From the launch of your company until the day you're ready to sell it and retire, opportunities abound to lower your tax liability.
As a savvy entrepreneur, you owe it to yourself to consider these tax-saving strategies. Not all will be appropriate for your particular enterprise, but some will – and they may save you thousands or even millions of dollars.
Here are six tax-saving tips for different stages in the life of private companies:
Early stage companies
Should you create a C corporation, S corporation, limited liability company (LLC) or some other structure? Your choice of a legal entity has big tax implications, particularly for your eventual exit strategy.
Consider, for instance, how your choice of entity could affect your tax bill if you someday sell the company to an outside buyer.
Suppose this buyer pays $10 million for your assets. If you are a C corporation, you would pay taxes both on the corporate level and on shareholder dividends. So the corporation would pay about $3-4 million in taxes on the sale, leaving $6-7 million for shareholders. Then shareholders would pay individual taxes that, at a federal capital gains rate of 15 percent (plus state taxes), would leave them with a net of about $4-5 million.
An S corporation or LLC, on the other hand, would pass all of that $10 million on to shareholders or members. After paying individual taxes, shareholders/members would be left with about $7 million, significantly more than in the C corp scenario.
That's, of course, an over-simplified example. Many other factors come into play in choosing a business structure, such as the nature of your enterprise, the sources of capital you'll be seeking and your exit strategy.
But it shows how big a difference entity selection can make in your tax burden – in this example, a difference of more than $3 million.
|C-Corp||S-Corp or LLC|
|Selling price of business||$10,000,000||$10,000,000|
|Corporate federal & state tax||-$4,000,000||0|
|Owner level federal and state tax||-$2,000,000||-$2,500,000|
|Cash after tax||$4,000,000||$7,500,000|
Buy-sell agreements are primarily a tool to avoid conflict among company owners over succession and a vehicle for dealing with the untimely death or disability of the owners. But if structured carefully, they can sometimes save you money on taxes.
For instance, a cross purchase agreement can reduce taxes for owners of S corporations. In a cross purchase agreement, the remaining shareholder buys the departing one out, rather than having the company buy him or her out.
Suppose two partners each put up $10,000 to start a company, and the company takes out a $5 million life insurance policy on each of them. One partner dies. If the company uses the life insurance benefit to buy out that partner's interest, the company now is worth more than $5 million. And the surviving partner now has a $10,000 cost basis in a $5 million company – setting the stage for a big capital gains tax hit when it is someday time to sell.
On the other hand, if the two owners create a cross-purchase agreement where each buys a policy on the other, then the surviving owner buys out the interest of the deceased one. His or her basis in the company is now $5 million plus that original $10,000 investment – which can make for considerable savings in capital gains taxes down the road.
Growth stage companies
Depreciation deduction. Section 179 of the federal tax code allows certain companies to deduct the entire value of eligible capital expenditures in the first year, rather than depreciate them over several years. And recent economic-recovery legislation created particularly generous deductions in 2011 – making this year a good time to save on taxes while stocking up on equipment.
Companies are allowed to write off up to $500,000 in purchases of new or used equipment and off the shelf computer software in 2011.You can also depreciate up to $250,000 in certain “qualified “real property costs, including improvements to commercial buildings and restaurants. Assets must be placed in service in the United States to qualify for the Section 179 deduction and there is a phase out threshold of $2 million in the tax code. Your deduction will be reduced dollar for dollar by the amount over the threshold.
In addition, “bonus depreciation” (part of the regular depreciation rules) allows you to write off 100% of purchases of new equipment in 2011. Unlike Section 179, there is no phase out threshold for bonus depreciation.
These depreciation deductions can help offset your profits this year and potentially reduce your 2011 taxes to zero. Or you can use them to create an operating loss to carry forward into future years.
Domestic production activity deduction (DPAD) – Section 199. This deduction grew out of a thirty-year trade battle between the U.S. and Europe, but you don't need to know its history to benefit from it. It's particularly useful for small and mid-size manufacturing companies.
Under Section 199 of the tax code, companies that produce goods, develop software, or construct property in the U.S. may be eligible for a tax deduction of up to nine percent. You compute the deduction by subtracting allowable expenses from qualified domestic production activities. If you're eligible, DPAD can result in a 3.15 percent reduction in your effective tax rate. However, you need to have a taxable profit in order to utilize it.
Computing the DPAD can be simple or enormously complex, depending on the nature of your business. Your tax advisors should be able to offer guidance about DPAD strategies and eligibility.
A company acquired $550,000 of new assets and $200,000 of used assets in 2011. It has no prior year assets and all assets were placed in service in the U.S.
|Case 1||Case 2|
|Net Taxable Income (before tax depreciation expense deduction)||$720,000||$450,000|
|§179 on used assets||-$200,000||-$200,000|
|§179 on new assets||-$300,000||-$250,000|
|100% bonus depreciation on remaining assets (new assets - §179 on new assets)||-$250,000||-$300,000|
Mature stage companies
Family limited partnerships (FLPs). Once your company has grown enough to generate wealth for you and your family, you need strategies to minimize the impact of the estate tax on your heirs. Family limited partnerships are one way to save taxes while transferring assets to your loved ones.
FLPs involve transferring your investments and other assets into a limited partnership, where with a managing general partner you select and your children or other heirs as limited partners. Because limited partners don't exercise control and can't easily sell their interest, their shares are typically valued at 20 to 50 percent below face value. That discount means you can effectively exceed the $13,000 annual limit on tax-free gifts to your heirs.
For instance, suppose a parent places 10,000 shares of stock worth $10 each in an FLP in which your daughter is a limited partner. Without an FLP, you would be able to give her 1,300 shares each year without incurring gift taxes. But as a limited partner in the FLP, her shares would have a lower value – perhaps $7 each – and so you could give her more than 1,800 shares each year tax-free.
With the help of an experienced financial advisor, you can use other vehicles such as Grantor Retained Annuity Trusts (GRATs) and Intentionally Defective Grantor Trusts (IDGTs) to get even more tax savings from a family limited partnership.
A daughter was given a gift of 1,300 shares of stock worth $10/share.
|Without FLP||With FLP|
|Value of 1,300 shares||$13,000|
|Gift of 13% of FLP using 23% discount||$10,000|
|1,300 shares||1,6888 shares|
388 more share are able to be transferred to the younger generation with estate or gift tax.
Charitable giving. While helping non-profit organizations that are close to your heart, you can use charitable giving to minimize taxes on the income from your successful business or your investments.
If you need a big deduction to offset income this year, one option is creating a donor-advised fund. These funds – typically administered by investment firms, community foundations or larger non-profits – allow you to donate a big chunk of capital and claim the tax deduction now, but advise how and when the money is distributed to each selected charity over an extended period of time. And if you donate stock to the fund, you can avoid capital gains taxes while receiving a deduction for the appreciated value of the stock.
Meanwhile, charitable remainder trusts (CRTs) are a way to shelter your capital gains and receive a deduction now – while retaining income for life and giving money to charity when you die.
With a charitable remainder trust, you donate the principal and take a partial deduction for it. Because CRTs are tax-exempt entities, neither you nor the trust owe capital gains tax if you donate appreciated stock. The trust can sell the stock, re-invest the proceeds, pay you a designated amount of income for life, and then give the remaining principal to charity upon your death.
For instance, suppose you have 10,000 shares of stock with a basis of $1 and a value of $5 million. If you simply sold the stock, you would face federal capital gains taxes of $1,250,000 and be left with $3,750,000 to reinvest. Buying bonds that pay 3%, you would receive income of $112,500 per year.
But if you created a CRT, it could re-invest the entire $5 million. At 3%, that would give you income for life of $150,000 – almost $40,000 extra each year (and an even greater difference after state taxes are counted).
And what about your heirs? When you die, the $5 million principal in your CRT would go to charity. But you could use some of the extra $40,000 earned each year to buy a $5 million life insurance policy for your family.
|Without CRT||With CRT|
|Sale of 10,000 shares||$5,000,000||$5,000,000|
These tips just touch the surface of strategies to minimize the taxes associated with your business. For details and an approach tailored to your unique needs, speak with your tax and financial advisors.
This publication contains information in summary form and is intended for general guidance only. It is not intended to be a substitute for detailed research nor the exercise of professional judgment. Neither BPM nor any member of the BPM firm can accept any responsibility for loss brought to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor.