Tax planning involves carefully evaluating business decisions to help reduce the tax burden of a company, while remaining in compliance with regulations, and thus improving financial results. Tax planning is a critical component of an entity’s business plan at all stages of the business life cycle, whether new startup or preparing to wind down.
Initial startup tax planning
The initial selection of entity structure determines how the entity pays income tax as well as how owners can be compensated.
Many small businesses often start as a sole proprietorship, which requires minimal setup time and cost. However, a sole proprietor has no legal liability protection for business operations, so often the next step is the formation of a legal entity.
One primary area of confusion for taxpayers is the difference of entity type for state law formation versus tax classification. In most states, the common legal entity types are limited liability company (LLC) and corporation. These designations have a default income tax status with the IRS, but an alternative tax classification can be selected upon setup. For example, an LLC could be taxed as a disregarded entity, partnership, S corporation, or C corporation.
For more details on the differences between a disregarded entity, partnership, S or C corporation, read this FORsights™ article A CPA’s Perspective on Small Business Entity Types.
In addition, choosing a tax-efficient employee benefit package for health insurance and retirement options is an important business decision and is impacted by the entity classification. For example, more than 2% of S corp owners are not permitted to enjoy the pretax treatment of health insurance premiums paid by the employer without following special rules; an employer can easily fall into a trap of these premiums being taxable to shareholders.
Business owners also must consider the options available for accounting methods, both for tax reporting and for internal use. Often, small to midsize businesses will use the accrual method for management use as it provides a more accurate snapshot of business performance at that moment in time. However, a different method, such as cash basis, may be an option for tax purposes so that taxpayers are not paying tax on revenue not yet collected.
Recurring tax planning
Throughout the lifetime of the business, there are tax planning items that need to be considered on an annual, if not quarterly, time frame. For many businesses, payroll may be the most significant cost of operations. Payroll decisions include classification of a worker as an independent contractor or W-2 employee and how to screen for various payroll tax credit opportunities such as the Work Opportunity Tax Credit, Employee Retention Credit, or FICA Tip Credit.
Other ongoing tax decisions include: the optimal use of vehicles—who should own the vehicle and how to manage any personal use; charitable giving and the related tax deduction; and choices about the timing of accelerated tax depreciation of capital assets.
Tax depreciation is the process that allows a taxpayer to deduct a portion of the cost of capital assets over time. The type of assets that are depreciated have a useful life of greater than one year, such as a building, furniture, or equipment. Taxpayers currently have the option of two accelerated depreciation methods, Section 179 and bonus depreciation, to claim the write-off in the first year. The timing of depreciation deductions is a helpful tax planning tool.
Tax planning for a future exit
And lastly, planning with the end in mind, considering the tax impact and structure of liquidation or sale of a business can generate tremendous value. Even if the sale of the company is not currently in the strategic plan, business owners should be aware that, most likely, a significant portion of their net worth is tied up in the business and may present an estate planning risk that could be entirely eliminated with good tax planning.
By evaluating your company’s entity structure now, rather than at the deal table, you’ll have more options available to help increase after-tax proceeds. The sale of a business is typically structured as the sale of either the individual assets or the stock of the company. The deal structure determines the tax consequences and whether the proceeds will be taxed at the current preferential capital gains rates or the individual’s ordinary income tax rates. For example, there are significant gain exclusion benefits available for qualifying domestic C corps under §1202 qualified small business stock.
In addition to considerations such as entity design, asset versus stock structure, electing in- or out-of-installment sale treatment, and allocation of purchase price, there are other strategies to defer or decrease the tax cost of a transaction.
Investing the sale proceeds in an Opportunity Zone business, property, or fund allows for deferral of tax payment on the gain and even partial exclusion of the gain. For the charitably inclined, there are many opportunities available, ranging from gifting appreciated stock to the more sophisticated vehicles, such as a charitable remainder trust. The proceeds can be donated to a charitable remainder trust, generating a tax deduction and stream of annual revenue for the donor during their lifetime, while the remainder of the trust goes to the designated charity at death.
The world of tax compliance and consulting is complex, ever-changing, and requires consulting a qualified professional. At a minimum, a tax professional can assist a business in meeting compliance obligations to help avoid penalties and business interruptions, but more importantly, a knowledgeable tax professional can provide timely, helpful advice for making business decisions throughout the life cycle of the organization. To help accomplish this objective, be an advocate for your organization—business owners should be in contact frequently with their accounting and tax team so that the professionals know what is going on in the business in order to offer quality advice.
This article is a selected piece from By the Books: FORVIS' Complete Guide to Small Business Accounting & Finance, which we are excited to release in April 2023. Subscribe to our Small Business list to get future updates and articles and be the first to receive the full guide.