Business owners have numerous ways to reduce their tax bills for both themselves and their companies. Some of the methods are more commonly understood; however, many tax strategies are relatively unknown to even the brightest of entrepreneurs.
Little-known tax strategies are not a secret because they are written in the tax code and approved by the IRS. Wealth managers, accountants, and tax attorneys should all know about these and other ways for you to avoid paying more than your share of taxes.
BUSINESS OWNERS TAX STRATEGIES: QUALIFIED RETIREMENT PLANS
A qualified retirement plan meets the definition laid out in Section 401(a) of the tax code, allowing both business owners and employees to make pre-tax contributions, which then grow tax-deferred. There are two basic types of qualified retirement plans: defined contribution and defined benefit plans.
Defined contribution plans, such as 401(k) plans, are more common. Business owners benefit from tax strategies in two ways from such programs. First, they can reduce taxable business income through employer contributions. Second, they can reduce their personal taxable income by deferring part of their salary.
If you are over 50 years old, looking for ways to reduce taxable income and sock away a larger retirement nest egg, then a defined benefit plan may be your answer and can be an ideal solution for many business owners.
Selling or transferring ownership of your business to new owners or family members can trigger a significant tax event. One strategy that you can use to reduce a hefty capital gain tax on the sale is to freeze the value of your business.
After you “lock-in” the business value, you will avoid capital gain taxes on any further increase in value. Additionally, freezing the value can reduce or eliminate estate, gift, and generation-skipping taxes on any further value increase. Freezing your business value can be a particularly effective tax mitigation strategy if you plan to transfer business ownership to children and grandchildren.
BUSINESS OWNERS TAX STRATEGIES: HIRE FAMILY MEMBERS
Hiring family members can yield significant tax benefits, particularly for small business owners under a sole proprietorship or single-member LLC. For example, you can hire your spouse and provide all or most of their compensation in the form of a medical expense reimbursement plan. This benefit is allowed in section 105 of the IRS tax code.
A section 105 plan allows for the tax-free reimbursement of healthcare and dental insurance premiums, along with out-of-pocket medical, dental, eye care, and other eligible medical expenses. Medical expense reimbursement plans can be significant tax savings for small business owners.
You can also hire your children to assist you in any number of ways. While they are minors, the salary you pay them is free from payroll taxes. The salary is taxed at their minimal tax rate, and you can help them save the income for college.
If your children attend college when they are 18 or older, they can claim themselves as dependents and receive tax credits up to $2500 annually. Since this is a credit instead of a deduction, they can earn close to $40,000 annually free from federal taxes. Compare that to the amount of taxes you would pay on the same $40,000, and you see how the tax savings of hiring your college-age children can add up.
CAPTIVE INSURANCE COMPANIES
Section 831(b) of the Internal Revenue Code allows business owners to set up their company as an insurance company as a wholly-owned subsidiary. This captive insurance company ensures the risks of the parent company.
The parent company funds the insurance operation tax-free. The parent company also controls the premiums and claims, taking the commercial insurance company’s profit and the claims hassle out of the equation. The investment income from the captive insurance operation is tax-exempt (not merely tax-deferred).
As a business owner, there are various types of captives for varying business needs. Still, most generally allow for tax-free funding of the insurance operation and tax-exempt income from the insurance operating profit.
You can avoid capital gain taxes on the appreciated value of your business by first gifting the shares to a charitable trust before the sale. Charitable trusts are powerful for business owners because it avoids capital gain taxes on the sale.
It is best to use charitable trusts in combination with objectives other than tax reduction. One example of this type of tax strategy is if you or a beneficiary you name can receive income distributions for life from the trust. When you gift appreciated assets to a charitable trust, you also receive charitable tax deductions to help offset taxes on other income sources.
The Internal Revenue Code has hundreds of sections, many of which establish legitimate ways for business owners to avoid taxes and reduce the amount you pay to Uncle Sam over a lifetime. Working with a tax-smart professional who understands your values, goals, and objectives can help guide you to the proper tax reduction strategies for you.
DISCLOSURE & ACKNOWLEDGEMENT
The information included in this material is for informational purposes only and should not be relied upon for any financial or legal purposes. Arlington Capital Management Inc, dba Arlington Wealth Management (AWM) is an investment adviser registered with the U.S. Securities and Exchange Commission. Our registration with the SEC or with any state securities authority does not imply a certain level of skill or training, nor are we selling you any product. Rather, we are seeking to provide you with advisory services. Please consult with your own tax and legal advisers before investing. AWM cannot and does not guarantee the performance of any investment. Past performance is no guarantee of future results.