One of the mantras at WealthAbility® is: If you want to change your tax, change your facts.
What does that mean?
The amount of taxes you owe is based on your particular business and personal financial situation, including how much you earn, how you earn it, and how your expenses are structured. When you change any of those variables, your tax bill will change as well. If you’re looking to reduce your taxes, you need to look at which of those facts you can and are willing to change in a way that will lower your bill.
These fact changes are powerful tax planning strategies. They involve analyzing your current financial situation to identify opportunities that will improve your tax efficiency. When you craft a tax strategy, you are creating a system that allows you to keep more of your money so that you can build wealth faster. Your tax strategy and your wealth strategy work hand-in-hand.
The best time to change your facts is now. No matter when you read this, you have the opportunity to make adjustments that can lower your taxes for the current calendar year.
Here are the top 10 tax planning strategies for anyone looking to change their tax by changing their facts:
1. Be strategic with your income.
How you earn your money has a significant impact on how much tax you pay. In most countries, governments incentivize business ownership and investment in real estate and the production of commodities such as agriculture and energy. Because these activities support economic growth, legislators structure tax codes so that these producer activities are taxed at much lower rates than the traditional salaries of most consumers.
Part of your tax planning strategy should be to closely examine how you earn your money. Look for opportunities that interest you that will allow you to move from being a consumer to a producer. You'll be able to keep more of the money you earn and accelerate your wealth building.
As you have more control of the money you make, you also will have more control of when you recognize your income from a tax year perspective. It's a common misperception that you're always better off pushing income into a later year to reduce your taxable income in the current tax period. However, there are times when the more strategic option is to accelerate your income. If you are a business owner, be mindful throughout the year to keep your income and distributions on track to support your tax planning strategy.
Work with your tax advisor to review your personal scenario. A few of the things they will consider with you are: whether reducing your income now causes you to lose any of your available deductions and whether you anticipate tax rates increasing in the coming year.
2. Review your entities.
An entity is what we call an organization formed to conduct business, and setting one up for your business is one of the best tools for reducing taxes. In fact, adding the right entity to your portfolio at the right time can save as much as $10,000 or more each year in taxes.
Entities take on additional importance for residents of high-tax states, such as New York, California, New Jersey, Illinois, Wisconsin and Connecticut. In some cases, you may find it advantageous to pay more tax as a business rather than as an individual.
The tricky part is that different types of entities are taxed differently, so it is essential to choose and plan wisely. Your tax advisor can help you determine whether it is most advantageous for your entity to be taxed as self-employed, an S Corp, a C Corp or a partnership.
Entrepreneurs often launch a venture as one type of entity with the intent of electing a different form later once the venture has reached a certain income threshold. However, it’s easy to forget to make the switch in the hustle of managing a growing business. That mistake can prove costly.
As part of your tax planning strategy, you should review your entities every year. The addition or removal of an entity or a status or ownership change can significantly impact your taxes and the preparation process for completing your tax return.
3. Review your accounting method.
Business owners whose gross income is less than $25 million have a choice of using either the accrual method or the cash method for their accounting. With cash accounting, you recognize income when it’s received and expenses when they’re paid. With accrual accounting, you recognize income when it’s earned and expenses when they’re incurred.
Typically – but not always, so check with your tax advisor – the cash method creates more tax benefits to the business. There are elections and forms to deal with if you’re making a switch, so be on alert.
4. Practice good bookkeeping.
Bookkeeping gets a bad rap. High achievers tend to think of bookkeeping as dull, tedious work; even those who recognize its importance rarely have it top of mind. Yet, accurate and timely bookkeeping is one of the best tools for reducing taxes.
As part of your tax planning strategy, make sure that your bookkeeping practice is up to par. This includes:
- Reconciling your balance sheet accounts
- Reviewing your balance sheet and profit and loss statement to check for errors
Stay on top of this, and you'll likely identify new deductions you can take on your taxes, AND you'll be ready for a smoother tax-filing process.
5. Keep documentation current.
While you’re working on your bookkeeping, be sure to extend proper documentation to other aspects of your business. Proper documentation is the most powerful way to support your facts and help your tax advisor do more to support your tax planning strategies. Proper documentation also provides the support you’ll need in the case of an audit.
Documentation may include:
- Meeting minutes for your businesses/entities
- Loan documents between you and your businesses/entities
- Agreements between you and your businesses/entities
- Mileage logs
- Activity logs (particularly in the U.S. for those who claim “real estate professional” status)
6. Evaluate personal loans and expenses related to your business.
Many people do not realize that one way to legally pay no tax is to pull money out of a business or real estate in the form of a valid loan. When you borrow money in this way, the loan money is not taxable. Work with your advisor to ensure that the loan is appropriately documented and that you make the principle and interest payments as spelled out in the loan.
Also, if you pay for any business expenses personally (whether or not you own the company), be sure you are correctly submitting those expenses for reimbursement. If you don't own the business, you want to make sure you get paid back. And if you do own the business, you could be missing a tax deduction. If you have unreimbursed expenses, be sure to review those with your tax advisor to see if there are opportunities for you to take them as a personal deduction.
7. Don’t miss out on deductions.
Many people pay more tax every year than they are legally obligated to pay because they fail to maximize their available deductions.
Some simply miss the opportunity. If that’s you, see #2 above for strategies for improving your documentation to identify all of your potential deductions.
But a surprising number of people knowingly skip some or all of their available deductions out of fear. What are they afraid of? An IRS audit. Someone told them that certain tax deductions raise red flags with the IRS, so they’ve willingly left deductions on the table.
When you take tax deductions appropriately and back yourself up with the appropriate documentation, you immediately improve your financial position.
Some of the most commonly missed deductions include:
- Home office. Taking a home office deduction isn't right for everyone. Still, in some cases, it can be the deduction that pushes you above the standard deduction amount. What's more, having a home office also can open up more opportunities for you to deduct automobile expenses. Work with your tax advisor to plan your best strategy.
- The 20 percent pass-through deduction. This deduction became part of the tax law in 2017 and can mean significant savings for small businesses.
- Bonus depreciation for real estate investors and syndicators. Since 2018, investors have had the choice to take bonus depreciation as a lump sum or spread it out. Your tax planning strategy should include a careful review of this deduction to determine the most advantageous approach. In some cases, most of a property can be written off in the year it is acquired.
8. Review your giving.
For many people, part of the joy of building wealth faster is being able to give more to support organizations they value. Charitable donations also are an opportunity to reduce your taxes if you handle the contributions according to the tax law.
As you plan and review your giving as part of your tax planning strategy, make sure the organizations you select to receive contributions are designated as a nonprofit 501(c)(3). If not, check with your tax advisor to see if the organization qualifies for tax deductions in another way; donations to churches and some trusts, for example, also can be eligible. Many states also give tax credits for charitable contributions, so be sure your advisor looks at both.
You don't need to make cash contributions to receive a deduction for giving. You can make in-kind contributions or donate other physical goods. For example, business owners can deduct donations of desks, computers, or other equipment based on their fair-market value. Donations of property valued at $5,000 or more, which often happens when it comes to jewelry, collectibles and real estate, require a written appraisal. Work with your tax advisor on the best way to document these types of gifts. Your advisor also can guide you if you’d like to make your donations in the form of stock.
Finally, many business owners work to create a spirit of philanthropy as part of their corporate values. This type of initiative could include giving employees paid time off to volunteer in the community or coordinating a company-wide day of service. In these cases, business owners can work with their tax advisors to document these events and deduct the salary, benefits and other expenses associated with that time.
9. Understand how property purchases and sales impact your taxes.
Rental property, equipment, business vehicles and other investments all can impact your taxes. By including a discussion of these items in your tax planning strategy with your tax advisor, you can create substantial savings opportunities.
For example, making a like-kind exchange with your real estate purchases can be a way to legally avoid taxes. This process involves selling a piece of real estate and then turning around and using the proceeds to buy another property, thus avoiding tax on the property you sold.
While not every transaction becomes a deduction, virtually every transaction could be an opportunity for one. By looking at your transactions through the lens of your tax planning strategy, you can unlock substantial savings throughout your life.
10. Consider hiring your minor children.
There are multiple advantages to working with your kids. First, their salary becomes a tax deduction for the business. You’ve created a job, and the tax law rewards this with a deduction.
Next, their income will most likely be taxed at a lower rate than yours. In the United States, children have a 10 to 12 percent tax bracket – far lower than their income-earning parents – and a $12,000 standard deduction. If you own a business and can legally hire them and pay them a salary, the first $12,000 can be tax-free, and the rest of the money they earn can be taxed at this lower rate. If your child does end up needing to pay taxes, they can reduce that by putting some of their income into a 529 college savings plan.
For some families, this is a wise strategy for helping children save for future expenses and teaching them the value of work in the family business.
Bottom Line with Tax Planning Strategies:
There are a lot of variables when it comes to creating a tax planning strategy. Carefully analyzing your current tax facts with your advisor is a great way to identify a path to significant savings year after year.