February Topic: Tax Planning

Feb 1
4 min read

Tax planning helps business owners understand how their structure and compensation affect how much of the pie goes to taxes.

Disclaimer: The information provided in this document/website does not, and is not intended to, constitute legal or tax advice; instead, all information is for general informational purposes only. Information in this document/website may not constitute the most up-to-date tax or legal information. Readers should contact their attorney or tax professional to obtain advice with respect to any particular tax matter.

Overview

Tax planning is an important part of managing the business. Often it can feel that taxes are a

once-a-year obligation, but knowing the rules and managing the company within their

framework can make year-end tax filings easier, more accurate, and more efficient. This

summary paper highlights some areas of business structure and management to evaluate while

running the business. In addition to structure, it is important to make timely estimated payments to avoid cash flow surprises, penalties, and interest.

Business Structure

Tax payments depend on the business type: sole proprietorship, partnership, Limited Liability

Company (LLC), S Corporation, or C Corporation. In the above examples, there are two types of

taxation structures: (1) pass-through and (2) non-pass-through.

Pass-through entities pay no federal income tax at the company level. Instead, all taxable income from the company passes through to the owners who pay taxes on behalf of the company. Passthrough structures include partnerships, S Corporations, and LLCs.
Non-pass-through entities are taxed at the corporate level. Therefore, the company is obligated to pay taxes on taxable income that the company generates. Retained earnings can then be reinvested after tax. However, if the company distributes earnings to its
shareholders, the shareholders will pay a second level of tax at the shareholder level. This is the case with a C Corporation.

It is important to highlight that both LLCs and Corporations have nuances with taxation

implications. A particularly important nuance is that an LLC can be taxed as a partnership, as

an S Corporation, or as a C Corporation.

If the LLC is taxed as a partnership, the owner’s compensation will be in the form of draws or guaranteed payments.
If the LLC is taxed as an S Corporation, the owners can be put on the payroll and will receive compensation as a W2. This has two main implications: (1) payroll taxes and (2) distributions. (Please see following section on Owner Compensation).

Corporations all start as C Corporations but can elect to become S corporations as long as the

election is made within the first three months of the fiscal year. Note: it is generally understood

that Corporations and LLCs provide similar levels of legal protection; we strongly recommend

that you check with your legal counsel for advice on this topic.

Owner Compensation

When owners receive compensation it can come in three forms: (1) draws/guaranteed payments,

(2) W2 compensation, and (3) dividends/distributions.

A draw or guarantee payment is a common form of LLC owner compensation. Compensation in this form is not taxed at the company level. Instead, the owner of the company will make estimated tax payments for this income as well as for their share of overall company taxable income. Estimated tax payments must be made to cover federal income taxes, state income taxes, and payroll taxes.
W2 compensation has federal, state, and payroll taxes withheld from the paycheck; therefore, estimated taxes do not need to be made for W2 compensation.
Dividends and distributions are paid to shareholders out of C Corporations and S Corporations. These are taxed based upon the tax bracket and tax basis of the company and shareholders.

Note: we strongly recommend that you check with your accountant when evaluating the most

appropriate structure for owner compensation.

Cash vs. Accrual Reporting

Often a company records income on an accrual basis but reports income on a cash basis. Accrual

accounting is often a more accurate way of accounting and is therefore the best practice for the

company. However, in some business models, reporting taxable income on an accrual basis

means that the company will be paying tax on funds not yet received. Therefore, when

appropriate, the company will report income on a cash basis but maintain internal bookkeeping on an accrual basis. In this case it is important to make sure that the accounting systems are in sync and that all adjustments are documented.

Tax Planning

Following are several observations on tax planning:

It is important to make use of tax deductions and incentives provided by federal and state governments.
Keep detailed records on expenses/investments and their purposes. Categorize these expenses appropriately.
Track and prepare for future tax liabilities.
Pay close attention to rules on depreciation and other tax credits such as R&D credits.
Make sure not to let the tail wag the dog. For instance, it does not make sense to spend $1 to save $0.5 in taxes. Every expense should have a business benefit to it.

Be Prepared

Create a separate bank account for withheld taxes so that these funds are designated for that

purpose and not mixed in with cash that may be spent. It is never a good day to receive a surprise

tax bill.

Summary

Plan for your company’s taxes according to your business structure. Evaluate the appropriate

form of owner compensation, and evaluate reporting income on a cash vs. an accrual basis. Keep

accurate, categorized records of expenses, and prepare for taxes in advance.

Always remember, paying taxes means you made, or are making money, so it is ultimately a

good thing.

February Topic: Tax Planning

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