A Practice Guide to Tax Planning for Business Owners

Keith Wetjen |
Categories
Tax Planning

Taxes are an unavoidable aspect of running a business, but with proper planning, you can minimize your liability and avoid unexpected bills. Together, let’s walk through the tax planning process and address three key questions:

 

1. How Do Taxes Work?

2. What Tax Strategies Are Available To Me?

3. How Can I Avoid an Unexpected Tax Bill?

 

Ready? Let’s go!

 

How Do Taxes Work?

 

Before jumping into strategies, it’s crucial to understand how taxes work for business owners. There are two different types of income you earn as a business owner and it’s important to know the difference between the two so you can fully understand your business-related taxes:

 

  • Ordinary Income: Earnings from your business operations, taxed under a marginal tax system. The more you earn, the higher your tax rate, but not all income is taxed at the highest rate.
  • Capital Gains: Income from selling assets like real estate, stocks, or your business. Capital gains are either short-term (taxed as ordinary income) or long-term (taxed at lower rates).

 

When it comes to ordinary income, it is subject to what is known as a marginal tax rate. This means you will not pay the same amount in taxes for every dollar you make. Instead, your tax increases as your income increases. As income grows, the highest dollar earned will fall into a higher tax bracket. Below is an outline of the 2024 federal tax brackets.

 

Tax rate

Single

Married filing jointly

Married filing separately

Head of household

10%

$0 to $11,600

$0 to $23,200

$0 to $11,600

$0 to $16,550

12%

$11,601 to $47,150

$23,201 to $94,300

$11,601 to $47,150

$16,551 to $63,100

22%

$47,151 to $100,525

$94,301 to $201,050

$47,151 to $100,525

$63,101 to $100,500

24%

$100,526 to $191,950

$201,051 to $383,900

$100,526 to $191,950

$100,501 to $191,950

32%

$191,951 to $243,725

$383,901 to $487,450

$191,951 to $243,725

$191,951 to $243,700

35%

$243,726 to $609,350

$487,451 to $731,200

$243,726 to $365,600

$243,701 to $609,350

37%

$609,351 or more

$731,201 or more

$365,601 or more

$609,351 or more

Source: Internal Revenue Service

 

It’s easy for business owners (or anyone, for that matter) to get caught up in the highest tax bracket they are in. However, your marginal tax rate or highest tax bracket doesn’t tell you the full story. For example, if you made $731,201, you wouldn’t pay 37% on the entire amount. Instead, you’d only pay 37% on the income over $693,750, leading to an average tax rate lower than 37%. So, knowing your effective tax rate is critical in making informed decisions.

 

Capital gains are the profits you get when you sell an asset. When it comes to capital gains, how you are taxed depends on how long the capital gains have been held:

 

  • Short-term gains are considered gains held for under 1 year
  •  Long-term gains are considered gains held for over a year

 

Short-term gains are treated like ordinary income and are taxed under the marginal tax system (brackets shared above).

 

Long-term gains are taxed differently and are subject to long-term capital gains tax. The rates are 0%, 15% or 20%, depending on taxable income and filing status:

 

Tax rate

Single

Married filing jointly

Married filing separately

Head of household

0%

$0 to $47,025

$0 to $94,050

$0 to $47,025

$0 to $63,000

15%

$47,026 to $518,900

$94,051 to $583,750

$47,026 to $291,850

$63,001 to $551,350

20%

$518,901 or more

$583,751 or more

$291,851 or more

$551,351 or more

Source: Internal Revenue Service

 

When it comes to tax planning, timing is crucial—it can be the difference between saving a little and saving millions. Maximizing your use of long-term capital gains rates is one of the most effective strategies.

 

For instance, when selling a business asset, the amount you’ll be taxed on is based on the difference between the sale price and your cost basis (what you originally paid minus depreciation). Understanding this helps you make informed decisions to minimize tax liability.

 

A Quick Note About Common Tax Planning Misconceptions

 

There are many misconceptions around the tax benefits of business owners. Yes, you can “write off” certain expenses - but, in every case, you’re still spending money in order to save money. So, it’s important to assess if there is an actual cost benefit to any purchase or investment.

 

For example, buying a $100,000 SUV might reduce your taxable income, but it only saves you a fraction of that in taxes. In this scenario, you might save $37,000 in taxes, but you still spent $100,000. Understanding deductions is key—yes, they lower your taxes, but they don’t eliminate them.

 

Another misconception is thinking tax planning is only for year-end. In reality, proactive, year-round planning ensures you’re not leaving money on the table and should be integrated into your year-round business finance planning and personal wealth planning.

 

Now that we’ve covered the basics, let's address specific strategies you can leverage to minimize your tax liability as a business owner.

 

What Tax Strategies Are Available To Business Owners?

 

As with any wealth management planning, tax planning should reflect your goals: Is your goal to save money this tax year? Or, is it to strategically minimize taxes in the future? Or, is it both?

 

Answering that question first - what are you hoping to achieve and by when - will help you determine the best strategy for you.

 

If you’re looking for present-year tax benefits…

 

Strategies That Can Help You Pay Less Tax Today:

 

  • 401(k) Contributions: By maxing out contributions, you reduce your taxable income now and defer taxes until retirement.
    • Example: Joe, a business owner earning $1M, contributes the maximum to his 401(k), saving thousands in taxes today while securing his future.
  • Wage Optimization: Structuring your salary to maximize tax-advantaged benefits can reduce your taxable income.
    • Example: Jane shifts part of her income from distributions to wages, boosting her Qualified Business Income deduction and saving $30,000 in taxes.
  • Tax Loss Harvesting: Selling underperforming assets to offset gains can lower your taxable income.
    • Example: During a market dip, Jeff sells losing stocks, reducing his taxable income and saving on taxes for the year.

 

If you’re interested in future-year tax benefits…

 

Strategies That Can Help You Pay Less Tax Later:

 

  • Roth Conversions: Convert traditional IRAs to Roth IRAs during low-income years to benefit from tax-free growth and withdrawals in retirement.
    • Example: After selling her business, Jill, now in a lower tax bracket, converts a portion of her IRA, paying less tax now for tax-free withdrawals later.
  • Roth IRA Contributions: Contributing to a Roth IRA allows for tax-free growth, perfect for those expecting to be in a higher tax bracket in retirement.
    • Example: John contributes to a Roth IRA during his high-income years, securing a tax-free income stream in retirement.
  • Portfolio Optimization: Adjust your investment strategy by allocating assets between taxable and tax-advantaged accounts.
    • Example: Jenn shifts from municipal bonds to higher-yield taxable bonds after her income drops, increasing her overall returns.

 

How to Avoid an Unexpected Tax Bill?

 

Avoiding a surprise tax bill requires regular, proactive planning with your team of tax and wealth management advisors (And, we can help coordinate this for you!)

 

Why?

 

Because you need to meet the safe harbor contribution.

 

The safe harbor contribution states that to avoid penalties, you must ensure you meet the safe harbor by paying either 90% of the current year’s taxes or 100% of the previous year’s taxes.

 

However, relying solely on safe harbor estimates can lead to surprises as they’re often based on what happened in the past and aren’t taking into account what is around the corner. This is especially true in a year when business is great and income doubles. 

 

The only way to avoid an unexpected tax bill is through constant communication with your team of advisors. Don’t wait until year-end—review your finances quarterly with your wealth management and tax professionals to adjust your tax strategy as needed.

 

Remember:

 

Tax planning doesn’t have to be complex, but it does require a strategy.

 

At Entrust Wealth Partners, we work with you and your trusted tax advisor to simplify the process and help minimize your tax liability - today and in the future. To learn more, contact us at entrust@entrustwp.com.

 

Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.

 

A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.

 

Entrust Wealth Partners and LPL Financial do not provide tax advice or services.  Please consult your tax advisor regarding your specific situation.​