Tax season is likely one of the last things on your mind in August. As an entrepreneur, it usually feels like you’re more focused on operating the business and putting out fires than growing your business.
As we forge ahead into the second half of 2022, you may be surprised to learn that now is a great time to review your business’ tax state. Performing a mid-year “tax liability check-up” for your business will allow you to stay up to date on the best ways to maximize tax savings, preemptively solve any potential pitfalls, and work to ensure the long-term success of your business.
You can start by assessing each of these three areas:
- Business Structuring
- Compensation Payouts
- Retirement Planning
We’ll unpack these more below. Remember, careful analysis and changes implemented today could mean benefits that last for years to come.
Your Entity Structure.
Ask yourself: “Does the type of business I have maximize my tax savings?”
There are three typical entity structure options currently in play for single owner small businesses: Sole Proprietorship/Schedule-C, C-Corp, or S-Corp.
Sole Proprietorship/Schedule-C
Many solo entrepreneurs choose to operate as a sole proprietorship. Since this structure requires little forethought and no formal paperwork, this path is often the easiest and quickest road for a budding business owner. Some do choose to register their trade name, get an EIN (Employer ID Number), purchase business insurance, and/or open a business bank account. A sole proprietor files taxes through an addendum to their individual 1040 tax return and is taxed only on net earnings (revenues minus expenses).
Once a sole proprietor is bringing in larger profits, though, there may be more tax advantageous entity structures to choose from.
S-Corporation
Up next is the small business corporation, or “S-Corp.” This special class under the federal tax code provides limited financial liability to the owner/shareholder. For business owners, they offer some tax benefits as well, including the ability to classify revenue as wages, which are subject to payroll taxes, or profit distributions, which are not.
C-Corporation
Like S-Corps, C-Corps offer limited liability to owners/shareholders but are a separate taxable entity which is taxed at both the corporate and shareholder levels. This “double taxation” is often presented as a negative aspect of using a C-Corp. The structure can work for service businesses like doctors, lawyers, or architects, who pay out all cash reserves at year-end as “bonuses” so the corporation itself has no taxable income. C-Corps require filing paperwork and annual fees with the Secretary of State and require oversight by a governing board of directors.
Your tax entity decision should ultimately be based on several factors, including where your money goes after profit. Our team here at Tremonte can help you make the decision that’s best for you.
**It is important to note that while you are reviewing your entity structure in the middle of the year, it is NOT recommended to change your business structure at the same time. You are assessing the benefits of making that change by the end of the year.**
Your Compensation Structure.
Ask yourself: “Have I allocated wages and distributions adequately so far?”
Compensation structure is a primary concern for S-Corps, where the goal is to minimize your payroll taxes. You can consider which contains the less severe tax implication to the shareholder: wages/salary vs. dividends/distributions.
Your wages are reported to the IRS as personal income. This is the same as what would be reported as your salary if you were an employee of any company.
Unlike wages, dividends/distributions are considered investment income by the IRS. Dividends can provide flexibility in how you save for retirement. And while you may be able to use them to avoid a higher personal income tax rate now, lack of careful planning can lead to some surprise tax bills later.
As a business owner, you will want to make sure that these are balanced. Swinging the pendulum too far one way can have significant negative impacts on your financial situation in both the long and short term.
For example, having a lot of distributions and hardly any wages could mean you’re on the slippery slope of not meeting reasonable compensation requirements. If, let’s say, you’ve only taken $20,000 in wages and you have $50,000 in distributions over the first half of the year, you will want to consider flipping those allocations for the second half of the year. If the IRS determines you’ve underpaid shareholders, you could be subject to tax, interest and penalties on the resulting increase in income.
Your Tax-Saving Retirement Plans.
Ask yourself: “Do I have the best retirement plans in place for my business now, or for myself once I’ve exited my business?”
Retirement plans are another way to maximize your tax savings. Instead of letting your profits sit in your business to be taxed, you can have that money work passively for you in a tax-friendly retirement plan.
There are many options out there for small businesses to open retirement accounts for themselves or for their employees.
If you don’t have any employees and are looking for a great personal option, the Simplified Employee Pension Individual Retirement Account (SEP IRA) could benefit you greatly.
As the IRS describes:
“Simplified Employee Pension (SEP) plans can provide a significant source of income at retirement by allowing employers to set aside money in retirement accounts for themselves and their employees. A SEP does not have the start-up and operating costs of a conventional retirement plan and allows for a contribution of up to 25 percent of each employee’s pay.”
If you have employees, the Simple IRA or 401(k) Plan benefits both you and your employees. The employees decide their deferral amounts.
The IRS explains:
“A SIMPLE IRA plan (Savings Incentive Match PLan for Employees) allows employees and employers to contribute to traditional IRAs set up for employees. It is ideally suited as a start-up retirement savings plan for small employers not currently sponsoring a retirement plan.”
The IRS explains a SIMPLE 401(K) plan like this:
“Under a SIMPLE 401(k) plan, an employee can elect to defer some compensation. But unlike a regular 401(k) plan, you the employer must make a minimum of either:
- A matching contribution up to 3% of each employee’s pay, or
- A non-elective contribution of 2% of each eligible employee’s pay.
No other contributions can be made. The employees are totally vested in any and all contributions.
If you already have a retirement plan in place, are maxing out your contributions, and still have a lot of free cash flow, it could be time for you to consider a type of defined benefit plan.
The benefit of having a pension plan as a sole owner of a business is that you are permitted to save a large amount of money pre-tax. These savings must be balanced, however, with your costs for the required annual actuarial report and the required contribution for employees.
The Bottom Line
Any one of these strategies can help you move the needle toward maximizing your tax savings as a small business owner. We encourage you to take some time in the coming days to conduct your own mid-year “tax liability check-up.” Perhaps you’ll uncover some moves that will help you turn your business into a profit-generating machine that just won’t quit.
Want help with your assessment or need help maximizing your tax savings? Here at TreMonte, our professionals are standing by to help you do just that. Schedule a call today!