Posted on: August 12, 2014 by Martin Curiel, CFA in Tax Strategy
One of the most inefficient ways to make money is to be an employee and only earn regular wages. Limited upside potential on salary and bonus increases, exposure to the highest marginal tax rates (salary is generally taxed at ordinary income tax rates), and the inability to control taxable income are some of the many reasons“working for the man” can be detrimental to one’s financial health. Instead, most people who will achieve great wealth have some kind of ownership in a business. An executive receiving stock options or restricted stock units (RSUs), a real estate investor owning an apartment building, and an engineer building a popular messenger app are all examples of business ownership that can accelerate wealth creation.
In this article, I’d like to touch on one option of business ownership, the entrepreneurial/ start-up option, and approach it from a tax perspective. As I know all too well from personal experience, the risks of starting a business are many, but the tax advantages of launching and operating a new venture can help mitigate those risks. The “tax man” can be both a formidable adversary and an essential partner in the process.
A successful entrepreneur is one who achieves a high return on investment of her (and others’) capital, time, and resources. Very rarely will you encounter a business owner who went into business for the sole purpose of minimizing taxes. Many of us launched our own firm because we wanted to pursue a passion and truly make a positive difference in the world through our enterprise. Once the entrepreneurial process is up and running, however, it’s all-consuming. Support functions such as taxes and finance can often take a back seat to seemingly more important issues, such as sales, marketing, and product/service delivery. The pain of tax inefficiency can be chronic and can go relatively undetected for many years. It is common to actually be very successful in business while simultaneously overpaying the IRS and other taxing authorities.
We want to present some of the common tax-saving tactics in the following general framework. A Tax-Efficient Entrepreneur follows three common strategies:
Limiting the money and resources poured into a new venture can not only be a good lean start-up strategy, but can save significantly on taxes. For example, suppose one decides to invest $25,000 in a venture that seemed like a good idea at the time, but ends up folding a few months in. If this is the case, the IRS might not allow the individual to write off any of the expenses incurred. The IRS might contend that the business was not really a business and classify it as a “hobby” – business deductions all of the sudden become what are called “miscellaneous itemized deductions” and will be limited to hobby income. An efficient strategy is to invest only a little capital to test one’s idea in case the write-off is not allowed. Another strategy is to earn revenue as quickly as possible – this minimizes the chances of a business being classified as a hobby. If the company does fold, then there might be an opportunity to write off business losses against other income, which could reduce the total out-of-pocket investment made (the tax man effectively becomes a business partner, sharing in the risk of the business).
A related issue surfaces when it comes to writing off start-up expenses. Generally, it is more efficient to classify expenses as operating expenses rather than as capital expenses, since the former allows immediate deductibility. An entrepreneur is allowed up to $5,000 to be deducted as start-up expenses and business formation expenses. Start-up expenses that exceed that amount must be capitalized and amortized over a period of 180 months or 15 years. For example, if one incurred $20,000 in expenses, the first $5,000 would be deducted in the year the expense was incurred and the rest – $15,000 – would be deducted $1,000 per year. The definition of “start-up expense” is loosely defined; some common expenses include advertising, website creation, prepaid rent, and purchase of equipment. When the entrepreneur is “ready” to be in business, the start-up-expense clock stops and future expenses can then be classified as operational expenses. An efficient strategy is to be “ready” for business as quickly as possible, so that one does not need to worry about capitalizing any recurring/operational expenses going forward. If the business will be incorporated, one is also allowed an additional $5,000 to cover expenses such as state LLC formation fees, attorney fees, and other incorporation costs. Organizational costs that exceed that amount will be capitalized as well.
Not all business entities are created equal from a tax perspective. At the basic level, there are flow-through entities and taxable entities. Which structure to use depends on the characteristics of the business, but tax strategy implications are also an important consideration. Below is a discussion of each common type of business entity and the important associated tax issues:
This is the easiest type of entity to set up. It typically doesn’t require much effort, just the wherewithal to be in business. There is no paperwork to file with the IRS, since the business activity – income and expenses – is reported in the owner’s Schedule C, using her social security number. However, depending on the type of entity, there may be requirements from the city or state (e.g., business license, D.B.A., etc.); some sole proprietors use an employer identification number (EIN).Tax Strategy Opportunities:
Pass-Through Characteristics - A sole proprietorship allows owners to combine income and expenses with other income, including that of a spouse. If the business is projected to have losses in the first few years, they can help offset other income and therefore reduce the overall investment risk.
Easy Dissolution - Since it is an easy entity to start and stop, it can make a lot of sense for those who are not sure if they are made for the entrepreneurial world; it is also a great structure for those wanting to do “side jobs” or part-time consulting gigs and write off business-related expenses easily.Issues to Consider:
Unlimited Owner Liability - The owner is responsible for all debts of the business, and a lawsuit may go after personal assets.
Self-Employment Taxes - In addition to regular federal and income tax, sole proprietors have to pay approximately 15% on net earnings as self-employment tax (employees only pay half the self-employment tax).
Risk of Audits - In addition to regular federal and income tax, sole proprietors have to pay approximately 15% on net earnings as self-employment tax (employees only pay half the self-employment tax).
Assuming an unincorporated partnership, this entity is also easy to set up. Partnerships must obtain an employer identification number (EIN) from the IRS and generally must file additional paperwork, such as a business license and D.B.A., with the local regulatory bodies. Partnership taxation is similar to that of sole proprietorships. The partnership itself is not taxed on its income; rather, each of the partners is allocated profit or loss at the end of the year and the partners get taxed individually.
Profit/Expense Allocation - There is a lot of flexibility on how profits, expenses, and income are allocated. If there are major differences in the partners’ respective marginal tax rates, there could be potential tax arbitrage that could add value to the partners involved.
Unreimbursed Business Expenses - If it is spelled out in detail on the operating agreement, partners can deduct certain expenses, such as home office, travel, computer equipment, etc., that may not be reimbursed by the partnership.
Distributions of Profits - A partner can receive money from the business, and these distributions are not taxed so long as the distributions do not exceed the respective partner’s tax basis in the partnership.
Tax Deferral of Enterprise Value - Depending on the success of the business, the enterprise value of the partnership can grow substantially over time. This increase in value does not get taxed until the partnership is sold (“kicking the can down the road”). If the enterprise is sold at a profit, the gain is usually taxed at the lower capital gains rate.
Unlimited Liability - Unless the partnership is incorporated, each partner has unlimited liability for all of the partnership’s debts.
Partnership Agreements - Having a clear operating agreement is not only good business practice, but can also help with IRS audits, particularly when it comes to unreimbursed business expenses.
Taxation of Profits - Generally, partners are taxed upon their allocated share of the taxable income, even if it was never actually distributed. This is analogous to taxing a stock’s dividend that was accrued but never actually paid. Speaking from first hand-experience: This really stinks!
Income Is Subject to Self-Employment Tax - This is similar to sole proprietorships.
This structure is common in partnerships or when a sole proprietor wants to have some asset protection. LLCs are state-created entities, so the rules will vary by state. In the eyes of the IRS, single-owner LLCs are treated as sole proprietorships, and multiple-owner LLCs are treated as partnerships.
Similar to unincorporated partnerships
Limited Liability - This will generally protect members from personal liability.
Administrative Hassle - Although the process of setting up one of these entities is not very difficult, it does require work, including setting up articles of incorporation, paying fees to the state (in California, there is a minimum annual fee of $800), and possibly paying a third party to set it up (we like Legalzoom.com for simple LLCs and recommend an attorney for more complex ones).
S-corps are essentially C-corps (see below) that are taxed as pass-through entities. There are some restrictions on the type of firm that can be considered an S-corp, including the fact that it must be a domestic corporation, have no more than 100 shareholders/members, and can have only one class of stock.
No Self-Employment Tax - Shareholders do not have to pay self-employment tax on their share of an S-corp’s profits. This could mean substantial savings (self-employment tax is about 15% of net earnings), particularly if the business is projected to generate a large profit immediately.
Tax Deferral of Enterprise Value - This is similar to other entities.
Shareholder-Employees - There are a lot of incentives for shareholders of an S-corp to distribute profits given the absence of self-employment tax, but there are also many restrictions. For example, before there can be any “profits” paid out, owners that work as employees for the S-corp will need to receive a “reasonable” amount of compensation. What is “reasonable” is not clearly stated by the IRS, so one needs to be careful with this issue – it is one of the first things an IRS auditor will look for.
Distributions of Profits - This is similar to partnerships – you might pay taxes on paper profits when you do not receive any cash.
Administrative Hassle - This is even more true than for LLCs because of the likelihood of having to deal with payroll procedures.
Inflexibility - S-corps limit the type of investors that can participate as owners; they typically can only be individuals, estates, and tax-exempt organizations. It almost never makes sense to put buy-and-hold property in an S-corp given the difficulties of doing things like 1031 exchanges. Modifying the profit allocation to partners can also be more challenging relative to partnerships and LLCs.
This is the most paperwork-intensive entity and typically requires the help of an attorney to set up. Unlike sole proprietorships or partnerships, C-corporations are taxable entities; this can result in the notion of “double taxation” – not only does the corporation itself have to pay taxes, but the shareholder-owners must also pay taxes on income distributed.
Income Splitting - Forming a C-corp has the potential to save the business owner money if she expects to earn more from the business than she’ll need for personal use. Corporations generally have tax rates that are more favorable than individual rates, so if the income can be split, a tax arbitrage exists. A certain amount can be left inside the corporation as retained earnings, which defer, or better yet can avoid taxation.
Fringe Benefits - C-corps can allow for additional deductions not afforded to other entities, including health insurance premiums, education assistance, company-owned cars, and moving and housing expenses.
Deferring Taxation - Corporations avoid double taxation by accumulating earnings, thus increasing the value of the stock. The unrealized appreciation of stock is not taxable immediately.
Tax Deferral of Enterprise Value - This is similar to other entities.
Double Taxation - As discussed earlier, the worst-case scenario is when profits get taxed at the corporate rate (around 35%) and then again when they get paid out as dividends (at around 15%). If the C-corp is highly successful, there will be no easy way to avoid this.
Limited Value on Losses - When a C-corporation incurs a loss, it cannot be used to offset the owners’ other taxable income, which can minimize the value of the loss. The corporation can, however, use the loss to offset its income from the two prior years, or up to 20 years in the future.
Limit on Use - Many types of professionals, including doctors and lawyers, are barred from forming C-corps in certain states. The IRS typically treats these as “Qualified Personal Service Corporations,” which are taxed at higher rates.
Raising Capital - Even if this form is tax-inefficient and overly burdensome, it may be the only practical choice available. A good example is some of our clients who are looking to raise money from professional investors such as Angels or Venture Capitalists; a C-corp is almost always a requirement.
Complexity - Keeping in compliance with all corporate requirements, such as keeping minutes for shareholder meetings and keeping track of corporate resolutions, can be onerous. Even if you are the only shareholder, you might be subject to employee reporting and compliance requirements for taking a salary.
Accumulated Earnings Tax - There is a risk that the IRS might assess a tax on excess retained earnings. Typically, a C-corp can accumulate up to $250,000 of earnings and profits without a raising any red flags with the IRS; beyond this amount, it might need to demonstrate that the accumulation of earnings is for a sound business case.
We are strong believers that individuals should not start a business for tax purposes alone. However, we are also strong believers that every business owner should maximize deductions. There is no honor in paying more to the taxing authorities than required. Below is a short list and description of some of the common deductions that enable business owners to stretch a dollar earned compared to employees.Additional Retirement Contributions
Employees of corporations or other businesses are only allowed to contribute a set amount to a retirement plan; for example, in 2014, employees were allowed to contribute $17,500 to an employer-sponsored 401(k). By contrast, a business owner could contribute to a SEP IRA the lesser of $51,000 or 25% of net earnings from self-employment. Like a 401(k), deferring taxation can be very powerful, since the taxpayer is essentially “kicking the can down the road” to a time when her tax bracket might be lower than today’s.
There was a point in time when deducting expenses related to a home office was a sure way to get an audit. As advances in technology have enabled contractors and consultants to work from home, this is less of an issue today. This can be a major deduction for entrepreneurs. To qualify for the deduction, the home office must be used “exclusively and regularly” as the principal place of business or place to meet with clients. Any expense directly related to the home office (e.g., desk, phone system, etc.) and a portion of most expenses related to the entire home (e.g., electricity, water bill, etc.) can count against business income. The portion of your home dedicated to your work can also be depreciated, which can be significant if the home is located in a high-price area like Silicon Valley.
If you are having a drink or a meal with a potential customer or client (even if that individual is your buddy and would be hanging out with you anyway), it can be deducted. As long as you’re talking business and it is “reasonable and ordinary,” you are allowed to deduct up to 50% of the cost of the meal. The IRS assumes that you would already be spending some of the money to nourish your body, hence the muted deduction.
The cost of commuting between one’s house and a place of employment is a nondeductible expense. However, trips to visit clients and prospects can be a great deduction. In 2014, one was allowed $0.56/mile in business mileage deduction – that’s whether you are driving a Tesla or a beat-up Honda from the 1990s. The rule for deduction of all expenses is that the trip must be used “primarily for business reasons”; if you don’t push this definition too much, you should be fine in combining vacation and business trips effectively. If the trip is primarily for personal reasons, then the expenses are non-deductible.
There are many other business deductions that can help minimize taxable income for entrepreneurs. The following web links are some that I have referenced in the past:
Deducting Business Expenses by the IRS - the definitive source for what can be deducted.
Definitive Guide to Common Tax Deductions - a good table that shows various categories of expenses, including deductibility criteria, specific deductions that can be made, and potential pitfalls when using the deduction.
Deducting Business Expenses by the IRS - a good article by a respected source, Mark J. Kohler, through Entrepreneur.com.
There are infinite ways to destroy wealth and there are only a few ways to achieve great wealth – the entrepreneurial route is one of those ways. Taxes are an important consideration for businesses both at the start-up level and ongoing. Starting small allows an entrepreneur to maximize the chance of deducting expenses incurred to start the business, as well as to offset losses that may result if the business is not successful. Using the right business structure can enable maximum after-tax income. Understanding the various deductions, such as a home office expenses, meals, and entertainment that are available to the entrepreneur can also offset taxes.
For many, the security of having a well-paid job with benefits is the ultimate form of success. To others, working for someone else is like kryptonite for Superman. There is no single right choice, only the right choice for the individual in question. Choosing the path of entrepreneurship is risky, challenging, stressful, uncertain, and sometimes even less lucrative than having a regular job. But the benefits, including those related to taxes, are many; for some of us, there is no other practical path.
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