Everything About The Comprehensive Guide to Planning Tax Efficiency

Planning Tax Efficiency

Why is it important that taxes be efficient? An efficient tax system minimizes the cost of complying with the tax code so organizations can pay the least amount required by law. When organizations choose an approach with a lower tax outcome, they are being tax efficient.  Tax efficiency can also extend to tax timing, to better align expenses and revenue.

Tax Efficiency For:

Read on to learn more about tax efficiency strategies for each of these categories. 

Independent Contractors/Self Employed

There are specific strategies for tax efficiency that independent contractors and self-employed people should know. By carefully balancing investments and income, entrepreneurs can effectively plan their Schedule C expenses.

 Corporations

Corporate taxation is perhaps more complex than taxes for self-employed people or independent contractors, but tax efficiency is entirely possible for large organizations. In fact, large corporations often have more strategies to use, with corporate tax credits, tax-efficient investing, and similar systems. 

Small Businesses

Small businesses need tax efficiency to remain profitable and keep cash flow going. If small businesses pay too much in taxes, they may not have the cashflow to make these payments.  Alternatively, if they pay too little in a given year, they may find that they have fewer expenses the following year, creating a cashflow issue down the road.

Independent Contractors/Self Employed

Tax Efficient Mutual Fund

A tax-efficient mutual fund will reduce tax liability, ensuring a tax-efficient system. To reduce the tax liability of a mutual fund, individuals must purchase tax-free or low-tax investments. The fund’s turnover should remain low, and individuals should avoid or limit income-generating assets as these create a tax liability. 

Deferring Income as an Individual

Individuals can defer their personal federal income tax bills, allowing for more cashflow in the present and potentially allowing for lower future tax rates. If an individual defers income and then tax rates are lower in coming years, the deferred amounts will be taxed at those lower rates. Many people defer income by pre-paying certain qualified expenses in December versus January or using tax-deferred accounts.

Reduce Taxable Income

One of several ways to reduce taxable income is to increase business expenses. This reduces net income and thus reduces self-employment tax. If you qualify, another option is to use the Section 179 deduction, which deducts the cost of some fixed assets used for business. 

Deferring Income Self-Employed

The CARES Act is an option for self-employed tax deferral. Presently, self-employed individuals can defer the payment of 50 percent of their Social Security tax on net earnings from self-employment income. This is for the period beginning March 27, 2020 and ending December 31, 2020. There are strict repayment dates. If individuals do not pay their deferred taxes at that time, they will face a penalty.

Tax Efficient Mutual Fund

Individuals can always develop a tax efficiency plan by carefully choosing their investments. Generally, it is wise to keep tax-efficient investments in taxable accounts, with tax-inefficient investments in deferred or exempt accounts. Investments that trigger fewer capital gains are preferable, as are tax-efficient bonds like municipal bonds, treasury bonds, and Series I bonds. 

Corporations

Accelerating Expenses to Lower Tax Liability

Individuals can always develop a tax efficiency plan by carefully choosing their investments. Generally, it is wise to keep tax-efficient investments in taxable accounts, with tax-inefficient investments in deferred or exempt accounts. Investments that trigger fewer capital gains are preferable, as are tax-efficient bonds like municipal bonds, treasury bonds, and Series I bonds. 

Accelerating or Deferring Income/Deductions

Accelerating or deferring corporate income can also be a useful tax efficiency planning strategy. Tactics like making deferred payments a part of business transactions can postpone income and taxes into a further tax year. Conversely, accelerating income can be useful during a year with a low tax rate or to avoid moving into a higher tax bracket the next year.

Tax Credits (R&D, Covid Relief/Cares Act)

Corporations can and should take advantage of credits that improve tax efficiency. Research and development tax incentives have been a long-standing option to finance R&D efficiently. More recently, COVID relief tax credits, such as the CARES Act, help employers reach efficiency with credits in areas like payroll tax. 

Cash vs. Accrual Tax Reporting

Corporations can and should take advantage of credits that improve tax efficiency. Research and development tax incentives have been a long-standing option to finance R&D efficiently. More recently, COVID relief tax credits, such as the CARES Act, help employers reach efficiency with credits in areas like payroll tax. 

Cash pros/cons

Using the cash accounting method is potentially simpler yet less adaptable. In this method, trans-actions are recorded when money changes hands. Income is recorded when the money is re-ceived. Expenses are recorded when they are paid. This allows certain expenses to be recorded in advance of revenue received, which can reduce the tax bill in the given year (but delay taxes until the following year).

Cash accounting is less adaptable because it does not show the full picture of business activity. The time frame in which money is received is often disconnected from the performance time frame. There is potential to defer tax liability by postponing revenue recognition and accelerating expense payments at the end of the year.

Accrual pros/cons

Accrual accounting brings increased complexity, but the method is more adaptable. Income is recorded when companies earn payment and send a bill. An expense is recorded when a bill is received. This is a more complicated method but it indicates monthly business activity clearly. However, it can force a business to defer certain prepaid expenses and pay more taxes in the current year.

Small Businesses

End of Year Tax Tips

Small businesses should consider well before the year end to decide if income deferral is wise before the calendar rolls over, depending on income levels. It is also a good idea consider deductions and if there are supplies or equipment to be purchased before the year end. It is also an excellent time to pay into funds like a retirement plan, or contribute to charity, to reduce income. 

Minimize Tax Liability

There are many ways small businesses can minimize tax liability, including starting a retirement plan, adopting a different business structure, and deferring income and accelerating reductions. Small businesses also minimize liability by adding to employee benefits or giving raises or bonus-es within the existing year.

To properly enact these strategies or other tax efficiency methods, it is important to stay up to date with current tax law and/or seek help from a tax professional.

Pros/Cons of Sole Proprietor, LLC, S-Corp, and C-Corp

The structure of a small business impacts tax efficiency and planning. Often, small companies are set up as a sole proprietorship or LLC but would see benefits from a C corporation structure. Under a C corporation structure, the first $50,000 of income is taxed at a lower rate. Companies looking at restructuring to a C-corp should be aware of double taxation, in which shareholders pay taxes on dividends after the corporation has already paid taxes.

Additionally, S-Corps may see potential tax savings as individual shareholders report earnings on their individual tax returns.

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