Entrepreneurs, Here Are Five Smart Ways To Lower Your Taxes Today
The following is an edited excerpt from the book Beyond a Million: The Entrepreneur’s Playbook for Expanding Wealth, Freedom and Time by Jim Dew.
Taxes have become straightforward for the average American worker who receives a W2 from his or her employer at the end of the year. These people may use TurboTax or pay a CPA a few hundred dollars to prepare the return. This isn’t the case for an entrepreneur. For entrepreneurs, looking at a tax return is like looking into a black box. And with good reason! The tax system is complicated and so are the forms. If it’s not something you look at every day, it will seem overwhelming.
There is a reason to respect the IRS — they carry a big stick. I tell clients when they walk into my office with their tax returns that taxes are not an opportunity to show off your cleverness. Following the letter and spirit of the law is crucial. Auditing does happen. It’s important, therefore, to know the laws and to document the various tax strategies you’re employing, in the event you need to explain them one day.
This doesn’t mean you should simply pay your rates without looking for ways to save money. If the speed limit is fifty-five miles per hour, you’d be foolish to drive forty to avoid the risk of being pulled over. There’s no reason you shouldn’t feel confident and calm driving the speed limit. I’ve had clients who refuse to list perfectly acceptable deductions because they assume all attempts to save money will appear to be shady and an effort to game the system.
Suppose I came to you with advice on how to hire a top-rate workforce for your company. Even though you only need fifty workers, I suggest you play it safe and hire a hundred. Pay them well above the market rate — don’t take a chance you’ll lose any of them to your competitors. As a successful entrepreneur, someone who surely knows a great deal about running a business, you would look at me as if I were crazy. Labor, you’d try to explain, is one of your greatest costs. It’s one of the major determinants of whether a business fails or prospers.
It’s true. Labor is a major cost, and you’re smart not to take my advice. Now, let me ask you a question. What will be the major cost in your lifetime? Mortgage, education, and food are reasonable guesses, and they will cost you plenty. Taxes, however, will be the number one expense for you and every other entrepreneur. The average American with a bachelor’s degree will make $1.8 million over a lifetime. Income taxes alone will amount to around $360,000. This figure doesn’t include sales and property taxes. The number is far higher for an entrepreneur who’s sold his or her company for millions of dollars. It’s potentially even higher for a billionaire, but do you think billionaires carry on without investing time and resources into considering a tax-saving plan? They don’t, and neither should you.
When a client sits down with me for the first time, I immediately inquire about his or her tax situation. They often tell me they’re paying so much in taxes that it’s impacting their ability to grow their company and enjoy the lifestyle they have worked so hard to achieve, at which point I ask about their current tax plan.
“Tax plan?” they ask. “The accountant tells me what I owe, and I write a big check. That’s the tax plan.”
That’s like trying to improve your health without a plan — it probably won’t work, and any results you do achieve almost certainly won’t last. An unhealthy person doesn’t spontaneously decide one day to eat a salad and go to the gym. Even if they do, there’s little chance this burst of clear thinking and motivation will bring them lifelong vibrant health. They need a plan, carefully considered for their situation, taking every aspect of their life into account.
Five Smart Ways To Lower Your Taxes Today
What can high-level experts do for your tax-saving plan? The same sorts of things they have done in family offices for ultra-wealthy people for years. Now, many of these strategies are available to you. Here’s a sampling of ways you can lower your taxes that you may not know about.
1) The Augusta Rule
The Masters Tournament is one of the four major golf tournaments in the world. It takes place at one of the most beautiful and exclusive country clubs, in a small rural town in the United States. There are a few hotels in the area, like a Motel 6, but there aren’t enough high-end hotels for all of the players and their families. The crowds of spectators who come in from all over the world to attend this four-day event add to the demand, which went unmet until people realized that many of the large, beautiful houses surrounding the country club might provide an answer.
In the 1970s, people who lived near the country club began renting out their homes for one week for thousands of dollars. The perfect solution! Eventually, though, the IRS found out about this cottage industry and demanded these homeowners report the one-week rental fees as rental income. The issue found its way to Congress, which promptly added an exception, Section 280A(g), to the tax law.
This exception, which is now known as the Masters Exemption, or the Augusta Rule, allows people to rent out their homes for fourteen days a year at fair market value without having to count it as taxable rental income. After all, it’s not truly a rental. This applies to a primary residence and vacation homes as well. It even applies to rentals, assuming the rental agreement allows for subleasing. Theoretically, you can rent out each home under your control for fourteen days each.
Now, how can you make this exception work to your benefit? Suppose you host your company’s planning retreat at the Four Seasons. It’s always worthwhile, but it doesn’t come cheap. In fact, it costs your company $3,000 for room rentals plus food and beverage. Why can’t you have the event in your own backyard? It’s a larger space with a beautiful pool and barbecue area. Your business, assuming it’s a separate entity, can rent the house from you. In addition, you can expense landscaping work and housecleaning before and after the party. Obviously, food and beverages are a business write-off. Finding legitimate ways to rent your house to your business for fourteen days a year could mean receiving $42,000 of tax-free income. If you’re in a 37 percent federal and 5 percent state tax bracket, it comes out to $17,640 in saved taxes.
Once again, there are potential tax savings available that you may not know about. Even if you did, you might not understand all of the ins and outs, like what’s required in a proper agreement and how much you can charge your company to host the business meeting. Luckily, you don’t have to know all that. Like the ultra-wealthy before you, you can discuss the options with an expert, so you know you’re following the law and creating the right documentation on why you’re renting your home to your business.
2) Captive Insurance Companies
In the 1950s, the Youngstown Sheet & Tube Company had a problem. Skyrocketing premiums and a limited supply of available insurers made it difficult to insure their operations through traditional means. Enter Frederic M. Reiss, an insurance broker who came up with the idea of captive insurance companies. The concept was that the corporation itself, instead of a third-party insurance company, would insure the risks of its owners. Soon, companies started using captive insurance companies to protect against anything out of the ordinary that commercial insurance companies refused to insure.
Let’s say a manufacturer has a customer that accounts for 60 percent of its revenue. If the customer went out of business or changed its supplier, it would be a catastrophe for the manufacturer. Yet, most insurance companies don’t have an insurance product to protect against such a risk. The company, through a captive, can establish a policy for itself. This self-insurance approach not only strengthens businesses, but it also contains significant tax incentives to help grow these insurance reserves.
Today, companies might use captive insurance for more unusual exposures, like reputational risk. After all, we live in an age where people know billionaires and the companies they run. Everything is public, and an unsavory undercover video put up on the internet can destroy even the most established business. A bad social media experience could very well spell the end of your career as an entrepreneur.
Given the security risks in some parts of the world, companies may use captives to insure against kidnapping. If the head of local operations were snatched off the street, the company’s operations would come screeching to a halt. Cyberattacks pose a similar risk with frequent examples of data being targeted or even held for ransom.
Captive insurance works like conventional insurance. The company setting up the captive must pool its risk with other companies, execute the actuarial work and risk analysis normally done when taking out policies, and pay a premium based on the actual risk. An actuary, for example, may determine protecting a CEO’s reputation will cost a $10,000 per year premium to transfer $2 million of risk. If a loss occurs, the company would typically pay 50 percent of the claim, and then the other companies from the pool would contribute to pay for the other 50 percent of the loss. Captives — especially when they are not created and operated correctly — may draw the attention of the IRS, which is looking to see if the law is being followed.
Bottom line: a captive insurance company is the same as any insurance company. It has to start with a desire for a professional risk management program to protect your company. It has to be based on the IRS’s rules for captives. Any tax benefit must be a secondary concern. If all you’re thinking about is the money you’ll save, you’ll increase the risk that the IRS will take notice in your case. You must document everything appropriately, execute legitimate risk analysis, and base the premiums on real data. Using experts can help you avoid an audit and/or pass one successfully.
Most companies in the S&P 500 have at least one captive insurance company, and the benefits of captives as part of a professional risk management program have been well demonstrated. This means it’s unlikely the government will take away the captive insurance option, and the IRS probably won’t challenge IBM and General Electric’s captives, because that would be a tough battle to win. In addition, they have helped establish a widespread body of legal precedents that set out the rules for operating captives correctly.
The details can get complex, and you need people on your team who keep up on changes. For instance, the IRS recently passed a rule saying companies need to give formal annual notice if they own an 831(b) captive. Many companies are now looking into other alternatives, such as a Puerto Rican international insurer option, or protected captive. A Puerto Rican protected captive, which is formed under Puerto Rico’s Chapter 61 international insurer rules, does not limit premium size, whereas, for an 831(b) captive, the annual premium cap is set at $2.2 million. In addition, protected captives have fewer restrictions on captive ownership and different tax rules on investment income — which may prove attractive.
A reliable wealth manager on your team can help you evaluate the alternatives, compare different types of captive formation, and educate you on how they work financially and legally. If you decide this might work for you, get your accountant’s and/or tax attorney’s support to ensure proper implementation and ongoing management.
3) Employee Stock Ownership Plan
When you decide to sell your business, you could sell it to a competitor, or to a group outside your field who wants exposure in that industry, like a private equity firm. Or, you could sell it to your employees in the form of an employee stock ownership plan (ESOP). When you sell to a competitor, they’re never going to pay you what you think it’s worth. They’ll try to get it for a steal. If you sell to private equity, you have the same problem. If you sell to your employees, though, you get the actual valuation of what your company is worth, not a negotiated value.
Selling to employees through an ESOP also turns your company into a tax-free entity. It’s never taxed again, so not only do you get the full value of your business today, you get to grow the business without the burden of taxation. So, you’re actually using what you would’ve paid in taxes to pay for the purchase of the value of the company. What this can do is get you paid today, and allow you to still run the company while participating in the future, tax-free growth.
What Is An Employee Stock Ownership Plan
An ESOP is simply a defined contribution retirement plan, similar to a profit-sharing or 401(k) plan. In fact, an ESOP is identical to a 401(k) plan in all respects except for the following four characteristics:
- Investments. The 401(k) plan invests in various assets — typically, marketable securities. Participants are encouraged to diversify their portfolios. In contrast, the ESOP will generally be 100 percent invested in employer securities.
- Allocation. Under the 401(k) plan, every asset held by the plan must be allocated as of the end of the plan year to a participant’s account. In contrast, the ESOP can acquire all of the company’s stock and hold it, unallocated, in a suspense account, with allocations occurring over several decades.
- Salary Reductions. The 401(k) plan permits employees to reduce their salaries and have the reduction amounts contributed to the plan to accumulate free of tax. The ESOP does not allow or permit employee money.
- Tax Feature. Only an ESOP-owned company can be free of tax.
Like the assets in a 401(k) plan, employee stock ownership plan assets are owned by the plan trustee. When the ESOP is first established, it is the trustee who is responsible for determining that the ESOP is not paying too much for the company’s stock, a decision that carries heady fiduciary responsibility. This position can be delegated to an outside, independent trustee or an internal trustee. While either approach is permissible, most companies structure the transaction so that the trustee making the decision about the stock purchase is independent but, after the purchase transaction, the trustee is a committee of internal people (in general, after the initial transaction, the level of activity and responsibility associated with trustee status is significantly less).
Since the sole asset of the ESOP is 100 percent of the company’s stock, the ESOP trustee is the owner of the company’s stock. It is important to understand that the trustee holds the stock for the benefit of the employees; the employees do not ever own or hold the stock; the employees do not vote on the stock, and, except in the case of major corporate activities (e.g., liquidation of the company, sale of substantially all of the company assets, merger), the employees have no shareholder rights. These rights belong to the trustee.
Many private business owners eschew the ESOP transaction because they fear that the company will be run by rank and file employees after the ESOP is implemented. They believe that employees will come to know about the company’s performance and compensation, and that the information will be used to sow discord or help a competitor. This is not how an ESOP operates; the employee-control scenario describes a worker’s owned cooperative. (In a worker’s owned cooperative, in contrast to an ESOP, each employee is a shareholder with one vote, and all employees make operational decisions collectively.)
In the case of an ESOP, the trustee is the shareholder. As a shareholder, the trustee has limited day-to-day responsibilities with respect to the operation and governance of the business. Its main activity is to select and oversee the board of directors. The board of directors, in turn, is responsible for big picture agenda items — such as the direction of the company, major purchases or acquisitions, and the selection of a president. It is the president and other officers who, just as prior to the ESOP, are responsible for the day-to-day operations of the company.
ESOPs can be an outstanding choice in the right circumstances. Yet, I hear a lot of negative beliefs around ESOPs quite often because they aren’t always designed well. The implementation of an employee stock ownership plan can be the best or worst thing a business owner ever does. This rests squarely on the experts you hire. Don’t dismiss this opportunity based on what you hear but absolutely make sure you use knowledgeable and experienced professionals.
4) Section 1202 Stock
In December 2015, the Protecting Americans from Tax Hikes Act (PATH Act) was signed into law. The PATH Act made several tax breaks permanent, including the Small Business Stock Gains Exclusion (Section 1202). This law made permanent the exclusion of 100 percent of the gain on the sale or exchange of qualified small business stock (QSBS) acquired after September 27, 2010 and held for more than five years. In addition, QSBS gain excluded from income is not subject to the 3.8 percent Obamacare tax on “Net Investment Income” from capital gains (and other investment income) on high-income taxpayers.
However, to take advantage of Section 1202, the business stock must meet strict qualifications. The company has to be a domestic C-corporation that had $50 million or less in assets on the date the stock was issued and immediately after. The exclusion is limited to the greater of $10 million or ten times the adjusted basis. There are other conditions that must be met so make sure your wealth team is carefully reviewing this.
If your company qualifies, this could save you millions of tax dollars. This is something you will want to know about before a potential sale. Furthermore, with the Tax Cuts and Jobs Act of 2017 cutting the corporate tax rate to 21 percent, utilizing a C-corp structure because of section 1202 might make sense for a start-up.
5) Benefit Focused Plan
Many entrepreneurs have retirement plans at work for their employees (think 401[k] and profit sharing). These plans are very common but are limited as to the amount that can be contributed annually. A few entrepreneurs have even looked at a defined benefit plan because there is the ability to fund toward a $220,000 annual benefit at retirement as of 2018. These result in larger tax deductions. Yet there is a little-known type of defined benefit plan that wealthy entrepreneurs can utilize for much more dramatic tax savings.
Here’s a case study of a very profitable small business with two owners, ages forty-seven and forty-one, with four employees. The goal is to maximize contributions in favor of the owners while providing benefits to the employees. The owners looked at some of the traditional options. They were considering a 401(k)/profit-sharing and potentially a cash balance plan, both good ideas. When they were introduced to a wealth manager who specialized in working with entrepreneurs, he brought them options they had never heard of before.
The biggest deduction they could get from other wealth managers was through a defined benefit pension plan. Here is a chart showing that option alongside a benefit-focused plan.
Here’s how the contribution distribution splits out among the owners and employees. As you can see, the owners are getting the biggest proportion of contributions, at 85 percent, with the benefit-focused standard plan. And the employees are still getting a big contribution.
Including life insurance in the plan allows some actuarial assumptions to really make this very powerful. This can be a great solution for a business owner with high cash flows, solid profitability, and the right employee census.
Bonus Strategy: Qualified Opportunity Zones
The Tax Cuts and Jobs Act created an opportunity to delay and even eliminate capital gains tax on a sale. Let’s say you sell your company (or stock or real estate) for a huge gain. To keep things simple, let’s assume the tax basis in your company is zero, and you don’t immediately need $1 million of the proceeds. What if you took $1 million of that gain and invested it into a Qualified Opportunity Fund? I’ll define what this fund is in a moment, but let’s take a look at how it affects taxes on this investment. If your capital gains tax rate is 25 percent (20 percent federal and 5 percent state), you would owe $250,000 in tax. Instead, you owe nothing right now. If you keep it in the fund for five years, the basis jumps to $100,000. After seven years, the basis jumps another $50,000 to $150,000. On December 31, 2026, you owe taxes on the remaining gain ($850,000). The tax owed at that time is $212,500. Once you have held this investment more than ten years, you will get a basis step-up to fair market value. If the investment is worth $2 million at that time and you sell it, you would owe zero tax. This creates a total tax savings of $287,500 — all for knowing about Qualified Opportunity Zones in the new tax law.
You don’t want to attempt this without a smart attorney or accountant and a quality wealth manager. That being said, here are some of the details. A Qualified Opportunity Zone is an economically distressed community that qualifies if they have been nominated for that designation by the state and that nomination has been certified by the Secretary of the US Treasury via his delegation authority to the Internal Revenue Service. You have up to 180 days after the sale to invest the cash into a Qualified Opportunity Fund. To qualify, this fund has to meet several tests. It must pass the entity test: it must be organized as a domestic corporation or partnership. Also, the purpose test: its purpose must be to invest in Qualified Opportunity Zones. And finally, the Asset Test: it must hold at least 90 percent of assets in stock or partnership interests in Qualified Opportunity Zone business and/or tangible Qualified Opportunity Zone business property. “Property” is tangible property used in a trade or business. This must be “new” property acquired after December 31, 2017. Do some more research to see if Qualified Opportunity Zones might be your big opportunity. For the latest Qualified Opportunity Zone map, visit https://eig.org/opportunityzones.
The Key Is To Have A Plan
The tactics and techniques you can use to receive tax benefits are countless. Only a professional who has experience working with entrepreneurs can help you identify the seemingly endless methods for lowering the amount of money you pass on to the government each year. If you do more than ten hours of work on a weekday or five hours on a weekend, for example for your C corp, you can reimburse — without receipts — seventy-five dollars for a meal. It doesn’t sound like a ton of money, but nine meals a month would add up to over $8,000 tax-free a year. Gym memberships, fitness and wellness programs, and even nutritional counseling can also be used as write-offs. Some of these benefits can only be done through a C corp, which is why hiring an expert tax attorney is important. This person will also take care of documentation, either personally or by showing someone in your company how to do it correctly.
Make sure you appreciate the risks involved in any of these tax-saving moves. Tax laws can change, and what’s legal and helpful today can cost you tomorrow. Does that mean it’s not worth keeping track of the law? Absolutely not. Some people hear the rhetoric coming out of Washington or their own state capital about proposed changes to the tax code, and they think there’s no point in investing time and money on a plan, as it may change tomorrow. Changes like the Tax Cuts and Jobs Act of 2017 are rare. The sooner you put together a responsible plan, the sooner you’ll come out further ahead. The billionaires know this and so do their family offices. Make sure your team is doing the same.
Some entrepreneurs make the effort to sit down with an experienced CPA and work out a forward-looking tax plan, and think their work is done. The bulk of the work is finished, but it doesn’t mean they can ignore the evolution of tax laws and their effect on their business. The passive approach routinely leads to unnecessary overpayment in the tax arena. The tax code defaults to extreme taxation on high-income earners and wealthy people. You need to be vigilant.
How A Tax Strategy Pays Off
Take the case of Debbie, a single-mom entrepreneur who supports her two teenaged kids and her elderly parents. Three years ago, she was making $200,000 a year and is now earning $2 million through her LLC. The wealth manager reviews her tax returns and sees she is paying $756,422.36 in taxes. The first step is to bring in a tax attorney who deals exclusively with entrepreneurs. The team puts together a plan that reduces her taxes to around $575,000. Part of the plan is creating a captive insurance company for risk management and utilizing the Augusta Rule to rent her home to her company tax-free. If her growth continues, she will add a benefit-focused plan next year. In total, Debbie will pay $20,000 to the tax attorney, who will end up saving her $175,000. This isn’t some extreme example. Even if tax laws change in three years, the plan she is putting in place today will save her around $525,000.
Entrepreneurs need a tax strategy if they are going to save money. If you feel like you’re paying too much in taxes, chances are you don’t have a plan. Maybe you feel resentful because you know you should be paying less, but you can’t figure out how to legally navigate the law, and you have nobody to help you understand your options. Having the right advisors in place can help you follow the rules and pay the lowest taxes legally possible. You still may end up paying a lot to the government, but you’ll lose the resentment of paying unnecessary taxes. In fact, you’re more likely to acknowledge that you’re paying a lot, but not paying too much. You’ll appreciate that taxes are part of the price of living in such a great country.
Some people get hung up on the cost and effort needed to put a solid plan in place. They’d rather pay the extra taxes and not have to deal with hiring a second or third professional. The cost is worth the benefit, and it doesn’t have to be complicated. Once the plan is in place, you can finally feel better about your taxes and move on to adopting the other strategies required to maintain your wealth. Remember, when you have the right wheel of advisors with the wealth manager in the middle, a small turn of the axle by you sets big benefits into motion.
To keep reading, pick up your copy of Beyond a Million: The Entrepreneur’s Playbook for Expanding Wealth, Freedom and Time by Jim Dew.
