In 1789 Benjamin Franklin wrote in a letter “…in this world nothing can be said to be certain, except death and taxes.” Almost 230-years later those words continue to hold true.
With half the year already behind us, the time for business owners to start thinking about effective ways to reduce taxes begins now. As a business owner, you have access to more options than individuals when it comes to tax planning.
And why shouldn’t you?
You create jobs, take risks, and are ultimately responsible for your own success or failure.
With proper planning, you can achieve significant tax savings. In fact, meeting with your CPA, tax attorney, or other advisors prior to year-end can result in a huge benefit for you and your business.
It is important to start the process sooner, rather than later. This will give you time to evaluate your options, understand them, and make a decision based on what’s most important to you. Since most strategies require establishing and funding a plan prior to your company’s year-end, time can become your biggest adversary.
Before we get into ways to reduce and defer income taxes it is important to realize one size does not fit all. Each business and its owner(s) are unique to themselves. And, while the strategies we review below are meant to provide you with a general understanding of the options available, they may not be suitable for your specific needs.
Traditional Retirement Plan Options
Qualified retirement plans are the most common way for business owners to reduce current income and defer tax liabilities. They allow for tax-deductible contributions, deferred taxes on the growth of the assets, and ordinary income tax on distributions during retirement.
There are a few types of qualified retirement plans for business owners to consider. Each with there own pros and cons. They include:
A SIMPLE IRA costs very little to setup and administer. SIMPLE stands for Savings Investment Match Plan for Employees. It must be established by an employer (which includes sole proprietors and partnerships).
A SIMPLE IRA requires the employer to match eligible employees contributions of at least 3% of the employee’s salary. However, the employer can reduce the matching amount to 1-percent two out of every five-year period.
Unlike most other employer-sponsored retirement plans, participants vest 100-percent of the employer matching contribution immediately.
Employees can contribute 100-percent of their income up to $12,500 (in 2018) or $15,500 if the employee is over age 50.
A SIMPLE IRA is best for business with a small employee base with an owner interested in starting a plan for themselves and their employees.
Like a SIMPLE IRA, SEP IRAs are less costly to establish than other plans, like a 401(k). SEP stands for Simplified Employee Pension.
A SEP IRA allows for a contribution of 25-percent of total compensation or $55,000 (in 2018), whichever is less. Contributions to a SEP IRA are made entirely by the employer. Employers must contribute the same percentage of salary to eligible employees as they do for themselves.
Eligible employees include employees 21 or older employed by you for three of the last five years earning $600 or more in the past year.
A SEP IRA is best for self-employed individuals or business without a lot of employees.
A 401(k) is an employer-sponsored retirement plan that allows employees to make pre-tax contributions for their retirement savings.
Participants can contribute up to $18,500 for individuals under age 50, and $24,500 for individuals age 50 and older. Participants can contribute 100-percent of their salary to a 401(k) plan.
Most commonly, employers will choose to match 100-percent of an employee’s contribution up to 6-percent of the employee’s salary. However, the employer is not required to match at all.
Any contributions made by an employer will often require the employee to “vest”. This requires the participating employee to work for the employer for a pre-determined number of years prior to being eligible to receive the matched portion of the contribution. Employers have a few different options when establishing an appropriate vesting schedule.
A 401(k) is generally most suitable for a business with 20 or more employees.
Profit Sharing Plan
A Profit Sharing Plan is a discretionary, employer-sponsored retirement plan. Contributions to a Profit Sharing Plan are made by the employer. The company can choose on annual basis to contribute to a Profit Sharing Plan.
While an employer is not required to fund a Profit Sharing Plan every year, there is a maximum amount they can contribute in the years they do decide to fund. The maximum contribution to a profit sharing plan is the lesser of 100-percent of compensation or $55,000 in 2018.
There are several methods for deciding how much each employee receives in the form of a contribution. Depending on the goals of the owner(s), an administrator can design a profit sharing plan that is most appropriate.
Like a 401(k), an employer can establish a vesting schedule to require employees to work a predetermined period of time in order to be eligible to receive contributions made by the employer.
A profit sharing plan can require a significant amount of administration. Working with a plan administrator who understands the ins-and-outs of administering a profit sharing plan can be a great benefit.
A profit sharing plan can be a great vehicle for businesses of any size.
Defined Benefit Plan
A defined benefit plan differs greatly from the other qualified plan retirement options. A SIMPLE IRA, SEP IRA, 401(k), and Profit Sharing Plan are defined contributions plan. A defined contribution plan tells you how much and what percentage of your income you can contribute to the chosen plan.
A defined benefit plan provides a guaranteed annual benefit when you retire. The amount received is based on various factors to include age, salary, and years worked. Benefits from a defined benefit plan are based on a formula that will provide for a specific dollar amount for each year you work or a percentage of earnings.
Depending on several factors a business owner can usually contribute much more ($100,000+) to a defined benefit plan than a profit-sharing plan. The most common factors include age and compensation.
Contributions to a defined benefit plan are made by the employer and are almost always tied to a vesting schedule.
A defined benefit plan is not a fit for all companies. Depending on the goal and objectives of the owner(s) it would be our recommendation to work with an administrator who can provide a proposed plan. From there, you can determine if a defined benefit plan makes sense for you and your organization.
Restricted Property Trust
A Restricted Property Trust is an employee benefit plan established by a business entity (S Corp, C Corp, LLC, or LLP). A Restricted Property Trust allows employers to make a fully-deductible contribution with tax-deferred growth and tax-advantaged distributions.
The plans main objective is to provide long-term, tax-favored accumulation and cash flow. What makes the Restricted Property Trust unique is the owner is not required to include or make any contributions for employees. In addition, contributions to an existing qualified retirement plan does not impact your ability to establish a Restricted Property Trust.
The downside of a Restricted Property Trust is the employer must be able to contribute a minimum of $50,000 per year for at least 5-years. However, for those interested in a Restricted Property Trust, contributions can be significantly higher, if desired.
A Restricted Property Trust is for business owners with income of $500,000 or more.
Captive Insurance Companies
A captive insurance company is a wholly owned subsidiary of a corporation. The captive insurance company is in a jurisdiction with captive laws. Allowing the captive insurance company to function as a licensed insurer.
The captive then insures the risks of the parent corporation and any subsidiaries it is going to underwrite. The captive analyzes risks, designs policies, and determines and accepts the premiums necessary to insure those risks.
The parent company and subsidiaries make tax-deductible premium payments to the captive insurance company. The captive then invests premium payments in order to payout any future claims.
Captive Insurance Companies can be very expensive to establish and maintain. For businesses with a large amount of risk interested in significant pre-tax contributions, a Captive Insurance Company can be an excellent choice.
As a business owner, you have several options to reduce your taxable income. These options range from smaller levels of contributions to contributions with the potential to exceed 7-figures.
What’s important to note, is most of these strategies have other factors that must be taken into consideration – from employees, salaries, risk, etc. It’s because of these factors you need to take steps NOW to reduce and defer your income taxes in 2018.
It starts by taking action. Only then will you put yourself in a position to take advantage of one or some of these plans prior to year-end.