Business decisions have tax consequences. Understanding the tax implications of the actions you take—from day-to-day activities to long-range planning—can help you conserve cash flow, run your business better, and avoid problems with the IRS.
1. Choosing the right entity
When just starting out, you can select the type of business entity that best suits your needs and goals. The five main choices are sole proprietorship, partnership, limited liability company (LLC), S corporation, and C corporation. The one you select depends on various factors, including:
- The number of owners
- Concern about personal liability protection
- Payroll issues, including payroll taxes, fringe benefits, and the opportunity for deferred compensation
- Whether the business operates in more than one state
- Exit strategies
From a tax perspective, the choice of entity impacts income taxes as well as Social Security and Medicare taxes. For example, a sole proprietor pays self-employment tax (the employer and employee share of FICA) to cover Social Security and Medicare taxes on his or her net profit. If the owner incorporates and takes a salary, only the salary is subject to FICA tax.
Owners aren’t locked into their initial choice for their business entity. For instance, if the business has been running as an S corporation, which is limited to 100 shareholders, but now wants to raise money from a large number of people through equity crowdfunding, the S election can be terminated. This makes the business a C (regular) corporation. Changing entities can trigger taxes, so planning and making the right choices are essential. Click here to learn more about how you can effectively structure your business.
2. Sheltering profits
When businesses are successful, how can owners minimize taxes and/or extract profits with little or no taxes? There are various legal strategies that can be used.
- Saving through a qualified retirement plan. Contributions are tax deductible, so to the extent profits are added to a plan, they are not currently taxed. Having a retirement plan is like insurance guaranteed to provide you with retirement income, even if the company fails along the way or does not sell at retirement for what you may have expected to receive. Click here to learn more about setting up a qualified retirement plan.
- Deferring compensation. Instead of taking all of the compensation ordinarily due now, such as year-end bonuses, corporate owners can agree to defer it in a nonqualified deferred compensation plan. As long as this plan has sufficient restrictions on access to the deferred funds, owners are not taxed currently on the deferred funds; the deferred compensation becomes taxable when actually received. Click here to learn more about nonqualified deferred compensation plans.
- Using fringe benefits. Owners who would otherwise have to pay for certain expenses with their after-tax dollars can have the business do it for them. The business gets a write-off; the owners in many instances have little or no income from the company’s payment of these benefits. Examples: Education costs for work-related courses (no income); company-owned vehicle (modest income reported for an owner).
- Borrowing. An owner can borrow from the company when funds are needed to buy a home or for other personal reasons as long as the company can afford to lend the money. The owner only picks up income to the extent that the interest charged on the loan is below IRS-set rates; these are at historic lows at this time (e.g., for a loan with a term of less than three years that is taken in February 2014, the IRS rate is only 0.3%).
3. Rewarding employees
Finding and retaining valued employees isn’t easy for small businesses that have to compete with large corporations for talent. Small businesses can help their situation by rewarding employees with raises, bonuses, and fringe benefits. Cash payments, while tax deductible for the business, are taxable to employees and subject to employment taxes. In contrast, fringe benefits may cost the business little or nothing and may be free from any employment taxes. For example, offering employee discounts within limits may be a low-cost way to benefit staff.
Businesses can also enable employees to pay for certain personal expenses on a pre-tax basis. This doesn’t cost the company anything other than modest administrative costs, but can save employees plenty. For example, businesses can set up flexible spending accounts for employees to pay for unreimbursed medical expenses and dependent care costs from their wages without being taxed on them.
Examples of fringe benefits:
- Education assistance
- Free parking
- Group-term life insurance
- Health insurance
- Monthly transit passes for commuting
- Retirement plans
4. Handling the unexpected
Businesses have their ups and downs. Economic conditions may hurt sales. Catastrophes may shut you down for some time. How these events are handled can have a great impact from a tax perspective.
- Business losses. If you have a down year, you won’t pay any taxes currently. What’s more, the loss may be great enough to generate a net operating loss (NOL). This can be carried back for a set number of years to offset profits in those years, producing an immediate cash refund to you. Unused NOLs can be carried forward for up to 20 years, saving taxes in the future.
- Casualty losses. Hopefully you have adequate insurance for damages to your property that result from a storm, fire, or other casualty event and to pay the bills until you resume operations. In some instances, however, insurance may fall short; the tax law lets you write off the losses from property damage that aren’t covered by insurance. Unlike personal casualty losses that are deductible only to the extent they exceed 10% of adjusted gross income, business casualty losses are fully deductible. On the flip side, if you have great coverage, you may have a tax gain when you experience a casualty loss. The reason: You may have fully depreciated the property, so the insurance proceeds effectively generate a tax gain. Fortunately, you can avoid tax on this gain by reinvesting the proceeds in other business property. Find details about involuntary conversions from the IRS.
5. Preparing for the future
Every business owner should have an exit strategy. This may be selling the business at retirement, passing it on to the next generation, transferring ownership to employees, or deciding what happens when the owner dies. These options entail tax considerations, including income taxes and, for transfers to family members, estate and gift taxes.
The good news: with careful planning, objectives can be achieved with taxes minimized. The bad news: the good news results only when planning begins early and owners get expert advice. Click here to learn more about how you can plan for a more effective business transition.
Taxes should be factored into business planning so that owners maximize their after-tax results. Always seek the counsel of a good tax advisor to understand the implications of business decisions and to plan business activities successfully.