For every startup, the goal is to earn as much as possible in your first couple of years, not wholly deter outright failure. Financial planning for maximum tax savings is tricky, especially if you’re unsure what to do. With the right tax planning team, there are ways to help you cut down your tax liabilities.
If you’re looking to get more out of your hard-earned money, proper financial planning now can save you a lot of money for future success. Here are x strategies for tax savings that every startup needs to do.
Take Advantage of the Qualified Small Business Stock (QSBS)
If you are a founder, among the most important considerations you need to add for your startup is the Qualified Small Business Stock or QSBS exemption. This type of stock has the potential to cover all or a good chunk of your gains when you sell.
QSBS is a type of stock that can give you 100% exclusion from capital gains tax for its sale. It follows several requirements so you can consider the stock as a QSBS, including:
- Direct stock acquisition from the company, either through a transaction or as payment for services; acquisition from another person does not provide a tax break
- Issuer must be a registered C corporation, rather than an S corporation
- Corporation’s assets must be below $50 million before and after the issuance of the stock
- The corporation must not be in a disqualified category, including banking, insurance, finance, investing, leasing, farming, mining, or hospitality
- Both corporation and shareholder must provide consent for documentation of the stock
If you have owned a stock past September 27, 2010, for more than five years, the gains on the stock are tax-free. You can exclude any gain of up to $10 million or ten times the asset’s original value.
Register Your Business as an LLC
If you’re planning to start your own business, one of the most important decisions you need to consider is the type of legal entity your business will be. While a C corporation is the usual choice, you can also evaluate other options, such as an LLC.
An LLC can give you more benefits than a corporation, including lower taxes, easier business management, liabilities protection, and financial flexibility. For example, taxes as an LLC are lower than the taxes you pay as a corporation. LLC also has fewer rules to follow than other types of legal entities.
As a business owner, you can protect your personal assets from your business liabilities, especially in the event of bankruptcy. You can also choose how your business will be organized, including compensating your employees.
Use A Parent-seeded Trust
One of the essential tax planning for startups is setting up a parent-seeded trust, which is a type of trust that spreads out your income. When you set up a trust, you can distribute your income to your child, grandchild, or sibling. If you’re the startup’s founder, this is a great way to plan for future generations while minimizing taxes.
A parent-seeded trust is a trust that can be set up by a business founder’s parents, with the founder acting as the beneficiary. The startup founder can then sell shares to the trust, eliminating gift taxes and not using any lifetime gift exemption. This, however, disqualifies the founder from using the QSBS.
One powerful benefit of a parent-seeded trust is removing the asset from the parents and the founder’s estate. This means the asset is not subject to potential estate taxes, and if you can find tax-exempt states to set up on, you can also eliminate home state-level taxes. With the right setup, this can build a 10% state-level tax savings.
Defer Income To Reduce Your Taxable Income
One of the common ways startups save money is by deferring income. According to the law, you can defer payment until a specific future date, making for a tax-free gain. This is especially useful for startups because startups are not taxed until their first income, unlike other businesses.
Deferred income can include a founder’s salary, employee benefits, dividends, and other distributions. For example, if you decide to defer your income, you would rather spread it out over time instead of taking your income in a fixed amount every year.
When your income is not taken in a fixed amount, your taxable income will be lower. This can reduce your tax liability, which is essential for startup founders.
Set Up A Grantor Retained Annuity Trust (GRAT)
A Grantor Retained Annuity Trust or GRAT is a type of trust that tries to minimize estate tax exposure by transferring your wealth outside of your estate. This robust process is helpful if you have a unicorn position with your startup and can’t use QSBS.
A GRAT allows founders to transfer their appreciable assets into the GRAT. The trust will then stream back in the form of annuity payments, with the IRS 7520 rate used as a way to calculate these annuities. The idea is to have the assets growing faster than the 7520 rates, the excess of which is paid back to the founder.
All the remainder from the GRAT is excluded from the owner’s estate, which can then transfer to the founder or their beneficiaries. If you have stocks that you’re expecting to grow in value, it’s best to transfer them into a GRAT, so the trust gets most of the value from the stock’s pop.
All this upside is gift and estate-tax-free, together with a structure that uses a grantor trust. These structures allow for the founder to pay for the taxes incurred by the trust. One downside of this process is that the founder/grantor needs to outlive and survive the duration of the GRAT, otherwise everything returns to their estate.
The Bottom Line
Starting a business can be scary, but you can minimize your tax liabilities and maximize your savings with proper planning and goal setting. Having proper tax planning strategies in place can help you save a lot of money, which you can use for other essential company needs.
While tax planning for startups is complex, you can better manage your taxes with the right professionals. If you’re looking for the right team to help you plan your startup, the right financial planning team can guide you to financial freedom.