The new tax code offers substantial breaks to small business owners – who know how to take advantage.
Finding ways to legitimately lower your tax burden is an attainable goal for business owners. But too many continue to overpay by overlooking deductions or structuring their businesses and retirement savings in ways that aren’t efficient for tax purposes.
It’s easy to understand why: navigating the thousands of pages that comprise the complex U.S. tax code is bound to cause headaches for even the savviest business owners. The path to lower taxes is littered with complicated issues, but the right strategies will enable you to keep more of your hard-earned business income in your pocket instead of Uncle Sam’s.
An experienced tax advisor can help you take advantage of all the new breaks and opportunities that are out there – while avoiding mistakes that can lead to hefty penalties.
Through a series of closed and open-ended questions that help them understand your business and personal goals, a professional advisor who thinks strategically and long-term will assess your situation and suggest a strategy that saves you a significant amount of money.
Step One: Transform Your S-Corp Into an Operating Company
An important decision small business owners face in the wake of the Tax Cuts and Jobs Act (TCJA) is whether incorporating as an S-corporation or a C-corporation will offer the greatest reduction in their tax burden.
The IRS starts out classifying every corporation as a C-corp, which pays taxes on its income. But if the company meets certain requirements of the tax code – and any shareholders desire – it can file to become an S-corp. In that case, taxes are not paid by the company because profits “pass through” to the shareholders, who are taxed under individual income rates.
The TCJA created advantages for both types of companies: tax rates for C-corps were slashed from 35 to 21 percent, although dividends are taxed again at the individual level, which makes them subject to double taxation. S-corp owners may benefit from a 20 percent deduction of pass-through income – the most significant tax break for small business owners in decades – within rules and limitations, of course.
But what many business owners don’t understand is that a multi-tiered structure can enable the business as a whole to take advantage of the tax benefits that both types of entities offer.
The Internal Revenue Service reports that nearly 62 percent of American businesses operate as S-corps. They are the most popular corporate structure in America and the cornerstone of the small business community.
S-corp owners avoid the double taxation that plagues C-corps by paying themselves a small but reasonable salary and then taking out the rest of the money as a distribution of profits. Paying less salary also significantly reduces the amount of FICA and Medicare tax S-corp business owners must pay.
Step Two: Create a C-Corp That Provides a Good or Service
Here’s where the creative tax benefits start: Business owners can transform their S-corp into an operating company, only taking income up to the minimum amount that they need for their living expenses.
The rest of the company’s profit – within limits – is moved to a C-corp that’s formed to provide a specific, legitimate good or service for the S-corp; for instance, management, human resources, or consulting services. Since C-corps are now taxed at a flat 21 percent rate, that means business owners can experience substantial savings on potential taxable income that would have flowed through their personal return, where rates can run as high as 37 percent.
Business owners can also extract money from the C-corp by taking advantage of an array of tax-free benefits that are not available in S-corps, such as providing health insurance, healthcare reimbursement, dependent care assistance, or educational assistance.
In a C-corp, these benefits are paid with pre-tax dollars; in an S-corp, individuals pay taxes on their income before paying for benefits. In fact, benefits costs are treated as wages for S-corp owners so they don’t interfere with their ability to claim the self-employment deduction on their personal returns.
Step Three: Create a Consulting LLC
Business owners can also vastly reduce their tax liability by splitting their company into a third entity: a consulting limited liability corporation (LLC).
This LLC can be paid for various services, and here’s one great example: The TJCA made it quite advantageous for business owners to employ their minor children, who can each receive up to $12,000 – the standard deduction they are entitled to on their personal tax returns – in wages tax-free. That’s up from $6,350 in 2017.
The business owner can then move funds from the S-corp or C-corp by establishing a consulting relationship with the LLC, which in turn pays the children a W2 for their services.
Children can be legitimately used to perform routine office work such as filing, cleaning, or internet research. They can be hired as models and used in advertising campaigns, on your company website, or as a picture on your business cards. Teenagers are perfect to manage or start your social media marketing.
In essence, you can shelter up to $12,000 of W2 income by putting your child on the payroll. Even better, hiring your children does not prevent you from claiming them on your tax return and taking the tax credit.
Step Four: Consult a Professional Tax Advisor for More Ways To Lower Your Taxes
The majority of American business owners operate their companies as S-corps, but many don’t realize the significant tax benefits they can enjoy by expanding their business into a three-tiered business structure.
Of course, that’s just one way that an experienced tax advisor can help business owners restructure their company and their income to minimize their tax burden. The skilled professionals at Calloway Tax Advisors can help you devise a strategy that’s the best fit for your business and its growth plans.