Since the enactment of the Tax Cuts and Jobs Act just over a year ago, American tax payers, and especially entrepreneurs, are experiencing the greatest shift in American tax policy in years. Despite all the press reports available, it can be difficult for business owner-operators to take a step back and identify the most important things they can do to both capitalize on the provisions of this legislation and maximize the after-tax benefits for their businesses.
I offer three strategies to help entrepreneurs address the best methods to achieving those benefits:
Minimize Taxable Income by Maximizing Retirement Plan Contributions
The statistics remain sobering. By some estimates, one-in-three Americans has less than $5,000 saved for retirement. Ironically, at the same time that corporations are paying lower taxes than any time in recent memory, individual taxpayers and even entrepreneurs are failing to make use of many simple vehicles explicitly designed to help them ensure financial independence in retirement. For instance, savings and investment pay: a 30-year-old earning $50,000 per year who defers 6 percent of his or her income and is matched on 3 percent can sock away over $500,000 by age 65.
What about entrepreneurs already saving in traditional retirement plans who have contributed the full amounts with regard to employee deferrals, matches and profit sharing contributions? Many might be eligible for higher-dollar savings vehicles, such as cash balance plans. A 50-year-old entrepreneur with sufficient income could save over $200,000 per year using cash balance plans with a 401(k) offset. With these levels of contributions, it’s possible to amass a sizeable nest egg in a relatively short time: this business owner, compounding at 6%, would have over $4.6 million by age 65 – all of which would have reduced taxable income by the full contribution given each year (within limits). You can learn more about these plans here.
Make Tax-Free Gifts of Your Business to Family Members
Many entrepreneurs are income tax-wise and transfer-tax foolish – They see the benefit of deferring $1 into a retirement plan to save $0.21 in taxes now, but they won’t gift $1 now to save $0.50 in estate taxes later. Why is this? Mainly because estate planning forces business owners to deal with the singularly unpleasant prospect of dying.
But, entrepreneurs who are willing to consider intra-family business transfer strategies have an opportunity unlike any in the past century of American tax law: the ability to transfer enormous amounts of wealth entirely tax-free to their family members. How? By using a grantor retained annuity trust (GRAT).
GRATs are relatively simple. If an entrepreneur has a rapidly appreciating business and a net worth high enough to approach the federal lifetime exemption amount of $11.4 million, he or she can set up a two-year trust. The trust can be funded with the shares of the business – LLC, C corp, S corp (possibly – check with counsel!) or partnership interests.
For example, let’s say the owner funds the GRAT with $5 million on day one, and the business grows at 10% per year. The owner will receive a payment back (that’s the “annuity” in the acronym) of $5,256,518 at the end of year one – basically the $5 million plus a pre-set amount of interest that the IRS determines is reasonable. The same occurs a year later, at the end of year two – the owner receives another $5,256,518. If the business grew at 10% each year, there would be $1,061,312 left in the GRAT that could then be transferred directly to another family member – without using any transfer tax exemption amount. This amounts to a $1 million tax-free gift to family members! Compounded over a period of years, the GRAT can provide incredible tax savings.
Engage in Pre-Transition Tax Planning
It’s estimated that 250,000 private middle market businesses – essentially, companies with sales between $5 million and $100 million – will attempt to go to market in the next decade or so. Yet, of these 250,000, only 50,000 will be deemed market ready. Within that smaller group of 50,000, only 30,000 will transact, and of those that do, more than half – 16,000 – will sell with concessions. This means that almost one-in-18 businesses will sell at their desired value.
The main reason this happens is that most entrepreneurs are too busy working in the business to be working on the business. However, presale tax planning and transition planning are indispensable for any entrepreneur at least three to five years away from transitioning their business. Consider meeting with your own CERTIFIED FINANCIAL PLANNER™ professional about your business transition, and what resources they might have to assist you in this area.
If you don’t know where to begin, below are a few examples of the questions you should ask:
- What do I expect to amass from saving through my business?
- Am I using it as efficiently as I could be to accumulate these savings?
- Am I at a point where my business or net worth is approaching $11.4million (single) or $22.8 million (married)?
- If so, have I done all that I can to ensure I don’t lose half or more of my wealth to transfer taxes?
- Do I have a timeline or plan for transitioning my business?
- Is it feasible?
- Am I implementing it?
In the public space, more than 25,000 companies have traded on the U.S. exchanges since 1926. About 1,000 of them produced virtually all of the investor value during that time, while only 30 of them produced almost one-third of this value. It can be difficult to succeed in business, but by making use of these strategies – and engaging a credentialed and experienced professional team – you will prepare yourself and your business to reap the rewards available to the American taxpayer today.