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Sheltering your profits: how owners of small businesses and professional practices can reduce taxes.

Some of the principal causes of failure among the 20 million small businesses in the United States are poor financial management and overpayment of taxes. This particular paper describes how the small business owner and professional can minimize federal and state income taxes consistent with a company's cash flow budget. The authors characterize the tax planning problem as a 0-1 knapsack problem and employ PROC LP to optimize the overall tax burden. The model is developed using tax law from the Internal Revenue Code of 1986 and all modifications since then. These tax planning strategies have been discussed on the evening news on KMGH-TV, the CBS affiliate station in Denver, Colorado.(1)

Existing organizational forms found in the United States today are sole proprietorships (70.4%), Partnerships (10.1%) and corporations (19.5%).(2) More specifically, this article describes a methodology for reducing income taxes that applies to Subchapter S Corporations, limited liability companies, partnerships and sole proprietorships. As such, the authors estimate their approach applies to 90% of all existing small businesses and professional practices.

To demonstrate the technique, consider a family owned sole proprietorship on a cash basis method of accounting. We assume the owner's 1992 marginal tax brackets are: Federal (28%), state (5%) and FICA (15.3%). We further assume his projected 1992 schedule C earnings are $53,000 before tax planning and his projected cash flow budget for equipment acquisition, retirement programs, expanding the business, etc., is $26,250. Note further the spouse has $35,000 of W-2 wages and the taxpayer plans on filing MFJ with itemized deductions. To keep the discussion simple, we will ignore any alternative minimum tax considerations.

The now classic words of Judge Learned Hand in Commissioner vs. Newman (1947) reflect the true values the small businessman should have in implementing an aggressive but legal tax planning program(3):

"Over and over again courts have said that there is nothing sinister in so arranging one's affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced extractions, not voluntary contributions. To demand more in the name of morals is mere cant."

The Model

For ease of exposition, assume the authors meet with the client in September of 1992 to discuss his year end business needs and tax planning strategies. After a careful discussion of his personal and business goals, let us assume we develop the following list of 20 tax strategies to be implemented by the client by December 31, 1992.

Year End Tax Strategies

1. Gifts and awards for employees 2. Buy new vehicle for business 3. Make 13 mortgage payments on house 4. Fund a Keogh retirement plan 5. Make cash contribution to the church 6. Pay all state income taxes 7. Host employee Christmas party 8. Buy office equipment as needed 9. Give Christmas gifts to all important clients 10. Put teenage son on payroll 11. Pay for tax return 12. Replace carpet in the rental unit 13. Pay January office rent 14. Take capital loss on stock 15. Buy theatre tickets to entertain clients 16. Pay all misc business expenses 17. Make business/personal trip 18. Pay off outstanding medical bills 19. Increase advertising budget 20. Purchase SE health insurance

In reality, this roster of tax strategies can typically extend from 40 to 50 tax strategies depending upon the client's cash flow budget. In developing this list, we discuss with the client the various methods of depreciation, luxury car rules, business use of automobiles, amortization schedules, types of retirement programs, travel rules, capital loss restrictions, 80% rules on meals and entertainment, etc. The next step in model development is to examine the impact that these strategies have on the taxpayers' cash flow budget and tax position. Table 1 outlines the cost and benefit of each tax strategy and

the particular tax schedule that it impacts.

For example, strategy #14 involves Schedule D, zero cash flow and results in $990 of tax benefit. Similarly, strategy #18 impacts the medical portion of Schedule A, results in a cost of $1,725 and has zero tax benefit. The rental property involved with strategy #12 uses MACRS depreciation and saves the taxpayer $71 on the Schedule E. In a similar fashion, strategy #1 costs $800 on the Schedule C but saves $361 in taxes. The bottom line is if the taxpayer has $37,791 of cash flow budget, we could save him $14,240 of federal and state income taxes. The problem is the taxpayer has only $26,250 of planning money available and therefore is forced to choose among the |2.sup.20~ = 1,048,576 combinations available. The problem becomes even more acute if we're talking about 40 to 50 tax strategies to implement.

To shed more light on the problem, the authors employ the linear optimizing model described by Wagner.(4) In this capital budgeting problem, the objective function maximizes overall tax savings subject to a single cost constraint limited by the size of the overall cash flow budget. The 20 decision variables take on the values of 0 or 1 depending upon whether a particular strategy is implemented or not. Using PROC LP in the SAS/OR users guide yields an optimal solution as follows(5):

Optimal Solution

* Maximum tax savings - $12,151 * Cash expenditures - $26,241

Optimal Tax Strategies

* Gifts and awards for employees * Buy new vehicle for business * Fund a Keogh retirement plan * Make cash contribution to the church * Host employee Christmas party * Buy office equipment as needed * Give Christmas gifts to all important clients * Put teenage son on payroll * Pay for tax return * Take capital loss on stock * Buy theatre tickets to entertain clients * Pay all miscellaneous business expenses * Increase advertising budget
Table 1
Impact of Strategies
Strategy Schedule Cost Benefit
1 C $800 $361
2 C 3,200 1,634
3 A 1,200 356
4 1040 6,216 2,051
5 A 1,000 330
6 A 900 297
7 C 350 158
8 C 4,500 2,032
9 C 750 339
10 C 3,400 1,535
11 C 400 181
12 E 1,500 71
13 C 475 214
14 D 0 990
15 C 525 237
16 C 3,700 1,671
17 C 2,750 903
18 A 1,725 0
19 C 1,400 632
20 1040 3,000 248
(Totals) $37,791 $14,240


The optimal budget allocation by schedule breaks down as follows:
Schedule A 3.81%
Schedule 1040 23.69%
Schedule C 72.50%


The reader will find it instructive to run a cash budget sensitivity analysis that plots tax savings vs. overall cash flow. Since the tax return is essentially a linear device for fixed marginal tax brackets, the client can easily plan where he wants to go with variations in overall cash flow budget. In closing, the authors would like to point out this 0-1 knapsack problem can be solved by Dynamic Programming(4) or by the Slippery Algorithm.(6) To deal with absolute must strategies and budget cuts, the accountant can easily employ weights in the linear objective function.

In our experience, characteristics of fear, greed and status all motivate clients to apply this particular methodology to their overall tax situation. By comparison, the operations research portion of the problem is really much simpler than the tax code itself.

Acknowledgements

The authors would like to thank the following professionals for their constructive comments on an earlier version of this paper: Robert E. D. Woolsey, PhD, Colorado School of Mines, The Institute for Tax Studies, College for Financial Planning, Jean Ann Hanson, CPA, MBA, Metropolitan State College of Denver, Brad L. Farr, CPA, Masters of Taxation, Arapahoe Community College and Andrew N. Martin III, CPA, The GBS Corporation. For further information, contact the authors at General Business Services, 7943 S. Gaylord Court, Littleton, Colorado 80122, (303) 798-8112.

Footnotes

1 J. R. Gibley and R. A. Gibley, "Optimal Tax Strategies for Small Businesses and Professional Practices," Proceedings of the SAS Users Group International, 17, Honolulu, Hawaii, April 1992, pp. 419-421.

2 C. R. Kuehl and P. A. Lambing, Small Business Planning and Management, Second Edition, Chicago, Illinois: The Dryden Press, 1990.

3 W. H. Hoffman, et. al, West's Federal Taxation: Individual Income Taxes, 1991 Edition, St. Paul, Minnesota: West Publishing Company, 1990.

4 H. M. Wagner, Principles of Operations Research, Second Edition, Englewood Cliffs, N.J.: Prentice-Hall Inc., 1975.

5 SAS/OR Users Guide, Version 6, First Edition, Cary, NC: SAS Institute Inc., 1989.

6 R.E.D. Woolsey and H. S. Swanson, Operations Research for Immediate Application: A Quick & Dirty Manual, New York: Harper & Row Publishers, 1975.

Raymond A. Gibley, MBA, is a tax specialist and business consultant with General Business Services in Littleton, Colorado. He is published in numerous professional journals and is a member of the National Society of Public Accountants and The American Management Association.

Janet R. Gibley, is Controller of Zimmerman Metals, Inc., in Denver, Colorado. She is an accounting specialist with General Business Services. A graduate of The University of Colorado, she has contributed to several professional journals.
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Author:Gibley, Raymond A.; Gibley, Janet R.
Publication:The National Public Accountant
Article Type:Cover Story
Date:Dec 1, 1992
Words:1536
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