December 3, 2021
The evolving tax landscape has led to changes to certain deductions for clients. In this article, tax guru Craig Smalley offers some tax tips to put tax-free money in your clients' pockets, as well as some best practices from his years as a tax planner.
I have provided tax planning to clients for the past 15 years. There are many ways to do tax planning; however, finding ways to put tax-free money into my clients’ hands has been the best approach. Here are some tips to help you do the same for your clients.
Should I Use Tax Planning Software?
When I first started doing tax planning, software programs that did this ancillary service did not exist. Today, there are several programs that will do tax planning. However, not all of these programs are up to par with my needs. Most provide only mathematical feedback, without any accompanying advice, similar to tax software. This is why I don’t use any software to do tax planning.
When Should Tax Planning Be Done?
First, tax planning should be done once a quarter. If your specialty is taxation, you should be providing advice to your client. For example, if you are merely doing accounting work for a client and sending them financial statements, the client likely doesn’t understand what you are sending them. Fewer than one percent of clients will even look at what you are sending them because they don’t know what it means.
Some people wait until the end of the year to do tax planning. However, the reality is that every business has cash flow issues. November and December especially are horrible for most businesses, unless they are retail. Therefore, your client may not have the cash to implement what you tell them to do.
A Misconception in Tax Planning
There is one theory among tax planning that is incorrect. Most people know that you can use the Section 179 deduction for any equipment that was bought in any year, provided it doesn’t exceed taxable profit. Further, you can use bonus depreciation, provided the equipment commences with the taxpayer.
In some schools of thought, the advice is to buy equipment that you may or may not need and take these deductions. However, this is short-sighted advice. Tax planning should consider the future as well as the present.
While these deductions can be valuable, unless the client needs the equipment, they are spending cash just to get a deduction. When thinking about tomorrow, remember that if the equipment is sold or junked and the Section 179 deduction was used, you must now carry back that depreciation, and your client may now be in a higher tax bracket.
How the TCJA Affects Tax Planning
My mantra in tax planning has always been the more money a client puts in their pockets tax free, the better. After the Tax Cuts and Jobs Act (TCJA) of 2018, tax election is extremely important. For example, setting up a company as an S-Corporation to avoid self-employment tax on a portion of the profits used to be the best advice 99 percent of the time. However, that may no longer be the case.
Under TCJA, there is the qualified business income deduction (QBI). However, there are several caveats to this deduction. For example, licensed professionals are excluded from this deduction and usually subject to a higher tax bracket. In addition, there are adjusted gross income (AGI) limitations. Conversely, a C-Corporation pays a flat 21-percent tax.
I realize there can be double taxation; however, if converting from an S-Corporation to a C-Corporation, Rev. Proc. 2019-1 allows the client to take all of the profit that has accumulated in the accumulated adjustments account (AAA) up to zero because it is previously taxed income. Further, in a C-Corporation, the owner can now reap the benefits of non-taxable fringe benefits, therefore avoiding the need to take a dividend.
The next situation that arises is reasonable compensation. In an S-Corporation, reasonable compensation is important because the avoidance of self-employment tax is just Social Security and Medicare. In a C-Corporation, taking too much compensation could be construed as the avoidance of taxes.
Reasonable compensation is also important because retirement plans are based on it. For example, you have defined compensation plans like SEPs, SIMPLEs, 401(k) plans and KEOUGHs, and then you also have defined benefit plans. All of these plans are based on earned income. In short, the more a client pays themselves, the more they can put into these plans.
For example, a business owner with or without employees can either start a safe harbor 401(k) plan or a Solo 401(k) plan, respectively. Both plans, between salary deferrals and employer matches, can be as high as $58,000 among those age 49 or under or $64,500 among those 50 or older.
What an employer does for themselves they must do for their employees. However, with a safe harbor 401(k), they only have to match the employee’s salary deferral by three percent. Typically, most employees do not participate in the plan. A safe harbor 401(k) and Solo 401(k) must be opened before the fourth quarter of the year. For high net-worth clients, a defined benefit plan may be the way to go.
Depending on the age of the owner, the owner can put up to $250,000 into the plan. They have to include the most senior employee in the plan; however, at a much lower rate than the owner. With a defined benefit plan, you can also have a safe harbor 401(k) plan; however, the owner can only match his salary deferrals by three percent.