Tax Strategy Basics For Your Business

Whenever you start your own business, it becomes very evident very quickly that taxes are incredibly stressful.

If we were playing family feud and asking entrepreneurs, “Name what is giving you the most heartburn on a daily basis,” and you ask them in April, taxes are for sure on that board somewhere. It’s a very high-level problem for countless entrepreneurs.

This time of year, as we wrap up the first quarter, I get numerous questions about tax strategy.

In this video, I’m going to outline some of the basic concepts of tax strategy.

This content is something you can speak with your CPA about and get specific guidance. This is not meant as guidance for you. (This is my “cover my butt” legal disclaimer starting off. Each situation is different, and rules and regulations are constantly changing.)

But the goal is to give you

1. A clear mental model so you understand more how taxes work in a business and where some of the leverage points are possibly.
2. Information so you can ask your CPA better questions and have the best results possible.

Understand Tax Basics To Manage Taxes

Let’s start with the basics of taxes.

I’m going to assume that you have an LLC like most business owners do, or even are a sole proprietor.

The way taxes work is that your total income minus your total expenses equals your profit.

Income – Expenses = Profit

Income is all the money that you were paid.

Expenses are all the money you had to pay out to run your business.

And profit is what’s left over.

In general, you are taxed on the profit.

From a high level, the more money you make, the more taxes you have to pay.

That’s not a bad thing! If you had to pay a lot of taxes, it meant that you made a lot of money in that same year! To some degree, those are latched together, and there’s no escaping that. Just accepting that reality is important because if you paid a lot of taxes, you made a lot of money, and that is okay and acceptable.

Reasonable Expectations

Before we move in too much further, though, the expectations part of this is very important. Oftentimes, as business owners, we are marketed to very heavily. We get ads like, “Pay $0 in taxes”. “I don’t care if you owe X amount; we’ll make it all go away.” There’s a lot of that stuff happening out there. Even this idea that “you should start a business because then you’ll pay less in taxes.”

All this marketing is meant to serve someone else’s purposes. But within that, there are plenty of half-truths and things that can be confusing. I want to just address that upfront, and I am addressing what is more of the “real”. There’s no magic wand here, but this will give you a clear mental model to work with.

The Elements Reviewed

Income – Expenses = Profit

Since taxes are based on Profit lets dive in a bit deeper to make sure each element is clear.

Income

We have the total income that you’re paid.

That’s everything everyone paid you.

Expenses

You have your expenses. That’s the money that went out that is actually tax deductible.

There are certain categories that are or are not tax deductible which can change based on the tax code year to year.

Profit

Then there is the profit.

A common rule of thumb for people just starting off—they don’t know what to do—is that self-employment tax tends to be around 20%.

Typically, whatever your profit is in an LLC, about 20% of that will be how much you’re taxed on, more or less depending on which deductions and expenses match or don’t match.

This is a very the basic overview, which is important before we move on to the next step.

Knowing that’s how taxes are calculated, what levers can you pull?

Strategic Expenses To Manage Taxes

The number one thing that people look at is strategic expenses.

If you think about the formula, income minus expenses equals profit, where can you be strategic?

Income, there’s not really much you can do around that. You got paid how much you got paid.

Expenses, though, you start to think

• What can I write off?
• How can I reduce my liability so my profit shows smaller?
• Where are the strategic expense opportunities here?

I’d say the number one misconception owners have is that they say, well, I owe the IRS $2,000. Can’t I just put $2,000 towards an IRA retirement fund? Now I owe the IRS $0. And that is not how it works, unfortunately.

For most expenses, you cannot write off the entirety of it and make it disappear.

With that IRA example, (again, this all depends. This is not tax advice directly), but it’s not uncommon that maybe 20% of that could be written off.

So that means that if you did put $2,000 in an IRA, you only get to write off about $400 of that. So you’d still owe the IRS $1,600. So you would spend $2,000 for the IRA and still owe $1,600 for the IRS, which means that your total taxable amount wouldn’t change much.

If you include your total taxes owed plus your IRA money, then $3,600 would be going out the door instead of the $2.00 required for taxes.

You wouldn’t actually have more money left over in the end. You WOULD pay less in taxes, but you had to have more cash to do that.

This is a great example of the whole situation with strategic expenses. You can’t “out expense” your tax liability.

Now, strategic expenses are great if you already have a surplus of money.

If you’re paying yourself everything you need to, you’re not stressed about money, and you say, “Well, I don’t really need this money just sitting in my savings account.” Then doing things like that IRA or writing off extra expenses can be very helpful, but it is not a tax strategy to avoid paying taxes.

It’s a good way to basically save money or get a discount on things you’re going to spend money on anyway.

This is where entrepreneurs do things like, buy cars in the company’s name, or have cell phones in the company’s name. They get a little bit creative with what their personal life and business are, and they determine how much audit risk they’d like to undertake within that with their CPA.

There is a little bit of a gray area, but you cannot basically outspend to owe less taxes. You’ll end up spending more and still paying taxes.

Don’t go buy useless things because you get to write them off and pay less taxes because now you will have paid for those things and still owe quite a bit in taxes!

I wanted to break this concept down because it tends to be one of the biggest misconceptions from owners.

Provable Income

The last important thing here is that you can get into a situation where you’re like the waitress who doesn’t declare tips.

Let’s say you work at a place, you’re a waiter or a waitress, you get your paycheck, and then you get your tips, and you under-declare those tips so you have to pay less taxes on them.

Well, that’s fine in the short term, but long-term, what happens is that you’d like to go buy a house, and now you have to have provable income, and that income shows up as less because you haven’t told the IRS you’ve made that money. Now you can’t get a loan.

As a business, this is the same thing.

If you’d like to get a loan on your business and you’ve been under-declaring your profitability or spiking expenses in a certain way, it can affect things.

The second part is that when you go to sell your business, if you’ve had some “shadow money” floating around, when you go to sell your business, a new owner won’t just take your word for it.

“Hey, he says he’s making this. He only declared this much to the IRS. I believe him. I will pay that premium price for the higher income amount he didn’t report to the IRS.”

They will typically only pay for what you did report to the IRS on the last three years or more of taxes. There’s not really a way to avoid and dodge this.

The income should be accurate, and for the expenses, you should be spending on what your business needs.

You can get a little bit creative for yourself, but you can’t outspend that as a tax strategy.

Strategic Structure To Manage Taxes

Number three, we’ll get onto the strategic structure.

Now this is the first lever where actually there’s something you can do in your business possibly.

LLC Tax Implications

Typically, a business starts off as an LLC, which is like a pass-through entity for taxes.

Basically, that means that the structure almost doesn’t matter. It’s like, you’re a sole proprietor. The money came to you. You had some expenses. You pay taxes on the total profit you made. (Income – Expenses = Profit)

You pay on that total profit you made, whether it stayed in your business account, or whether you paid yourself; however that worked, whatever that money was, you pay on that.

S-Corp Tax Implications

An S-corp is a way you can elect to have your LLC taxed, and that changes tax implications.

You should consider being an S-corp whenever you’re making around a hundred thousand dollars a year in profit.

When you get to about a hundred thousand dollars a year there, then it starts to make sense because there are extra fees, administrative work that have to be done to be an S-corp. When you’re smaller, those start to eat into what your tax savings would be costing you more to be an S-corp than you save.

When you get to 80, a hundred thousand dollars of profit, it starts to really become very beneficial.

Here is how an S-corp works in general.

There are a few rules.

Consistent and Reasonable Salary

One, you have to pay yourself a reasonable salary. And this is a specific terminology I’ll come back to in a bit.

But the idea is that in an S-corp now you are taxed only on the reasonable salary you pay yourself.

Dividends or Disbursements

In addition to your salary, you’re allowed to give yourself dividends or disbursements. These are not taxed.

An Example Explained

Let’s say your business is making a hundred thousand dollars of profit under just an LLC taxation.

That profit entirely would be taxed a hundred thousand, whether it stayed in the business bank account, or you took it out for yourself. It doesn’t matter.

You’d be taxed on that in its entirety.

Now, if instead you have an S-corp, you could pay yourself a reasonable salary.

Let’s say, for today’s example, that’s $50,000 for the year. So you would write yourself a W-2 paycheck, just like your employees. You’ll take out your taxes just like any employer would at the business level.

Now that you’ve paid yourself a reasonable salary, you can also pay yourself dividends or that disbursement.

Let’s say you want to keep $20,000 in the business as an emergency fund and want to pay yourself a disbursement of $30,000.

Technical Requirements For An S-Corp

This would typically be allowed. One of the rules is your disbursement must be less than your reasonable salary, which means you couldn’t pay yourself $1 and take $99,000 in disbursements. That would be abusing the system.

You have to actually pay yourself more in salary than you do in dividends.

The salary has to be reasonable. A reasonable salary is somewhat of a judgment term, but running your business is likely a job that should pay more than the minimum wage. Think about what you would need to pay a manager in the future to do your work or how much a similar job at another company may be paid.

As long as you’re following those rules, you’re well on your way to being a compliant S-corp. There are other areas too that your CPA can discuss with you as far as filing, but for an owner planning a strategy, these few points are some of the key elements.

Example Continued

Now that $30,000 in dividends could be considered essentially non-taxable. That saves you a lot of money on taxes. (Remember, in an LLC, you would have been taxed on the Profit no matter how you managed it.) Here you were taxed on the payroll salary you paid yourself, but the disbursement gets to bypass taxes. Taxes on $30,000 add up quickly!)

That’s the big benefit of an S-corp if you’re over that $100,000 or so level.

There are other areas too, but that’s one of the first big milestones where things get a lot easier for a business.

This can save you $5,000 – $10,000 or more pretty quickly.

Strategic Profitability To Manage Taxes

Moving on to the next area of tax strategy is strategic profitability. And this is where the real opportunity is.

When people ask me, “How can I have a better tax strategy?”

What they’re really asking is, “How can I have more money?”

That’s the real core of the question.

As we’ve discussed, once you know the basics.

Income – Expenses = Profit.

Taxes are based on Profit.

The more money you make, the more taxes you pay.

That means the more lean and the better efficient your company is, you’re going to pay a lot of taxes, but you made a lot of money, so that’s not so bad.

When you get to a certain level of profitability now, you can actually be an S-corp and save some money on taxes.

You can choose to be strategic with your expenses, but spending more means you have a less lean business. A lean business generates more profits and is generally a better answer and less complex.

The real core is, “How can I have a more profitable business to where I have enough oomph to get above that S-corp level and be making enough money I can set some aside for taxes and not be hurting too bad?”

That’s the real question.

This is where we talk about switching between the various hats you wear running a business.

This whole question about tax strategy is a CEO-type question.

• What is the vision of the company?
• Where am I headed?

This is where the CEO hat has to talk to the CFO hat and say, “What is the situation in this company right now?”

Managing The Profitability Of Your Business

There are a few things that you should do to manage the profitability of your business.

• Know your numbers
• Review your numbers monthly
• Use your numbers strategically.

Know Your Numbers

Number one is that you have to know your numbers.

I have helped people in the past who have done the shoebox yearly tax plan, where they put all their receipts in a shoebox. They may log into their CRM, point of sale system, or bank accounts to have more information; they give that to their accountant every year who does their taxes.

They find out how much they owe, they pay it, and they move on to the next year.

If you go from a system like that to tracking your expenses on an ongoing basis, using Wave or QuickBooks, whatever tool you’d like, doing bookkeeping where you’re matching each transaction, your life becomes drastically different!

Number one, you have to know your numbers.

Review Your Numbers Monthly

Number two, you have to look at your numbers on a monthly basis.

One of the biggest problems with the shoebox method is that you don’t know anything about the finances of your business besides your gut instinct and your gut feel until the end of the year, when you can look and be like, “Oh, I spent $3,000 on advertising.” “I could have spent more.” “Or I spent too much.”

You know nothing until the end of the year.

Having access to the numbers in a bookkeeping software allows you on a monthly basis to check in and make changes in month one as opposed to a whole year later.

You can fix things very, very quickly.

I have seen businesses go from that shoebox method to the bookkeeping method and be pretty close to double their profits in one year without major changes, just being aware of the small ways they were getting nickel and dimed and making minor mistakes.

Use Your Numbers Strategically

Element one is know your numbers, two is know your numbers on a monthly basis.

Three is to use these numbers strategically.

Look at your numbers with a critical and discerning mindset. Thinking about what they mean

Do I need to raise my prices?

Is it time to cut expenses and start to shop for some other opportunities for my vendors?

Are there areas that I have an offer that’s not making me as much money as I thought that it was where I should focus on a different offer as my primary selling opportunity?

There are a few areas like that where you can really focus your energy and make fantastic progress very, very quickly.

Manage Your Profit Margin Per Job

Is my marketing ROI actually worth it?

A lot of people spend money on marketing, but they don’t know their numbers well enough to know what their profit margin per job is and to realize that actually with that marketing expense attached, all of these jobs are losing money and spending zero on marketing and missing on these jobs would be a problem, but it actually helped profitability.

There are levers you can figure out within that system to help you run a more profitable business, leaving more money for you. So that tax is less of a pain.

These are the essential ideas around profitability.

You have to know your numbers. You have to track them on a monthly basis. You have to use them to make your strategic decisions, putting on your CEO hat.

Basically, running a great, profitable business reduces the pain of paying taxes.

We’ve elaborated on the basics of how taxes are calculated, strategic expenses, strategic structure, and profitability.

Tax Strategy To Manage Taxes

Now, the final thing is just the tax strategy overall.

At the end of the year, when you do file your taxes, it is very essential that you actually ask your CPA questions.

Ask Your CPA Questions To Help Them Help You

One of the biggest misconceptions entrepreneurs have is that when they hire a CPA or a bookkeeper, that that person is critically thinking about the entrepreneur’s business. And that is almost never the case.

What I mean by that is that the CPA’s job is to make sure that the form that the IRS needs to file taxes has the correct information in the right box.

So how much was advertising? Take it from over here off the client’s info sheet and add it to this box to file with the IRS.

The CPA’s goal is to keep all the things checked and balanced.

Their number one goal to submit an accurate tax return.

It is NOT to say for your business, you should have been doing more profit or your expenses should be a lesser ratio versus that.

They are not thinking that way.

So many entrepreneurs just think, well, the CPA didn’t say anything so it’s probably okay.

Just like going to the doctor. He didn’t say that I’m sick. And so it’s all probably fine. Nothing I have to do.

That is very rarely the case. Their job is to submit the taxes, making sure that they’re not stepping over any legal liability areas. And that’s it.

It’s not an overall actual analysis of the financial health of your business. Same with bookkeepers, people matching your transactions to categories that you might have throughout the year.

They are very rarely actually using a critical eye to tell you when things are out of alignment with what they would assume and they would expect to see.

That is why that previous step of that strategic profitability and being involved is so important.

If you don’t feel like you have those skills, I can’t recommend enough how important it is to add those skills to your toolbox so that you personally have the ability to manage the profitability of your business, to manage the numbers. (Reach out if you need help developing these financial skills.)

Most businesses, once you have those skills, this is like an hour or two hours a month.

Doing this strategic oversight versus not is an ability to earn five, 10 X the amount of money with, again, just an hour or two extra time a week so that you’re efficient in your money making potential for all the work that you do.

Asking your CPA questions is very essential to better understand the impact of your business decisions. Anything you ask them they can probably answer, but if you don’t ask they are unlikely to have an opinion that they volunteer.

Set Aside Money For Taxes

Number two is actually setting aside money for your taxes.

When I have a first meeting with brand new entrepreneurs, I always suggest they create a separate tax account and they deposit that throughout the year. There’s a whole system set up to make that very, very easy.

I help people set that up, but setting aside that money throughout the year allows it to become not a problem for you. And it’s earmarked specifically for taxes, not part of your general overall bank account where you might spend it on other expenses and not think, oh yeah, this is actually Uncle Sam’s money.

Conclusion

I hope this broad overview helps.

The idea was that taxes are figured based on the profitability of your company.

The more money you made, the more taxes you pay.

It is hard to try to “out expense” your taxes.

That strategic profitability is really the key of how to manage the profits in your business.

And then using your tax strategy to ask questions of your CPA and say, if I did this instead of that, how would this affect my taxes in the coming year?

Those are the key opportunities.

The More Money You Have The Easier It Gets

And the last thing I’ll leave you with is that there is nothing more expensive than being broke.

When you have a lot of money, it’s easy to get more money.

When you don’t have much money, it’s very, very hard.

Taxes is definitely that way. When you get to a spot where you are at the S-Corp level, you save money in taxes.

When you get to a spot where you can pay yourself more salary than you actually need, now you can actually invest money and get an IRA retirement fund. And you’re basically buying that on sale at a discount via reduced taxes. It doesn’t equally offset your taxes, but it makes it cheaper to buy into that IRA. In the future, when you do retire, you saved tax money on your money invested into that.

Your business becomes more valuable when it is time to sell.

This is a theme overall, and trying to use tax strategy as a way to avoid or duck this so you have more money doesn’t typically work as well as focusing on profitability and growth and just “taking your medicine” as far as taxes go. They aren’t fun. But getting up that ladder tends to be the best way to move forward.

I hope this has been helpful for you building a better mental model.

May this year be your best year.

Have a wonderful rest of your day.