Every April I get the same phone call.
"Luke, you aren't going to believe what my CPA just told me I am going to owe in taxes."
It is like deja vu every year.
If this is you read every word of this blog.
As specialists in wealth management for business owners, we have found tax planning for business owners to be the single biggest win for our clients.
In this blog, we are going to give you a behind-the-scenes look at our tax planning strategies and implementation for business owners.
Tax Planning for Business Owners
Taxes are part of making money, but we never want to leave the government a tip.
So how where do we start?
We are going to walk through the tax planning process today and answer three key questions.
How do taxes work?
What tax strategies should I use?
How to avoid an unexpected tax bill?
Let's dive in.
How do Taxes Work?
We have all had car problems. You get that nasty yellow check engine light on and take your car to the mechanic. The first thing they are going to do is diagnose the issue. The way they do this is by reading the error code in the computer of your car that tells them the issue. They then explain the issue to you and strategies to fix it.
Many people jump straight to the tax strategies without first understanding taxes. This would be the equivalent of your mechanic telling you it could be 100 different fixes without first diagnosing the problem.
So how do taxes really work for business owners?
There are typically two types of income categories.
Ordinary Income - Earned income from your business.
Capital Gains - Income generated from the sale of an asset. (Business, Real Estate, Stock, ect.)
Ordinary Income:
The US operates on a marginal tax system. This means that for every dollar you make you will not pay the same amount in taxes. Think about your ordinary income as the money you are making from operating your business. Below is an outline of the current federal tax brackets.
Many people get caught up in the highest tax bracket they are in. For example, if you made $731,201 I hear people tell me they are paying 37% in taxes. (Married Example) In reality, they are only paying an average of 26.74%. This is because of the marginal tax brackets. Knowing your average tax rate will allow you to make better tax planning moves.
Now that we understand how ordinary income is taxed let's look at capital gains
Capital Gains:
When you sell something that you own personally or in your business you will get taxed at capital gains rates. Capital gains have two different classes. The sale will be treated as a short-term gain or a long-term gain.
Short-term gain - Held for under 1 year.
Long-term gain - Held for over 1 year.
Now the important part. How are they each taxed?
Short-term capital gains will get taxed as ordinary income. You can simply revert back to the section on ordinary income and review the chart.
Long-term capital gains are a different story. They receive special tax treatment and get preferential rates.
When we are looking at different tax planning strategies timing can be the difference in millions of dollars saved in taxes. Anything you can push to long-term capital gains treatment will save you money in taxes.
So if you are looking to sell an asset at a gain how much will be taxed? This is where tracking your cost basis is important. If you sell a building your business owns you will only pay taxes on the difference between your cost basis (What you paid for it - depreciation) and the sale price.
Now that you know about the different types of income let's dive into something more fun.
Tax Deductions:
Tax deductions are a business owner's friend, but they need to be understood properly in order to maximize the benefit. The most famous tax deduction for a business owner is buying an SUV over 6,000 pounds. Everyone has seen their friend go to the dealership in December because they could "right it off".
Let's look at what they really mean.
In 2024 you expect to make $1,000,000 in total income. As part of your tax planning, you purchase a new company vehicle for $100,000. How much money does this really save you?
Without Car Purchase.
Income - $1,000,000
Taxes - $294,966
With Car Purchase.
Income - $1,000,000
Tax Deduction - $100,000
Adjusted Income - $900,000
Taxes - $257,966
You have saved $37,000 in taxes and spent $100,000 on a car.
So remember, a tax deduction only reduces your taxable income.
We hope that this gives you clarity about how the tax system works. Now let's look at how we make tax planning decisions to never leave the government a tip.
What Tax Strategies Should I Use?
Tax planning is a never-ending game of chess. There are always moves to be made both today and in the future.
How do we do that?
We focus on two areas for tax planning.
Future Year Tax Benefits - Strategies that help us pay less tax later.
Roth Conversions
Roth IRA Contributions
Portfolio Optimization
Present Year Tax Benefits - Strategies that help us pay less tax today.
401(K) Contributions
Wage Optimization
Tax Loss Harvesting
So how do we know when to use a future-year strategy or a present-year strategy? It is my favorite answer. It depends. In order to determine which strategies to use it is about understanding where we are at today and where we are going in the future.
Let's look at a real-life example that we can see both present and future year benefits pan out.
A common situation we see for business owners is a high income for a sustained period of time with the culmination of a business sale. After the business sale, the income dramatically drops. Let's look at the case study of Joe.
Case Study - Present Year Tax Strategy
Joe is making $1,000,000 in his business and continues to get beat up by taxes. He is trying to determine what he can do to save money on taxes now because he is in the highest tax bracket.
After reviewing Joe's tax return it is clear that he is not optimizing his salary to maximize his qualified business income deduction.
Joe is paying himself the following between wages and distributions.
W2 - $100,000
Distributions - $900,000
This will result in a $50,000 deduction for qualified business income. The simplified way to think about this deduction is the lesser of 50% of W2 wages or 20% of distributions.
After reviewing the situation we switch his W2 wages and distributions.
W2 - $300,000
Distributions - $700,000
This tweak results in a $140,000 deduction for qualified business income which will reduce Joe's taxable income by an additional $90,000.
This alone saved Joe around $30,000 in taxes.
Now let's take a peek at a future year strategy.
Case Study - Future Year Tax Strategy
Let's continue on with Joe. Joe ended up selling his business 1 year ago and his new hobbies don't pay him any income. This results in Joe moving from the 37% marginal tax bracket to the 22% marginal tax bracket.
Joe has always invested in municipal bonds because they are tax-free and he was always in the highest tax bracket. With the dramatic drop in income, we reviewed if this was the best option moving forward.
Current rates for taxable bonds are 6% while municipal bonds are paying 4%.
After performing an after-tax yield calculation it is determined his municipal bonds are paying him a 4.7% taxable yield. This means that for every $1,000,000 Joe had invested in municipal bonds, he was leaving over $10,000 on the table.
The solution is to optimize his portfolio by rebalancing from tax-free bonds to taxable bonds.
As I discussed in investment planning for business owners this is a key consideration in a portfolio.
There is no one-size-fits-all when it comes to tax planning for business owners. The key is to understand taxes are like a game of chess every move matters both for today and in the future.
How to Avoid an Unexpected Tax Bill?
One of the best qualities you can have as a business owner is seeing around the corners. You are able to make changes in your business before the masses see the new trends coming. The best advisors have the same skills but for your personal financial life.
Avoiding the unexpected tax bill is all about being proactive vs reactive.
So how are we proactive?
It all starts with what has happened in the past. Typically when you file your tax return your accountant is going to give you estimated payments. Those estimated payments will be based on last year's income.
Here is how it works. It is called the safe harbor contribution.
What is the safe harbor contribution?
2023 Total Tax - $250,000
In order to avoid penalties and interest you need to meet the safe harbor contribution in this current year.
90% of the tax owned in your current tax year 2024
100% of the total tax paid in the previous tax year 2023
This is where business owners get in trouble. They are told in April to pay quarterly payments based on 2023 taxes, but you are having another great year and expect to make twice as much money.
You get to the end of the year and ask your accountant for an estimate. Your accountant looks at your books and says wow you are having a great year you are going to owe a lot of money in taxes.
We avoid this perpetual system by proactively looking at tax planning on a quarterly basis.
Rather than waiting until the end of the year their needs to be constant communication with your team. If this isn't happening for you there is a tax surprise waiting around the corner.
So remember tax planning doesn't need to be complex. At Moment Private Wealth we simplify tax planning to help you pay the least amount in taxes today and in the future. My encouragement to business owners is to start with the basics before choosing a strategy.
Understand How Taxes Work.
Build a Plan with Your Team.
Execute that Plan.
Taxes don't need to be complicated but you do need to have a plan. Without one you are sure to be stressed about taxes and leave the government a tip.
If you are a business owner who is looking to find a financial team that specializes in you, schedule a call, and talk with a Moment founder.
Not sure what questions to ask, check out this video on 10 questions you should ask when interviewing a financial advisor.
Get in Touch With An Advisor
Frequently Asked Questions
Here are some answers to questions I received frequently about this topic.
Are you a fiduciary? Moment Private Wealth serves clients as a fiduciary 100% of the time.
How does Moment Private Wealth make money? W We are only paid in one transparent way, by our clients. We receive no kickbacks or participate in any profit-sharing arrangements. Our fees are simple, transparent, and clear for our clients.
How are you different than other financial advisors? We are specialists in working with professional athletes and business owners. We limit the number of new clients we take on. This allows us to provide unparalleled value and highly personalized service to professional athletes and business owners. We work as a team to service our clients. We believe in building a team of “A” players. This ensures our clients receive world-class tax, estate, insurance, and investment strategies. We focus on educating first, then executing.
Where do you hold my investments and how can I see them? Moment Private Wealth uses Fidelity Investments as a third-party custodian for our client investment accounts. As a third-party custodian, Fidelity safeguards and provides reporting to you and the IRS each year. Clients can also access all financial information via the Moment Private Wealth Client Portal.
How do you work with other members of my team? W We believe in the power of the team. Our client teams consist of Moment Private Wealth, an accountant, an attorney, a banker, and an insurance specialist. We help our clients build out their team of individuals or work with existing partners clients have. Our goal is to ensure every family has a team of experts to protect their interests.
How do you choose investments for clients? As independent financial advisors, we can gather research and make recommendations based on all available options. We determine clients’ portfolios in partnership with some of the largest asset managers in the world. Each quarter, we have calls with teams of CFAs (Chartered Financial Analysts) to ensure our clients are receiving the most up-to-date strategies and recommendations.
What does your average client look like? Our clients are nearly all athletes and business owners. Our average client has a net worth greater than $5M. The strategies, solutions, and planning that we implement have a high-net-worth and ultra-high-net-worth client in mind.
How to pay less in taxes as a business owner? Taxes are going to be your largest lifetime expense. Our goal is to help you pay the least amount possible and never leave the IRS a tip. Our team of specialists understands this and works to reduce your taxes today and in the future.
How do taxes work as a business owner? When you own a business you are going to get taxed in two ways. First, you will be taxed as an employee through the W2 wages you take from the business. Second, you will be taxed on the profits that your business earns.
What are the best tax strategies for business owners? The best tax strategies can save you thousands if not millions in taxes. The best strategies will be specific to your needs and goals. Strategies most business owner consider take into account what they expect to make in income this year as well as in future years.
*Moment Private Wealth offers information on tax and estate planning that is general in nature. Tax and Legal advice are not provided by Moment Private Wealth. Consult an attorney or tax professional regarding your specific legal or tax situation.
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