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My software company has no employees but me, and makes a million dollars a year. I expect it will do so for about 3 more years and then close its doors.

I'm 30 years old. My family lives below our means: we spend $60,000 a year. Ignoring tax, the basic plan would be to save this ~$3 million windfall, and draw $60k/yr in "salary" for a long time.

If I worked for a company making $60k a year, our tax rate would be low. But because all the money comes in at once, I'm facing nearly 50% in federal and state taxes.

How can I avoid this, so we are taxed as if we are making the $60k/yr that we want to receive? Ideas that probably won't work:

  • Create a pension fund in the corporation, feed it all profits, and pay out $60k/yr of "pension". I doubt that the corporation could deduct a million a year in pension funding.
  • Buy a million dollars in "business equipment" of some sort each year to get a deduction, then sell it over time to fund a $60k/yr salary. I doubt such a vehicle exists.
  • Do crazy Section 79 life insurance schemes to tax-defer the income. The law caps this so I can only deduct < $100k of the $1 million annually, and there are other problems with this approach.
  • Do some tax avoidance like Facebook does with its Double Irish trick, storing the income in some foreign subsidiary and drawing $60k/yr in salary to be taxed at $60k/yr rates. This is probably cost-prohibitive for a $1MM/yr company.

The situation is actually a little more complicated -- after we make the nest egg, the company may continue to make money, and we'll give 100% to charity. So I'm viewing the potential 50% tax bill as "hundreds of thousands of charity dollars that I have to instead pay to the government." Yuck. Help me find a way around this :)

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the answer seems to be find a professional adviser. –  mhoran_psprep Feb 4 '13 at 20:11
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I've got one, I'm looking for a second (the 1st hadn't heard of some of the tax laws I had suggested), and I'm checking here in case local talent isn't as good as a guru who hangs out on SO :) –  user9202 Feb 4 '13 at 20:48
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@user9202 tax adviser who does your personal taxes may not be a good fit. Look for advisers who work with startups and entrepreneurs. And yes, they're much more expensive. –  littleadv Feb 4 '13 at 20:56
    
Thanks @littleadv -- great advice. Accepting your answer now. –  user9202 Feb 4 '13 at 21:02
    
Maybe i misunderstood, so apologies in advance, but is it not possible to keep the company 'going' and just take small chunks each year? Instead of closing the doors and taking out 3 million? –  Victor123 Feb 6 at 18:44
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2 Answers

up vote 5 down vote accepted

How can I avoid this, so we are taxed as if we are making the $60k/yr that we want to receive?

You can't. In the US the income is taxed when received, not when used. If you receive 1M this year, taking out 60K doesn't mean the other 940K "weren't received". They were, and are taxable.

Create a pension fund in the corporation, feed it all profits, and pay out $60k/yr of "pension". I doubt that the corporation could deduct a million a year in pension funding.

You cannot do that. You can only deposit to a pension plan up to 100% of your salary, and no more than $50K total (maybe a little more this year, its adjusted to inflation).

Buy a million dollars in "business equipment" of some sort each year to get a deduction, then sell it over time to fund a $60k/yr salary. I doubt such a vehicle exists.

If there's no real business purpose, it will be disallowed and you'll be penalized. Your only purpose is tax avoidance, meaning you're trying to shift income using your business to avoid paying taxes - that's illegal.

Do crazy Section 79 life insurance schemes to tax-defer the income. The law caps this so I can only deduct < $100k of the $1 million annually, and there are other problems with this approach.\

Yes. Wouldn't go there. Added: From what I understand, this is a term life insurance plan sponsored by the employer for the employee. This is not a deferral of income, but rather a deduction: instead of paying your term life insurance with your own after tax money, your employer pays with their pre-tax. It has a limit of $50K per employee, and is only available for employees. There are non-discrimination limitations that may affect your ability to use it, but I don't see how it is at all helpful for you. It gives you a deduction, but its money spent, not money in your pocket. End added.

Do some tax avoidance like Facebook does with its Double Irish trick, storing the income in some foreign subsidiary and drawing $60k/yr in salary to be taxed at $60k/yr rates. This is probably cost-prohibitive for a $1MM/yr company.

You're not Facebook. What works with a billion, will not work with a million.

Keep in mind that you're a one-man business, things that huge corporations like Google or Facebook can get away with are a no-no for a sole-proprietor (even if incorporated).

Bottom line you'll probably have to pay the taxes. Get a good tax professional to help you identify as much deductions as possible, and if you can plan income ahead - plan it better.

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Re income being taxed when received: that's my point. If I could e.g. make a C corp who could somehow reinvest the revenue, then it wouldn't be taxable profit. Re biz equipment: what do you think of KeithB's real estate suggestion? I'm trying to avoid, not evade. I'm happy to create a biz purpose for something I had to buy -- morphing my company in order to make this work. Re Section 79: Thx. Why wouldn't you go there, specifically? In case I don't know something you do? Re planning income ahead: hah, that's exactly what I'm trying to do :) –  user9202 Feb 4 '13 at 20:49
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@user9202 but the C-Corp will be taxed on that income at corp rates (about 33% federal, and check your state for State), and then you'll get taxed again on that very same income (even if the lowest dividend rate it will be additional 15%). Also, if its personal services - corp rate is 35% flat, not marginal, meaning - you'll end up paying even more tax. –  littleadv Feb 4 '13 at 20:50
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and as I said in the comment to the other answer - investment is not a tax deduction. You invest after-tax money. You can only deduct expenses, and for those you have to show a business purpose, and it must be related to the generated income. –  littleadv Feb 4 '13 at 20:52
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also, with C-corp you have a problem if you retain too much earnings. You get hit with an additional tax. Talk to a tax adviser, I'm not fluent with corp taxation (or any taxation), I only know the very basics. –  littleadv Feb 4 '13 at 20:53
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The Dutch sandwich works because these companies already have tax lawyers working them all the time. They are spending a few million to save hundreds of millions in taxes. You would spend a few million trying to avoid a million in taxes, and with out the might and backing of the megacorp the government is liable to go full force after you for trying. –  user4127 Feb 4 '13 at 22:19
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I agree with the other posters that you will need to seek the advice of a tax attorney specializing in corporate taxation.

Here is an idea to investigate:

Could you sell the company, and thereby turn the profits that are taxed as ordinary income into a long-term capital gain (taxed at 15%, plus state income tax, if any)?

You can determine the value of a profitable business using discounted cash flow analysis, even if you expect that the revenue stream will dry up due to product obsolescence or expiry of licensing agreements.

To avoid the capital gains taxes (especially if you live in a high-tax state like California), you could also transfer the stock to a Charitable Remainder Trust. The CRT then sells the shares to the third-party acquirer, invests the proceeds and pays you annual distributions (similar to an annuity).

The flip side of a sale is that now the acquiring party will be stuck with the taxes payable on your company's profits (while being forced to amortize the purchase price over multiple years -- 15, if I recall correctly), which will factor into the valuation. However, it is likely that the acquirer has better ways to mitigate the tax impact (e.g. the acquirer is a company currently operating at a loss, and therefore can cancel out the tax liabilities from your company's profits).

One final caveat: Don't let the tax tail wag the business dog. In other words, focus your energies on extracting the maximum value from your company, rather than trying to find convoluted tax saving strategies. You might find that making an extra dollar in profits is easier than saving fifty cents in taxes.

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Nice idea, didn't know such thing existed! But that assumes the corporation is sell-able and the profits are preset. –  littleadv Feb 4 '13 at 23:39
    
Good point, not every business is a salable asset, especially if it is centered around a single person. Even then, an acquirer may demand a significant discount. On the other hand, a larger buyer may be able to extract more value from the software due to greater marketing resources or product synergies, and therefore might pay much more than the OP's $3m figure... –  Tony the Pony Feb 4 '13 at 23:52
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