Why are tax writers missing the #1 tax-saving opportunity?

“The perfect tax plan or tax shelter, if such a thing exists, would allow us to do most or all of these things:

1. receive or gain control money without paying taxes,
2. take a tax deduction for the amount invested,
3. allow that money to grow and accumulate without paying taxes, and then
4. allow us to disperse, spend and distribute that money as we wish without paying tax”

Yesterday I read the PwC “Wealth Planning Guide 2019” with special focus on the tax planning section. Today I read the Wall Street Journal’s Report “The New World of Taxes: 2019“. Both reports are written and edited by the top tax professionals in the industry. Yet I was surprised and perhaps even dismayed to find out that neither publication included the tax strategy that has become core of my financial plan and the legal tax avoidance strategy of many of my most successful clients. As a sole practitioner tax adviser, it would be great to read that big tax writers recognized and endorsed this strategy. That is not the case. It doesn’t mean that my tax strategy isn’t valuable. It does mean that I should ask some more questions to learn why big publishers ignore such an attractive way to reduce taxes.

This blog post is meant to explore the question of why the big tax writers miss the tax saving strategies we use most often in my small business practice.

The ideal tax plan

It makes sense to first take an abstract high level view of tax planning. The perfect tax plan or tax shelter, if such a thing exists, would allow us to do most or all of these things:

1. receive or gain control money without paying taxes,
2. take a tax deduction for the amount invested,
3. allow that money to grow and accumulate without paying taxes, and then
4. allow us to disperse, spend and distribute that money as we wish without paying tax

Not every tax-smart strategy will achieve all the goals. In fact few if any will. That’s OK. The point is that we want to be aware of the ideal situation, the Holy Grail, of tax planning in a perfect world. Of course, in the real world these four points are never the only factors to consider; there are always other factor and trade-offs.

It makes sense, in this adviser’s mind, to rank tax planning strategies in terms of how close they come to this ideal. So, by this system, the “#1 tax strategy” would be the one that comes closer to this ideal than any other.

The small business market

My world is small business; mostly people who have worked hard through their own labor to achieve financial success. They may define that as a half million dollars or ten million dollars. The represent the top 1 in 5 most financial successful in their community but not the top 1 in 100 (aka “1 percenters”) who are mostly not in my market.

It seems clear that while this small business market is the focus of my world, it is not a focus of PwC or The Wall Street Journal. Neither report mentioned above uses the term “small business” even once. Yet I could easily argue that there is no better tax planning vehicle than a small business. The fact that our audiences differ likely explains the largest difference in tax strategies used.

Lower corporate tax rate

There is much discussion in the tax community this past year that the lower flat tax rate of 21% in corporations makes this a more attractive organizational form. Think about what this means: no matter what business, no matter what industry or transaction, no matter what money-making scheme is used – the tax is always just 21%! For those of us who have worked hard to get clients down to a 21% tax rate in the past, this new law seems too easy. 21% tax on recognized income!? I’ll take it. (Remember that unrealized income including appreciated value of assets avoids this current tax anyway).

Avoidance of double taxation

Advisers may caution that the corporate tax strategy above is only part of the story. There is a second tax when the money leaves the corporation. We refer to that two step tax as “double taxation”. But in the small business world, double taxation is seldom a problem. Owners and family members typically tax planned salaries and benefits. Those two strategies – spreading salaries among family members and awarding generous tax-advantaged employee benefits – save small business owners huge amounts in taxes. That money is not subject to the 21% tax. Most of the remainder of accumulated earnings is invested in making the business more valuable. Other strategies like corporate borrowings tend to amplify this effect.

Qualified small business stock

Section 1202 of the Internal Revenue Code makes it relatively easy for small business owners and investors to avoid tax altogether by holding qualified small business stock for five years. Five years is a short time in the life of most successful small businesses. The rules are relatively simple and there have been relatively few problems or controversies in this type of tax shelter. If properly structured, it is possible for an investor to benefit from a tax deduction shortly after investing, to avoid taxation on all or most of the stock acquisition, to allow assets to grow tax-free and then cash in with no tax. It can come close to the ideal tax strategy described above. In almost all cases, this tax strategy comes closer to the ‘ideal’ than tax strategies covered in by the major tax planning publications.

A starting point, not an end

Tax free qualified small business stock, along with other small business strategies mentioned, is the starting point of a winning long term tax strategy. It is not the only strategy. It will be used in combination of other financial, business, estate and tax planning strategies. But the point of this blog post is that this strategy can easily be the core of tax-free retirement future for many small business owners and investors.