Summary/TL;DR
Low hanging fruit for essentially every business owner includes ensuring that they are maximizing the Qualified Business Income Deduction (while it remains available to them), picking the most appropriate entity to structure their company, starting a 401(k), making backdoor Roth IRA contributions, and hiring a team of professionals to implement all of these correctly and remain on top of future opportunities as they arise.
Introduction
Most business owners have at least one thing in common – they pay too much in taxes! When poorly understood and planned for, the tax code can be a business owners’ worst nightmare. If it is understood within the context of one’s personal circumstances, however, the tax code can save a business owner significant sums through some simple and proactive pieces of tax planning.
Today’s post focuses on what I consider to be the five easiest strategies that almost every small business owner can take advantage of.
1. Maximize the Qualified Business Income Deduction
At the simplest level, the Qualified Business Income Deduction will allow business owners to deduct 20% of their qualified business income from their Adjusted Gross Income (AGI). Unfortunately, the QBID is also one of the most complicated provisions of the tax code, resulting in it commonly being underutilized by business owners who could otherwise realize a significant amount of tax savings.
All corporate entities except C-Corps may claim the QBID. Depending on your AGI, the type of business you own, and your entity type, your QBID could be anywhere from 0% to 20% of your qualified business income. Partnerships might find it more advantageous to switch to S-Corp status, or vice versa, and other proactive strategies can ensure that no amount of your potential deduction is wasted.
The QBID is currently scheduled to “sunset” at the end of 2025, leaving only a couple of years to ensure that you’re making the most of it. Many tax professionals believe that it will ultimately be extended, so proactively educating oneself on its basics and working with a CPA to stay on top of it can still produce big results.
2. Picking the Right Entity
Entity structure can make a huge difference, potentially positive or negative, to your overall tax liability as a business owner. The most well-known example of this is to claim S-Corp status, pay oneself a “fair wage” as a salary, and avoid self-employment tax on the remainder of business profits. This single change commonly saves many business owners thousands in taxes annually.
While S-Corps can be great, it’s a myth that they are the “best” entity or that they’re right for everyone. Because of the QBID (discussed above), some may find that being a partnership is actually more advantageous because the tax savings realized from maximizing QBID exceeds the tax savings in self-employment tax from being an S-Corp. And others might find C-Corps to be most appropriate because of the relatively low tax rate that their profits are subject to and the potential tax-savings windfall of selling C-Corp stock under Section 1202 of the tax code.
Due to the complicated and interrelated nuances that belong to both the tax code and one’s personal circumstances, the only way to ensure that you are getting this one right is to work with a proactive professional. And don’t shy away from a second opinion! I’ve personally witnessed multiple instances of business owners being structured a certain way at the recommendation of their CPA, only to discover that they were given poor advice.
3. Start a 401(k)
Starting and funding a 401(k) is one of the easiest and most cost-effective ways to immediately impact your tax liability as a business owner. The high contribution limit of $23,500 ($30,000 if one is over the age of 50) combined with the additional potential for profit sharing contributions up to a maximum of $69,000 ($76,500 if over the age of 50) can save one over $28,000 annually in taxes depending on their age and tax bracket. Spouses that are on payroll may also have and maximize their own plan, doubling the potential tax savings.
401(k)s also offer opportunities for additional tax planning strategies. First, contributions may be made to a 401(k) on either a pre-tax or Roth basis, giving one more flexibility than is ordinarily available in other small business retirement plans. Roth conversions may also be made within the plan during low-income years, and 401(k)s are the only vehicle in which the extremely powerful “mega-backdoor” Roth strategy is available. Finally, pre-tax IRAs may be rolled into the plan to open the “backdoor” for making Roth IRA contributions, which is the next strategy discussed below.
Finally, thanks to some recent legislation, there are also numerous tax credits that small- and mid-sized businesses are eligible for that can eliminate a significant amount of the cost of starting a 401(k), which is already mild to begin with.
4. Make Backdoor Roth IRA Contributions
Many business owners believe that they can’t contribute to a Roth IRA because they “make too much money”. Fortunately, this is a myth, as anyone can make what are called “backdoor Roth IRA” contributions to get around the income phaseouts for ordinary Roth contributions.
The “backdoor Roth IRA” is a simple transaction that involves making a non-deductible contribution to a Traditional IRA and then converting it to Roth. Since the funds enter the Roth as a conversion instead of as a contribution, it will always be allowed regardless of one’s income level. This same transaction may be made within a 401(k) at contribution amounts up to $46,500, earning it the title of “mega-backdoor” Roth contribution.
One important detail involving backdoor Roth contributions is the pro-rata rule, which simply states that if pre-tax and after-tax funds are mixed in a Traditional IRA, then all future distributions from that Traditional IRA will be partially taxable. The only way around this rule is to make sure that all Traditional IRA accounts have a $0 balance by December 31st of the tax year, which is commonly achieved by either converting all Traditional IRA balances to Roth, or rolling them over to a 401(k) plan. Finally, the pro-rata rule is applied at the level of the individual. In other words, if you are married and aren’t able to clear-out your Traditional IRA, but your spouse is, then your spouse can make a backdoor Roth IRA contribution without any problem.
Great care must be taken to ensure that the contributions and conversions are done correctly, as it’s easy to create a mess with the backdoor Roth if you don’t know what you’re doing. These headaches will lead to you overpaying your taxes and then overpaying a CPA to clean up what you should have paid them to avoid in the first place.
5. Hire a Team of Professionals
None of these strategies should be pursued without the assistance of competent and knowledgeable professionals. The tax code is complex, nuanced, and constantly changing. Instead of trying to become an expert in it, you should be focused on growing your business. Attempting to “do it yourself” will lead to missed or underutilized opportunities at best, and tax-related nightmares at the worst.
A small team consisting of a financial planner and CPA is often all that’s needed to make sure you’re capitalizing on every opportunity at your disposal. If you already work with one of these professionals, I recommend asking them for a referral to someone who they are used to working with and have confidence in the quality of their services.
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