Why You're Probably Paying More Taxes Than Required
1. Wrong Legal & Tax Structure
Business owners often pay more taxes than required when their legal and tax structure isn’t aligned with the goals of their business. For example, many companies are legally structured as LLCs for liability purposes and file a Schedule 1120s for S corporations. This can be appropriate for some.
However, with the recent Tax Cuts and Jobs Act (TCJA) 2017, several significant changes were made to the tax code, including the lowering of the top corporate tax rate from 35% down to a flat 21%. This can provide for significant tax savings—depending on your situation.
As another example, a C corporation, unlike an S corporation, is allowed to fully deduct premiums paid for health insurance premiums while the employee does not have to claim those benefits as income. If monthly premiums for health insurance are $1,200 ($14,400 annually), the deduction can be significant if the owner/employee is in a 37% federal tax bracket. If the owner/employee lives in a state where state income taxes are an additional 5%, the total deduction equals 42% on $14,400—or a tax savings of $6,048.
A C corporation can have unlimited shareholders and issue different types of stock, which allows for certain shareholders to have more voting power than others. This can make a difference when it comes to deciding the amount of each bonus and when they are paid. The more control you have over such decisions, the more you can implement strategies which benefit you rather than the other shareholders. This can be particularly valuable when choosing the type of qualified retirement plan—and the investments within the plan—that best suits you and the taxation of the assets within the plan.
Of course, there are many factors and circumstances to take into consideration, and no particular structure is inherently better than another.
K2 Business Group will guide you to the best options for your individual situation.
2. No Tax Strategy
Tax strategy is forward looking, not just keeping a record of what has happened during the past tax year.
A busy CPA or tax preparer—there is a big difference—can prepare about 1,500 tax returns or more per year. Considering most of those returns are done over an 8-month period (about 240 days), most tax preparers simply don’t have the time to formulate good tax strategies for all of their clients—especially during tax season.
Because of the ever-increasing workload on tax preparers, they are often forced to delegate tax preparation to clerks or junior preparers with less experience. This is an efficient way for your tax preparer to get your tax return completed in time and in compliance.
But a compliant tax return is not the same as a sound tax strategy. Providing the proper business and expense receipts in a shoe box one week before a filing deadline is not a strategy. Properly reporting income on the correct line of a tax return is not a strategy, either.
Tax preparers use software that, in large measure, is designed to keep you from getting audited—not to take advantage of every benefit legally available to you as a business owner. This protects you and the tax preparer from being audited but does not do you any favors when it comes to tax savings. No one wants to be audited. Nor do we condone violating the tax code. However, there is no moral or legal obligation to avoid proper planning, nor to take advantage of every tax strategy allowed by the tax code.
3. Having Money in the Wrong Tax Buckets
In 1954 and 1974, Congress created a path to help small business owners succeed. Their goal was to support and encourage American entrepreneurship and strengthen the tax base by providing small business owners specific tax incentives. The pathway has four simple goals, to:
- provide a secure income for you, your family and your employees
- accumulate wealth
- protect widows and retirees
- protect against the failure of your business and stock market loss
Follow the path and you’ll achieve maximum tax savings. Wander off the path, get out of order, or out of balance, and you’ll pay more than your fair share of taxes. It’s that simple.
For small business owners, the key is in today’s modern tax code.
By employing tax strategies for small business owners, you can decrease your income taxes, self-employment taxes, or both, and redirect the tax savings to build wealth faster and safer than what you’ve been taught.
Most small business owners use just one tax path to build wealth. We call it the default plan. It is the least tax-effective option, and it yields the highest tax rates. But you don’t have to settle. There’s a better way.
Your money can only get taxed one of four ways. We call these the four tax buckets. Each bucket has its proper place and purpose. But understanding how much and when to put money into each bucket is absolutely key in proper tax strategy.
Bucket one is the lifestyle bucket. We pay taxes on all the money going into this bucket. The more you put in bucket one, the higher your tax rate.
Bucket two money is the least tax-efficient of all because it is taxed twice! Once when we put it in, and once again on the growth. This bucket is usually comprised of savings and after-tax investments, including money invested in your business.
Bucket three is the most tax-efficient because we get a tax break for every dollar we put in, and we can pick up other tax deductions the more we put in this bucket. It can also receive favored tax treatment when it comes out. This bucket holds assets within defined benefit plans.
One of the most powerful strategies for the self-employed is a properly designed defined benefit or pension plan. These types of plans allow business owners to make much larger tax-deductible contributions to a qualified account than to defined contribution plans such as SEP IRAs and 401(k)s. It’s not uncommon for our clients to reduce their taxable income by $50,000, $100,000, or $200,000 every year.
Bucket four money gets a tax break going in, but we pay more in taxes than bucket three when it comes out. This bucket is referred to as defined contribution plans such as 401(k)s, IRAs, SEP IRAs, and similar plans.
Understanding these tax buckets is vital.
For example, if a 50-year-old puts $50,000 per year into bucket two and three, and both buckets earn identical rates of return over the same time period, bucket three will provide nearly twice the amount of income at retirement.
When it comes to building wealth, understanding how your money is taxed is one of the most important things you can learn…perhaps even more important than rate of return.
4. No Exit Plan
Most mountain climbers don’t die on the way up, they die on the way down.
The rate of successful transition from one business owner to another is staggeringly low for a variety of reasons.
The good news is that most deadly mistakes can be avoided with proper planning. But most business owners spend more time planning a family vacation than they do planning how to exit their business.
If you think owning a business is full of stress and emotion, exiting a business—especially a family business—can be even more fraught with emotional, personal, and financial pitfalls. Even worse, the fallout from failing to plan for a pre-mature death or disability of a business owner can be even more devastating.
Who wants to be in business with your late partner’s wife? Or her new husband? Or her new husband’s attorney? Or her new husband’s CPA?
In addition, failing to plan can result in the IRS ending up with more money than you do after the sale.
Joe sells his business to Brad, a key employee, for $1,000,000. Brad must come up with approximately $1,640,000 for the sale because, at a 40% tax bracket, he’ll have to pay $640,000 to the IRS leaving him with $1,000,000 to pay to Joe. If Joe is in a 40% tax bracket, he’ll end up paying another $400,000 to the IRS in taxes—leaving the IRS with $1,040,000 and Joe with only $600,000!
This situation can be minimized with the right guidance and exit plan.
Part of an exit plan is knowing the current value of your business and knowing what adjustments can be made years before the sale to maximize the selling price.
A great exit plan addresses family dynamics between family members who are involved with the business and those who aren’t.
A great exit plan means you pay less taxes now and in the future. It means lowering or eliminating the risks of business succession. Great exit planning also brings guaranteed income during retirement.
The path on the way up matters. But the path on the way down, and when to start on that path, can be even more critical.