It happens every year at this time. I start seeing emails from small business owners asking if there is any way to “shelter their business income from taxation.” Usually, this question comes from newer business owners who are accustomed to having Federal income tax withheld from their paychecks as employees, but failed to do it as an owner who pays themselves.
The bad news is that there is no silver bullet for avoiding taxation on significant amounts of your business income. The idea of a “tax shelter” is a neat one, but they don’t really exist in reality. If you want to lower the taxes on your business income, it ultimately requires you to divert the money into an IRS-approved deduction.
Keep in mind that a deduction might only save you 20-30 cents of each spent. It does not allow you to avoid paying tax on your income and then spending it on whatever you please.
Here’s the first part of my longer list of the favorite “tax-favored” expenditures for small business owners:
Any Type of Qualified Retirement Plan
If you can put off enjoying some of the profits of your business until later (as in age 59 ½), you can avoid taxation on whatever you are willing to contribute to a retirement plan for your company. In essence, anything you put into a tax-deferred retirement plan is deducted from the taxable net profits of your business.
There are limits on what you can contribute to the different plans, and provisions about how much you have to contribute for yourself if you have employees. But, many of the newer plans such as the Solo 401k’s and Simple IRA’s make it extremely easy and cheap to get one of these plans up and running.
FSA’s, HSA’s, and HRA’s (Oh My!)
Most of us have some predictable level of health care costs every year. If a small business owner is paying those out of their pocket, with after-tax earnings, they’re missing the boat. While you might be able to deduct these on your tax return, the amount may be limited by your adjusted gross income.
The IRS allows small businesses to use certain tax-favored accounts to remove money from an employee or owner’s paycheck, on a pre-tax basis, to pay for medical expenses during the year. When medical expenses are actually incurred, the employee or owner is reimbursed for their costs out of this pre-tax account, totally circumventing taxation on those amounts.
Flexible Spending Accounts (FSA’s) are formal plans that are usually set up in conjunction with medium size businesses through their payroll service. The funds in an FSA are subtracted on a pre-tax basis from each paycheck.
Health Reimbursement Accounts (HRA’s) are pre-tax plans that prepay an employee or owner their expected medical expenses each month, with no tax every being due on the money if it is actually used for health purposes. These funds are not considered part of an owner’s income, and are considered a benefit offered by the business to its employees.
Health Savings Accounts (HSA’s) are used in conjunction with high-deductible health medical insurance plans, and allow a self-employed person to make a deductible contribution to a private account. If the money does not get used for medical expenses, the HSA basically functions like an IRA and allows for withdrawals in retirement after age 59 ½.
Be sure to check back for more updates to this series. For more information on these topics, be sure to consult your accountant or tax professional.