Salaries Vs. Dividends
Pay yourself appropriately
This is a big and often confusing issue. Do it right, and you can get big savings; do it wrong, and IRS scrutiny will almost certainly follow. If you've set up your business as a C corporation, your compensation qualifies as a deduction at the corporate level and is taxed at the individual level at marginal rates. If the payment is made as a dividend, it does not qualify for the deduction at the corporate level, but the recipient will be taxed at the low dividend rate of 15 percent. Which is the better strategy? That depends on whether you're trying to reduce tax at the corporate level (by paying out higher salaries and taking larger deductions) or at the owner level (by using dividends). You can't go overboard on salaries here to get a massive deduction, though. Tax rules require salaries to be "reasonable" (there is no set definition, but authorities look for salaries to be generally in line with salaries at similar companies); if they're not, the IRS may redesignate some portion of them as dividends.
The situation is reversed for S corps and other pass-through entities because the business itself owes no tax on the income; the owners do. If you're the owner, you'll have to pay self-employment tax on your compensation (12.4 percent for Social Security up to the cap, plus 2.9 percent for Medicare) but not on flow-through income from the business. Obviously, the less money you take as compensation, the lower your tax bill will be. But you can't go overboard here either. The same rules about reasonable compensation apply; in other words, you can't pay yourself nothing and expect to get a tax break as a result. In fact, says Skoda Minotti's Steven Hartstein, the IRS has begun scrutinizing certain companies that have done precisely that. "This is the hottest issue," he says. "Some advisers told their clients that they didn't need to take any salary whatsoever, and those people are getting killed in audits."
Cash Vs. Accrual
Change the way you count your cash
The way you account for your cash has a huge impact on your bottom line and your tax bill. Broadly speaking, there are two ways of accounting for tax purposes--the cash method (meaning you report income in the tax year you receive it and deduct expenses in the tax year you pay them) and the accrual method (in which you report income when you earn it and deduct expenses when you incur them, regardless of when the payments are made or received). Large businesses and those that keep inventory on hand are required to use the accrual method, but smaller companies get to choose. Which one's better? It depends on your cash flow and overall level of income and expenses. One advantage of the accrual method is that it tends to smooth out net income, eliminating peaks that may be taxed at a higher marginal tax rate. The cash method, however, offers more flexibility in pushing income to a later year or accelerating deductions into the current one.
But beyond the broad decision between accrual and cash accounting methods, there are numerous other accounting choices--on items such as advance payments and prepaid expenses, for example, or depreciation--each of which has its own impact on the bottom line and your tax bill. You'll need to talk with your accountant to figure out which ones are best for you. Many changes can simply be reported to the IRS, though certain moves require advance approval. "You shouldn't shy away from changing to a beneficial accounting method just because it is something that the IRS will be aware of," says PricewaterhouseCoopers' Carolyn Canova.
Real Estate
A new way to depreciate
Accountants are talking a lot about something called "cost segregation" for real estate assets. It could save you a bundle if you operate a major manufacturing facility. With cost segregation, instead of simply depreciating your holdings in one big lump sum over 39 years (as required for commercial real estate), you divide the property into pieces, some of which (specialized plumbing or electrical systems, for example) can be depreciated much more rapidly. The result is a lower tax bill and improved cash flow today. Real estate investors have been doing this for years, but tax accountants have only recently begun applying the strategy to a broader range of clients. You'll likely need to do a cost-segregation study before you proceed, which can cost thousands of dollars. David Grant, director of the real estate group at Mintz Rosenfeld & Co., an accounting firm in Fairfield, New Jersey, says that 20 percent to 40 percent of the cost of a property typically can be reclassified to a shorter depreciation timetable. "A warehouse will be closer to 20 percent and a nursing home or manufacturing facility will be closer to 40 percent," he says. Margaret Amsden, an accountant at Clayton & McKervey in Southfield, Michigan, adds that if you've purchased a building with extensive electrical, mechanical, or plumbing upgrades, carving out those pieces for shorter depreciation will likely give you bigger tax savings.
A couple of caveats: If the real estate is held in an entity separate from the operating company of the business, you may run up against the passive-activity loss rules, which limit losses permitted for tax purposes and could reduce or wipe out the benefit. What's more, the strategy is best suited for properties valued at $1 million or more, given the up-front costs involved.
