How to avoid tax when taking a windfall in small chunks?

Question

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 :)

Answer 1

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.

Answer 2

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.

Answer 3

You can buy another company that has had a long string of losses but is in a business you understand and believe you can turn around. That way you can apply their net operating losses to your future income and receive at least break even income from the purchased company. Plus (I believe) the costs of the other company are a business deduction in the year purchased.