Some people have a tax problem. Yet even more people have an income problem.
We all hate overpaying in taxes. But if you are making less than six figures, focus more on increasing your income.
Invest in yourself.
Discover your skill sets.
Add more value.
Expand your vision and value.
The greatest tax shelter in the world is to…wait for it…wait for it…
…earn another dollar.
You’ll end up with more in your pocket, even if you pay more in taxes.
Growing up, I often overheard things like, “If I take that overtime shift and work more, I’ll get killed with taxes.”
But the real killer is limiting your value, putting a cap on your production to save on tax.
Plus, there are so many ways to lower your tax burden. As you grow your income, improve your tax team. The more money you make, the more opportunities to save on tax you will have if you own a business or capital gains assets that is.
Use a Tax Attorney
To save on taxes, it takes a village. Well, not quite a village, but definitely a team.
For business owners doing six figures+ in revenue—and especially those earning $650,000/year+ in net taxable income—it’s absolutely vital that you have an attorney on your team.
Without an attorney, people pay too much tax because they don’t classify, or reclassify, their income properly.
Classifying your income can drastically reduce your taxable income, even eliminate tax in some cases.
There are four ways to reclassify your income:
- Active to passive.
- Ordinary Income to capital gains (helpful for people in the higher brackets).
- Tax arbitrage.
Incorporate to Reduce Your Tax Rate
If you have a great tax strategist, wonderful. If not, read this.
As your revenue grows, how you pay yourself and the type of corporation you choose becomes more necessary and valuable.
A competent attorney, who coordinates the strategy with your tax strategist/CPA, can help you choose the right entity.
Do not let an accountant talk you out of incorporating—it is not their expertise. Being a sole proprietor is risky. Incorporating limits your liability, protects your assets, gives you tax advantages, and may help you build more value if you exit your business.
An attorney who focuses on setting up corporations is a great start, but as you have more income, you may want to consider adding a tax attorney.
Convert Active to Passive Income
Your W2 income—your paycheck—has the most tax assessed against it.
By incorporating, you can differentiate income. Taking distributions can reduce tax by up to 15.3 percent, moving from active to passive income.
For example, if you are the sole owner of your business, you may select an S-Corporation. If you take a reasonable salary (there are calculations/apps/programs to determine this for your industry) and then take the rest in 1099 distributions, those distributions avoid self-employment tax (FICA/FUDA).
This can even work if you have a side hustle or any 1099 income.
Investment income doesn’t have FICA/FUDA taxes either.
Eventually, you will max out self-employment taxes, but you will still save 2.9 to 3.2 percent by taking distributions over salary.
Turn Ordinary Income into Capital Gains
You may have heard the story of Warren Buffet having a lower tax rate than his executive assistant.
First, capital gains are at a lower rate than ordinary income. Second, people with substantial stock valuations can borrow money against the stock to avoid paying taxes as well.
Loans are not taxable. They represent the asset but don’t require cashing in or out.
Here are the current rates, and potential savings, going from ordinary income to capital gains:
0 percent for individuals in the 10 and 12 percent income tax brackets.
15 percent for individuals in the 22, 24, 32, and 35 percent income tax brackets.
20 percent for individuals in the 37 percent income tax bracket.
If you’re doing business internationally but you’re a U.S. citizen, one way to go from capital gains to ordinary income is an IC-DISC (Interest Charge Domestic International Sales Corporation). You could use an IC-DISC as a tax advantage by effectively converting what would be ordinary income into qualified dividends for its shareholders.
Real estate, stocks, and businesses are examples of assets that are taxed at the capital gains rate.
You don’t pay income or capital gains tax on assets that are appreciating until they are liquidated.
If you sell within one year, it would become short-term capital gains and therefore taxed at your ordinary income rate. If you hold the asset for one year or longer, it becomes long-term capital gains and follows the percentages above.
There are several strategies to address this future tax: like-kind exchanges and Charitable Trusts (more to come on these).
If you are charitable, there are amazing opportunities to serve others while minimizing tax. An example is a Charitable Trust.
An effective way to use these trusts is to take highly appreciated capital gains assets, donate them to a qualified charity (501(c)3), sell the assets, have the full amount fund the trust (without tax), and get a partial tax deduction as well.
This financial arrangement allows an individual to provide for both charitable giving and cash flow for themselves or their beneficiaries. The donor receives an income stream from the trust for a specified period or life. After this income period, the remaining assets in the trust go to a designated charitable beneficiary or beneficiaries.
This can lead to increased cash flow and lower taxes, and if done properly, you can donate your money, spend more, and still leave money to your heirs.
For those that have a whole life policy already in place, the death benefit can replace the amount of the gift to the family trust to perpetuate wealth as I teach in What Would the Rockefellers Do? (get the audiobook for free here).
Another example of a tax-free strategy comes from using section 1202. If you have a C corporation), and it is at least five years old, you may qualify for up to $10 million per partner of tax-free income upon selling the business.
Tax Arbitrage: Spend a Dollar to Save More than a Dollar
Before spending money to save tax, ask yourself, Would I spend this money if it weren’t for the tax benefit?
Consider the economics first, and the tax benefits second.
Don’t let the tax tail wag the dog of production. I’ve talked to so many entrepreneurs who are buying a car they don’t want or need, simply to take a 179 write-off the year they buy it. Is the car going to appreciate or depreciate? What is the opportunity cost? Time, money, etc.? At best, it is spending $1 to save .37 cents.
If you are going to spend a dollar, look for ways to save more than a dollar.
For example, I’ve purchased large collections of art. After holding them for three years, it goes from book value (what I paid for it), to appraised value. Because I buy them as collections, and then get them appraised individually, there is a higher appraisal, and more value. Then I donate to museums and get the tax deduction.
This has created more credits than I spend on the pieces. Plus, my house has been filled with great art over the years.
Other examples are conservation easements or historic easements.
Easements are where ecology meets economics. If you have land and you are willing to give up development rights, that’s where a conservation easement comes in.
You decide together to put a cap on certain activities that could harm the land’s unique qualities—whether it’s picturesque landscapes, ecological diversity, or historical charm.
It’s your land; you still own it. But giving up the rights to development creates a massive tax advantage.
In the last several years people started buying into these with groups of other investors. This can be risky because it requires a process and protocols to qualify. An example would be voting as a group or the tax advantage could be disallowed.
Review, Reclassify, and Save
I’ve given you a few examples in each category, but those are only a few of the possibilities. There are dozens—really hundreds—of strategies that can help you to keep more of what you make without cutting back.
The framework is key:
- Active to passive
- Ordinary income to capital gains
- Tax arbitrage
Boost your bottom line by paying yourself most efficiently. Take control of your finances, taxes, and life.