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Play Smart Offense to take full advantage of tax benefits and increase current or future cash inflow

October 5, 2015

Smart tax planning is not always about safeguarding against risks and avoiding penalties. If done the right way, you will hear “the crack of the bat” in terms of improving your cash inflows now, and into the future.

Consider the following example of Denise – who is an outstanding software developer, and was brought into a promising start-up as the CTO. While the company had no customers (hence no income) and limited financial backing, Denise was eager to join the firm because they were close to launching an excellent MVP (minimum viable product).

The startup founders offered her equity as compensation, with a standard four-year vesting schedule.

tax benefitsDenise did not make an 83(b) election to include the current value of her shares as part of her annual income. In general, equity offered for services rendered is considered compensation. This compensation occurs when the restrictions have lifted, or upon vesting. The amount of compensation will be based on the value of the shares at the time of vesting.

So if the company is successful and their share valuation increases, the compensation will grow with it; and the tax liability will increase as well!

Since the equity is illiquid at this point, how will she pay her tax bill at ordinary income tax rates (maximum being 39.6%) plus state and local tax? This is a really bad deal for Denise, as the more successful her new employer becomes, the poorer she gets on an after-tax basis.

tax benefitsHow might Denise avoid this mess? When she gets the equity Denise has 30 days to make a 83(b) election, making the compensation taxable immediately – at today’s lower company stock valuation. Future equity appreciation will be taxed at a significantly lower long-term capital gains rate, saving Denise money in the end. Through savvy tax planning she is converting ordinary income into capital gains.

To take advantage of available tax benefits and incentives, consider the following five major area of smart tax planning available to entrepreneurs:

  1. Pay Later: Maximize your deductions / losses as soon as possible upfront and recognize your income as late as possible. This way the value of your current cash flow is enhanced.
  2. Pay a Lower Rate of Tax: By minimizing ordinary income on compensation (39.5% max rate) and maximizing capital gains (23.8% max rate).
  3. Arbitrage Your Tax Rates: For your LLC by writing off deductions at an ordinary tax rate, but obtain the tax rate for the related gain at a lower capital gains rate.
  4. Pay Less Tax: By accumulating/maximizing all of your available tax credits. For example software development often qualifies for an R&D credit. This requires documentation.
  5. Get Money Back: By claiming refundable grants from the state.

This material has been prepared for general informational and educational purposes only and is not intended, and should not be relied upon, as accounting, tax or other professional advice. Please refer to your advisors for specific advice.