Tax Planning is the organized and legal process of crafting your taxes to fit your needs. Notice how I said that this is the “legal” way. I would certainly never discuss nor even consciously consider any of the illegal ways.
In Tax Planning most people immediately think about paying less in income taxes, and saving income tax is primarily a matter of good bookkeeping. If your books are kept properly, then none of your deductions will be missed. As such, our normal process of doing the monthly books will legally reduce your income taxes.
But payroll is often overlooked or ignored when in many instances your payroll taxes can be more expensive than your income taxes. Please allow me to explain using a question.
If an Entrepreneur pays themself $100 on a W-2, how much does it cost in taxes?
a) 20% – 30% b) 30% – 40% c) 40% – 50% d) 50 – 60%
Most will answer either a or b thinking that it will cost about 30%. The correct answer is actually d.
There are two sides to payroll, the Employee Side and the Employer Side. Since an Entrepreneur is responsible for both, it’s much more expensive for us. To explain, let’s set up a $100 payroll check assuming a 20% federal withholding tax, a 5% state withholding tax, and a 5% unemployment tax.
Employee Side Withheld From Check Employer Side Added To Payroll Liabilities
$20 Federal Withholding $7.65 Social Security & Medicare
$5 State Withholding $5 Unemployment
$7.65 Social Security & Medicare
$32.65 Total Withheld From Check $12.65 Added To Payroll Liabilities
You started with a $100 gross payroll, ended up with a net check of $67.35, but it cost you $112.65. In other words using rounded numbers, that $67 will cost you $45 in taxes.
Yes, it’s true that the unemployment stops at around $13K in payroll, but even after it stops that’s still $40 in tax for every $67 in your pocket. The correct answer was d.
Payroll is by far the most expensive way that Entrepreneurs take money out of their companies. The rules are different for us. We’re not employees. But every crisis is also an opportunity.
If you have a C Corp, there’s not much that can be done. You don’t want to pay double income taxes, so you’re stuck with payroll and the smaller amounts that can be saved through retirement plans. But if you have an S Corp, or an LLC that can be converted into an S Corp, we can use distributions to significantly reduce your payroll tax expenses.
If you’re currently taking a $100K salary and a $20K distribution you’re paying $15,300 in social security and medicare taxes alone. If, after looking at the reasonable salary test which is necessary, we’re able to reduce the salary to $40K and increase the distribution to $80K, you’ll save a little over $9K annually on your payroll taxes alone.
If I can save a person $9,000 every year in taxes on the $120,000 they take out of their business, that’s not nothing. Their income taxes won’t change, but their payroll taxes will go down significantly.
Let me leave you with this.
This isn’t as easy as it looks, so let’s go a bit deeper into the problem.
In the example originally they were paying income taxes on $120K and payroll taxes on $100K. After the change they’re still paying the same income tax on $120K but the payroll taxes are only being paid on $40K.
If they just drop their payroll $60K a year, the withholding coming out of that payroll will drop as well leaving a rather significant income tax bill when they do their income tax return the following April.
What must be done to accommodate the change in taxation is they need to increase the federal and state withholding on the smaller payroll to its prior levels. At that point they’ll cover their income taxes and still save the additional payroll tax.
Handling payroll for Entrepreneurs is not a routine matter. Many Entrepreneurs only use their payroll as a savings vehicle for their eventual income taxes, while living mostly off of their distributions.
From a personal standpoint, I can tell you that my net paycheck every two weeks is a penny. My wife doesn’t even show it to me anymore. I use my payroll as a way to save for my eventual income tax because it’s easier to save in smaller increments every two weeks than coming up with a large estimated tax deposit every quarter.
This presupposes that you have someone handling your payroll that has some idea what they are doing. In most instances this is a bad presumption because most payroll services are staffed by people who don’t know a debit from a credit.
What we’re talking about is sophisticated, and not easy to do. But it is possible to do all three things. An Entrepreneur can reduce their salary saving payroll taxes, increase their distributions to cover the difference, and increase their withholding on the remaining salary to cover their eventual income tax bill.
It can be done. The problem is that few are capable.
If you would like to save money on your taxes or need someone handling your payroll who knows what they’re doing, please give us a call.
We are doing a webinar on August 9th, 2022 at 2:00 pm (CST) on “How To Get Your Company Through A Bad Economy”. It will cover issues like Inflation, the Difficult Hiring Market, Supply Issues, and Replacing Clients.
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Accounting Solutions Ltd. stands ready to complete our mission and purpose of protecting you, your family, and your business. Whether you need Employee Retention Credits, M&A Due Diligence, Payroll Services, or Accounting and Tax Work, you have but to ask. I’m here and I remain,
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