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.
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 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. Pass-through 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 or as an S 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) dividends. (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 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. 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.
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.
Green Energy Tax Credits Resources:
Investment tax credit (ITC): credit for percentage of solar panel installation cost
OR (cannot use both)
Production tax credit (PTC): credit for first 10 years of electricity from solar panels (per kilowatt-hour and adjusted for inflation each year)
Credit for builders of new energy-efficient homes: must meet Internal Revenue Code (IRC) Section 45L requirements:
2023-2032 eligible for a $5,000 credit maximum per house
Must be built by contractor claiming credit and sold to someone intending to use as a residential property during tax year
Must be in U.S.
Most of construction must have been done after Section 45L was enacted
Must meet Energy Star Single-Family New Homes National Program requirements
For NJ, version 3.2 is not yet required (date defined 1/1/2025)
Energy Star Single-Family New Homes National Program Requirements, version 3.1
Energy Star Single-Family New Homes National Program Requirements, version 3.2
Commercial clean vehicle credit: maximum of $40,000 credit per IRC 45W
Credit is calculated as 15% of basis in the vehicle (30% if not powered by gas/diesel) or incremental cost of vehicle, whichever is less
$7,500 maximum for vehicles weighing less than 14,000lbs
No limit on number of credits claimed
Can carry over as a general business credit
Disclaimer: M & A Consultants and Advisors, LLC, is in the operation and strategy consulting practice. Any views and guidance set out in this document are provided for information purposes only, and do not purport to be legal or tax advice or a definitive interpretation of any law. Anyone contemplating action in respect of matters set out in this document should obtain advice from a professional adviser based on their unique requirements.
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