In Part 7 of this series, we discussed how your MSP's business structure determines how you are taxed under U.S. federal laws. Tax planning starts with choosing the correct business structure. This time, we'll look at ways to use tax planning strategies to minimize your tax burden.
First, it's important to understand the big difference between tax avoidance and tax evasion. In a nutshell the first is legal and smart; the second is a criminal offense and not smart at all, if you want to stay solvent and stay out of jail. Tax planning is a way to avoid paying any more tax than you absolutely have to, while staying within the law. Many people pay more than they have to, because they don't take legitimate deductions or credits to which they're entitled, or they time expenses or revenue in such a way that it increases their tax burden.
Another important point is that your goal isn't just to reduce your taxes, but to maximize the amount of profit that you get to keep. Spending money just to get a tax deduction, which you wouldn't otherwise have spent, might still leave you with less money than you would have had without the expenditure. It also amuses me when people say something like, "Oh, we can buy the expensive one because it's a tax write-off," as though a deduction reduces your tax dollar-for-dollar. It doesn't. If you have a $100 business expense, it reduces the income on which you are taxed by $100 – it does not reduce your total tax by $100.
The actual tax reduction depends on your income bracket. Let's look at an example (which is overly simplified for the purposes of illustration): If you take a $100 deduction, and you're being taxed at 30 percent, your tax will be reduced by $30. You'll still have $70 less money after the write-off than you would have had if you hadn't made the expenditure.
The difference between a tax deduction and a tax credit is important and substantial. A tax credit can reduce your tax by the amount claimed. So if you take a credit for $100, your total tax is actually reduced by $100. Credits, however, are given only for a few specific expenditures and often come with limits. For example, there are tax credits for hiring persons from certain target groups (such as wounded war veterans) or for making your company more "green." You should have your tax accountant explore all avenues for possible tax credits.
You've probably heard the old saying that "timing is everything." It's certainly an important thing when it comes to reducing your taxes. Accelerating or deferring an expense or income can help you to control your taxable income for the year. Shifting income and expenses that come up near the end of the year over to the next year can save you money if it helps you avoid being bumped up to a higher tax bracket for one of those years. Of course, if tax rates are scheduled to increase next year (as they are expected to do in 2013), it would be smart to accelerate income into the current year and/or delay expenses to help reduce your income under the new, higher tax rates. You can do this by billing early, by trying to get more customers to pay in advance for long-term service, and by selling capital assets before the end of the year. Similarly, wait until next year to make big expenditures where you can, so you'll have those deductions next year when you need them most.
Finally, avoid the cost of penalties and interest by filing returns by deadlines and making estimated and other payments on time. You can request an extension for filing a return but you still most pay what you estimate you owe along with the extension request, and if your estimate is too low, you'll have to pay a penalty on the amount not paid on time.
Dealing with the complicated tax code can be frustrating and stressful, and tax planning isn't one of the most fun parts of running an MSP, but it can make the difference between a successful business and one that fails. Although a tax professional may seem like an unnecessary expense if your business is small and you're on a tight budget, it's an expense that will more often than not pay for itself – and more – both in monetary savings and in peace of mind.