by Stephen, Jean Mathieu, Legacy Financial Solutions, Inc. & Dawn Santoriello, DS Financial Strategies
One of the great challenges facing every business owner is how to get money out of their business in the most tax efficient manner possible. Yet most business owners with capital intensive businesses miss out on one of the most lucrative ways to save taxes and dramatically increase the return on their personal investments. First, you must understand that there are 5 ways for a business owner to extract money from their businesses: Salary, Dividends, Withdrawals, Loans and Deductible Business Expenses, (such as utilities, retirement plan contributions, health insurance, etc.) One business expense not often utilized fully is interest payable on loans: loans you make to your own business. This can be a huge source of income and a tax reduction technique.
To best illustrate, let us the example of a Dentist, a Car Dealer or a Restaurant Owner – all of whom invest in capital equipment. Let's further make 3 assumptions:
a.) the business is profitable, b.) the business needs to purchase a new piece of equipment (or finance inventory) for $100,000 and c.) The business owner has investment assets of $100,000 or more outside of the business.
Using conventional planning, the business would finance the new equipment in one of 3 ways: pay cash, lease, or borrow the money. Let's look at each alternative.
First, they could pay cash out of the business. The result of paying cash would be that liquidity of $100,000 is lost to the business and the business would lose all future growth on the money (otherwise known as lost opportunity cost). This means that if we project out 25 years, not only has the business owner lost the $100,000 paid for the equipment, but the interest that could have been earned on that money. (At 4% annually, that's a loss of $166,583 of interest.) Assuming a Section 179 (accelerated depreciation) deduction in year 1, you could deduct the full $100,000, thus giving you a significant tax savings.
Second, leasing the equipment requires fixed payments which are based upon the cost, useful life and salvage value of the equipment. The typical financing cost of this type of financing can be 12% or more, followed by a "fair market value" purchase at the end of the lease term. If we assume a 5- year useful life of the equipment with a fair market value of $0 at the end and a 12% lease rate, you will have paid out $133,466 in 5 years. You get a full deduction for each lease payment in the year it was made, thus, about $26,693 in tax deduction in each year.
Next, borrowing the money from a bank or finance company could allow you to get a low interest rate, and at a 4% rate with payments made monthly over 5 years, you would have paid out approximately $110,499. A section 179 deduction may be taken for the $100,000 in year 1, and the interest deduction for the years in which the interest was paid.
Now let's look at non-conventional financing: a loan from the business owner to the business. Let's assume that you have an investment account currently earning 4%. Using the concept of "collateralization", you borrow personally from a bank or other financial institution and collateralize the loan with your personal investment account. (This loan can also be from a non-MEC* cash value life insurance policy.) The financial institution charges you 4%, interest only, for 5 years (at today's rates) for this fully collateralized loan. Your account continues to compound, uninterrupted.
Here's where it gets exciting! First, there is no limit as to the interest rate that you are allowed to charge the business. So, we'll assume that you elect to loan the money to the business, interest only, for 5 years, at a rate of 12%. At the end of 5 years, you could renew the note or begin a structured payment plan, including principal and interest payments. The business gets both a federal and state income tax deduction for the interest paid and the Section 179 deduction for the $100,000 purchase.
Next, since this money was paid out to you as interest, there are no employment taxes on the distribution. That means no Social Security tax, no Medicare tax, and no Unemployment tax. That savings will be a minimum of 2.9 or as much as 15.3 or even more!
When you receive the income, it will be taxable to you, to the extent that you did not incur expenses in providing the loan. However, if you've borrowed the money as described above, you get to deduct the interest expense, and thus, only 8% is taxable to you personally in this example.
So, to summarize, the business pays you 12%, you payout 4%, but get that 4% back on your money that is still invested, without you interrupting the compounding on that money. Depending on where and how that money is invested, the growth of that money may be tax free. Net result: You make 12% (gross) on your "investment". But it gets even better!
The interest expense reduces your state business profit, thus reducing the amount subject to the State Tax. You will have to declare the interest as income for purposes of the State Income Tax, but that tax is less than the business taxes you otherwise would have had to pay on the profit inside of your business.
Question: Do you have any other place that you can go to invest money with a 12% rate of return? Do you consider your business a good credit risk? In addition to earning 12%, would you like to learn how to recover all of the interest that you pay out to the financial institution tax free for the benefit of your family? These are some of the interesting concepts that are available to the astute business owner. If you're currently expending $50,000 or more a year on capital equipment or inventory, or paying out $25,000 or more in interest annually, wouldn't you rather pay it to yourself?
Three caveats: first, the loan must be a bona-fide business loan between you and the business. A written agreement should always be present. Second, a repayment plan should be in place. Third, although we used a 12% rate in our example, you are free to use any interest rate you deem applicable. However, just remember that old axiom: pigs get fat, hogs get slaughtered! Keep your loan interest rate "reasonable".
For more information or sample loan agreements, contact Dawn Santoriello: DS Financial Strategies (609)303-0277 or (570)499-4821 email: email@example.com www.dsfinancialstrategies.com
* "non-MEC" is a term to describe a life insurance policy that is not a Modified Endowment Contract. Loans from a Modified Endowment Contract are taxed as interest to the extent they exceed the cost basis of the life insurance policy.