Taxes are going up. Way up. Starting this year and continuing through 2018, a series of taxes on earned income, investment income, payrolls and certain benefits will increase dramatically. Healthcare reform, the Fiscal Cliff resolution, adjustments for inflation and other factors are the root cause. The net impact on business owners will be greater than that experienced by workers because there are tax increases at both the company and the personal level. There are different strategies you can implement—with proper planning—to soften the blow of these tax increases. A single approach just won’t work anymore. It’s important to coordinate your personal and business tax planning strategies to reach the goal: paying the least amount of taxes required to comply with the law.
Borrowing money is a relatively simple and proven way to lower your business and personal income taxes. Borrowing just for the sake of lowering your taxes may not be a good idea, but the ability to put that money to work and pay lower income taxes—as an added benefit—is attractive. Here are some simplified examples.
For businesses, interest expense lowers your taxable income dollar for dollar. Let’s assume that your company is a single-member LLC, which for tax purposes means that your profits flow through to your personal income taxes and you will pay personal income tax rates on the business income. If you have taxable income of $300,000 and zero debt, then your tax liability would be $82,900 (27.6 percent) on this income using 2013 tax brackets.
Let’s assume now that the same business borrows $500,000 at 6 percent with monthly payments and a 10-year payback period. During the first year, the company will have accrued $28,976 in interest expense. This lowers the taxable income from $300,000 to $271,024 which in turn lowers the income tax liability to $72,760. This $10,040 represents a 12.2 percent reduction in your income tax liability. Another way to look at it is to say that your interest cost wasn’t really 6 percent but instead 3.9 percent if you consider the tax savings as a reduction to your interest costs ($28,976 - $10,040 = $18,927). Either way, you benefit by borrowing, assuming that you have a good use for the funds.
The interest costs of some types of personal debt can also lower your tax liability. This is a little trickier than business-related interest because the use of borrowed money impacts tax deductibility. There are two types of personal interest expenses which are not tax deductible:
Consumer loans: Interest that you pay on your credit cards for personal use, money that you borrow from a friend for personal reasons and other personal loans don’t offer any type of tax benefit.
Tax-exempt investments: If you borrow money to invest in municipal bonds or other types of investments where you don’t have to pay taxes on the profits, you can’t deduct the interest expense.
Other types of interest expenses are deductible for tax purposes, including:
- Interest on mortgage debt to purchase a primary or qualifying secondary residence
- Interest on money borrowed for investments whose profits are taxable
- Interest on money borrowed to advance your education
- Interest on money borrowed to invest in passive activities. Passive activities are business-related activities where you do not materially participate. (The IRS has a series of rules to determine if you materially participated or not.)
But not all tax-deductible interest expenses have the same benefit. Interest on mortgage debt and on money borrowed for taxable investments are considered itemized deductions. This means that they are subject to certain limitations. For federal tax purposes, higher income earners are subject to phase outs, which reduce the benefit of itemized deductions. Many states also do not allow taxpayers to use itemized deductions to reduce their tax liability.
The remaining types of interest are worth much more, because the IRS allows you to deduct them directly from your adjusted gross income. This reduces dollar-for-dollar your taxable income and isn’t subject to phase outs. You keep this benefit for your state income taxes as well.
Borrowing money is always an important decision and you should consult with your tax and financial advisors before making any decisions. But, if it's something you've been considering to grow your business, it might be a win-win at the right time.
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