Starting Your Own Business To Minimize Taxes

I have taken an interest in studying the operation of family farms and the difficulties that have arisen due to falling crop prices in recent years. Many farmers, who are distrustful of attorneys—can ya blame them?—refuse to meet with one and form an LLC or some other type of business entity that not only could provide some measure of protection against liability arising from a tractor accident or illness-causing crop sale, but also provide immediate tax benefits that are unique to business entities which a person acting in an individual capacity does not enjoy.

For instance, a farm owner will frequently turn to selling timberland on the property that has grown over the years as a useful one-time cash infusion to address a pressing cash-flow issue. Because of the often one-time nature of the event, some timber owners will just make arrangements to have the timber cut and sold without including it as part of an LLC, c-corp, or s-corp.

Starting your own business gives you access to deductions and tax rates that are not available if you exist as a sole proprietorship.

In most states, timber sold in your individual name is eligible for no tax deductions and you have to pay tax on your timber sales at your ordinary income tax rate. The practical effect is that all revenues from the timber is treated as profit, and the tax rate required can cross into the 30% range depending on your state.

Contrast this experience with a difference farmer who chooses to form “Farmer Brown Timber LLC”, meets his state’s requirements for commercial timber activities, and then harvests the trees on his property through the conduit of a business entity before extracting the cash himself upon the project’s completion.

By using a business entity, the farmer is able to deduct the consulting fees from the forester, any “prep” costs such as pre-commercial thinning that removes the overcrowding unprofitable trees, the costs associated with leasing equipment or conducting the sale of the trees, and in some states, even the property taxes on which the timberland sits. And best of all, the tax rate is capped at the 23.8% capital gains rate.

Imagine if you have $150,000 in timberland to realize from your sale of trees. And the costs associated with executing this plan are $30,000. If you conduct the sale in your own name, you pay a higher tax rate and you won’t be eligible to deduct that $30,000. The $150,000 gets treated as pure profit under the tax code in this scenario, even though it’s not. If your state and local taxes are around 35%, you will get to keep $97,500 from your timber activities but you won’t get any deductions on the $30,000 in expenses so your net gain on the timber sale is only $67,500.

Meanwhile, the exact same transaction conducted through an LLC can will yield dramatically different results. The $30,000 is possibly deducted in full, though some states place limits on the amount of miscellaneous itemized deductions. This leaves you with $120,000 taxed at a rate of 23.8%, leaving you with $91,440.

This is one of the reasons why I think Warren Buffett’s tax management strategies have often gone unnoticed. I get that it can be boring and tedious. But it can end up meaning just as much as the asset itself. When Buffett exchanged Berkshire’s billions in Procter & Gamble stock in exchange for P&G giving Berkshire ownership of the Duracell brand plus cash, Berkshire shareholders ended up with over a third more assets than if Berkshire’s P&G stock were sold on the open market and the proceeds were used to, say, acquire an interest in Energizer batteries.

How you own and execute transactions can be just as meaningful as what you own. As simple as that sentence is, a lot of investment analysis proceeds as though that were not true. It can seem counterintuitive—if someone is spending $20,000 on hot dogs and selling them for cumulatively for $60,000, you would expect the result to be somewhere around $40,000. But it’s not. You have to pay attention to the tax code by leveraging the LLC wrapping to figure out what you need to do in order to get that $20,000 deducted, and also what you can do to capture the 23.8% maximum capital gains rate rather than your personal income tax rate. In many though not all instances, the answer involves forming an LLC and keep a meticulous accounting of expenses.

Originally posted 2017-06-18 06:00:47.

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