The 12 Tax Days of Christmas: Day 2
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Rather than your true love sending you a partridge in a pear tree, wouldn’t you appreciate some money-saving tax tips? For my year-ending 12 Tax Days of Christmas series, I’ll dig back into the archives of previous topical columns to reiterate understandable, realistic and legitimate tax strategies that you need to implement now in order to have a much smaller tax bill come April 15.
For this second tax day of Christmas, it's worth noting that most tax strategies implemented before year-end are meant to save taxes in the current year. Thus, a frantic rush of reviewing financials and speaking with tax professionals bears down on us as we try to enjoy our holiday. However, many taxpayers don’t realize that there are several tax strategies for 2020 that must be implemented at the beginning of the year, or they could miss out on thousands of dollars in savings.
Again, many of these strategies apply to business owners, but we’ll start the list with one any taxpayer could utilize if their situation applies. And remember: If the shoe fits, pull the trigger before January 1.
Health Savings Account (HSA)
This strategy is as strong as ever and a huge opportunity for taxpayers who don’t use all of the health insurance they're paying for. Thus, if you are generally healthy, you may want to consider a high-deductible health care plan so you have a safety net if something really bad happens, but in the meantime you can save on premiums and build a tax-free savings account.
HSA contributions are deductible from your gross income on the front page of your tax return (whether you own a business or not) and not only save you taxes, but could also place you into a lower tax bracket. In 2020, the tax deduction is up to $3,050 for singles and $7,100 for families. The funds grow tax-free and aren’t considered a "use it or lose it" plan (called a Flexible Spending Account). The account is yours, and you can take it with you anywhere you go and build it for your future healthcare needs. You can take tax-free withdrawals for qualified medical expenses, and you can invest the money in much the same way you invest an IRA. You can even self-direct an HSA and invest the funds in real estate.
So what’s the catch? If you don’t have the account set-up and effective in 2020, you can’t take the write-off next year. Many taxpayers are choosing their insurance for next year in December and January, and you want to make sure you don’t miss out on choosing a high-deductible HSA qualifying plan. For more information on the HSA strategy, read my thoughts on “Why an HSA may be your Best Tax AND Health Care Strategy”.
Health Reimbursement Arrangement (HRA)
This is NOT an account that you can invest and take with you like an HSA. It is also NOT a "use it or lose it" plan. The HRA is a "reimbursement" plan adopted by small-business owners to pay for health care expenses over and above health insurance. However, if you want to implement one in 2020 and get a coveted tax write-off for all of those health care expenses, you have to implement it on January 1.
The HRA allows you to set up your own “benefit plan” for health care and reimburse yourself for ALL of your health care expenses -- thereby getting a 100 percent write-off for all of your medical expenses. Now, this strategy must be used by a small-business owner, and again, the average American can’t even dream of implementing it. The only challenge can be the structure you need to use in order to make the plan work. Sometimes, it takes a little extra business planning and structuring -- and certainly some attention to bookkeeping -- to make it happen. But again, it can be very lucrative and worth the extra time.
With a little bit of tax planning with a CPA who understands the HRA, you can take massive tax deductions for your healthcare expenses over and above your health insurance. For more information, read my thoughts on “How an HRA can save you Thousands when Facing Extra Health Care Costs”.
S Corporation (S Corp)
If you missed the boat on the S corp tax-savings strategy in 2019 and paid far too much in self-employment taxes, don’t delay and make the same mistake twice. The S corp is the top small-business tax-savings strategy and critical for any business owner netting more than $40,000 a year in profits. It’s such an important tool for entrepreneurs that it was our first tax strategy of the 12 Tax Days of Christmas.
If you know that 2020 has good things in store for you and your business, make sure the S corp is set up and effective January 1. We can’t backdate the set-up of an Inc. later in the year if you forget to take action now.
LLCs aren’t just for holding rental property or a partnership. They can also be a great stepping stone for a new business owner once they have an operational business. The same holds if the owner sees a potential for growth and the need to save on self-employment tax or has some liability exposure from the operations and needs a formal entity to legitimize the business.
Now, if you KNOW you are already going to net $40,000 or more in 2020, then go back to the previous strategy and just set up your business with the S corp Entity/Inc. However, if you don’t know for sure, but HOPE to make $40,000, set-up the LLC now with the ability to make an S election retroactively to the beginning of any tax year without a timing problem.
In this situation, an LLC can be a great starting place and even help keep costs down. It typically involves a Single-Member LLC, owned 100 percent by one individual who gets asset protection, yet no extra tax return, and again the ability to "go back in time" and make it an S corp on January 1, 2020.
Again, the only way to implement this strategy is to set up the LLC now and make it effective January 1. We can’t backdate the set-up of an LLC later in the year, so look into your crystal ball and see if this strategy could get you out of hot water in late 2020 when your business takes off and brings in the big bucks. For more information, read my answer to the question of, “Should I have a Limited Liability Company (LLC)”?
199A Pass-Through Deduction
Under the new Tax Cuts and Jobs Act, effective January 1, 2018, small businesses began receiving a big tax break with a 20 percent deduction off their bottom line. However, it’s more simply said than explained and implemented. If you are in an industry considered to be an "out-of-favor specified service trade or service," you lose out entirely on the tax deduction when you have taxable income greater than $415,000 (married filing joint), or $207,500 (single or head of household).
These "out of favor" businesses include professions such as dentists, doctors, accountants, lawyers, actors, actresses, athletes and financial advisors, just to name a few. The new strategy that has evolved after the final regulations were issued on IRS Section 199A is that a business owner that is "out of favor" can now spin off operations that aren’t related to the "out of favor" service and get the 20 percent deduction on the "other" income they are generating.
For example, if a veterinarian is also selling dog food and boarding animals, they could set up a separate entity (an S corp, probably) for the operations unrelated to the medical services provided to animals and cash in on a whopping 20 percent deduction of all profit off the bottom line.
The catch is, if you want to capture all this income in a different bucket for 2020, you have to set up the entity and structure now so it’s effective January 1. Again, you can’t just wish it so or backdate documents later in the year when you get around to considering the strategy.
In summary, the time is now if you want to carve up your business operations or implement strategies for some big write-offs in 2020. Proactive planning is critical and a huge reason why tax advisors are swamped in December and not in April. If any of these strategies look like they may work for you, don’t watch too much football during the holidays and take a little time to do some strategic planning.