It’s that time of year again where you need to start implementing your tax planning strategies before the year is up. With all the new regulations and an unknown election, tax planning definitely has it’s challenges to say the least. Depending on Senate, the tax structure as you know it now might change significantly. This could include tax rates increasing, capital gain rates increasing, and estate/trust rules changing once again. What makes this even more difficult is we won’t know who wins Senate until January 5th. Oy vay!
Here are some tax planning strategies that you can use as a business owner:
1. Start a tax-favored Retirement Plan, such as a 401k, SEP, Defined Benefit Plan.
Traditional 401(k): It is the most popular employer-sponsored retirement account. A 401(k) allows employees and owners to dedicate a percentage of their pre-tax salary to a retirement account. Your company has the option to match up to a certain percent and add on a profit sharing component.
Make sure to maximize your 401(k) contributions (In 2020 & 2021, $19.5k, with an additional $6k if 50 or older). Keep in mind that contributions to a traditional 401(k) reduce your taxable income. These contributions are made on a pretax basis, which removes them from your taxable income and thus reduces the taxes you’ll pay for the year. Business owners can contribute a max of $57k ($63.5k if 50 or order) in 2020 or $58k ($64.5k) in 2021 based on compensation of $285k for 2020 and $290k for 2021.
SEP IRA: A SEP or Simplified Employee Pension plan provides business owners with a simplified method to contribute toward both their employees’ retirement and their own retirement savings. Typically, SEP IRAs are funded by employer contributions alone. They are low maintenance accounts, they give you the ability to contribute generously, contributions and employee requirements can be adjusted. SEP contributions reduces the business’ adjusted gross income, reduce taxable income, and thereby reduce the federal income tax.
The max deductible contribution is the same as the 401(k).
Date to establish plan: Return due date, including extensions, for the year the plan is to be effective.
Defined Benefit Plan: A Defined Benefit is a type of pension plan typically provided by government and public entities or large corporations. However, it’s become more practically used in small businesses that have high profits and want to contribute significantly higher contributions away in their retirement. It traditionally focuses on the ultimate benefits to be paid out—-the company promises to pay their employees a certain amount at the time of their retirement and is responsible for making sure that there are enough funds in the plan to eventually pay out this amount, even if plan investments don’t perform well. Neither the employer nor the employee pays tax on initial contributions or accumulating plan earnings. However, employees pay tax when they withdraw funds, as in the other plans above.
Date to establish plan: The SECURE Act provides that qualified retirement plans adopted after the close of a tax year but before the due date (including extensions) of the tax return may be electively treated as having been adopted on the last day of the tax year.
2. Hire your kids
Hiring your kids may sound funny but it actually has a lot of tax benefits! It is a great way for your kids to earn some spending money, teach them about your business (and have an extra set of hands), plus you get a business tax deduction for employee wage expense. The deduction reduces your federal/state income tax bill and your self-employment tax bill (if applicable).
In fact, with the Tax Cuts and Jobs Act increasing the Standard Deduction up to $12,400 (in 2020), children employed in a family business can earn that much in income and enjoy a 0% tax rate on their income (at least for Federal tax purposes). Keep in mind that you must provide age appropriate work in the business that is a “real” job and you must pay them a “reasonable” wage—that is not excessive. We recommend filing jobs, organization, cleaning, errands, etc.
3. Use credit cards to pay deductible expenses before the year end.
Did you know that you can use your credit card to pay deductible expenses for this year to claim the deduction, even if you don’t pay off the credit card balance until next year? This is a great way to save on cash flow, while saving on taxes and earning cash back/rewards.
Be cautious… just because you can put something on a credit card doesn’t always mean you should. Some items to avoid putting on a credit card: payroll, legal settlements, cash advances, and high dollar purchases that you can’t payoff by the statement due date.
4. Explore the purchase of fixed assets before year end
A fixed asset purchase is something that when purchased is used for long-term use and are not likely to be converted quickly into cash, such as vehicles, equipment, and machinery.
Why is this important for tax time? Fixed assets are capitalized—the benefit of the asset extends beyond the year of purchase, unlike other costs, which spreads the expense over the useful life that is predetermined by the IRS. However, in the year of purchase, you can elect to take 100% of the expense in that year. By making the election, it will lower your taxable income in the year you made the purchase. Make sure you time this appropriately. See the next tax planning strategy below on timing your business income and deductions.
Did you know… that if you purchase a vehicle through a loan, you still get the deduction in the year you purchased it? That’s correct. It doesn’t matter if you pay for the vehicle through cash or a loan, you receive the deduction in the year it was purchased.
5. Time your Business Income and Deductions
Deferring income into next year while accelerating deductible expenses into this year makes sense if you expect to be in the same or lower tax bracket next year. However, if you expect to be in a higher tax bracket next year (which is unfortunately foreseeable for some due to the election and the pandemic), you would reverse this approach. Accelerating your income into this year (if feasible) and postponing deductible expenses until next year.
6. Prepay your deductible expenses
One way you can accelerate expenses is by prepaying expenses. The rule regarding prepaid expenses is that you can deduct a prepaid future expense as long as the benefit or right extends no longer than the earlier of 12 months or the end of next year. For example, you can not prepay 13 months of insurance.
7. Research and Development Credit Opportunity
The Research and Development credit opportunity (R&D) is not just for scientists! The R&D Tax Credit, may be claimed by businesses that develop, design or improve products, processes, formulas or software. Most businesses don’t realize how expansive this tax credit actually is. It can be used by companies of any size in industries ranging from software development to breweries.
Good tax planning and projections allows you to stay compliant while positioning yourself to pay as little in taxes as possible. We advise you to reach out to your CPA regarding your specific tax situation. There are still plenty of opportunities for tax planning and savings. If your accountant does not handle planning or you are looking for an accountant, please reach out to us. We are happy to help!