Aligning personal and business tax strategies can save you thousands of dollars

By Robert C. Jones, CPA, Liberty, Mo.

Often, when entrepreneurs decide to create their own businesses, they focus solely on the enjoyment they’ll receive from doing something they’re good at and being financially rewarded for it. Typically, new business owners don’t think about the administrative side of the business and merely back their way into a tax strategy. In effect, these entrepreneurs allow the IRS to tell them what to do, when actually they need to understand the impact their approach to setting up and running their business will have on both their business growth and their personal taxes. If you own a business, you can save thousands of dollars each year on income taxes by being proactive about seeking advice from a CPA, attorney or other business consultant and by understanding your own financial objectives.

Determine your business goal

Before starting a business, you need to determine why you are doing it. Are you grooming the company to sell it for a profit? Or are you using it to fund personal life goals, such as a college education or a mortgage? The strategies you pursue for these objectives are completely different. Furthermore, every business owner should plan how he or she eventually will get out of the business. Will the kids take it over? Will it be sold to employees? Or will you simply let it wither and die? Again, each of these goals requires different financial strategies.

Decide your business type

The first step in creating a business is to decide what type of business entity it should be: a sole proprietorship, a partnership, a limited liability company (LLC), a C Corporation or an S Corporation. The choice of entities depends in part on your personal financial situation and goals. Are you married? Do you have a business partner? You’ll want to select the entity type that best matches your particular circumstances. A CPA can help create the entity in a way that changes the manner in which the IRS looks at your income to determine how much is salary and how much is derived from investments. Each of these streams of income is taxed at much different rates, and you should do all you legitimately can to get the lowest tax rate on the greatest proportion of your income.

For example, an LLC usually is a good choice of entity for a small business run by a husband and wife or a family unit. In a member-managed LLC, we may establish the wife as the operator of the business and the husband simply as a passive partner in the partnership. We set up the business so the wife owns 20 percent, yet is the managing member, and the husband owns 80 percent while having no control of the daily operation of the business. When the IRS considers the company’s income, only the wife’s 20 percent will be subject to self-employment tax or employer-side FICA and Social Security taxes. Furthermore, the husband’s 80 percent is considered investment or passive income and is taxed at a much lower rate than a salary or even pass-through net income would be, especially if the couple is in a high income bracket. Structuring a business in a way similar to this example can cut self-employment taxes by thousands of dollars a year.

Choose the right deferred income option

Another way to reduce taxes and still access your money for personal goals is to choose the right deferred-income option, such as a traditional IRA, simple IRA, SEP IRA, 401(k), Roth 401(k), 401(k) profit sharing with safe harbor option (which automatically satisfies certain nondiscrimination testing requirements), or even a deferred benefit plan. Higher-income-earning individuals can place as much as $60,000 a year into a deferred-income option if they are a principal of the business, versus just $14,000 allowed for an individual with a conventional 401(k). This type of 401(k) plan entails higher administrative costs, but those are far outweighed by the tax benefits of the program. Your choice of a deferred-income program depends on how much you’re willing to spend for its administration. SEP IRAs are simple and inexpensive, while defined benefit plans are more costly but provide a wider range of potential benefits, such as a “golden parachute” that provides large benefits if the company is acquired and the current owner is fired.

Pay your children royalties for tax-free educational funds

You can save money tax-free for your children’s education by paying them royalties from advertising and other promotional work. Put your children in your television spot or your print ad and pay them a royalty for every time the promotion appears, rather than a W2-based salary. The first $4,000 of income can go tax-free into a child’s SEP IRA or 401(k) and never be taxed. When the child is ready to enter college, you can pull the funds out with no penalty and no taxes applied, because higher education is one of the exceptions allowed by law that permits early withdrawals. The result is a tax-free way to transfer money to your children. You can do the same thing with regular earnings, as well, but they will be subject to Federal Insurance Contributions Act (FICA), Social Security, Medicare and unemployment-insurance taxes, unlike earnings from royalties.

Lease personal assets to your business

The building you own for an auto-body shop or office also can become a source of income for you that is subject to lower taxes if you handle the acquisition of the building correctly. You should consider owning assets personally and leasing them to the business. In this example, buy the building with personal funds and lease it to the company you own. All the lease payments are tax-deductible to the business, whereas only the interest payments would be tax deductible if the business had bought the building directly. Even after lease payments have compensated completely for the original cost of buying the building, you can continue to collect rent from the company and deduct the cost of repairs and maintenance that you make. You are making your building 100 percent deductible to the business and lowering the amount of income that is passed through to you personally from the corporation. You are lowering your taxable income without changing any of your cash flow. The same technique can be applied to equipment, real estate and other high-ticket items.

One of the keys to setting up your business, then, is not to react to your situation but to be proactive with your team of advisors and plan around your particular circumstances. Tax savings are out there waiting for you to take advantage of them; successful people manage their tax situation, not react to it. Above all, find an advisor you trust to be shoulder deep in your personal and business financials, and then listen to him or her. You’ll live a wealthier life and run a more successful business.

About the author

Robert C Jones, CPA
RC Jones and Associates, Inc.
Office (816) 792-9966
Fax (816) 792-8622
Mobile (816) 419-7864
info@rcjonesinc.com
www.rcjonesinc.com

Note: The following information is provided to you by third parties for informational purposes only and shall not constitute tax or legal advice. Microsoft Corp. has not checked or verified any of the information provided and makes no representations or warranties as to its accuracy. Each individual’s tax situation is unique, and you should check with your accountant or other tax professional for particular advice on your situation.