can control it. A fire hydrant, you just open it up and you’re going to get hit in the face.
Deferred retirement vehicles fall into two buckets, defined contribution and defined benefit. Defined contribution are just what I mentioned, 401ks and IRA. There’s all sorts of variations. Simple 401k, SEP-IRA, simple IRA, Roth IRA, Traditional IRA. There’s whole types of different defined contributions, but what you need to know about defined contributions is it is based upon the election by the employee versus the defined benefit.
A defined benefit, think back to the old GM, GE pensions. They’re not referred to as profit-sharing plans in the small business community, and defined benefits are based off of a percentage of your salary and the profit from the business. So that’s the main difference. A defined contribution is an election. Defined benefit is based off of other factors, not to mention the net profit of the business.
Both of these types of deferred retirement vehicles are governed by what’s called ERISA, Employee Retirement Income Security Act. That’s the governing body that, if you wanted to run out and start your own C Corporation while you had your business and the only employee in that C Corp is going to be you because you wanted to be able to only contribute to a retirement plan for yourself and not your employee, ERISA is the one that pulls the back in and says, “No, no, no, no, I see what you’re trying to do,” and ERISA says you have to give what you give yourself or offer yourself to your employees.
I want to go through a real simple scenario, so bear with me here. Just think through this. We have $1 million business, annual revenue, $120,000 in payroll costs, $640,000 in other overhead. Your net profit is $240,00 . Well, say you turn to me and you say, “Ryan, I need $15,000 a month to live—mortgage, eating out, car payment, whatever it may be. I need $15,000 a month.” That’s a $180, 000 a year. So I would turn to you and I would say, “Great! You have $60,000 that we can use to be tax efficient.”
So how are we going to do that? On the left-hand side here, you see the example by not making deferred retirement contributions, and on the right-hand side, you see the example of making the deferred retirement contributions. So you take your net profit at $240,000 and then say you’re going to max out your contributions to a 401k. Well, the max is $17,500. See, that’s the middle of the screen, the owner, $17,500.
The 401k safe harbor match, which is the amount that you have to contribute in order for you to max out, is 3 percent. Remember, I said our payroll cost was $120,000, so that means $3,600 goes to our employee. That’s $21,100.
Then we layer on top of that a profit-sharing plan, a defined benefit deferred retirement vehicle.
Actuaries derive figures for how much as an owner you can contribute to this. It’s based off age and net profit, a whole bunch of other factors. But just imagine somebody who’s about 45, maybe 40, can contribute $30,000 as the owner. The safe harbor match for defined benefits is somewhere around 7 percent, but remember, we already gave away 3 percent in the 401k, so we give away that additional 4 percent in the profit sharing plan. The total of our deferred retirement contributions for the owner and the employee is $55,900. Now that brings our new taxable net profit to $184,000.
You’re probably thinking, “Why in the world am I giving away $55,000?” I’m about to show you. If you look on the left hand side, our tax, at a 35 percent individual income tax rate, think of the S Corporation, is $84,000, so that means our after-tax earnings are $156,000. Now remember, we took that same $240,000, we subtracted the $55,000 we put into the deferred retirements for us and the employees, and now our new taxable net profit is $184,000. At 35 percent that bring your income tax to $64,435.
So your after-tax earnings, which you physically take home after you pay your taxes, is $119,000. You’re probably thinking to me, “Ryan, I need more than $119,000. I was going to get $156,000 if I didn’t contribute.” Well, yes, you’re right, but remember, we also have that $47,500, the $17,500 for your 401k, and the $30,000 for your profit sharing plan that’s now an investment. The real difference is $167,000 in net wealth increase, your after-tax earnings plus your investment, minus your $156,000, which was your after-tax earning, so you saved $11,165 on your taxes and have $47,500 sitting in an investment account. That’s a simple scenario. I know it may not have seemed all that simple, but that’s how it works, and that’s how you really start saving some tax dollars.
The deferred retirements are huge. If I can save you on taxes before you put the money in your pocket, I’ve done my job. If you put it in your pocket and then come to me and say, “Hey, Ryan, I want to save on my taxes,” it’s going to be very difficult for me to do that, so deferred retirements are the key and biggest perpetuator of tax efficiency and tax savings.
I’m going to briefly go through estate planning, and I don’t want to stop here very long. For those of you that have some very quickly, rapidly-growing businesses, and you’re accumulating some very serious wealth, know that estate tax planning is going to be a huge concern for you, and I want to walk through that with you. There is this thing called a death tax of 40 percent, that if you have assets in your estate, in your name, of $5 million or more, I actually think it’s $5.37 million, then you will be subject to the death tax of 40 percent if you were to pass away with those assets in your name now.
The goal for CPAs and attorneys is we take those assets out of your name and we put them into a separate vehicle, in this case I’ve highlighted a family member partnership, so you gift them into the family member partnership and then you gift them to your heirs. It’s extremely complicated. Like I said, here’s the things you need to understand, do you have a business that’s growing super fast? Do you have significant assets that are accumulating in your personal name or will begin to? Or do you sit right now, have significant assets at or close to the $5 million mark. Just keep that in mind. We can take that entire estate planning thing offline, but I did want to point that out to you, because that is a significant tax savings break there.
A couple of tax myths debunked. Two of these are new for 2013 and 2014, so I did want to mention recover in the interest and the depreciation. The others are some common questions I get.
The first one, interest deductibility. After 1/1/2013, your mortgage interest is no longer fully deductible if you are at a certain income threshold, and the thresholds differ between single, head of household and married filed joint.
This has changed our mentality. If we have an interest rate on our personal mortgage of 3 percent and we only get to deduct 50 percent of our interest that we pay because of the new laws, and we have an interest rate of 6 percent on our business loan, guess what? Those are now equal, because we get the full deduction at the business level. That’s something to consider when you look at what I’m going to pay off in the usage of your money, then paying down your debt, which one should we do first?
The next topic is depreciation. This is a big one, especially for those of you that are in high cap businesses. Anything in the past, we used to write off depreciation in an accelerated level, very, very quickly and most of it all in one year. Now, as of 1/1/14, it’s down to $25,000. We don’t know yet. There is word out there that that’s going to come back up to $147,000 or some number like that. We have no idea, and I am not planning on that coming back up. I’m tax planning for just the $25,000 in what’s called section 179 for 2014. Those of you in high cap businesses, look into leases. I know that’s not ideal, but from a tax efficiency standpoint, it could actually be more to your benefit.
The next thing, and I hear this most often, and even when Sabrina was talking earlier about spending on marketing and things like that, if it’s for the business, to grow the business, it makes sense. If you need it, buy it. If you do not need it, there’s no reason for you to ask me, “Ryan, I need more business deductions. What should I spend money on?” If you don’t need it, there’s no reason to buy it, because all you’re doing is saving 35 cents and you’re spending a dollar. I don’t know about you, but I’ll keep my 65 cents all day long. Just think about…
Sabrina: That’s great, great advice, Ryan, and I’m so glad you said it because yeah, you’re right. I don’t want people to confuse what I was saying. If you need it and if you felt like you couldn’t afford it and all of a sudden you can, great! That’s when you go out and spend it, but Ryan’s right. You don’t want to just spend to not pay taxes.
Especially those of us who have weathered the economic downfall, I think a lot of us didn’t give employees bigger raises and bonuses, because we were just trying to get through this recession, and so if it’s a place where you feel like you’re going to get a big benefit, understand and know that you have to have money available, but if it’s not going to give you a big benefit, I am with Ryan. Don’t spend the dollar just to save the 35 cents. Just keep the dollar.
Ryan: That’s absolutely right, and that’s a question I hear so often, especially at the end of the year. Being efficient with your money, going back to that deferred retirement thing, at least then you get a business deduction, but it’s still your money, and that’s why it’s such a huge plan for us on the tax side, to use those vehicles.
The next thing I hear questions about, “Should I put my spouse, significant other, or child on payroll?” The only thing you need to understand here is if we are doing it for deferred retirement purposes or for some type of insurance purpose, it makes sense at certain ages. If we’re not and we’re just doing it because we think it’ll help us on our taxes, that way won’t necessarily work, because if you’re filing a joint return, pay your wife $50,000, you reduce your business taxes by $50,000 or your business income by $50,000, but now you pick up that $50,000 from her wages on your personal return. It’s a net zero sum game.
And that leads me directly into the next point, management companies. I hear a lot about management companies. Because our firm specializes, or we work a lot in multi-entity situations, management companies are a huge play for us but they’re not for everyone. They’re used particularly for efficiency and administration. They’re used for efficiency in an ownership type of structure, but they’re not necessarily something. They’re just set up because now you have two businesses and you need a management company, because you think they’ll help you save on your taxes.
It won’t necessarily, because you reduce your business that’s paying your management company by a dollar, and you pick up a dollar in your management company. It’s the same thing. It’s like having $2 in my right pocket, taking one of them out, putting it in my left pocket, then you ask me how many dollars I have. The answer’s still two. So management companies are good. They’re used for structuring, certain transactions, but they’re not for everyone. Don’t get fooled into thinking that, “Hey, I need to go out and start a management company; I read something about it in Google.” Again, go back for good guidance, good advice. I can’t tell you that enough.
Sabrina, that’s kind of all I have. I know I covered a lot, but the biggest thing here was just get the topics out there to get some good questions in, and maybe follow up with those offline later, so anything you think I missed?
Sabrina: No, I think you were very comprehensive. We definitely had a good number of questions that I was fielding what you were talking about so, we will be following up with some links and resources on where people can understand a little bit more about whether they have chosen the right legal entity.
I do also want to make sure I emphasize what Ryan was saying is you’ve got to think about your goals and objectives, because there’s not one entity that’s right for everyone. It all depends on what you’re trying to accomplish, so we’ll send some resources out.
This is why people work with Ryan and M. White, because the next step after you start to understand the pros and cons of all the different entities, is to really then match it with your financial goal, the time, your time and life, kids that are young are old or you’re thinking of passing the business on at some point. There’s a lot of different factors to think about, and depending on where you are in your business life and in your personal life, those factors will end up pointing to different kinds of entities.
There’s not just a one size fits all approach, but we’ll follow up with resources on that. There’s a couple who’ve joined us internationally, UK and Canada, where tax laws are different. A lot of the same principles apply though. You don’t want to go spend money just to avoid taxes. You want to think about the right entity in those countries as well.
Ryan: Sabrina?
Sabrina: Yup? Go ahead.
Ryan: One of our partners, his name’s Eddie, he’s actually from Ireland but has done a whole lot for KPMG for a number of years and worked on an international basis, so from that perspective, if there’s questions people have, we’d love to field them even on international taxes, because he’s very, very knowledgeable, and I’m sure we can get those answers for folks.
Sabrina: Great, so those of you who have questions about Canada and UK, we’ll send them on to Ryan and the follo- up email that we have thanking you for attending the webinar, giving you a link to the webinar, which will also have all the slides in that can webinar. We’ll also then address some of those international tax questions.
But definitely, Ryan, I think you did a really great job, and like I said, it looked like there was a lot of questions about the entity. There were some questions actually, someone asked one question that might be a quick one for you to answer. Sara asked about long term capital gain and what is that. Maybe you can just give a short little definition. We will make sure that we send you a link in the follow-up email to definitions and resources for all these tax terms that you can just look things up, but I thought that one would be a nice, easy one in the last five minutes for you to answer, Ryan.
Ryan: Absolutely. Long-term capital gains are whenever you have an asset, and an asset is defined as something that creates monthly income. If I go buy a building and I rent it out to someone, that is an asset that is driving rental income. If I buy it for $500,000 and, say that it’s a really good year, I sell it for $1 million a year later, as long as it’s past a 12-month mark from the time I bought it to the time I sell it, it is a long-term capital gain. So capital gains are from holding investment assets, and then later selling them for more money than you purchased it for, and it’s just kind of that straightforward.
Sabrina: Great. Thank you. That, I think, was really helpful. There’s again a couple more questions here, but I think we are going to send out as many resources as possible, and then one of the questions is, Pamela is wondering if there’s someone she can talk to about questions that aren’t tax-related. Pamela, if they’re related to starting your business, check out Bplans.com. I’m going to put it into the answer here and send it to everyone. It’s a free content site that we actually run. It’s not a sales site. It’s just content, and it’s all about starting a business, so start there and then go ahead and tweet me, @MommyCEO, and ask me any questions.
If it’s tax-related, we’ll punch it over and have Ryan and maybe some of his associates help us out. If it’s related to starting a business, we will point you in the right direction. We want to hear from you guys, and this is why we’re here providing all this information.
Ryan: Sabrina, one of the things we offer from a business perspective is more of a practictional or part time CFO. Once you kind of get up and running, we do have a department of tax folks, and the we have a full-time department of consulting individuals as well that help to take that business plan and that business startup plan and really turn it into a reality on an ongoing relationship basis, so that’s also something. If anybody has questions about that, we can definitely help them out. We’ve started many a business.
Sabrina: Great. Great, so you heard it there. That’s great, and we’re pretty much here at the top of the hour. I can see there’s still a couple more questions, so Kelly, Louise, Pamela, don’t fear. We will make sure to follow up and give you guys access to resources and people, so that you can get your questions answered. It is a timely topic and like Ryan said, it’s one that sometimes can stress people out if they don’t know, and going to Google maybe stresses you out more [LAUGHING] because there’s just so much there—
Ryan: Right.
Sabrina: —and you don’t even know what is right, what you should trust, so we’ll work with Ryan and M. White & Associates and put together this email with lots of resources, and also how you can go to M. White and get additional help, and how you can get access to get some more information about tools like LivePlan to help you to really manage your business in the best way in an ongoing basis.
With that, at the top of the hour here, I’d like to thank everybody for joining us. Ryan, thank you so much. There’s so much great information in here.
Ryan: Absolutely.
Sabrina: Based on a lot of these questions, we’ll probably be following up with Ryan and doing some more webinars. It’s been great to see how many people attended and how many people are really actively just in asking questions. This is exactly what we wanted to see and will help us determine some topics for our future webinars related to small business and taxation. Thank you everybody, and contact us, contact Ryan, but wait for that email, because there’s going to be a lot of information in it. Thank you very much.
Sabrina has served as CEO of Palo Alto Software since 2007.
