By Tammy Trenta, MBA, CFP, CTC, CEXP; Founder and CEO – Family Financial
Owning a small business means you’re on an exciting path toward controlling your destiny. Securing your financial future is a critical part of that. But making money is only one side of the proverbial coin. The other side? Leveraging that money wisely.
As a wealth advisor, I urge clients to take a holistic approach to financial planning; while investments are important, other matters that affect your bottom line are equally important – like the taxes you pay, the cost of living, and the legal issues that may influence both. In this article, we’ll look at the bigger picture by breaking down five smart moves that may help you keep more of what you earn.
1. Buying a second vehicle.
Many people either don’t know about Section 179 of the tax code, or find it mysterious. But one part is fairly straightforward: when you purchase certain passenger vehicles for commercial use, you may be able to take a large depreciation deduction for the purchase price of the car all at once. The IRS lists specific restrictions, like the vehicle needs to be over 6,000 pounds. But if you’re thinking of buying a vehicle anytime soon, talk to your advisor to see if you’re able to take advantage of this great perk.
2. Incorporating your business.
If yours is one of the millions of new sole-proprietorships that came out of the Great Resignation, congratulations. But I hope you weren’t too surprised to find out your net business income is subject to self-employment tax and personal income tax. That’s correct – as both the employer and the employee, sole proprietors have the dubious honor of being taxed twice. The good news? By forming an S-corporation, you may be able to keep a lot more in your pocket.
Here’s a quick example:
Let’s say you have $100,000 in revenue, and $10,000 in expenses. This leaves you with a profit of $90,000. As a sole proprietor, you’d pay both self-employment and federal/state income tax on $90,000 – costing you approximately $13,770 in additional self-employment tax.
But as an S-Corp, Uncle Sam insists you receive a “reasonable” salary from the business. So, let’s say you elect to give yourself a salary of $25,000 – reducing your self-employment tax to $3,825. You could take the remaining $65,000 as a shareholder distribution, avoiding the self-employment tax on that remaining income.
Incorporating a business sounds complicated (and, to an extent, it is), but the potential for savings makes it worth looking into. Of course, there are expenses that come with it (like filing an additional tax return, and possible payroll costs) so you’ll need to look closely at the numbers to be sure your savings outweigh the costs.
3. If you don’t need every penny to live on, maximize retirement savings.
Using the $100,000 example above:
- For yourself: Those under 50 can shelter up to $20,500 of that $25,000 salary into an individual 401K as an employee. You’ll still pay self-employment tax, but you will not pay personal income tax on the 401k contribution. The 401k also allows you to contribute another 25% your salary – or $6,250 – as the employer. Deducting this from the remaining $75,000 left in profit reduces your taxable income to $68,750.
- Hire your spouse: If your spouse works with you, your spouse can also shelter up to $20,500 of their $25,000 salary in a 401K with the same $6,250 employer contribution.
- Hire your children. The standard deduction on a tax return is $12,950; if your children earn under that amount, they’ll pay no federal or state income tax, yet as their employer, you still get to deduct their pay from your profit. They’d need to be eligible for a work permit according to your state’s individual requirements. To take it one step further, your children could then invest up to $6,000 of that money into a ROTH IRA to start saving early and growing their money, which can be withdrawn for many purposes tax-free.*
4. Look at your Qualified Business Income Deduction (QBID).
For certain types of businesses*, the IRS may allow you to deduct the lesser of 50% of your salary, or 20% of net profit. Using the same $100,000 profit example, you would then get another $12,500 deduction if you’re an S-corp. *Unfortunately, specified service businesses such as doctors, lawyers, and financial planner may not qualify for the QBID perks. Darn.
5. Own a commercial property? Look into a cost segregation study.
This one pertains to larger “small” businesses. Commercial real estate is depreciated gradually, over a span of 39 years. A cost segregation study may identify components of the structure (like anticipated roof or plumbing repairs) that would allow you to accelerate that depreciation in the first several years. These front-loaded deductions create a paper loss that can be deducted against the taxable income from your salary or business. Here’s an example:
Let’s say you earn $200,000 per year. You purchase a commercial property for $1,000,000, rent it to your business, and perform a cost segregation study. The study identifies additional opportunities to accelerate depreciation in the first year of $100,000 in excess of your rental income. You can deduct that $100,000 against your $200,000 salary, thereby cutting your taxable income in half.
Keep in mind, the above examples are simplified – you’ll definitely want to consult with a qualified advisor before diving in. But the lesson is to stay on the lookout for smart ways to keep what was yours in the first place.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.