Tax Mitigation Strategies for Business Owners

Author: Kristin Carter, CPA, Head of Tax Advisory

As a business owner, you’re always looking for ways to maximize your profits and minimize your expenses. One area where you can save a significant amount of money is through tax reduction strategies. Taxes can be a considerable expense, affecting cash flow and profitability understanding and managing your taxes efficiently can significantly impact your business growth and eventual succession. 

Compound Planning understands the unique challenges business owners face and has solutions designed specifically to guide them through the complex landscape of tax mitigation. We help you make strategic decisions that minimize tax liability and support your business's long-term growth and success.

By making the right choices about your business structure, investments, and expenses, you can drastically reduce your tax liability and keep more of your hard-earned money in your pocket. 

What is tax mitigation? 

Tax mitigation refers to the strategies and techniques business owners can use to legally minimize their tax liabilities. Effective tax mitigation involves understanding your tax obligations, leveraging available deductions and credits, and making smart decisions about your business structure and investments.

Why tax mitigation is so vital for business owners

Taxes represent a significant business expense, impacting cash flow, profitability, and investment opportunities. Ensuring tax compliance helps business owners avoid penalties and interest charges that further erode profits.

Understanding your tax obligations allows you to take full advantage of available deductions, credits, and tax planning strategies, thereby minimizing your tax burden. For example, startups could overlook R&D tax credits, and small businesses might not take full advantage of the Section 179 deduction for equipment purchases. A thorough tax strategy can help prevent these costly mistakes.

Here are 4 key ways you can mitigate taxes and save money.

1. Choose the right business entity 

One of the most critical tax reduction strategies for business owners is selecting the right business entity. The type of entity you choose can have a significant impact on your tax liability, as well as your personal liability and ability to raise capital.

Whether you choose a sole proprietorship, partnership, Limited Liability Company (LLC), S Corporation, or C Corporation, each business entity type has its own tax implications. 

Pass-through taxation

Pass-through taxation allows earnings to "pass through" directly to the business's owners or shareholders, who then report this income on their personal tax returns. This method is used by sole proprietorships, partnerships, S Corporations, and Limited Liability Companies (LLCs), all of which avoid the double taxation faced by C Corporations. 

Self-employment taxes

Self-employment tax, applied to net earnings from self-employment, currently stands at 15.3%. This tax encompasses both the employer and employee portions of Social Security (12.4%) and Medicare (2.9%). 

In an S Corp, only the owner's salary is subject to this tax — the remaining income is treated as a distribution and exempt from self-employment tax. This structure can lead to substantial savings compared to a sole proprietorship or a single-member LLC, especially for those generating high income.

For example, let’s say you're a freelance graphic designer currently operating as a sole proprietor. By forming an S Corporation, you could potentially save thousands of dollars in self-employment taxes each year. That's because you can pay yourself a reasonable salary and distribute the remaining profits as dividends to yourself, which are not subject to self-employment taxes.

Reinvesting profits

Unlike S Corporations or LLCs, C Corporations face "double taxation." This means that profits are taxed at the corporate level when earned and again at the individual level when distributed to shareholders as dividends.

Although a C Corporation may face double taxation, it offers the advantage of reinvesting profits at a lower corporate tax rate than an LLC or S corporation. 

Companies looking to attract venture capital or provide stock options to employees may find the C corporation designation particularly beneficial.

2. Investing in Qualified Small Business Stock (QSBS)

Another strategy to mitigate taxes is using Qualified Small Business Stock (QSBS). QSBS refers to stock issued by a qualified small business (QSB) that meets specific criteria, such as:

• The company must be a qualified C corporation with less than $50 million in gross assets.
• The stock must be acquired directly from the company (not from a secondary market) and held for at least five years.

If you meet these requirements, you can exclude up to 100% of your capital gains from the sale of QSBS (up to $10 million or 10 times your original investment, whichever is greater). This can result in substantial tax savings, particularly for high-growth startups.

For example, say you invested $100,000 in a qualified small business and held the stock for five years. If the company grows rapidly and you sell your shares for $1 million, you could potentially exclude the entire $900,000 capital gain from federal taxes, saving you hundreds of thousands of dollars.

Some founders start their companies as LLCs, grow the valuation, and then convert the entity to a C Corporation. This conversion has many nuances but may lead to a 10x in potential QSBS benefits. If executed correctly, the conversion may trigger QSBS treatment on 10x the company's value at its conversion, which could be much higher than $10 million. (If the company was worth $10 million at its conversion, it may be eligible for up to $100 million in QSBS benefits.)

3. Leveraging depreciation

Depreciation is a tax reduction strategy that allows businesses to deduct the cost of specific assets over time. By spreading out the expense, you can lower your taxable income and reduce your tax bill. 

Here are some ways to leverage depreciation: 

• Section 179 deduction: Allows you to deduct the full cost of qualifying equipment and software in the year of purchase (up to $1.22 million for a total limit of $3.05 million in 2024).
• Bonus depreciation: Permits a 100% first-year deduction for qualifying assets placed in service after September 27, 2017, and before January 1, 2023 (phasing down to 80% in 2023, 60% in 2024, 40% in 2025, and 20% in 2026).
• Cost segregation: A strategy that can speed up depreciation by identifying and separating short-lived assets (e.g., carpeting, fixtures) from long-lived assets (e.g., building).

Let's say you purchase $100,000 worth of equipment for your manufacturing business. By using the Section 179 deduction, you could potentially deduct the entire $100,000 in the year of purchase, reducing your taxable income by that amount. 

One crucial consideration for business owners is depreciation recapture. This tax provision lets the IRS collect taxes on the sale of an asset previously used to offset taxable income. While depreciation can offer substantial short-term tax savings, it's important to recognize that these benefits might be partially offset when the asset is sold at a gain.

By understanding the tax implications of depreciation recapture, business owners can make more informed decisions about their assets. They may hold onto assets longer, engage in like-kind exchanges, or employ other tax planning strategies to minimize the impact of depreciation recapture. A thorough understanding of depreciation recapture is essential for effective tax mitigation strategies.

4. Maximizing your retirement contributions 

Another tax reduction strategy for business owners is to contribute to a retirement account. By setting aside money for your future, you can also lower your current tax bill. Here are some retirement plan options for business owners:

• SEP IRA: Easy to set up and allows for high contribution limits (up to 25% of your net earnings or $69,000 in 2024).
• Solo 401(k): Offers even higher contribution limits (up to $69,000 in 2024, plus a $7,500 catch-up contribution if you're over 50) and can be used for both you and your spouse.
• SIMPLE IRA: Ideal for small businesses with 100 or fewer employees, allowing for employee and employer contributions.

Take a 45-year-old consultant who earns $200,000 in net profits per year. By contributing the maximum amount to a Solo 401(k), they could potentially reduce their taxable income to $131,000. That could translate to around $22,080 in tax savings (assuming a tax rate of 32%).

How Compound Planning Helps

Implementing these tax mitigation strategies effectively requires expertise and experience. 

That's where Compound Planning comes in — we provide a holistic approach, helping business owners navigate the complexities of business taxation. We assist our clients with entity selection, offer guidance on QSBS considerations and depreciation planning, and help create a comprehensive tax strategy aligned with the business's financial goals.

Remember, tax planning is an ongoing process, not a one-time event. 

Though taxes present complex and often challenging aspects of running a business, they also offer opportunities to save money that can be put back into the business. With the right guidance, business owners can transform tax challenges into advantages, boosting their bottom line and securing long-term success.

If you're ready to learn how to mitigate taxes for your business, sign up for a dashboard and schedule a free consultation to learn how our advisors can guide you on your journey from inception to exit.

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