Tax payments are one of the biggest pain points for many business owners. Federal, state, self-employment, and payroll taxes are just some of the obligations that a business owner must plan for throughout the course of the year. Here are a few tax tips that business owners can implement to be as tax efficient as possible.
The Augusta Rule
Named after the annual Masters golf tournament in Augusta Georgia, the Augusta rule stipulates that homeowners can rent out their home for up to 14 days per year without needing to report the rental income on their tax return. Hypothetically, if you owned a $500,000 house and charged $500/night for a rental for 14 days, that amounts to $7,000 of revenue that you would not need to report as income. If you are in the highest tax bracket (37%), this amounts to a tax savings of $2,590 each year. As a business owner, you can rent out your house to your own company for board meetings, monthly meetings, etc. to take advantage of this rule. It’s important to keep notes and records of these meetings for documentation.
If your car weighs over 6,000 pounds, you can deduct the percentage of that car for business use (Section 179). For example, if your car was worth $100,000 and 90% of the time you used it for strictly business purposes, you can deduct $90,000 off your tax return. If you are in the highest tax bracket (37%), this amounts to a tax savings of $33,300 today. Proper and detailed records are necessary, and the IRS would most likely want to see that you have two cars (one for personal use, one for business use) in a potential audit. Another way to be tax efficient with your vehicle is to take the business mileage deduction. You can deduct 58.5 cents per mile driven for business use, as long as proper records are kept. Keep in mind, you can either utilize Section 179 OR the mileage deduction, but not both. To use Section 179, you must put the car in place the year you take the deduction. This is a calendar year deadline.
Hiring Your Children to Work in Your Company
If your children are under the age of 18, are actually doing documented work for your company, and are paid less than $12,550, this would avoid any federal income taxes on the business owner’s behalf. For example, let’s assume you had a 16-year-old child who did bookkeeping for your company, and was paid $10,000. If the child then funds that $10,000 into his/her 529 plan, that costs you zero dollars in federal taxes to fund. Otherwise, you’d be funding your child’s 529 plan with money that has already been taxed. If you are in the highest tax bracket of 37%, this amounts to a $3,700 tax savings today by paying your child and having them fund the 529, as opposed to the business owner funding the 529 directly with their own after-tax income.
Implement a 401k and a Cash Balance Pension Plan
Establishing the correct retirement plan structure is one of the biggest ways to maintain tax efficiency as a business owner. In a 401k plan, if you are under the age of 50, you can defer $20,500 of your salary (402g limit) and contribute $40,500 as a profit sharing/matching contribution to accumulate an annual total of $61,000 that can go into your 401k plan every year (2022 limits). This combined maximum is known as a 415c limit. If this $61,000 is entirely a pre-tax contribution, and you’re in the highest tax bracket of 37%, this results in a $22,570 tax savings today. If cash flow allows, implementing a cash balance pension plan in addition to the 401k plan allows for additional tax savings today. An actuarial formula determines the amount of your contribution, but these contributions are likely greater than and on top of the $61,000 you are limited to inside of your 401k plan. Again, all cash balance pension plans contributions are tax deductible in the year in which you contribute, so you will see an immediate tax savings.
Utilizing an S-Corporation Election to Lower Salary
Filing as an S-Corporation and paying yourself a lower salary with a higher distribution would mean you’re paying less in Social Security/Medicare tax, as well as less in local tax if you are in a state that assesses them. For example, let’s assume you’re a business owner making $100,000 as a sole proprietor vs. making $100,000 as an S-Corporation (with $50,000 as W2 salary and $50,000 as a distribution).
From a federal and state tax standpoint, these two entities are subject to the exact same amount. However, Social Security taxes are subject to 12.4% as a sole proprietor on the full $100,000, but only on the $50,000 of W2 income from the S-Corporation. This results in a $6,200 Social Security tax savings by avoiding the tax on the $50,000 of distributions as an S-Corporation.
Local taxes and Medicare taxes work the exact same way– subject to the full $100,000 as a sole proprietor, but only on the $50,000 of W2 income as an S-Corporation. So, the lower your salary as an S-Corporation, the lower your tax liability.
However, there is an audit risk associated with making a salary that is lower than it should be. Additionally, if you sought to implement a 401k or cash balance pension plan, you are only allowed to use W2 income, not distributions, for contributions.
If you are a business owner seeking to lower your overall tax liability, it would be wise to consult a financial and/or tax professional before implementing any of the above changes. Information is for educational purposes only. EWA, a registered investment adviser, does not provide tax or legal services.
Equilibrium Wealth Advisors is a registered investment advisor. The contents of this article are for educational purposes only and do not represent investment advice.
Stock markets are volatile, and the prices of equity securities fluctuate based on changes in a company’s financial condition and overall market and economic conditions. Although common stocks have historically generated higher average total returns than fixed-income securities over the long-term, common stocks also have experienced significantly more volatility in those returns and, in certain periods, have significantly underperformed relative to fixed-income securities. An adverse event, such as an unfavorable earnings report, may depress the value of a particular common stock held by the Fund. A common stock may also decline due to factors which affect a particular industry or industries, such as labor shortages or increased production costs and competitive conditions within an industry. For dividend-paying stocks, dividends are not guaranteed and may decrease without notice.
Past performance is no guarantee of future results. The change in investment value reflects the appreciation or depreciation due to price changes, plus any distributions and income earned during the report period, less any transaction costs, sales charges, or fees. Gain/loss and holding period information may not reflect adjustments required for tax reporting purposes. You should verify such information when calculating reportable gain or loss.
This content has been prepared for general information purposes only and is intended to provide a summary of the subject matter covered. It does not purport to be comprehensive or to give advice. The views expressed are the views of the writer at the time of issue and may change over time. This is not an offer document, and does not constitute an offer, invitation, investment advice or inducement to distribute or purchase securities, shares, units or other interests or to enter into an investment agreement. No person should rely on the content and/or act on the basis of any matter contained in this document. The tax and estate planning information provided is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
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