Tax Planning, Part 1: Projecting operational outcome and choosing business entities

By Jeff Taksey and Edward Neff

With the end of the year approaching, a quote from Benjamin Franklin comes to mind: “In this world nothing is certain but death and taxes.” Surely, old Ben would agree that now is the ideal time for business owners to engage in year-end tax and business planning. This planning sets the stage for business owners to not only save taxes in the current year, but in future years as well. It is a must for any business, be it a sole proprietorship, partnership, Limited Liability Company (LLC), S corporation or C corporation.

Since business and tax planning can be somewhat overwhelming, this article will be presented in three parts. The second and third parts will follow in the SNEWS® Training Center during the month of November (www.outsidebusinessjournal.com/trainingcenter). This first article deals with projecting your current operational outcome and understanding the pros and cons of choosing available business entities. There are a few reasons why you need to consider these things early in the process. First, you need solid financial projections to plan your taxes. Second, you may need to take legal action to change business entities before the end of the current year. Also, regulations may require that you make tax elections within the first two-and-a-half months of the following year. Bottom line: The things we’ll discuss in this article should be first on the to-do list as you build your tax strategy.

Plan of action

The first thing you need to do is put together a checklist of all the steps you’ll need to take in the future to reduce taxes as much as possible.

To start, prepare a tax projection for the business. You should do this by using current financial information and projecting the taxable income of the business through the end of the year. It is very important that the business keep its accounting records current and accurate. An accurate tax projection provides the information necessary to do year-end tax planning and allows business owners to plan for future tax liabilities.

Now, it’s time to put together your list of strategies to minimize current-year taxes. The following year-end tax planning strategies should be considered:

1. Business owners should determine whether income and expenses should be accelerated into the current year or deferred until next year. Normally, a business with significant taxable income will attempt to defer revenue and accelerate expenses. However, there are situations where a business may want to do the opposite. For example, if a business has low income in the current year and is expected to have higher income in the following year, accelerating income and deferring expenses may produce a lower overall tax. The following examples illustrate ways to defer income and accelerate expenses:

>> Cash basis businesses can slow down collections of income by delaying billings to customers.

>> Accrual basis businesses can delay until the following year by finishing a job or delivering merchandise.

>> Cash basis businesses can pay all deductible bills by the end of the year. This includes bonuses paid to employees and owners. The business can also prepay bills up to 12 months in advance.

>> Accrual basis businesses can incur expenses this year for merchandise or services that are received. This includes accruing bonuses to employees to be paid within two-and-a-half months after the end of the year.

2. An accrual basis business should review the accounts receivable and write off all bad debts. It should also review its inventory and adjust the books for shrinkage or perishable items.

3. Consider funding a retirement plan. Most retirement plan contributions can be made after the end of the tax year and still be deductible in the current year. But several types of retirement plans have to be set up (not funded) by the end of the tax year to allow for current-year deductions.

4. Businesses that are C corporations should determine if taxes were paid in the prior two years and consider creating a net operating loss carry back from the current year to recover prior year taxes paid. After two years, taxes paid cannot be recovered.

Protecting your assets

In addition to reducing taxes, there is another issue to consider early in the tax-planning process — your business entity. Normally, one of the main objectives in forming a business entity is to obtain legal liability protection. Thus, most businesses are formed as LLCs, S corporations or C corporations. As shown in the “Pros and cons of business entities” section below, each type of entity has its set of advantages and disadvantages. In the small and medium-sized business arena, LLCs and S corporations are used frequently due to the single level of tax at the individual owner level. S corporations have more restrictive rules than LLCs, now the entity of choice in many situations.

C corporations require more planning because profit retained by the corporation is taxed at the corporate level in lieu of the individual tax. Subsequent distributions of the profit to the shareholders will be taxed a second time. Nevertheless, there are situations where a C corporation may be desirable. For example, a growing business that wishes to retain its profit for expansion purposes may pay less tax in the early years because of the lower C corporation tax rates. It would then be possible to convert to an S corporation when growth stabilizes. The double tax that a C corporation may have to pay in the event of a sale of the business often causes it to be the least desirable choice.

When forming a business, owners should thoroughly review the different entity options and choose the one that best fits the situation. Once the type of entity is chosen, it is often difficult to change to another type of entity without a significant tax consequence. So, careful consideration must go into the initial decision.

At this point, you should be thinking about the entity you have and investigating if it is the best fit for the future. Articles to follow in the SNEWS® Training Center will consider accounting methods, as well as retirement and fringe benefits plans and succession or sale of the business. Some decisions need to be deployed 10 years before a sale to preclude the government from collecting a double tax. Accordingly, visiting the issue annually with your accountant and attorney can avoid a trap from robbing you of the best result.

Don’t be afraid to ask your accountant for help projecting your year-end operating results. With a little input from you, the accountant can minimize the effort required to achieve a reasonably accurate result. The projection can be a work in progress that is updated as the real numbers come in.

Pros and cons of business entities

The type of entity chosen by a business can have serious tax, financial and legal implications. The following are the main types of business entities and some of the advantages and disadvantages of each:

Sole Proprietorship

>> Advantages

• Ease of setup and operation.

• Business income is taxable to owner using individual tax rates.

• Owner can deduct losses to offset other income subject to passive activity and at-risk rules.

>> Disadvantages

• No legal liability protection.

• Income subject to self-employment tax.

• Limitation on deductions of fringe benefits.

General Partnership

>> Advantages

• Ease of setup and operation.

• Business income is subject to tax at the owners’ individual tax rates.

• Generally, no taxability on contributions of property to a general partnership.

• Owners can deduct losses to offset other personal income subject to basis, at-risk and passive activity rules.

• Distributions of appreciated property to partners generally not taxable to partners.

• Special allocations of profits and losses allowed.

>> Disadvantages

• No personal legal liability protection.

• Limitations on deductions for fringe benefits.

• Income subject to self-employment tax.

• Must use a calendar year.



Limited Liability Company or Limited Liability Partnership LLC or LLP

>> Advantages

• Legal liability protection.

• Business income is subject to a single tax at the owners’ individual tax rates.

• Generally, no taxability on contributions of property to an LLC or LLP.

• Owners can deduct losses to offset other personal income subject to basis, at-risk and passive activity rules.

• Distributions of appreciated property to partners generally not taxable to partners.

• Special allocations of profits and losses allowed.

>> Disadvantages 

• Income generally subject to self-employment tax.

• Costs of formation and maintenance.

• Limitations on deductions for fringe benefits.

• Must use a calendar year.



S Corporation

>> Advantages

• Legal liability protection.

• Business income is subject to a single tax at the owners’ individual tax rates.

• Business income not subject to self-employment tax.

>> Disadvantages

• To deduct corporate losses, shareholder must have personal money invested or loaned.

• Distributions of property by corporation to shareholder is taxable.

• Allocation of profits and losses must be pro rata to stock ownership.

• Limitations on deductions for fringe benefits.

• Costs of formation and maintenance.

• Must use a calendar year.



C Corporation

>> Advantages

• Legal liability protection.

• Certain income levels may be taxed at a lower rate than the individual owner’s tax rates.

• Very few limitations on fringe benefits.

• Businesses can possibly use a fiscal year for tax deferral purposes and allow for inventory and other year-end procedures to occur at an optimal time of the year.

>> Disadvantages

• Income subject to corporate tax and dividends paid to shareholders subject to individual tax (double tax).

• Losses not deductible by owners.

• Costs of formation and maintenance.

• Non-personal service businesses must use accrual method of accounting if over $5 million of average annual revenue.

Part one of SNEWS®’s tax planning series — “Tax Planning: Projecting operational outcome and choosing business entities” — was originally published in the fall 2007 eFitBiz by SNEWS®. Be sure to check out the next two articles in this series in the SNEWS® Training Center throughout November.

Taksey, Neff & Associates LLC was founded in 1977 by Jeffrey Taksey. The firm (www.tncpas.com) is located in the Washington, D.C., market and handles national and international clients, including numerous retail fitness dealers. Many dealers and manufacturers know Jeff Taksey from the 20 years he’s been attending various fitness industry trade shows, where he’s gained enormous insight on the market. To contact Taksey, email jtaksey@tncpas.com.