Tax planning is the analysis of finances from a tax perspective, with the purpose of ensuring maximum tax efficiency. Through tax planning, all elements of the financial plan work together in the most tax-efficient manner possible. Tax planning is an essential part of a financial plan. Business owners have a numerous number of approaches to cut their taxes, unlike W-2 employees, who are not as flexible. However, it necessitates proper planning to make the most of it.
Small business taxes can be confusing and tricky. As a small business owner, the last thing you want to do is pay more of your hard-earned business income to the government. Taxes may be the least favorite topic for small business owners, but it's one of the most important ones. The steps you take before the end of the tax year may help your business save money.
Implementing the right strategy to minimize the amount of tax you pay means that you get to keep more of the money you earn. Failing to properly manage your taxes means that your business might wind up in trouble. There are many approaches to utilize to reduce and defer your small business taxes but depending on the type, domicile, and size of your business, the right holistic tax reduction strategy should be crafted and implemented with the right combination of those approaches to maximize present and future tax savings of your business. In the long run paying less tax can have a significant impact on the growth of your business and your future wealth.
To demonstrate the potential impact of a few percentage points of tax savings, assume a business owner with an annual net income of $200,000 before taxes, an after-tax rate of return of 5%, an income growth rate of 6%, a savings rate of 5%, an expense rate of 55% of the income, and a tax rate of 40%. By calculating the future value of the business cash flow, the owner will be able to accumulate approximately $1.5 million of wealth after 30 years. Now If the owner uses a strategy to reduce his/her tax rate by 5% to 35% and hence increase his/her savings from 5% to 10%, assuming the other parameters remain the same, S/he will be able to accumulate roughly $3.0 million of wealth after 30 years. And if the tax rate is reduced by 10% to 30% and the rate of savings is increased to 15%, his/her wealth will be $4.5 million after 30 years, assuming the other parameters remain the same. As you note, the differences may be very considerable.
Unfortunately, many small business owners and medical/dental practices overpay on their taxes by missing out on certain deductions, not having the right business structures in place, or managing their businesses and retirement plans in a way that is not efficient for tax purposes. Certainly, there are many complexities to deal with when trying to minimize your tax bill, but the reward will be substantial.
Here is more good news. The Tax Cuts and Jobs Act brought the biggest changes to both individual and corporate taxes in the past 30 years. Included in those changes was IRC Section 199A, which is a new section of the tax code that introduces a 20% deduction on qualified business income (QBI) for the owners of various pass-through business entities (which include S corporations, limited liability companies, partnerships, and sole proprietorships). Fortunately, the QBI deduction will provide big tax breaks for many business-owners, but unfortunately, the new deduction is highly complicated. However, the reality is that the planning opportunities created by IRC Section 199A are tremendous.Just think about it – if your qualified business income is $200,000, then you could possibly qualify for a $40,000 deduction! Lawmakers gave us quite a gift with Section 199A.
Unfortunately, the deduction is not as simple as it first seems. If your taxable income is equal to or below the threshold ($160,700 single or $321,400 married filing jointly for 2019), then you qualify for a deduction equal to 20% of your qualified business income (or taxable income; whichever is lower). But that still leaves the question of how to calculate your qualified business income. You also need to know if your specific type of business activity qualifies for the deduction.
When your taxable income exceeds the threshold, matters get even more complicated. The calculation is no longer as simple as 20 percent multiplied by your qualified business income. When your income exceeds the threshold, you need to know whether your business is considered an in-favor business or an out-of-favor specified service trade or business.
The calculation differs for in-favor and out-of-favor businesses. And once taxable income exceeds $210,700 (single) or $421,400 (married filing jointly), then the out-of-favor business gets no deduction. What if you have multiple businesses that may qualify for the deduction? That will require even more know-how and calculations.
Final ThoughtWhile tax planning is a year-round activity, you may be able to achieve savings by taking actions at the end of the year. You may be able to reduce the amount of taxes you pay if you take advantage of breaks and opportunities that are out there. It’s up to you (and your tax advisor) to discover new ways to lower taxes for your small business. This is especially important because of the new tax law. With all the new rules for personal and business tax deductions, the moves you make now can potentially save you significant amounts of money this year and into the future.
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