Tax reform has been a contentious issue for decades. Although most people would agree that the tax code is complex, and costly to comply with, there has been little agreement as to what reform should look like. Consequently, tax reform has gone nowhere. President Joe Biden’s bid to create a global corporate tax rate is the most ambitious bid to reform tax, but it still leaves the domestic tax code intact. Small businesses are still stuck with a suboptimal and complex tax code. Navigating through it is one of the most challenging and costly parts of doing business. In this article, we will discuss how to approach small business taxation.
Deal with Executive Compensation
Reducing business taxes is easier done by reducing business income. Since the Bush tax cuts of 2003, businesses have been able to make even great tax savings based on how they classify compensation. It’s important to realize that as a business owner, there are a number of ways that you can pay yourself. Indeed, there are a number of tools you can use to compensate your executives. Executive compensation can be done, in the most basic ways, using a straight salary or dividends. The choice has tax implications. A salary will subject you to personal taxes on your salary. If you pay yourself through dividends, then your company will pay corporate tax on earned income and you will have to pay personal tax on distributed dividends. Whereas dividends are not deductible, salaries are. Salaries can, therefore, be used to reduce the business’ income, thereby reducing the corporate tax rate facing that company.
Claim Credit for Child Care Expenses
If your business provides child care expenses, you business can receive a tax credit amounting to 25% of expenses paid, for as much as $150,000 a year. In some instances, this is a better option than claiming a child tax credit on individual tax returns.
Set-up a Retirement Plan
As a small business owner you give up having an employer contributing into a retirement account a sum that will be matched by you.However, you do have various options to maximize retirement savings and earn significant tax savings. For instance, with a one-participant 401(k) plan, the Internal Revenue Service (IRS) allows you to contribute as much as $57,000 in total contributions for your retirement. AMong the available retirement planning vehicles you can choose from are:
- Simplified Employee Pension Plan (SEP
- IRA or Roth IRA
- 403(b) plans
The IRS offers a number of retirement plan options for business owners that you can use to limit your tax bill.
Contribute to Pre-Tax Retirement Accounts
Contributing to traditional IRAs and 401(k)s has the potential to reduce taxable income. Qualifying contributions are deducted from a business’ Adjusted Gross Income. Since 2019, businesses have been allowed to contribute $19,000/person into a 401(k) or $25,000/person for employees over the age of 50. So, as a business owner, if you are also married, you can contribute $38,000 to $50,000, depending on the combined age of you and your spouse. If your business earns $100,000 and contributes $38,000 or $50,000 into a 401(k), taxable income drops from $100,000 to $50-62,000.
Businesses contribute as much as $6,000 into an IRA for persons under 50, or $7,000 per employee over the age of 50. So, if as a business owner you are also married, your business can make a combined contribution of $12-14,000 depending on the combined age of you and your spouse.So, if your business earns $100,000 and contributes $12-14,000 into an IRA, then taxable income declines from $100,000 to $86-88,000. Combining this with maximum 401(k) contributions reduces taxable income by $36-40,000.
Contributions reduce not just your current tax bill, but future tax bills as well. Combining these pre-tax contributions with various other investment strategies can increase your income over the rest of your life.
Tax Loss Harvesting
Tax loss harvesting is a tax reduction strategy in which non-qualified, floundering investments are sold at a loss in order to offset any gains that you will have enjoyed. In this way, gains from investments are removed and taxable income can be reduced by as much as $3,000/year.
For example, between October and December 2018, the stock market was in a steep decline. Many people took the opportunity to sell positions at a loss, investing the earnings into similar asset classes, in the hope that the market would rebound.
When done correctly, this strategy wipes out any gains you would have made in the rest of the year. It can even generate $3000 in losses, wiping off $3000 in adjusted gross income on tax returns. This is a strategy you are advised to implement with a qualified certified financial planner.
Set Up a Health Savings Account
The Health Savings Account is another tool that you can use. It’s a wonderful tool that allows you to make a deposit as well as get a tax deduction. If the money is used for qualified purposes, it can be withdrawn tax-free. I can’t think of any other vehicle like that. Of course, 529 plans do offer tax advantages on a state-by-state basis, but in terms of federal tax reductions, the Health Savings Account is the best place to go.
Your family can deposit $7,1000 if you meet the Health Savings Account’s eligibility requirements. Individuals may contribute as much as $3,5000 into a Health Savings Account. Contributions into this vehicle will go a long way to reducing your tax bill. If, for instance, you are in the 50% tax bracket, your tax liabilities can fall by $3,550. That’s a great return on any investment! It’s also a return with a long lifecycle.
Deduct Charitable Contributions
In your bid to reduce taxes, you will find that one of the most popular tools for doing so is reducing charitable contributions. Limited Liability Companies (LLC), partnerships, C-corporations and sole proprietorships cannot deduct charitable contributions as business expenses, but a business owner can do so, claiming the business’ contributions as itemized deductions on Schedule A of Form 1040.