Part II: Why You Should Start A Personal Business; The Nitty Gritty On Tax Advantages

Monday, February 22nd, 2010 at 9:41 pm

In my previous post “Why You Should Start A Personal Business”, I made the statement that obtaining Financial Independence and becoming Wealthy is simply the process of continually increasing the gap between the amount of money that comes in and the amount that goes out. The greater the gap the faster your wealth pot grows and multiplies. The goal is to learn how to optimize what you currently have by learning how to keep less of your money from going out. The next step is to learn how to bring more money into the pot. Starting your own personal business is such an efficient weapon against ‘The war on Wealth” that in my opinion absolutely every one should have one. I also want to reiterate the fact that it is not necessary to plunk down $100,000 to start a printing shop. You can get started for as little as a few hundred dollars and a lot of sweat equity in any number of things that are available to you. The only thing that I would suggest is to find something that you love or can get passionate about. However for our purposes neither one of those is necessary. I just believe if I am going to spend my time doing anything, I am going to be passionate about and love everything about my life. I am also not concentrating on the earning of income in this post as I am going to assume that whatever you choose it is with the intent of making money. What I am going to dive right into is how you can keep more of the money that comes into your pot just by having a “personal Business”.

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The Importance Of Choosing The Right Business Entity For Your Business

So you have decided what type of business you are going to operate but you are not sure of what type of entity it should be. Should it be a sole proprietorship, s corporation, c corporation, limited partnership, general partnership, or an llc? Here are just a couple of very quick notes on these entities. This is by no means as exhaustive list.

Sole Proprietorship – There is not one redeeming thing that I can say about this structure. You have maximum liability and maximum taxes. This entity is a plaintiff’s best friend. You are paying the full 15.3% self-employment tax, and all of your personal assets are a risk from lawsuits and creditors.
C Corporation – Gives you great asset protection in a business structure. Because it pays tax in it’s own tax bracket, the first $50,000 in income is only taxed at 15%. This entity also allows you to do a myriad of other things to reduce your tax bill which I will cover a little later.
General Partnership – this entity gives you no liability protection, meaning there is no distinction between your business and personal assets. Ouch! Also a general partnership must pay the full 15.3% self-employment tax which is usually divided in a typical employer/employee w-2 relationship. So you get no liability and maximum taxation with this entity.This is a great entity to own real estate from a tax perspective however the other two negatives usually outway this positive.
Limited Partnership – Because the general partner has all of the liability, this entity provides liability protection to the limited partner, however the limited partner cannot operate, manage, or work in the business so the limited partner still must have a general partner who does all of those things.
S Corporation – Great for businesses that generate earned income. Not so great for owning real estate, and owners of S corporations have to be on the payroll. The income is pass through income and as long as the income generated is not generated from your personal services performed you do not have to pay the 15.3% self-employment tax. So the income can be generated from employees, machinery, etc. You could have a lot of fun with this one.
LLC – This entity is great for owning real estate, but is lousy for operating a business that generates earned income. It works great for real estate because income from real estate is not earned income.

C Corporation Advantages

Because of its many advantages we are going to concentrate on the C corporation for the purposes of our discussion. There are five pillars of tax deductions really worth our discussion that are available to you just by owning your own personal business. The five pillars are:

Fringe Benefit Deductibility
Retirement Plan Magic
The Child Advantage
The Power Of Income Shifting
Abundance Through Real Estate

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Fringe Benefits

The IRS defines a fringe benefit as certain types of compensation or other benefit received by an employee that is not payable in the form of cash. Sonme examples of fringe benefits could be; Health Insurance, medical reimbursement plans, education assistance, child care assistance, adoption assistance, employer-provided vehicles, group term life insurance, qualified retirement plans, retirement planning services, deferred compensaation, etc. This is by no means an exhaustive list but your wheels should be turning about the possibilities here.

Retirement Plans

One of the largest tax deductions available to a business is a retirement plan. Just maximizing the retirement plan for your business alone could make you a millionaire. If we look at the retirement plan from both a tax-saving strategy and tax-free growth strategy we can really begin to see the awesome power of the retirement plan.

Tax-Saving Strategy – Let’s assume to are in a 34% tax bracket (25% federal and 9% state in California). If you put $1000 into a retirement plan, you have saved $340 in taxes in the current year. In 2009 you can contribute up to 49,000 per year to a retirement plan. Imagine the tax savings on $49,000 at 34%.

Tax-Free Growth – Somewhere along the line you have heard of the Rule of 72. Essentially the Rule of 72 is how long if takes your money to double earning a certain interest rate. This is how it works. Take the expected rate of return on an investment and divide that number into 72. As I mentioned before, the result is how long it takes your money to double in years. So if you had and investment that earned 8%, you would take 72 and divide by 8, and it would give to 9 years for your money to double.

If you are 35 years old and put $5000 into a retirement plan this year with no other deposits and expect a 8 percent return on your money over time, the rule of 72 says you yould have the following amounts;

Age 44 – $10,000
Age 53 – $20,000
Age 62 – $40,000
Age 71 – $80,000

Now what if you put $5,000 every year into the plan at 8%;

Age 44 – $67,432.81
Age 53 – $202.231.31
Age 62 – $471,694.14
Age 71 – $1,010,351.58

How about if you not only put the $5,000 in every year but you also added the $1,700 in tax savings from being in a 34% tax bracket (state and federal combined) for a total of $6,700 going into the plan every year?

Age 44 – $90,359.97
Age 53 – $270,989.97
Age 62 – $632,070.17
Age 71 – $1,353,871.16

What if you were able to put in the full $49,000 per year into a retirement plan every year. Can you imagine? I hope you are beginning to see the beauty in the retirement plan for a business entity. This one advantage alone could have you sitting pretty.

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The Child Advantage

By incorporating your children into your business, your children can earn just over $5,000 without being taxed. You can take a deduction for having your kids perform services for your business. Instead of sending money to a child in college and being stuck with a nondeductible expense why not have that child perform some services for your business and have that money become tax deductible for your business. As long as the payment was for expenses that are ‘ordinary and necessary” to your business the expense would be tax deductible.

Again, put yourself in the 34% tax bracket we spoke about earlier, paying your child $5,000 for services they performed in your business would save you $1,700. You can even multiply that by how many children you have.

And it gets better. did you know that your child is also able to contribute $4,000 to a traditional (deductible) IRA or a Roth IRA if they have earned income. Yes! so it works like this. You pay your child $9,000. Your child could contribute $4,000 to their traditional IRA. Your child would still have $5,000 of taxable income in which they will owe no tax. Your child could use that $5,000 to save for college, etc. You would get a $9,000 deduction which would save you $3,060.00 in taxes assuming a 34% tax bracket. Are you convinced yet?

Income Shifting

This is a great tool that is really effective in family businesses. Just because you are in a 25% tax bracket, it does not mean that all of your income is taxed at 25%. Some is taxed at 0%, some at 10%, some at 15% and some at 25%. By shifting income to other members who may be in a lower tax bracket you can effectively reduce the overall tax that is being paid.

Abundance Through Real Estate

Real Estate is a business opportunity that allows you to build wealth without paying taxes and then subseuently pay reduced taxes when the time comes to pay the piper (Uncle sam).

Even though there are many way to make money in Real Estate, we are going to focus on the two most common:

Rental Income
Appreciation

Rental Income

Imagine you purchased a a rental property for $100,000 and found a tenant who paid $1,100 rent per month. Let’s also say that your monthly out of pocket expenses averaged $1,000. The expenses would included mortgage payments, property management fees, repairs, incidentals, etc. Even though this situation gives you a positive cash flow, because you are able to depreciate the property, it would probably result in a paper loss. The magic of depreciation enables you to recoup the purchase price of your property over time through annual tax deductions. This is in effect a non-cash expense that you are able to deduct. Paper losses usually come from combining your depreciation and your rental expenses. This paper loss can than be used to offset your w-2 income.

Appreciation

There are six pillars of Appreciation Magic that just makes this part all worthwhile. The six pillars are:

Increased Networth
Preferential Tax Treatment On Sale
Zero Percent Capital Gains Through 1031 Exchanges
Cost Segregation And Front-Loading Of Deductions
Fiscal year Manipulation
Magic of section 179 Depreciation

Increased Networth

Over time real estate values tend to increase. If over a 4 year period the property we purchased increased in value to $130,000 and the monthly mortgage payments decreased the balance to $95,000, you would have increased your networth by $35,000. You increased your networth without paying a dime in taxes.

Preferential Tax Treatment On Sale

When you sell the property to turn the equity into cash the majority of the gain is taxed as a long-term capital gain that has preferential tax treatment. The long-term capital gains tax rate is currently 15% and is set to expire and go to 20% in 2011. I do not know if that will change but even 20% is still better than your current tax bracket in the example above. The best way to see this is to compare this to getting a second job. With that second job you would be paying close to 40 percent in taxes on the additional income (federal and state income tax, Social Security, and Medicare). Using the real estate method you are ony paying 20 percent assuming you are in a state that has income taxes.

Zero Percent Capital Gains Through 1031 Exchanges

A 1031 or Like-Kind Exchange allows you to sell a property at a gain and then roll that gain into a like-kind property. The gain that was generated by the first transaction is deferred into the new property using section 1031. The tax is due if you later sell the property, but what if you did another 1031 exchange at that time? You would want to make sure that you are working with reputable firms when you do this as the exchange must be done at tmem of sale and there are very important timelines that need to be followed.

Cost Segregation And Front-Loading

Cost Segregation has to do with depreciation. As I mentioned above, depreciation allows you to recoup the purchase price of your property over time through annual tax deductions. You have to depreciate all assest placed into service in your business. Business and Commercial property is decpreciated over 27.5 years or 39 years accordingly. Personal Property is depreciated over 5 to 7 years. When you purchase residential property it is depreciated over 27.5 years

Think about the things that you purchased when you purchased the residential property. You purchased the physical structure but you also purchased the refrigerator, stove, microwave, light fixtures, washer and dryer, etc. These assets can be depreciated over 5 to 7 years. You can generate tax savings just by allocating the purchase price to these various items. This essentially front-loads your depreciation deductions to generate current tax deductions instead of waiting 27 or 39 years. You in effect have a much larger current deduction to maximize your current tax savings.

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Fiscal Year Manipulation

Choosing a Corporation as your form of business gives you the flexibility to choose an off calendar fiscal year end. This could be a year end that is other than December 31.

Let’s say you had a C Corporation with a year end of January 31, 2010 and your personal taxes of December 31, 2009 and you paid yourself a bonus through your C Corporation in January of 2010. Your tax on that bonus would not be due until April 15, 2011. There are many situations where this could be advantages.

You could also choose an accrual accounting method or a cash accounting method. The accrual basis taxpayer reports income when it is earned and deducts expenses when they are incurred. A cash basis taxpayer records (or pays taxes on) income when it is received and deducts expenses when they are paid. People using a cash basis will usually load up on expenses at the end of the year.

The Magic Of Section 179 Depreciation

This deduction has been around for some time but the limits are currently giving us the greatest tax benefit it ever has. Section 179 allows a business owner to currently deduct up to $108,000 of assets purchased and placed in service in the business during the year. This section allows you to take deductions in the current year that you would normally have to depreciate over time.

The magic of this is, you could combine the depreciation benefits of Section 179 with the accrual basis method of accounting to deduct up to $108,000 of asset purchases while actually spending little or no money now. Some examples of deductible assets that fall under Section 179 are:

Airplanes
Automobiles
Computers
Tractors and Equipment
Office Furniture
Livestock
fences In A Farming Business
Computer software
Automobiles
Machinery And Equipment
Oil And Gas Well And Drilling Equipment
Copy Machines And Equipment

If by now you are not convinced as to why you should have a personal business than I give up. A Personal Business is one of the greatest weapons constructed that can be used in “The War On Wealth”. Utilized effectively, it can be probably the single most important weapon that you would have in your arsenal.

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Disclaimer:

The examples presented here are just examples. To see how your particular situation might fit these scenarios I urge you to seek out advice and consultation from a qualified CPA to determine how you can best use these strategies.

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Part II: Why You Should Start A Personal Business; The Nitty Gritty On Tax Advantages

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