The Difference Between the Tax You PAID vs the Tax You SHOULD HAVE PAID
My goal is to help entrepreneurs pay fewer taxes, and also enjoy their businesses. You went into business for yourself to enjoy life, not to work harder. I'm very passionate about being available to you and giving the advice to help you make the most of your business. I believe that our country is what it is today because of small businesses, and one of my favorite things to do in my industry is to strategize on your taxes.
Doing your books is fun, don't get me wrong, and taxes are fun as well. But it's the in-between part that I enjoy the most, and that is my secret sauce for paying less in taxes: tax planning.
What is tax planning?
A lot of people don't talk about tax planning because they don't know how to do it. For most people, taxes mean getting your books together, printing out that profit and loss and balance sheet, giving it to your accountant or tax preparer, and then they prepare the taxes.
Doing that is not saving you any money. That's just the nuts and bolts of taxes. We need to take it to another level so that you can actually save. So with that, I want to say that tax planning is not the same as tax preparation. They're completely different. And, I'm going to tell you a couple of things and how that is.
So tax preparation is simply the filing of your tax return and taking the basic deduction. Now tax planning is actually using the tax codes to your greatest advantage. So people say to me, “Oh, I don't want to do anything that's gonna get me in trouble. I'm really scared of the Tax Man.” And I’ll tell you this: there are two things here. You have tax avoidance and you have tax evasion.
Tax avoidance is tax planning. That's lessening your tax liability based on the tax code. They wrote it that way, and we have to take advantage of it. Tax evasion is when you do things deliberately to underpay your taxes. So tax planning is not tax evasion.
Let’s go over a few things about planning before we get into a few planning tips that I like.
Planning requires a lot of understanding of tax. It requires you to know the tax code (by the way, there are over 4,000 pages of tax code) and how it affects your tax return. You also have to know business accounting.
So you have to know all of those things, which brings me to a question I’m asked on a regular basis: What is the difference between a bookkeeper, an accountant or CPA, a tax preparer, and a virtual CFO or strategist (which is what I do)?
A bookkeeper basically knows the ins and outs of your check register. They know what's coming in and out and they categorize those expenses.
An accountant/tax preparer/CPA knows a lot about tax codes. A lot of them are also bookkeepers, so that's a plus. I also want to touch on some additional questions I get here: Do I have to have a CPA or can they just be an accountant? What are the requirements? You need to know that your tax preparer does not have to be a CPA. I will say from experience that there are some bad CPAs and good CPAs. They're bad tax preparers and the good preparers, do your due diligence. Don't just look at the three letters behind their name. Do your due diligence to make sure that the person knows their stuff, and also to make sure that you and that person can get along and converse, that you’re on the same level.
Then you have the virtual CFO or strategist. This person actually takes the work from the bookkeeper and the work from the accountant and they all work together to create your strategy. So, a CFO is going to do a lot more planning and strategizing for your business. I look at this person, whether it be a bookkeeper, accountant, or your virtual CFO as a doctor. You want to be comfortable with them, you want them to be able to answer your questions, and be confident that they know their stuff. Just like with a doctor, talking about your business finances is very private.
Also, planning is a long-term event. This is not something that you're going to sit down with your accountant or your virtual CFO for one time per year and do the planning. That’s how tax preparation works, but not planning. So it’s an ongoing event, looking at the future and seeing what things you can change in your business to benefit you in the long run.
Also, remember planning is a very tedious job. What I like to do with my clients when I do analysis is to give them options. So I may say “Your tax savings if you go with Options 1-3, you’ll get X, but if you only choose 1, it’s X.” That’s my strategy and by doing all of those different analyses, you can see the different types of returns as we go.
It's not an easy task, and it's not a quick task, but it's something that you do on a regular basis and you do over a period of time. There is a saying by Benjamin Franklin: if you fail to plan, you are planning to fail… It's true. You have to plan ahead. You can't just do things on a whim and feel that it's going to affect your business in a good way.
Let’s get into my top 5 favorite planning tips.
Time Your Income and Expenses
This means planning out certain things based on the date. So if it’s towards the end of the year, maybe you don't invoice your clients in the latter part of December until January because your accounting is on a cash basis (you count the income as it is received).
So say you have a big project. The client owes you $5,000 and you invoice them on December 31, and they pay you on December 31. Then, you're going to pay taxes on those $5,000 in that same year - let’s say it’s 2020. But if you were to wait and invoice them, or have them actually pay you in 2021, you do not pay the taxes on that money until 2021. So that is how you time your income.
Now to time your expenses, you would need to go ahead and pay your vendors, pay your utilities, and all those things before the end of the year. So all your checks have to be written then be mailed out, credit cards paid, etc. by December 31st to count for that tax year.
So accelerate expenses and defer income. Remember that this only works if your business runs on a cash method basis.
2. Make the Most of Depreciation
Depreciation is the expense write-off of any asset that you purchase in your business. So say you are a consultant and you had to buy a new laptop. That laptop will be depreciated over a lifespan, but with the tax cuts and Jobs Act of 2017 that was expanded, you are allowed 100% depreciation on most assets up to a million dollars.
So let me give you an example of that as well: Say I am a plumbing company, and it's December, and I need a new work truck for my company. So I go and buy a new work truck and it’s $50,000. I'm going to finance that work truck, which means I'm going to pay payments on it over a period of time. With this particular tax and Jobs Act, you can write off $50,000 of the truck against your income in 2020, even though you're making payments on it. Then as you make those payments through the period that it's on, you write off the interest. So you have to purchase it and it needs to be in service before the end of the year. This applies to printers, computers, furniture, and equipment - those types of things are what I'm referring to. So this allows up to 100% differentiation on assets up to $1 million in the year that it is applied, and that would help tremendously. Say your profit is $50,000 and you need that new work truck. Well that work truck being depreciated wipes out all of your income.
Now, I will go ahead and just throw out here that I do not advise that you go and purchase just things just to wipe out your tax liability. It's not dollar for dollar. If you need it, that's great. But make wise businesses decisions.
3. Qualified Business Income Deduction (QBI)
This was also part of the same act that I was discussing with the depreciation, but this allows some business structures to deduct 20% of their net business income as a deduction. It really depends on how you set up LLC, S Corp, C Corp, not all of them are able to get this deduction.
4. Fund Retirement Accounts
This one gets missed a lot, especially when you're self-employed. When you're an employee, and you’re given information every year for you to decide whether or not you want to participate in your 401K retirement plan, it's really easy to check the box and say ‘yeah, you know, withhold 3%.’ But when you're self-employed, it seems to me that this gets put on the back burner.
You work your tails off your entire life being self-employed. You get to the end of the road and you're ready to retire, and you look back and go ‘oh crap. I don't have any money. Nothing is set aside.’
So let's talk a little bit about funding your retirement accounts. You have several options, being self-employed, and I will say here to consult a financial advisor on which one works best for you. Your financial advisor and your accountant can work together, between the two of them, to come up with the best solution between making you more money in retirement and saving money because there is a middle road there, and they need to work together.
The first option is going to be a SEP IRA, which is only for self-employed individuals. And you can contribute up to 20% of your self-employment earnings.
The second is a self employed 401K Plan. With this option, you're going to have to be on the payroll, and you can actually contribute $57,000 a year to that plan between the employer side and the employee side.
Then you have an IRA. There are two types of IRA and there are benefits to both. An IRA also has a max of $6,000 for 2020. And if you're 70 or older, you can contribute $7,000. A traditional IRA saves you money on your taxes, so you get the tax benefit of it now, but you're gonna pay taxes on it later when you go to retire.
A Roth IRA is different. With a Roth IRA, you are not going to get the benefits now, but you're going to get the benefits later. Doing a bunch of analysis with this and actually working with a financial advisor a few years ago, I strongly recommend a Roth IRA. That's just my personal opinion, again, that's not tax advice for you specifically, talk to a financial advisor. But a Roth sees more benefits in the long run, and I'm a long-term planner, not a short-term planner.
No matter which one you choose, please put some money away for retirement. It's very, very important. Don't work so much and spend all your profits without putting some away so that when you retire, you have a little nest egg.
Leverage Health Savings Accounts (HSA)
Again, this is one of those things that, as an employee, was easier for you. You put little chunks away every paycheck. HSAs and funding the retirements are a little different when you're self-employed because there are a lot bigger chunks coming out.
So what is an HSA? That means putting money aside for qualified health expenses. So if you are part of a high deductible health insurance plan (or if you bought your health insurance off the marketplace), then you can contribute to an HSA. Those contributions are tax-deductible, the contributions grow and that growth is tax-free, and when you withdraw the money for qualified medical expenses, those withdrawals are also tax-free. The contributions on those in 2020 were $3,550 just for you, or if you have a family, it’s $7,100. So you can put $7,100 aside for medical (copays, prescriptions, your deductible, etc.) expenses, and it's tax-free.
Three Quick Bonus Tips
Know Your Entity Type - Advantages & Disadvantages
There comes a time when there is an advantage for moving from an LLC taxed as a sole prop to an LLC taxed as an S Corp. There comes a time when you hit a sweet spot. If you do it too soon, you're paying too much tax. If you do it too late, you're paying too much tax. And that's all part of planning.
2. Add Your Kids to Payroll
Of course, there are some rules and rights to this. The kids have to work, like, really do some work as not just sit around and play video games. They really have to do some work in your business. And, their wages have to be normal wages. You can't pay your kid $100 to take out the trash, or things around the house. But, there's no age limit on it. So you may have a 10-year-old who's on payroll or a 15-year-old that's on payroll, and it's completely legit.
3. Home Office Deduction
Most of us are home now! We're working from home and have expenses involved that we typically didn't have before. So take advantage of the home office deduction.
With all that being said: please be proactive instead of reactive. Once your taxes are filed, once 11:59 happens this year on December 31st, you can't make any changes, it's done. The books are closed, they are finished.
If you’re ready to get proactive before your books start piling up, book a complimentary call with me today, or get empowered to DIY with the Calculated Tax Planner.
