Whenever you generate profits, you’ll have to answer to the Tax Man. The challenge is to use every legal means of reducing your tax liability to the lowest possible amount. Here are some ways to meet this goal.
The first step in cutting your taxes to the legal minimum is to create and maintain reliable financial records. Your record-keeping system should give you a clear understanding of your financial affairs—income, loans, purchases, losses, investments, interest paid and earned, etc.—and enable you to quickly access your financial data at tax time.
An enterprise with a complex business model will require a fairly detailed financial record-keeping system. A wage earner who is maintaining a household and supporting a family can make do with much simpler record-keeping. A small to medium-size business has needs that fall in the middle. Ask yourself, What works best for me? Then implement that system.
A wage earner’s system might consist of maintaining a file of Forms W-2 and 1099, payroll check stubs, and other documents received from third parties (interest statements from banks, for example); allowable deductions can be flagged with check-writing software and/or spreadsheet software. An entrepreneur operating a small to medium-size business might need a formal “double-entry” bookkeeping system (your accountant can explain this, but generally it means that fiscal records are maintained in two places so errors are easier to detect) that’s supported by hard-copy or electronic documents such as receipts.
Working With a Competent Tax Adviser/Preparer
Although tax laws aren’t intended to punish income-earning citizens, their complexity may make you think so. You should have a basic understanding of tax laws that apply to you and your company, whether you personally complete your returns or hire professional help. Your tax adviser can explain things you don’t understand, or if you’re going it alone, you should routinely seek and read timely, relevant articles about income tax and/or review Internal Revenue Service publications at IRS.gov. In addition, world-class tax experts offer many free or low-cost articles online; some accounting firms’ websites post helpful information; and IRS Publication 334, Tax Guide for Small Business, is excellent. Find it at this shortcut: goo.gl/6mhF1U.
If you delegate to a pro, cultivate a lasting relationship based on mutual trust. Trust is essential for effective communication, collaboration and the best possible tax result.
Many people think of taxes—and ways to reduce them—either in late December, when they toss up a Hail Mary in hopes of reducing their taxes for the past year, or in April, when they’re scurrying to file a return by the 15th. But effective tax planning is a year-round process. As significant financial events occur—you win a big charity raffle, you receive a large performance bonus, or you sell a real estate parcel—ask questions and find informed answers regarding potential tax consequences. So this means you should be in the final stages of 2014 tax planning as you read this!
Of course, your opportunities to reduce the taxes triggered by a major financial event may be limited. When that’s the case, the most effective tactic is to predict, as precisely as possible, how much money you’ll need to cover the tax liability.
There are many ways to predict the income tax consequences of an event. The easiest way is to access the IRS tax rate schedules and apply the applicable income tax rate to the income amount. If you are using tax return preparation software, you can play “what if?” by inserting the income from the event into the return; you’ll instantly see the increase in your tax bill. Then set that amount aside until the tax is due. Otherwise you could be late coming up with the payment and face penalties on top of the taxes you owed in the first place! (I recommend that you buy a single-user version of this inexpensive software—it’s deductible. You can find options by searching for “tax preparation software” online.)
When you develop a financial plan for your business, start with an inventory of financial resources (cash on hand, money owed to your accounts receivable, etc.) and then list future expected earnings, existing debts and future financial commitments like a capital expenditure for new equipment. Each financial resource has the potential to grow, shrink or remain constant; future ups and downs affect your taxes. So as you consider strategies to make the most of your financial resources, you also should consider the related tax implications.
Under the current U.S. taxing scheme, some earnings and gains are exempt from taxation by law—for example, interest income from a bond issued by a state, county or local government is generally tax-exempt. Also, death benefits received as a beneficiary of a life insurance policy are generally tax-exempt. Taxable earnings and gains are generally taxed when “realized,” meaning when the money comes to you. In some cases, the tax on certain realized earnings and gains may be postponed (deferred) until a future date. And the increase in value of your investment portfolio is not taxed until you sell one or more of the securities in the portfolio. Distributions (money you receive) from a retirement plan such as an Individual Retirement Account or a 401(k) are usually taxable, so try to time the arrival of that income to when you’re in a lower tax bracket.
As the Benjamin Franklin saying goes, “A penny saved is a penny earned.” Paraphrasing Franklin (sort of), “A tax deferred is a tax saved.”
In executing financial strategies such as when to buy, borrow and sell, tax rates are always a factor to consider but should never be the most important factor. Consider these ideas, presented in no particular order, for trimming your taxes:
•Claim deductible expenses as soon as you can. Tax laws change, and some items that are allowable deductions now may not be in the future.
•Consider incorporating an unincorporated business. Sometimes employee benefit and other programs sponsored by a corporate employer are more tax-efficient (meaning they reduce the owner’s tax liability) than those available to owners of unincorporated businesses. Generally, there are minimal adverse tax consequences of incorporating an unincorporated business.
•Look into employing family members—these include close and extended family, in-laws, and significant others—in the family business because you might be able to have the combined family income taxed at a lower aggregate rate. And while it would be nice to pay Mom $100,000 a year to answer the phone, salaries must be reasonable in relation to the services performed. Performance evaluations lend credibility to the aggregate-rate strategy.
•Optimize retirement savings (IRAs and 401(k)s, for example) and/or deferred compensation arrangements. Put as much as you possibly can into your retirement savings plan without sacrificing the personal liquidity you need for emergencies. And whenever possible, try to qualify for the maximum amount of employer matching funds. That’s optimizing at its best: free money!
The financial advantages can be significant because, No. 1, money you save for retirement will earn compound interest and, No. 2, you can defer the payment on your earnings until you are retired, when most people earn less and thus pay a lower percentage of their income to Uncle Sam. The tax aspects of retirement savings and deferred compensation arrangements are very technical, so seek recommendations from experts (tax and financial advisers, actuaries, plan administrators, etc.) to maximize your legal tax avoidance.
Your Bottom Line
Planning well and having access to the right information about your finances as well as tax rules are keys to holding onto your profits when you go up against the Tax Man. Plan your work and work your plan.
And remember: It’s not how much you make; it’s how much you keep.