How to Truly Save Taxes

Tax
November 15, 20226 min read

It's almost Thanksgiving, and like the Pilgrims of 1621, entrepreneurs will soon be enjoying pumpkin pie and talking about year end tax planning.

Okay, maybe it's a stretch to say the Pilgrims discussed tax planning over Thanksgiving dinner. Perhaps taxation didn't become a hot topic until 150 years later when neighboring Bostonians tossed tea in the harbor. Incidentally, that tax rebellion happened a few weeks after Thanksgiving (had it been a holiday) in 1773.

Depending on which history book you read, we're 401 years past the first Thanksgiving and 249 years past the original Tea Party. Americans (at least some) still dread taxes like the dentist. For profitable companies, Thanksgiving and tax planning unfold together every year with the reliability of the fall equinox.

Quick pro tip: If you identify with your rebellious early countrymen and are looking for a way to overcome those feelings (without destroying private property), consider a Thanksgiving approach to taxation. Each time feelings of tax disdain surge up, replace them with feelings of gratefulness for 1) your country, and 2) the money you're making.

Didn't come to this article for a pro tip like that? Fair enough. Let's move to Plan B.

How to Truly Save Taxes

First, let me shout something out: YOU DON'T SAVE MONEY BY BUYING THINGS!

Let's say your company is sitting at $50,000 in tax profit right now. You're looking at two options:

  1. Buy a forklift for $50,000 to reduce your taxable income (and ultimately your cash!) to $0.

  2. Pay $20,000 in tax on the $50,000, but pocket the remaining $30,000.

The knee-jerk reaction of most entrepreneurs is to go with Point 1, even if they don't really need a forklift. Point 1 is clearly a tax reduction strategy, but not an overall money-saving strategy. Plus, in the case of something like a forklift that holds its value, the income tax is often merely delayed until a future year when the forklift is sold.

This point applies to purchases of things you don't really need. If you need a forklift, that is simply an expense like office supplies. Do not think of the forklift as a tax deduction to reduce $50,000 of profits. Think of it as a true expense, and the remaining $0 profit as the true profit of your company.

Forklift

Image by Pickawood on Unsplash

If your company earns a true profit of $1 million over its 10-year life, you will pay income tax on that million. If that number doesn't include two $50,000 forklifts you consumed along the way, then the business didn't earn $1,000,000. It only earned $900,000, and you will pay tax on that amount.

Short of engaging in felony tax avoidance, that's just how it works. You can shift profit between years, but in the end you still have $1,000,000 of total taxable income.

How then do you save taxes?

Let me demonstrate true tax savings with two examples. Both examples are identical companies that earn $1 million over 10 years. Don't spend time on the details; just look at the circled numbers.

Company A Swings Between High Tax Profit and $0 Tax Profit

Company B Maintains Steady Tax Profit

There are really only two things that matter on these charts:

Point 1. The companies earned the same amount of overall profit, but one paid $335,000 in taxes over 10 years and the other paid $300,000. They both purchased the same amount of equipment and earned the same income.

Point 2. The reason for the $35,000 tax difference is that Company A drove tax profit to $0 some years. The first dollars of business profit are taxed as low as 0%, but Company A wasted those low tax brackets by having $0 income. In later years, the profit swung back and was taxed at higher than average rates.

Company B, on the other hand, carefully used up the low tax brackets each year and maintained a consistent optimal tax rate across all years. They had no years where they wasted the 0% brackets, and no years where they paid tax at 40%.

Company B achieved $35,000 in true lifetime tax savings by:

  1. Understanding the optimal average profit level for their company.

  2. Doing their best to maintain that level each year.

This simple exercise of intentionally paying a reasonable level of tax each year is one of the most under-rated (and most effective) strategies in the country. It's not popular because, like their Boston forefathers, many small business owners cannot wrap their minds around paying tax when it could be wiped out to $0.

How to Do This

Maybe you're wondering: How could a person smooth out taxable income to make it look like Company B's example?

Obviously it's not possible to have a picture-perfect chart like Company B. However, with well-intentioned year end tax planning, it is possible to get fairly close.

Here are a few tricks thoughtful entrepreneurs use to create an optimal income level:

  1. Keep up-to-date books. You have to know your current taxable income to be able to manage it.

  2. Pay down payables to decrease income or delay payments to increase income. This point assumes the company is on the cash basis for tax purposes. The reverse point can apply to collecting receivables, but it is easier to control money going out (payables) than money coming in (receivables).

  3. Speed up or delay placing new assets in service. Most business owners don't know this, but an asset is only deductible for tax purposes when it is placed in service. You can buy a tractor in December but not "place it in service" until January. Conversely, you can place a new pickup in service on December 31, 2022 but not pay for it until 2024. The only event that matters for the tax deduction is when you starting using the asset.

  4. Strategically pay employee bonuses. Pay discretionary bonuses in December or January depending on which creates the optimal income level.

Those are just a few examples. The main goal is to create enough taxable income to use up the low tax brackets, yet not surge into the highest brackets (unless your company is consistently in the highest brackets).

This consideration is especially relevant for these unique post-COVID times. Many companies did very well in 2022, and might need to shave off taxable income that is in the high brackets. Others got hit hard with various issues and weren't profitable. In that case, it's a good year to make sure you have at least some taxable income to use up the low brackets.

Either way, a little strategic planning along with your pumpkin pie can go a long way to truly reducing your long-term tax bill.

Scott Hoover

Back to Blog

Be Your Own

How to Truly Save Taxes

Tax
November 15, 20226 min read

It's almost Thanksgiving, and like the Pilgrims of 1621, entrepreneurs will soon be enjoying pumpkin pie and talking about year end tax planning.

Okay, maybe it's a stretch to say the Pilgrims discussed tax planning over Thanksgiving dinner. Perhaps taxation didn't become a hot topic until 150 years later when neighboring Bostonians tossed tea in the harbor. Incidentally, that tax rebellion happened a few weeks after Thanksgiving (had it been a holiday) in 1773.

Depending on which history book you read, we're 401 years past the first Thanksgiving and 249 years past the original Tea Party. Americans (at least some) still dread taxes like the dentist. For profitable companies, Thanksgiving and tax planning unfold together every year with the reliability of the fall equinox.

Quick pro tip: If you identify with your rebellious early countrymen and are looking for a way to overcome those feelings (without destroying private property), consider a Thanksgiving approach to taxation. Each time feelings of tax disdain surge up, replace them with feelings of gratefulness for 1) your country, and 2) the money you're making.

Didn't come to this article for a pro tip like that? Fair enough. Let's move to Plan B.

How to Truly Save Taxes

First, let me shout something out: YOU DON'T SAVE MONEY BY BUYING THINGS!

Let's say your company is sitting at $50,000 in tax profit right now. You're looking at two options:

  1. Buy a forklift for $50,000 to reduce your taxable income (and ultimately your cash!) to $0.

  2. Pay $20,000 in tax on the $50,000, but pocket the remaining $30,000.

The knee-jerk reaction of most entrepreneurs is to go with Point 1, even if they don't really need a forklift. Point 1 is clearly a tax reduction strategy, but not an overall money-saving strategy. Plus, in the case of something like a forklift that holds its value, the income tax is often merely delayed until a future year when the forklift is sold.

This point applies to purchases of things you don't really need. If you need a forklift, that is simply an expense like office supplies. Do not think of the forklift as a tax deduction to reduce $50,000 of profits. Think of it as a true expense, and the remaining $0 profit as the true profit of your company.

Forklift

Image by Pickawood on Unsplash

If your company earns a true profit of $1 million over its 10-year life, you will pay income tax on that million. If that number doesn't include two $50,000 forklifts you consumed along the way, then the business didn't earn $1,000,000. It only earned $900,000, and you will pay tax on that amount.

Short of engaging in felony tax avoidance, that's just how it works. You can shift profit between years, but in the end you still have $1,000,000 of total taxable income.

How then do you save taxes?

Let me demonstrate true tax savings with two examples. Both examples are identical companies that earn $1 million over 10 years. Don't spend time on the details; just look at the circled numbers.

Company A Swings Between High Tax Profit and $0 Tax Profit

Company B Maintains Steady Tax Profit

There are really only two things that matter on these charts:

Point 1. The companies earned the same amount of overall profit, but one paid $335,000 in taxes over 10 years and the other paid $300,000. They both purchased the same amount of equipment and earned the same income.

Point 2. The reason for the $35,000 tax difference is that Company A drove tax profit to $0 some years. The first dollars of business profit are taxed as low as 0%, but Company A wasted those low tax brackets by having $0 income. In later years, the profit swung back and was taxed at higher than average rates.

Company B, on the other hand, carefully used up the low tax brackets each year and maintained a consistent optimal tax rate across all years. They had no years where they wasted the 0% brackets, and no years where they paid tax at 40%.

Company B achieved $35,000 in true lifetime tax savings by:

  1. Understanding the optimal average profit level for their company.

  2. Doing their best to maintain that level each year.

This simple exercise of intentionally paying a reasonable level of tax each year is one of the most under-rated (and most effective) strategies in the country. It's not popular because, like their Boston forefathers, many small business owners cannot wrap their minds around paying tax when it could be wiped out to $0.

How to Do This

Maybe you're wondering: How could a person smooth out taxable income to make it look like Company B's example?

Obviously it's not possible to have a picture-perfect chart like Company B. However, with well-intentioned year end tax planning, it is possible to get fairly close.

Here are a few tricks thoughtful entrepreneurs use to create an optimal income level:

  1. Keep up-to-date books. You have to know your current taxable income to be able to manage it.

  2. Pay down payables to decrease income or delay payments to increase income. This point assumes the company is on the cash basis for tax purposes. The reverse point can apply to collecting receivables, but it is easier to control money going out (payables) than money coming in (receivables).

  3. Speed up or delay placing new assets in service. Most business owners don't know this, but an asset is only deductible for tax purposes when it is placed in service. You can buy a tractor in December but not "place it in service" until January. Conversely, you can place a new pickup in service on December 31, 2022 but not pay for it until 2024. The only event that matters for the tax deduction is when you starting using the asset.

  4. Strategically pay employee bonuses. Pay discretionary bonuses in December or January depending on which creates the optimal income level.

Those are just a few examples. The main goal is to create enough taxable income to use up the low tax brackets, yet not surge into the highest brackets (unless your company is consistently in the highest brackets).

This consideration is especially relevant for these unique post-COVID times. Many companies did very well in 2022, and might need to shave off taxable income that is in the high brackets. Others got hit hard with various issues and weren't profitable. In that case, it's a good year to make sure you have at least some taxable income to use up the low brackets.

Either way, a little strategic planning along with your pumpkin pie can go a long way to truly reducing your long-term tax bill.

Scott Hoover

Back to Blog

Scott Hoover, CPA

About The Author:

Scott lives in Wisconsin with his wife Priscilla and their active family of eight children. 

He has worked as a CPA and part-time CFO for over a decade, and draws on this experience to provide practical, down-to-earth guidance to his clients.

In addition to his CPA day job, he and his family have a small farm where they raise calves and produce.  In his "spare" time, Scott enjoys writing articles on finance and faith.

Send any comments or feedback directly to scott@beyourowncfo.com.

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