Tax Planning: A Great Way for Business Owners to Thrive Their Businesses
The goal of tax planning is to arrange your financial affairs so as to lawfully minimize your taxes. This is called "tax avoidance," as opposed to "tax evasion," which is a crime.
There are a multitude of tax planning strategies, particularly if you own a small business. Some are aimed at one's individual tax situation, some at the business itself. Many are extremely sophisticated and specific in focus.
But regardless of how simple or complex a tax strategy is, its goal will be one or more of the following:
reducing your (or your business's) taxable income through entitity analysis, investment strategy, deductions, and tax credits,
reducing your tax rate,
delaying the time when you must pay the tax.
What is tax planning all about?
Tax planning involves taking a pro-active approach to paying taxes. While it is illegal to avoid paying taxes that you owe, there is nothing wrong with looking at your income and potential deductions in advance to pay the least amount of tax possible under the law. There are several steps you can take to reduce your tax obligations depending on your situation.
Income taxes on the federal level are a fact of life, and many people also must pay state and local taxes.
When you try to plan around taxes, you can save yourself money that you would otherwise pay to the federal, state, or local governments.
While you may not notice the impact of federal taxes, they are the biggest expense that most families incur in a year. There are tens of strategies out there to reduce your taxes. There are many areas of your financial life that can benefit from tax planning.
For example, if you save for retirement, whether in the form of an employer-based program such as a traditional 401(k) or individual retirement account (IRA) or both, you can save money on taxes. You don't get a current tax deduction for contributions to a Roth 401(k) or Roth IRA, however. Saving in a traditional 401k or traditional IRA reduces your taxable income when you contribute, but distributions are taxed. While a Roth 401(k) and Roth IRA offers no deduction for contributions, but qualified distributions (including earnings) are not taxed.
Some Basic ways to reduce taxable income
Everyone's situation is different, and experts caution against making tax considerations the predominant factor in your financial decision-making process. That said, there are several strategies and some basic information that you should be familiar with as you formulate a tax plan.
First, regarding your investments, recognize that there are many sound assets that will increase your wealth over the long haul, but which produce little or no current income. Raw land or rental real estate that barely breaks even on a cash flow basis both can offer significant long-term appreciation in value.
The same is true of buy-and-hold growth stocks whose value you expect to increase over time, but which pay scant or no dividends. The same is true of good old U.S. savings bonds. You can defer federal income taxes on your earnings (except for Series HH bonds) if you wait until the bond reaches final maturity or cash it in. Moreover, savings bonds are state and local income tax-free. Better yet, municipal bond interest is free from federal tax, and in most cases, free from tax in the state in which they are issued.
With any investment, it's also usually wise to plan your eventual sale more than a year after your purchase, so that any gain is considered a long-term capital gain. As such, it will be taxed at a lower rate than will a short-term capital gain, which is taxed at your ordinary income rate.
Learn about deductions and credits
Another tax-planning approach is to reduce the part of your income that is subject to tax by taking full advantage of the many tax deductions and tax credits available to both businesses and individuals. Some of these are very narrowly focused, while others apply to a much broader group of taxpayers. Consulting with a tax-planning professional is the best way to learn which deductions and credits are available to you.
The self-employed or small business owner, for example, may be able to take advantage of deductions for business meals and entertainment, automobile expenses, and business travel, among many others. Also, there is a new 20% deduction for pass-through business income. But there are always special rules that apply to these types of deductions, so again, the services of a tax professional can be invaluable.
For the moment, keep in mind the difference between a tax "credit" and a tax "deduction": A tax deduction reduces the amount of taxable income you have. A credit reduces the actual tax you owe, within limits, usually dollar for dollar (e.g., a one-dollar tax credit reduces your tax bill by one dollar). Sometimes, tax credits are refundable, which means you can get a check from the government if you owe no tax at all. Clearly, tax credits are more valuable than deductions.
The most common itemized deductions are mortgage interest, charitable contributions and state and local taxes. You should always take the higher of your standard deduction or your itemized deduction. For 2020, the standard deduction is $24,800 for married couples filing a joint return; $12,400 for singles; and $18,650 for head-of-household taxpayers.
As of 2020, the mortgage interest deduction is limited to interest on acquisition indebtedness up to $750,000 (though grandfathering rules apply); and the state and local tax deduction, together with the property tax deduction, are limited to $10,000 ($5,000 for married taxpayers filing separately).
Nearly two out of three taxpayers, however, take the standard deduction — available to all — rather than itemizing. In other words, they find that the standard deduction is larger than the total of all itemized deductions they would be able to take; given the large increases in the standard deductions in 2018, this option may become attractive to even more filers.
Thus, the standard deduction saves most people more on taxes.
Adjustments to income
You can also reduce your adjusted gross income through various adjustments to income. Adjustments are really a special class of deductions that you take on Schedule 1 of your Form 1040. They are traditionally called "above the line" deductions, and they reduce your adjusted gross income whether you choose to use the standard deduction or itemize your deductions.
Reducing your applicable tax rate
Strictly speaking, one cannot lower his or her own tax rate. There are a limited number of steps and strategies, however, that have the same result, as a practical matter.
The kiddie tax
The kiddie tax generally kicks in when investment income in your dependent child's name is greater than $2,200.
The kiddie tax will be in effect until your child reaches age 19, or to age 24 if he or she is a dependent full-time student.
If your child is older than that, you can still place your investments in his or her name, but in that event, of course, those assets are not legally subject to your control.
The type of organization matters
Choosing the form of organization under which you do business also can help lower the applicable tax rate. The "regular" C corporation, for example, is itself a tax-paying entity, yet distributions from it (whether as salary or dividends) are taxed again to whoever receives them.
On the other hand, if you conduct business as a sole proprietorship or a "pass-through" entity (e.g., a partnership, limited liability company or S corporation), there is no tax at the entity level. Instead, income is taxed only once. The 2018 Tax Cuts and Jobs Act, passed in late 2017, introduced a new deduction for pass-through business income. Taxpayers with pass-through businesses will be able to deduct 20% of their pass-through income.
For example, if your business earns $100,000 in profit, you will be able to deduct $20,000 of it before normal tax rates kick in. The law uses phaseout income limits that apply to various "professional services" business owners. Given how new the law is, it may be wise for business owners to consult a tax professional for guidance.
Summary of tax planning
The goal of tax planning is to arrange your financial affairs so as to lawfully minimize your taxes. We have looked at just a few of the multitude of tax planning strategies available, especially to those who own a small business.
Regardless of how simple or complex your tax strategy is, the goal will be one or more of the following: reducing your (or your business's) taxable income through investment strategy, deductions and tax credits, reducing your tax rate, and/or delaying the time when you must pay the tax.
Tax planning is such a complex field that, especially if you are self-employed or own a business, it's wise to at least consider working with a tax professional.
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