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I hear it all the time from business owners and CFOs, what’s the best way to preserve our profits, reduce our tax liability, and increase employee morale and retention?

My Accountant says to Spend it NOW!

Before we begin, I want to review a strategy that many of our clients hear from their accountant and show you it’s not bad advice, it’s just not long term advice. Accountants often times advise a business that had a good year to go on a spending-spree in December — here’s why.

For example, the owner of a small manufacturing plant forecasts in October that their profits by December 31st should be approximately $800,000 after all expenses and bonuses. The accountant, among other strategies, may tell the client to do a needed office renovation, purchase extra material, update software, or any other expense that could have been done at a later date, but now is the time to do it to reduce taxes and increase next year’s profits. It’s not bad advice. It works. If you’re in that circumstance you should listen to them.

But what if you’ve done that already in past years? What if you don’t necessarily want to “kick the can down the road?” The truth is, this strategy works best for those businesses with up and down years, not a business in maturity with a very low deviation of income and profits from one year to the next.

Many of our business owners have correctly stated that I’m reducing taxes this year, but next year I’ll have an even larger tax burden due to reduced expenses next year.

This is normally the case with established businesses who know that next year will be very similar to this year. The fact of the matter, each consecutive year of implementing this strategy becomes harder and harder as there may be less renovations to do and less expenses to pay in advance. Eventually, you’re still left with the inevitable — how do I reduce tax liabilities while keeping more profits?

Am I really keeping the profits by paying for expenses in advance?

The answer is not really. In the case of investing in renovations, you may be improving your building or property making it more valuable, or at the very least increasing your cost basis of the property. However, paying for expenses of next year this year only reduces expenses next year — it doesn’t put any money in your pocket. If you want to keep more profits you must invest in yourself not in your vendors and creditors.

What are your “better” options?

Let’s look at our example of a business with $800,000 in profits at the end of the year.

Implementing a 401k

A 401k is a defined contribution plan that allows the employer and the employee to contribute a set amount from their paycheck. Implementing a 401k will allow the business owner to put away $18,000 personally, reducing his/her personal income by $18,000. At a 35% marginal tax rate and a personal annual income of $500,000, he/she pays $6,300 less in taxes. If the business matches the $18,000 contribution the business also gets to write off the $18,000 which again reduces the business’ tax liability. However, depending on how many employees are also enrolled in the 401k plan the same matching structure would be mandatory. This matching on the part of the business would also be tax deductible, but it invests in the employees, not the business owner. This isn’t a bad thing, but depending on the objectives of the business owner, it may not make a dent in the grand scheme of things. Safe harbor laws should be understood before implementing this strategy.

Profit Sharing Plan (PSP)

A profit sharing plan allows the business owner to create an employer sponsored retirement plan that allows enrolled employees and the employer to share in some of the profits of the company. Profit sharing plans allow the employer to be much more intentional in which employees participate in the plan, the amount contributed can be much larger allowing greater deductions and greater tax-deferred growth, and normally gives participating employees a much greater boost in morale as 100% of the contribution is coming from the employer.

The PSP also allows for much greater flexibility giving the business owner the ability to contribute more or less depending on that year’s profitability. In this example, let’s say the business has 19 employees plus the business owner and everyone is participating in the plan. The team of advisors will IRS Test the plan and tell the employer how much of the contribution goes to him/her and how much goes to each employee.

For example, the business owner has 71% of the plan and the other 29% of the plan is divided up among the other employees based on age, salary, and rank. Let’s assume the business owner wants to contribute $100,000 to the plan. $71,000 would be placed in his/her account and the other 29% would be divided among the employees. This $100,000 contribution would reduce the profits of the business, reducing the tax liability of the company by roughly $40,000 or more while the business invests in the business owner and the employees.

Defined Benefit Plan

A defined benefit plan is the exact opposite of a defined contribution plan in that the defined contribution plan such as the 401k and the Profit Sharing Plan allow the employer or the employee to define just how much they want to contribute, but not necessarily knowing how much of a benefit the employer or employee will have in retirement. A defined benefit plan allows the business owner to define how much they want the retirement plan to benefit them in retirement. For instance, the business owner may want a retirement income of $100,000 per year at age 65 until age 85. If the business owner is 55 years old when the plan is put into place, the business owner has 10 years to fund the plan. The contribution over those 10 years will be based on getting that result. The plan may require the business owner to contribute $190,000 in the first year, but the following years contributions may be more or less depending on the investment performance of the Defined Benefit Plan.

The defined benefit plan may allow for the greatest contribution depending the business owner’s age, the defined benefit, and the number of years he/she has to fund the plan. The defined benefit plan may be the most useful to those who have a profitable company and looking to catch up on their retirement savings.

Other Strategies?

  • Family Limited Partnership
  • Captive Insurance Company
  • Non-Qualified Deferred Compensation

Which strategy is better for me?

Work with a team of advisors that knows the space intimately and collaborate with your current advisors such as you CPA, Wealth Manager, and Attorneys.

The plan that may make the most sense is different depending on your age, your business, your objectives, and your timeline to get there. Work with a firm that knows the ins and outs of the trade.

When should I do this?

Most businesses look to do this towards the end of the 3rd quarter or early in the 4th quarter when they have a pretty good idea of what their year is going to look like at the end of December. You need to allow enough time for your advisory team to collect the necessary data from your employee census, look at your business, understand your objectives, and then explore the potential options that best fit you and your business. This isn’t something you want to rush in the last days of December.

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