Stop Tax Surprises: 4 Levels of Tax Planning

Did you know there are different levels of tax planning? That’s why you may have experienced a tax surprise even though you paid your estimated tax payments.

Here are the main 4 levels of tax planning and how they affect cashflow.

  1.  Avoid Penalties

The basic level of tax planning is to calculate the minimum amount you owe to avoid paying a penalty to the IRS and state.

Background: The IRS requires taxpayers to pay at least 90% of the tax for the current year or 100% of the tax shown on the prior year return, whichever is smaller.

The simplest version of tax planning is to pay 100% of the prior year return.

Example:

Prior year taxable income is $35,000

30% tax

Prior year tax $10,500

Your tax accountant gives you estimated tax vouchers that total $10,500.

This level of tax planning

  • Eliminates tax penalties
  • Does not reduce financial surprises

The problem with relying on this tax planning method is you’ll most likely experience tax surprises, because the calculation does not consider changes that are guaranteed to happen.

  1.  Adjusted Prior Year

This level of tax planning considers the changes the tax accountant knows will happen even if everything in your business stays the same.

The most common example of this is related to depreciation expense. The section 179 deduction allows companies to claim 100% of the purchase price as a depreciation deduction in the first year. The depreciation deduction is zero for the remaining years of the asset’s life.

With this level of tax planning, the tax accountant will adjust taxable income for the section 179 deduction claimed in the prior year.

Example:

Prior year taxable income is $35,000

Add back the section 179 depreciation deduction of $65,000

Adjusted prior year taxable income = $100,000

30% tax

Estimated tax $30,000

See the difference the adjustment makes. Nothing else changed in the business other than the depreciation deduction is zero in the following year.

The estimated tax owed increased almost $20,000 from $10,500 to $30,000

This is why tax surprises happen!

The good thing about this level of tax planning is that you’ll know the total tax is $30,000 so you can plan for it.

This level of tax planning

  • Eliminates tax penalties
  • Reduces financial surprises, but does not eliminate them.
  • Does not consider changes in your finances for the current year
  1.  Annualize Current Year

Your tax accountant will review your financial reports for the current year to estimate the annual taxable income. The accountant looks for changes in assets and net income. This type of planning is usually provided during November or December by reviewing the previous 10 months.

Example: Business grew and taxable income increased to $175,000.

30% tax rate

Estimated tax $52,500

If continue to pay the minimum of $10,500, you’ll likely owe the difference of $42,000.

This level of tax planning is great when taxable income fluctuates from year to year.

  • Eliminates tax penalties
  • Reduces financial surprises
  • Consider changes in your finances for the current year
  • Does not include tax strategy to save money

Even if you know you’ll owe $42,000 by April 15th, do you wonder if you could have reduced the tax bill?

  1.  Tax Strategy

With this level of tax planning, your accountant will run tax projections based on various scenarios.

What if we…

  • Elect S Corp status?
  • Start contributing the maximum amount to a retirement plan?
  • Borrow money to buy two new trucks?
  • Buy a competitor that will double our sales?

This level of tax planning helps estimate how much tax you’ll owe for the current year and consider the pros and cons of making big financial changes.

  • Eliminates tax penalties
  • Reduces financial surprises
  • Consider changes in your finances for the current year
  • Includes tax strategies to save money
  • Does not consider affect on cashflow

Caution: The only way to reduce income taxes is by spending cash. Balancing tax deductions while preserving cash – working capital – is a key to growing a financially strong business.

Tax Planning vs Cash Management

Now that you know how much tax you’ll owe, it’s time to consider when to actually pay the tax.

From a cash management standpoint, you have options:

Option 1: Pay the minimum of $10,500 through quarterly estimated tax payments. Save the difference and pay the balance by April 15th.

This helps you avoid penalties while waiting to the last minute to pay the tax authorities.

Caution: Don’t spend the tax money or April 15th will be painful.

Option 2: As you update the total estimated tax due, change the tax payments to cover the increase. You’ll likely owe $0 when you file your tax return.

By matching the money coming in with the tax period it applies to, you’ll avoid paying penalties and stay off the cashflow rollercoaster.

Bonus: you’ll sleep well at night knowing your taxes are paid.

Bottom Line

Tax planning is a vital part of running a financially strong company. When done correctly, you’ll feel confident you are claiming everything you legally can without tax penalties or cashflow surprises.

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