By: Amir Naghshineh-Pour
October 15, 2020
Tax planning is the process of looking at various tax options to determine when, whether, and how to conduct business and personal transactions to reduce or eliminate tax liability.
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 can help your business save money practically immediately.
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, you will be able to accumulate approximately $1.5 million of wealth after 30 years. Now If you use a strategy to reduce your tax rate by 5% to 35% and hence increase your savings from 5% to 10%, assuming the other parameters remain the same, you 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 to 15%, your 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.
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