Tax planning is a procedure for reviewing various options for conducting business and personal transactions to reduce tax liability.
Tax planning may result in substantial tax savings.
We will discuss ways to reduce tax liability:
– Income that is subject to taxation
– Making the most deductions and tax credits
– How investing impacts tax planning
– Tax savings through retirement contributions
– Education incentives
– Business and tax planning
– Strategies for the self-employed taxpayers
– Estimated tax
What is Tax Planning?
Tax planning primarily involves the timing and method by which income and deductions and credits are claimed. The premise for tax planning is to time income so that it is taxed at lower rates and to time deductions/credits so that they are declared in years that one is in a higher tax bracket.
1. You Can Plan Your Losses
– Business and tax planning through purchase or sale of assets
The purchase and/or sale of business-use assets may help in maximizing tax benefits.
Selling the equipment at a tax loss can be strategically timed for years when the taxpayer is in a higher income tax bracket.
Similarly to selling equipment, buying equipment may be timed in a year where the taxpayer is in a higher tax bracket due to an increase in income.
The tax law allows for the costs associated with the purchase of business assets to be deducted in multiple ways. A taxpayer may choose to elect an accelerated cost recovery method or take a prescribed depreciation allowance to write off the assets in the year of acquisition.
2. You Know the Best Time to Get That Loan
Typically money is needed in the starting or the operational phases of the business cycle. A company in need of finance may require a loan. Obtaining debt to make purchases is a way to deduct expenses yet to be paid. As long as the business is technically liable for the business debt, the items purchased will be eligible for a full or partial deduction.
3. You Become Aware if a Change in Business Structure is Needed
When first starting a business, a common question clients will typically pose is, “what type of entity should I form?” and this is an excellent question. Unfortunately, there is no fast way to answer this question, as much will depend on the industry, the legal exposure involved, the owner’s tax and financial situation, state/jurisdiction of business affairs, and multiple other very important factors.
It takes an experienced accountant working alongside a knowledgeable attorney to guide the client in the right direction for correct entity type selection.
There is no one strategy that will apply to every business as much will depend on many other moving parts, and this is why we often advise most start-ups to choose an LLC type of structure. An LLC is a one size fits all type of entity, and the LLC may elect in future years to be treated as an S or C type corporation for tax purposes.
An excellent way to know when it is time to convert entity status would be to have a discussion with your accounting team ahead of forming the entity and to be on the lookout for changes down the road. Once things change, that is the time to consult with a tax advisor to see if it is the right time to modify.
4. You Can Defer Salaries
One of the basic tax strategies of tax planning is shifting income from one year to another. The premise is to recognize revenue in the year when the tax bracket is lower. To accomplish this, we would want to either postpone or accelerate receipt of income into later or earlier tax years. This strategy will work with cash basis taxpayers. By default, most individuals and businesses are on a cash basis of accounting for tax purposes. The cash basis of accounting means that you recognize income, not when earned, but when it is constructively received or when there is an economic benefit of receipt.
POSTPONEMENT OF INCOME
Delayed collections: The self-employed can choose to delay year-end billings.
Deferred compensation: If you are employed, consider negotiating a deferred arrangement as part of your compensation package. It is important to note that the deferment of payment cannot be retroactive. Additionally, employers will typically pay interest on the compensation held on the account but not paid to the employee.
Year-end bonuses: Bonus compensation may be announced in one year, and paid in the following year. Strike up a deal with your employer to ensure that is how you would like to receive your bonus and reduce your taxable income. The employer will typically not lose the deduction in the year the bonus awarded to the employee; however, the employee will have fewer income and taxes that year, so it works well for both parties.
Incentive Stock Options (ISO): The receipt or exercise of qualified incentive stock options (ISO) is not taxed for regular income tax purposes until the stock is sold.
Interest income: Interest received from Treasury bills or bank certificates having a term of one year or less is excluded from your income until you receive it at maturity. Transferring funds to these types of interest-bearing accounts may delay the receipt of income. Similarly, if you own Series EE U.S. savings bonds may elect to defer reporting your interest income until the bonds are redeemed.
Annuities: Another way to defer income is to set up or to transfer funds from commercial interest-bearing accounts to an annuity account.
Retirement plan contribution: As old as time, this is still a great way to defer income. Maximize the amount you are contributing at work, or on your own. There are multiple options available.
Like-kind exchanges: Section 1031 of the Internal Revenue Code allows for real property exchanged for comparable property. The 1031 exchange may allow for the partial or full deferral of income taxation. The trade applies to business-use real property and not personal-use real property.
Installment sale: This strategy will allow for the recognition of income into future years by splitting the sales proceeds of an asset to be paid for by the buyer over the course of multiple years.
The above strategies to decelerate income may be reversed to accelerate the revenue into lower tax bracket years:
Collection of receivables are accelerated
Year-end bonus renegotiated into a current year
Restricted stock and ISO’s vested or liquidated
Retirement plan distributions
Installment sales are undone or sold to a third party
5. You Can Estimate Payments
Failure to pay your anticipated tax liability as it gets incurred may result in a penalty for underpayment of tax.
Generally, you are required to pay estimated tax if you anticipate that you will owe at least $1,000 in taxes after subtracting any income taxes withheld from your wages. The computation of your estimated tax liability should include not only your income tax liability but also your liability for:
- self-employment taxes;
- untaxed income such as from investments, personal sales or property rentals;
- the 3.8% net investment income tax;
- the additional 0.9% Medicare tax not withheld from your wages;
- partnership and S corporation income; and
- any income you receive or are entitled to receive from an estate or trusts
6. You Can Remove Idle Inventory
Inventory is not tax-deductible. Inventory is written off when sold, discarded, or gifted. A business that carries inventory should account for the inventory on a routine basis. Holding on to unused inventory is not a wise tax or financial decision.
Planning for non-working age is specific to each situation, and there are many options and many limitations.
Retirement planning is essential from a tax and financial planning perspective. There are many different options made available to the taxpayer when it comes to retirement plans. It should always be a top priority to maximize the amount of retirement savings as early in life as possible.
The general rule of thumb is to contribute to a retirement plan and defer taxation now in hopes of having the money distributed when one is in a lower tax bracket – when in retirement. This strategy is a widespread one, and indeed this strategy has its place in the world of tax strategies; however, there are some significant flaws with this school of thought:
1) deferral of taxation now with the hopes of being in a lower tax bracket in retirement is going by the assumption that tax rates and tax law will remain constant today as it will be in the indeterminable future, and that the income you have in the future will be lower than it is today.
Deferring taxation today through retirement plan contributions is a good strategy for those closer to retirement and not so much while one is in their working prime.
2) no one wants taxation in old age regardless of the retirement time horizon.
Explore Other Tax-Sheltered Savings
- 529 Education Savings Plans
- Health Coverage Savings Plans
- Dependent Care Savings Accounts
- Coverdell ESAs
Qualified State Tuition Plans
- Prepaid tuition is considered an asset of the parent for financial aid purposes and may be utilized to pay for in-state college credit at today’s cost.
The benefit of prepaying educational costs today is that you lock in the price for the future.
The risks involved would include the following:
– Only earn a return equal to tuition inflation
– Scholarships earned by the child will mean that some of the prepaid tuition would not be utilized
– Any unused tuition is returned as principal only, and no interest is paid when the funds are returned
– The child may choose a different school or the school you selected does not offer the right curriculum
– Prepaid tuition does not include the cost of room and board
- A 529 savings plans allow for funded savings to grow income tax- free if the funds are used for qualified educational costs when distributed. These programs will typically allow for some state income tax deduction (there are limitations).
The 529 savings plans are considered an asset of the parent for financial aid.
Anyone can contribute to a savings plan that invests in a diversified portfolio based upon the child’s age.
Appreciation in the asset value is tax-free if used for qualified education expenses.
An individual can contribute up to $70,000 (5 x $14,000) in one year, without any gift tax consequences. It’s 5 x the annual gift tax exclusion amount.
A couple that elects gift splitting can contribute $140,000 ($14,000 x 2 x 5) in one year.
Contributions recognized as being made ratably over a five-year period.
The account owner has ultimate control over the assets and can change the beneficiary or remove the assets from their gross estate at any time.
There is a 10% penalty on the earnings, and the gains would be added to gross income if not used for qualified education expenses. Hence, there would also be income tax implications on earnings unused for eligible purposes.
Qualified education expenses for 529 plans include tuition and fees, books, supplies, equipment, along with room and board for students enrolled at least half-time.
Other options available:
- Coverdell Education Savings Accounts.
- Roth IRA.
- Series EE Savings Bonds.
- Uniform Gift to Minors Act.
Dependent Care Savings Accounts
Taking advantage of a flexible spending account (FSA) through the employer’s cafeteria plan can result in some significant tax savings.
A cafeteria plan is an employer provided benefit program in which an employee can contribute pre-tax wages to pay for eligible benefits, such as health care, dependent care, or adoption expenses.
Be careful with these accounts. The way an FSA works is that if you do not use the funds within the designated time frame, you will lose the funds. You typically have until the start of each year to have the money spent.
Health Coverage Savings Plans
In our tax system, health care costs are not very likely deductible. The reason being is that they would have to itemize their deductions, and even then there are additional limitations to the medical deductions. With the new tax law enacted in 2018, many taxpayers will now be even less likely to benefit from the medical deductions, as they are less likely to itemize their deductions because the standard deduction is now double the amount it was in prior years.
If a taxpayer has the ability to utilize a tax-advantaged health savings account (HSA), they should make the most of the opportunity and use the account to its fullest potential.
The amount that one may contribute to an HSA in 2019 for a family is $7,000. Whatever amount not spent on medical costs in any particular tax year will remain available for use in the future, much like in a bank account, and grow in interest, tax-free, as long as the funds are ultimately used on eligible health care expenditures.
Tax Planning Can Mean Financial Planning
To make your tax planning successful and effective, you must have an accurate picture of your tax situation for this tax year and years beyond.
We often see people become preoccupied with the day to day activities, and they will put taxation and accounting on the back burner. In business and in personal life, it is essential to emphasize tax projecting as it is easy to miss the opportunity to save in tax as well as fall behind on tax liabilities. If one allows for taxes to fall behind, they will ultimately find themselves financing multiple years’ worth of taxes with potentially high-interest rates.
Do you want to be tax-smart this year? Speak with us today, so we can create an excellent plan for you!