The Do-It-Yourself Tax Cut
You can lower your tax bill, provided you're willing to do some planning
Although accountants love to emphasize that tax planning should begin on day one of a company's operations, this seldom happens -- especially when the company intends to remain private. And that's all right. Most entrepreneurial ventures generate losses for years, which keeps Uncle Sam's tax bite tiny at best.
But for growing businesses, there comes a time when tax planning becomes desirable -- even essential. For every company, the impetus is different: it might come from a business event, such as the acquisition or sale of a unit; or from a personal matter, such as the death of a partner, a divorce, or the birth of a child. When venture capitalists or investment bankers become involved, they will probably insist on seeing some tax planning. And for some companies, it simply evolves from the owner-manager's gut instinct that he is paying too much money in taxes, money he'd rather use to grow the business.
"I never thought about things like tax planning," says John Richardson, chief executive officer of Morpheus Lights Inc. "For about 10 years I just stayed with the same accountant my mother had found for me when I was in high school. All I cared about was getting my checkbook balanced."
Back in the early 1970s Richardson was a San Jose, Calif., teenager who earned money by manning the lights for local rock-and-roll bands. He stored his supplies -- mainly a few fixtures, cables, and slide projectors -- in his mother's garage. His vision of success was a road show, when he'd load his lights onto a truck and spend a few weeks traveling with the guys in the band, setting up and dismantling his equipment at auditoriums along the California coast.
Today Richardson's company, with projected 1989 revenues of $14 million, is one of the nation's top lighting-service companies, shining the spotlight on such celebrities as The Grateful Dead, Bruce Springsteen, and Oscar of Academy Awards fame. With a 40% annual growth rate for most of the 1980s, Morpheus now employs about 175 people and has spun off a separate unit to sell its founder's patented, computer-operated lighting systems both in the United States and overseas. But it's taken years for Morpheus's tax savvy to catch up with this growth.
For Richardson, the push came four years ago when he applied for his first bank loan: $1 million to finance the purchase of state-of-the-art computer and lighting systems. Richardson brought in an experienced accountant, Bill Burt, to get his finances out of the garage and to generate the frequent and detailed financial reports the bank required. After two years as a consultant, Burt joined the company as director of finance and brought in a team from the San Jose office of Price Waterhouse because, as he puts it, "I was so busy trying to keep up with our expansion that I didn't have time to do the tax returns, let alone think about tax planning."
Tax planning means different things to different people. A manager who decides to buy a piece of equipment in December instead of January is doing a pretty good job of anticipating and reducing taxes. But for larger, growing companies, the most effective approach is a comprehensive one, similar to a medical checkup, that is carried out by a tax expert.
If done thoroughly, the initial stage takes months. Dave Dillwood, the Price Waterhouse accountant who worked with Morpheus Lights, came with a mandate to examine everything from the company's legal structure and accounting methods to the costs of developing the equipment Richardson kept tinkering with in the back rooms. Often, as happened with Morpheus, it is the chief financial officer rather than the CEO who is most closely involved at this stage. "I was like a sponge," Burt recalls. "Dillwood just kept squeezing more and more numbers out of me."
Although tax planning might sound off-putting to nonaccountants, it's similar in many ways to drawing up a business plan. First you do research, attaching a number to every expense, activity, product, and so on. Then you estimate what those numbers will look like three to five years from now, provided the company grows at its current pace. Finally there's the $64,000 question. If the company stays on course, how big will its tax bill be over the next five years, and what can you do to bring it down?
From Dillwood's point of view, Morpheus represented a host of opportunities -- for tax savings, that is -- just waiting to happen. But convincing Richardson and Burt was another matter. "You've got a company that's doing great and suddenly the accountant comes in and says, 'Yeah, but you'd be even better off if you did this, this, and this.' It takes time," Dillwood admits, "and the accountant has got to prove that his suggestions make sense from the business's point of view, not just for tax purposes."
Tax-planning prescriptions will differ depending upon a company's industry, product lines, research activities, and location. Dillwood's wish list began with research-and-development expenses, since Richardson was the type of CEO who couldn't stop inventing new systems for computer-controlled stage lights, even new truss structures to carry his light systems. For the preceding five years, Morpheus had been on an R&D fast track. Yet the company had no sense of the cost of developing each of its new products or how much it had spent on R&D equipment, personnel, and so forth.
That was an expensive oversight, since research and development adds up to a double benefit at tax time: first, R&D costs get expensed (that is, subtracted) from a company's tax bill during the year in which they are spent; second, R&D assets are depreciated faster than normal assets, so their cost is usually deducted over five years, rather than seven.
For Morpheus to qualify for these R&D benefits, it had to begin keeping more detailed records, and it had to transfer its R&D efforts to a separate locked room. (Internal Revenue Service rules require R&D assets to be used "principally" for research, so companies have to be able to demonstrate that the equipment is either kept apart from other equipment or is used no more than 20% of the time for non-R&D activities.) But the payoff has been enormous, Burt says: "We've generated more than $300,000 of R&D credits since we started doing tax planning."
Dillwood's next recommendation, that Morpheus switch to S-corporation status, didn't particularly appeal to Richardson. He was wary of a change from the standard C corporation, which had worked well for more than a decade. But Dillwood and Burt emphasized that the switch would affect only the company's tax status (S corps are taxed the same as partnerships, not corporations). For legal and other purposes, Morpheus would be the same as it always had been.
Finally, after about a year of discussion, the numbers sounded too good for Richardson to resist any longer. Here's how they work: if a standard corporation earns $100 of income, it pays $34 in corporate taxes; when the remaining $66 gets distributed as dividends, another $22 goes to pay personal taxes. Aftertax income: $44, assuming a 33% individual tax rate. But if an S corporation distributes the same $100 to its shareholders, all that is charged is one tax, the personal tax. Aftertax income: $67.
S corps represent one of the last great tax breaks for small businesses. But in order to qualify, companies must meet certain standards. These include the following: no more than one class of stock, which precludes most venture capital deals; no more than than 35 shareholders; compliance with passive-income restrictions; and no wholly owned subsidiaries. But there's no need to worry about S-corp status turning into a straitjacket. If and when it stops making sense for a company, opting out is as simple as filling out some paperwork or selling a different class of stock.
In Morpheus's case, there were other tax changes as well. Some were as seemingly obscure as using different depreciation schedules for certain assets at the state level, which enabled it to capture some deductions faster by taking advantage of California tax laws. And more changes will come as the company grows and diversifies. International tax planning, for example, will become essential if Richardson succeeds in exporting his lighting services and products.
After two years of tax planning, John Richardson -- who hits the road occasionally with longtime clients like Huey Lewis and the News and, for the past year, Rod Stewart -- doesn't pretend to be involved with the minutiae of accounting methods or depreciation schedules. Nor should he be. But he and Burt are more than satisfied with the results of good planning. Burt estimates that Dillwood's efforts have saved 10 times as much in taxes as he has charged over the years, savings that reach well into the hundreds of thousands of dollars.
Richardson, who still shows up at the office in sunglasses and shorts, leans back in his chair and smiles. "What tax planning has given me is even more money to invest in building my business."
THE ABCS OF TAX REDUCTION
How to start the planning process
For many entrepreneurs, tax planning sounds as unattainable as a month's vacation in the Caribbean. Not true. Here are some simple ways to get started:
* If you don't have an experienced tax person in your company, get an outside accountant to do a comprehensive tax checkup that includes analyses of accounting and record-keeping methods and tax returns for previous years. (You should understand, Dave Dillwood of Price Waterhouse says, that if you amend prior returns to capture missed deductions, you run a higher risk of being audited by the Internal Revenue Service.)
* Schedule two to four tax-planning sessions with your outside accountant each year to evaluate the following: your company's performance; timing of purchases, sales, and other business activities; and possible new tax-reduction strategies.
* Focus on tax strategies that add business benefits, not those that just refund dollars or reduce audit risks.
* Coordinate corporate tax planning with personal tax planning, since there is often an overlap of interests. In the case of Morpheus Lights Inc., director of finance Bill Burt handles CEO John Richardson's taxes but consults with Dillwood on how to maximize the personal/corporate bottom line.