In our lifetime, taxes will be the #1 expense that eats away at our income over time. With the US Treasury & CBO projecting that the future federal deficit will far exceed the GDP, it’s critical that you think about near and long-term tax planning as part of your overall wealth strategy, especially for high income earners. If you live in a high-income tax state (e.g., NY), your 2023 tax when you include federal, state and city, it could be greater than 50%! While I am not a CPA, the most valuable lessons I learned to legally reduce my taxes as a high-income earner and small business owner is to think strategically about the following variables that influences your tax obligation and how you can apply these tactics to your current situation:
- Type of revenue (e.g., ordinary income, portfolio income/capital gains and passive income)
- Deductible expenses
- Tax credits
- Tax advantaged retirement accounts
- Debt
As Robert Kiyosaki, renowned financial guru and author of Rich Dad Poor Dad said, the US tax system is all about incentives and the type of behavior our government wants us to apply to our daily financial lives. For 2022 taxes, the official date when taxes are due is April 18, 2023, so get ahead start in optimizing your tax filings!
***DISCLAIMER: Before reading below, please note that the following information is NOT tax advice and should be interpreted as strictly educational to be discussed with your own CPA.
Below, please find the 10 most valuable lessons I learned to optimize my taxes allowing me and my wife to retain more of our earnings:
1. Start a business and deduct all appropriate expenses
Most wealthy individuals initially start a business or side gig not only to increase their income, but also to deduct appropriate expenses used for their business. Instead of spending your own money out of pocket, business owners deduct these expenses when they file taxes so long as there is appropriate documentation. Depending on the type of business, these deductible expenses can be significant! For example, if you own a restaurant business, you can deduct your grocery expenses. If you are a services business, you can deduct all expenses relating to the delivery of that service (e.g., rent, internet, office supplies, furniture, travel, etc.). This is likely the number one strategy that business owners and entrepreneurs utilize to substantially lower their taxable business income by maximizing their appropriate expenses as business expenses. Make sure you are maximizing your appropriate expenses with the proper documentation!
2. If you are a business owner, delay revenue and pre-pay expenses at year-end
One of the easiest business strategies that is often overlooked is trying to delay revenue and pre-pay expenses at the end of each calendar year if you are using the cash accounting method (e.g., revenue reporting based on cash received in the bank). Often times, we would intentionally wait to cash checks from A/R until the 1st week of January so that the revenue would be recognized in the subsequent year vs. the existing calendar year. Secondly, we would pre-pay any expenses in December that we knew were fixed expenses that we would have had to pay out in Q1 of the following year anyway (e.g., employee bonuses, vendor services), which created additional deductible expenses. These deductions reduced our taxable business income and if you typically have a large Q4 in terms of revenue, the tax savings from this strategy can be material.
3. If you are a business owner, add your spouse or children to payroll
Many savvy business owners employ their spouse and family members by adding them to the payroll because they are able to 1) increase their post-tax retained income due to having more deductions and variable tax brackets for each individual, 2) contribute more to pre-tax retirement accounts for each individual and 3) lower the overall tax burden at both the individual and business level due to payroll expenses.
Let’s discuss an illustrative example for a business owner in NY that makes $1M in annual gross income and compare both the retirement contributions and after-tax income for the scenario of adding spouses and family members to payroll vs. taking the entire $1M salary through one individual.
Please note that in the example above, the source inputs and assumptions for the tax rates were applied from the [1] IRS website, [2] KFF report, [3] IRS 2023 tax brackets, [4] NYS 2023 tax brackets and [5] SS & Medicare websites. In the above example, the difference in pre-tax 401K contribution is $67,500 and the difference in post-tax income is $75,524, which is a total of $143,024 in value! Keep in mind that the savings may be greater depending on how you allocate the salaries across the primary, spouse and child 1 and child 2. The trick is optimizing the salaries based on the tax rates. It’s no wonder this is a no-brainer and how it pays to have your kids on payroll!
4. If you are a business owner, consider a S-Corp to reduce your self-employment tax
Most new entrepreneurs incorporate as an LLC (limited liability corporation) partnership. However, LLCs are subject to the full self-employment tax of 15.3%. On the other hand, S-Corp entities pay the self-employment tax only on the portion of their business income that is processed via payroll. Therefore, in order to reduce the tax burden, business owners may split their total annual compensation between payroll income and end-of-year distributions with only the payroll income portion subject to the self-employment tax. Hypothetically, if a business owner were to make $1M in total annual compensation as an S-Corp, they could elect to take a $300K base salary and a $700K end of year distribution. In this manner, the 15.3% self-employment tax would only apply to the $300K rather than the full $1M if earned via a LLC. The important consideration here is that the payroll income needs to be a defendable compensation amount, likely based on local salary benchmarking for comparable roles. For LLCs, all income no matter how it’s distributed (payroll vs. distributions) would be subject to the self-employment tax. Consult your CPA on whether converting from an LLC to an S-Corp may generate self-employment tax savings for you.
5. If you are a business owner, use debt to help expand and deduct the interest
Instead of using net income and cash to grow their business, savvy business owners may use their business credit line to accelerate their growth where the funds may be used for hiring additional staff, securing additional office space, as well as other business development costs to drive growth. By using the business credit line, businesses are able to write off the interest expense as a deductible expense against their taxable income while growing their business simultaneously.
A key driver of using this debt of course will be the interest rate of the loan. If you can attain a low interest rate credit line and favorable repayment terms where the capital can be deployed to immediately generate business returns, then this is a strategy that may be worth considering. However, it’s important NOT to only use debt to get an interest expense but that the capital goes directly towards areas that immediately help grow the business.
6. If you are a business owner, do research and qualify for any business tax credits
Another under-utilized resource are tax credits that are offered by either the Federal or local state government. As a prior Life Sciences software development firm, we were able to qualify for R&D credits because we were continuously dedicating resources to creating custom software and developing intellectual property in new applications both internally and for our external clients. This led to significant tax credits which was able to reduce our taxes anywhere from 10-20% for a given year. There are specialized tax legal firms that help you calculate and apply for the R&D credits alongside your CPA.
7. Own real estate to take advantage of depreciation and qualify for real estate professional status (REP) to apply depreciation to offset your active income
One strategy that wealthy couples employ for those that are jointly filing their tax returns is having their business buy real estate so that they take advantage of depreciation to lower their taxable ordinary income from their business. This strategy is valuable for high ordinary income earners and only feasible when one spouse is designated as a real estate professional (e.g., either being a licensed real estate broker OR documenting that they spend greater than 750 hours per year on real estate) so that the depreciation can offset their ordinary business income.
One real world scenario can be that the husband runs the business that buys the real estate and then, the wife runs a real estate management company that manages the property or properties. The wife in this scenario would have the designated real estate professional status allowing the depreciation to offset the ordinary income. Given that the wife would need to be able to demonstrate 750 hours per year dedicated to real estate, most couples that employ this strategy would likely own multiple properties; otherwise, they could be subject to an audit by the IRS challenging the REP status. If the REP status is not obtained, then the depreciation can only be applied to passive rental income and cannot be used to offset other ordinary income.
8. Conduct year-end tax-loss harvesting to offset capital gains
As you approach the end of the year, if there are losses that you can taken to rebalance your investment portfolio, this would be a good time to take them so that you can offset your capital gains with capital losses to minimize your tax burden. However, it’s important that you run an analysis with your CPA and financial advisor based on your capital gains to understand the impact of tax-loss harvesting in terms of how much you could save in taxes. The “harvested” capital losses essentially means that you realize an unrealized capital loss and apply it to your capital gains revenue. It works by reducing your taxable capital gains income dollar-for-dollar, thereby, lowering your taxes.
In some cases, it may not be worthwhile to recognize this loss just for the sake of paying less in taxes. It’s important to consult your CPA and financial advisor that applies to your own financial situation.
9. Consider moving to a lower tax state and own real estate as a business asset
Beyond trying to reduce the federal tax burden, most wealthy individuals own multiple homes and offices in states that have a low income tax rates so that they can further reduce their local tax burden. This is the reason why many renowned Hedge Funds (e.g., Citadel, ARKK) and PE firms (e.g., Blackstone) that previously were in NY moved their offices to Florida so that they are subject to no state income tax. Business owners also open multiple satellite offices for different divisions of their business based on their client and revenue mix to strategically have offices in different geographic locations. For example, business departments that have a large client presence in the West Coast may have a strategic office in Nevada or Wyoming or Washington. The business may also have a satellite office in Florida to service clients on the East Coast.
Additionally, when businesses move to favorable no income tax states, they may look to purchase their commercial real estate so that they can benefit from depreciation and lower their taxable income as well at the federal level (discussed in #7 above)
10. Fund tax-advantaged retirement accounts (e.g., Roth IRA, HSA, 401K, 529 plans)
Finally, wealthy individuals typically fund multiple tax-advantaged retirement accounts. They try to maximize all eligible pre-tax and tax-advantaged accounts to lower their taxable income which can span: Roth IRAs, HSAs, 529 plans, defined benefit cash pension plans, etc. Each of these retirement investment accounts can either directly lower their taxable income as a pre-tax deduction OR be a tax-exempt investment vehicle so that any gains or income generated during the lifetime of the investment is free from tax, which can become extremely valuable in the future when tax rates are likely to be higher in the future given the current US debt levels-to-GDP!
Hopefully, this post was helpful and you can see that those that own businesses have significantly more flexibility when it comes to tax optimization options. If you have further questions to see if these strategies can be applied to you, please consult your CPA and financial advisors. Thanks!
If you like our content above and want to be notified of our latest posts as well as additional content on personal finance, investing for beginners and smart money, please subscribe to our email list here or follow us on Twitter @stretchmypenny!