Getting Your Tax Planning in Shape

By Catherine Tindall, CPA

As a tax practitioner who serves advisors, I’ve found there are many common errors in how advisors approach their own income tax planning. This is especially true for those who are completely self-employed, like most Fee-Only advisors who receive 1099 compensation or who own their own businesses independently, like an RIA.

Start With Entity Structure

The first area of our focus with self-employed advisors is entity structure, typically evaluating the appropriateness of an LLC taxed as an S corporation versus as a sole proprietor on Schedule C on Form 1040. Much of this determination depends on whether the advisor is allowed to have their LLC earn revenue, which is determined by how the advisor or LLC is licensed and how their income is issued throughout the year. Usually this tends to be less of a problem for Fee-Only advisors because the quality of their revenue is not restricted in the same way commission-based income is. It is, however, still an area to discuss with a tax practitioner.

If an advisor receives a Form 1099-NEC issued under their Social Security number and personal name because of licensing restrictions, this can significantly limit the ability to use an S corporation due to tax law (see Fleischer v. Commissioner).

S Corporation Benefits

The primary benefit of an S corporation is the ability to limit self-employment taxes to the portion of income paid as W-2 owner compensation. We typically recommend using a compensation survey to arrive at a figure that is defensible to the IRS based on how much time the advisor is spending in the business, the location of the advisor, and the particular tasks the advisor does for the firm. We find advisors who pick an arbitrary figure or do the Social Security maximum are often significantly over or under what it should be. Underpaying can run afoul of IRS rules and restrict the qualified business income (QBI) deduction or ability to participate in retirement plans. Overpaying can also negatively impact the QBI deduction, overpay self-employment taxes, and limit benefits of passthrough entity tax programs. 

A second potential benefit of the S corporation structure, particularly for advisors above the state and local tax (SALT) cap at higher adjusted gross income levels, is the ability to deduct state and local taxes at the entity level by paying a passthrough entity tax on behalf of the individual. The net effect is similar to their marginal federal tax rate. This applies to partnerships as well. These state-specific programs can be beneficial even for those below the phase-out cap, including when the advisor does not itemize deductions and how the structure affects the QBI deduction. The QBI deduction for advisory income is subject to limitations as a service business.

Focus on Profits

Once entity structure is addressed, the next major focus is how taxes are triggered in the first place—profits. In the U.S. tax code, two of the most effective ways to substantially reduce taxes involve business ownership and real estate. In the case of real estate, this is largely due to depreciation benefits. And as a business owner, an advisor can decide how much taxable income to recognize in any given year through revenue recognition and deduction timing. 

This begins with forecasting annual profit to determine tax liability from normal operational performance, and then considering using a discretionary portion of that profit to make deductible investments back into your practice. These investments reduce taxable income at ordinary income tax rates while ideally producing a return. Examples include marketing initiatives with measurable performance, hiring staff who generate revenue, or engaging coaching that removes operational bottlenecks. We recommend advisors calculate the minimum profit level they want first, such as, for example, 20% to cover owner distributions, servicing of debt, and building up cash (all activities that typically do not impact taxable income). Once they have attained that 20%, additional profits should be considered for strategic reinvestment back into their practice when the aim is growth.

By doing this, advisors are effectively deferring ordinary income tax on profits that are not otherwise producing strong returns and shifting value into higher future profits and/or higher exit value in capital gains treatment.  

In this example, we assume the $250,000 in strategic deductions produces a 50% return in annual recurring revenue. This would add approximately $312,000 in exit value (assuming a 2.5 multiple), subject to lower capital gains treatment upon exit instead of current higher ordinary income tax. 

Focus on Deductions

After deciding on an appropriate profit target for the year, we then look at what I refer to as “pick-them-up-as-you-go” deductions. These include strategies such as home office reimbursements, putting children who can legitimately work on payroll, retirement contributions, and similar smaller techniques. While these can add up and be helpful, they typically do not create a material reduction in overall tax liability on their own. 

Pre-tax retirement contributions are best viewed primarily as tax deferral rather than true tax savings. For that reason, I generally deprioritize them relative to strategies that create permanent tax benefits, such as improving the QBI deduction, reducing self-employed taxes, or income smoothing between brackets on an annual basis. 

What all these considerations highlight is the fact that effective tax planning depends heavily on the quality of recordkeeping and profit forecasting. Early in the year, advisors should ensure their bookkeeping is done in a timely fashion, on a monthly or at least quarterly basis, ideally not by the advisor themselves. This allows for regular review of year-to-date results and more accurate forecasting of total annual profit. With reliable financial data, advisors can perform tax projections throughout the year to determine which strategies to deploy, how much tax to expect, and how much cash needs to be set aside. This also informs estimated tax payment decisions.

Focus on Safe Harbor Payments

A final important area to address is when advisors make safe harbor payments (110% of the prior year tax) without forecasting their actual expected liability for the year. This can result in significant underpayment or overpayment. Either scenario can quickly create operational strain by distorting available cash flow and causing serious surprises.

For self-employed advisors, particularly those experiencing significant year-over-year growth, we generally recommend paying only safe harbor estimated tax payments during the year. The difference between those payments and the projected actual tax liability based on expected profits should then be set aside in a separate tax savings account to accumulate until the next filing deadline (April 15 of the following year). This allows the funds to earn some income while remaining available, and avoids prepaying the IRS or state unnecessarily if profit performance falls short of expectations. Unfortunately, when taxes are overpaid, the only way to recover funds is through filing a return, whereas meeting the safe harbor requirements prevents interest and penalties. 

Prevent Surprises

The solution to paying less tax as an advisor is a coordinated process: forecast income, project tax liability, decide which planning techniques to implement, make safe harbor payments, and set aside the remaining expected liability. By doing so, advisors can approach April 15—when both the prior-year balance and first-quarter estimated payment for the current year are due—without surprises.

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Catherine Tindall, CPA, is a lead tax planning manager for Dominion Enterprise Services, a niche CPA firm serving the wealth management industry with proactive tax planning and preparation for advisors. Catherine hosts the Financial Advisors Want to Know Podcast, conducts regular education sessions for advisors, and has a tax-focused newsletter for staying up to date on practice needs. To connect with Catherine directly, email ctindall@dominiones.com.

image credit:  nelyninnell