It's A (Tax) Drag: Combating Tax Drag Through Tax Reduction And Tax Efficient Investing

What could be worse than doing the all the right things, managing your taxes, investing your money for the future, and watching your returns cut down by the taxes you pay? 

Short answer, nothing - and this is called tax drag, which far too many taxpayers fall victim to.

So, what can we do?

What Is Tax Drag?

In simple terms, tax drag is the delta between the tax you should have to pay and what you actually pay. This is what we resolve for our clients day in and day out. We say it all the time, “you have a tax problem, but you don’t realize it”. 

The tax code is so vast and complex that no business owner trying to operate their business could ever be expected to be fully informed and aware of all the ways they could reduce their taxes and free up more of their hard-earned money.

Paying more than what you should is a drag, a tax drag, but you don’t have to just accept that what you're paying in taxes is what you should be paying. 

How do you mitigate drag? Strategic tax reduction.

Strategic Tax Reduction 

Strategic tax reduction goes beyond simply finding deductions. It's a detailed, proactive approach that analyzes your full financial picture, requires a deep understanding of tax laws and tax law trends, and implements strategies to minimize your tax liability. There are many approaches to this and many look at investment strategies to reduce drag, we prefer to get to the root cause of the problem and focus on reducing tax liability in ways many others overlook.

Here are some of the strategies we deploy.

Optimizing Executive Compensation

How you structure compensation at your company can has a significant impact on your tax liability and your ability to keep more of what you earn.

This could include:

• Performance-based bonuses: Tying a portion of compensation to company performance incentivizes growth and may be taxed more favorably than a straight salary.
• Stock options and restricted stock units (RSUs): Offering equity-based compensation allows executives to share in the company's success and provides tax benefits when exercised under certain conditions.
• Benefits with tax advantages: Offering benefits like health insurance, retirement plans, and educational assistance can provide value to executives while offering tax deductions for the company.

Overall, an executive compensation study is a valuable tool for mitigating tax drag by promoting informed decision-making when structuring compensation packages for your leadership team.

Choosing The Right Accounting Methods 

Amongst the many tools available, choosing the best accounting elections is one of the most powerful. And, there are many opportunities to explore, including:

• Cash vs. Accrual Accounting: Cash accounting recognizes revenue when cash is received and expenses when paid. Accrual accounting recognizes revenue when earned and expenses when incurred. Choosing the right method can impact your taxable income in a given year, potentially smoothing out tax drag over time.
• Inventory Valuation Methods: FIFO (First-In-First-Out), LIFO (Last-In-First-Out), and Average Cost are different methods for valuing inventory. During periods of inflation, LIFO can reduce taxable income by reflecting the higher cost of goods sold, potentially minimizing tax drag.

Additionally, we can explore depreciation strategies like 179 expense elections for qualified equipment purchases as well as bonus depreciation on top of regular depreciation for qualified property, further accelerating tax deductions and potentially reducing tax drag.

Important notes:

• Accounting elections have long-term implications, impacting future tax years as well.
• Consulting with a tax professional is crucial to understanding the specific benefits and drawbacks of each election in the context of your business.
• The goal is to choose accounting elections that provide a fair and accurate representation of your business's financial performance while minimizing tax drag over time.
  
  

Selecting The Right Entity Structure 

Strategic entity structuring is crucial in mitigating tax drag for your business. For example, in Sole Proprietorships and Partnerships, owners report business income and losses on their individual returns which can put them in a higher tax bracket if they perform well. LLCs allow for pass-through taxation which can be a benefit for businesses with lower profits while C Corps can lead to double taxation for owners. There are many options for business owners, but making an informed choice for their entity structure will significantly impact tax liability. 

Ultimately, the optimal entity structure depends on your business goals, growth potential, and risk tolerance. Entity structuring is a complex area with legal and tax implications. Always consult with qualified professionals to ensure you choose the most appropriate structure for your business and effectively minimize your tax drag.

Planning for Exit 

Exit planning is a powerful tool for mitigating tax drag. Different exit strategies have varying tax consequences and planning helps you evaluate options like mergers & acquisitions or management buyouts from a tax perspective.

At the end of the day, a primary goal of exit planning is to structure the transfer to minimize capital gains taxes on the profits from selling your business which could mean holding onto the business longer if tax rates are expected to be lower in the future or structuring the sale to receive a mix of cash and stock.

If you properly plan your business exit, you can identify opportunities to reinvest your sale proceeds into tax-advantaged investment vehicles.

Earlier, we mentioned having an up-to-date business valuation. Knowing the fair market value of your business is crucial for negotiating the sale price and minimizing potential tax liabilities. Overvaluing could lead to higher capital gains taxes while undervaluing means leaving money on the table.

Business Valuations 

• Optimizing Ownership Structure: Understanding the fair market value of your business allows you to structure ownership strategically. This could involve gifting shares to family members in lower tax brackets, reducing your overall tax burden.
• Negotiating Sale Price (M&A):  An accurate valuation ensures you don't undersell your business during a merger or acquisition. This maximizes the capital gains you receive and minimizes the potential tax impact.
• Charitable Giving:  Donating appreciated assets like company stock based on a fair valuation can maximize your charitable deductions and lower your taxable income.
• Executive Compensation:  Structuring executive compensation packages with stock options or performance-based bonuses tied to the company's valuation can incentivize growth and potentially reduce payroll taxes.

With an up-to-date business valuation, you gain an understanding of your company's worth, allowing you to make informed decisions that minimize your tax liability and maximize your after-tax profits.

Estate Planning 

• Estate planning strategies like utilizing trusts, charitable giving and lifetime gifting which allow heirs to receive the assets outside of your estate, potentially reducing their tax burden. 
• The type of assets you leave your heirs can impact their tax situation.  Estate planning can help you minimize taxes on inherited assets.  Leaving assets with a low basis and high potential for future growth can expose your heirs to significant capital gains taxes when they sell. Strategies can involve using assets with a higher basis to minimize this impact. Assets held in retirement accounts like IRAs or 401(k)s are generally subject to income tax when withdrawn by beneficiaries.  Planning can involve maximizing Roth conversions or other strategies to minimize this tax burden.
• Efficient Distribution of Assets:  By outlining how you want your assets distributed, you can potentially minimize the tax impact on your beneficiaries. For example, spreading out distributions over time can help your heirs avoid being pushed into a higher tax bracket due to a sudden influx of income.
  
  
  

Real Estate Incentives

Real estate investments offer several advantages when it comes to mitigating tax drag. Here are some key ways real estate interests can help you reduce your overall tax burden:

• Depreciation deductions allow you to deduct a portion of the building's cost (not the land) from your taxable income each year. This spreads out the cost of the property over its useful life, reducing your taxable income and potentially minimizing tax drag in the early years of ownership.
• A 1031 exchange allows you to defer capital gains taxes when selling an investment property and reinvesting the proceeds in a similar property of equal or greater value. This can be a powerful tool for growing your real estate portfolio while minimizing the immediate tax impact.
• Over time, as you make capital improvements to your property, the basis (original purchase price + improvements) increases. This can reduce your capital gains tax. 

Additionally, there are several other techniques that can help minimize the impact of taxes on your investments. These include:

• Tax-loss harvesting: This involves selling investments that have experienced a loss to offset gains in other investments, reducing your overall tax liability.
• Asset location: By strategically allocating your investments across different types of accounts, such as taxable accounts, tax-deferred retirement accounts, and tax-free accounts, you can optimize the tax efficiency of your portfolio.
• Charitable giving: Donating appreciated securities to charity can provide a tax deduction while also eliminating the tax liability on capital gains.
• Roth conversions: Converting traditional retirement account funds to a Roth IRA can provide tax-free growth and withdrawals in the future.