Succession and Estate Planning: Differences and Commonalities

While the two share some components, they have very different implications

Key takeaways:

  • Succession planning helps business owners or leaders plan for the transition when they leave the business
  • Estate planning is focused on how your personal wealth will be distributed and managed after you’re gone
  • Most people need an estate plan, but not everyone needs a succession plan
  • Planning both together helps optimize unique tax obligations 

It isn’t always easy to face the reality that one day you won’t be around. But taking steps to protect your assets, business, and personal wealth now will help you leave things the way you want after you pass. And part of that effort for entrepreneurs involves having the right succession plan in place to protect their legacy.

Many people go through the estate or succession planning process without considering how the two are intertwined. Let’s walk through these essential planning processes and some key ways they differ—but influence each other.

What is succession planning?

When you own a business, succession planning helps you develop a strategy for what happens when you leave it, whether you want to pass it to the next generation, sell to an outside buyer, or allow your family to distribute the associated assets when you die.

Succession planning answers these questions:

  • Who will take over after you’re gone?
  • What will the staff and management structure look like?
  • How will the transition be handled?
  • What are the goals for the future organization?
  • Should the business be sold instead of continuing to operate in the family?
  • What will the tax implications be?
  • How can I lower the tax burden?

For a succession strategy to succeed, roles must be clearly defined, and all details must be outlined. The goal is to ensure that everything continues to operate when a leader (or leaders) passes away, retires, or sells. 

What is estate planning?

Estate planning, of course, is about passing along overall wealth rather than a business. A person’s estate refers to their assets, including their financial accounts, car, properties, investments, valuable possessions, life insurance, and more. Estate planning aims to create a strategy for distributing these assets after someone passes or becomes incapacitated.

Estate planning answers the following questions:

  • Who will manage your financial affairs?
  • What beneficiaries will receive your property, financial accounts, and other assets?
  • Who will be the guardian for your children’s care if they are minors?
  • Who will be responsible for your debts?

The planning process includes creating a will, a living will, and/or a trust. The will outlines precisely how assets will be distributed to beneficiaries but usually has to go through probate, which can take a while, is a public record, and may be stressful for any heirs. Funding a trust allows individuals to avoid probate while providing unique tax benefits and methods to protect the assets.

An estate plan considers all of these moving parts so that the wealth you’ve worked hard to build can be distributed and managed according to your wishes.

The differences and similarities of succession and estate planning

Most people need an estate plan, whereas not everyone needs to worry about succession planning. If you don’t own a business or aren’t involved in a family business, you won’t need to go down that path. 

Succession planning can become heated fast. Not only are you figuring out what to do with the business, but other stakeholders will have opinions about what should happen. Your family members could disagree with your choices, and things could become emotional and stressful quickly. But without a plan, the business will have no clear goals or direction, there may be no clarity about who is in charge, and things can fall apart quickly. So it’s wise to start and solidify this process as soon as possible.

Similarly, estate planning helps you put out potential fires after you’re gone or incapacitated. When you have everything outlined, there is no question about your wishes and what should happen. Loved ones might be unhappy with your choices—but with a strong estate plan, there’s little they can do about it. And you don’t necessarily want any heirs to deal with a lengthy, frustrating probate process when they’re already handling a tragic loss. 

Both of these processes are key to tax optimization. Estate planning helps you ensure that there won’t be surprising tax liabilities for your heirs once you’re gone, and succession planning both improves the business while you own it and prepares for an eventual—and smoother—transition. 

One good example of structuring things well is considering a family limited partnership. This business type can help reduce the tax liability when shifting wealth to other family members. These partnerships limit your taxable estate because you are transferring business assets to your heirs. Business interests will also qualify for the gift tax exclusion when you pass them on.

Talk through your succession and estate planning questions with a professional when you’re ready to put strategies in place to protect your loved ones.

Contact Provident CPA and Business Advisors

Succession planning is one of the best steps you can take right now to ensure your business is set up for success after you’re no longer around—ideally in happy retirement. Provident CPA and Business Advisors is here to help you create a plan with the proper steps for a smooth transition. We can also help you understand the implications of your chosen business structure and minimize your taxes as part of an estate plan.

Contact Provident CPA and Business Advisors to learn more.

What Changed About Excess Premium Tax Credits?

The IRS announced that taxpayers with excess advanced premium tax credits didn’t have to report the excess for 2020

Key takeaways:

  • Premium tax credits are available to some eligible taxpayers who get health insurance coverage through the Marketplace
  • Usually, taxpayers must report any excess advance tax credits on their tax returns, and it may increase their tax liability
  • For 2020, the IRS announced that taxpayers did not have to file Form 8962, Premium Tax Credit, or report excess credits on their individual returns—but 2021 is back to normal

The American Rescue Plan Act of 2021 introduced several changes to give taxpayers additional relief during the COVID-19 pandemic. Eligible Americans received another round of stimulus checks, supplemental unemployment benefits were extended, and the Child Tax Credit and earned income tax credits were expanded for 2021, among other changes.

Another change in the law that the IRS announced in April was the suspension of the increase in tax liability for any excess advance premium tax credit payments for the 2020 tax year. What is this excess tax credit, and what changed?

What are excess premium tax credits?

Eligible taxpayers can claim a premium tax credit (PTC) for their health insurance plan using Form 8962, Premium Tax Credit. This credit lowers the monthly insurance premium they pay. The amount is based on a taxpayer’s income estimate for the year and other household information outlined on an application for Marketplace health insurance coverage.

Typically, those with a PTC must pay the difference between their advance PTC (APTC) payments and what they qualify for based on annual income. This discrepancy is usually repaid on a yearly tax return, and filers use Form 8962 to calculate the amount of their PTC compared to the APTC. 

The form tells taxpayers whether they have to pay more in taxes that year or whether they can claim a net PTC. Conversely, if taxpayers used less PTC than they qualified for that year, they get the difference as a refundable credit. Put simply: the excess APTC is the amount that a taxpayer used in advance payments that exceeds their PTC.

Who is eligible for premium tax credits?

Not all taxpayers who get Marketplace health coverage are eligible for a premium tax credit. The IRS outlines the following eligibility requirements:

  • If a taxpayer or their family member were enrolled in Marketplace health insurance coverage for at least a month in a year when they were not eligible for affordable coverage through an employer or for Medicare, Medicaid, TRICARE, or another government plan
  • If a taxpayer’s premiums for at least one of those months is paid by the due date of their tax return
  • They are within certain income limits:
    • Household income must be at least 100% but no more than 400% of the federal poverty line for the applicable family size
  • They don’t file a married, filing separately return
  • They aren’t claimed by someone else as a dependent 

Taxpayers with healthcare insurance coverage purchased outside of the Marketplace are not eligible for the PTC. Eligibility factors vary based on where taxpayers live, their family size, and the cost of available insurance coverage.

Changes that applied to the 2020 tax year

In April 2021, the IRS announced that taxpayers with excess premium tax credits did not have to file Form 8962 as they usually would to report those excess credits. Taxpayers also did not need to report the excess on their regular Form 1040 when filing their individual tax returns

The American Rescue Plan Act of 2021 suspended the requirement to pay taxes of all or part of their excess APTC for 2020. However, there is no change in the process for taxpayers claiming a net PTC for 2020, so they still had to file Form 8962 with their individual tax return if applicable. 

If a taxpayer already filed their 2020 tax return with an excess APTC before this announcement was made, they didn’t need to file an amended return or contact the IRS. The IRS automatically reduced the excess APTC to zero, so no further action was required, and the agency reimbursed taxpayers who paid the excess APTC.

Form 1095-A, Health Insurance Marketplace Statement, is the document taxpayers should check with their tax preparer to find the amount of allowable PTC versus the APTC.

At the moment, this change only applies to 2020 taxes. The process was the same for prior tax years, and 2021 taxes will generally return to normal. But the APTC did extend to this year “eligibility to taxpayers with household income above 400 percent of the federal poverty line by lowering the upper premium contribution limit to 8.5 percent of household income.” 

And if you paid the excess and qualified for an automatic refund but did not receive it, be sure to contact the IRS or speak with a tax professional.

Getting help on your taxes

To stay abreast of changes and opportunities, contact a tax professional who understands temporary tax law adjustments and can advise accordingly. 

The team at Provident CPA and Business Advisors are experts who understand how evolving rules may impact you or your business. We also ensure that you pay the least tax legally possible while helping you plan for a successful future.

Contact our team today to learn more about our tax and business advisory services.

Tips for Paying Yourself as a Business Owner

Running a business can quickly get in the way of paying yourself appropriately. Here’s how different business structures handle payments to owners, plus tips for including yourself while managing the budget.

Key takeaways:

  • A salary is a regular payment an employee receives, and an owner’s draw is a withdrawal of business funds that can be more sporadic
  • Each business structure has its own implications for paying taxes and paying yourself, and sometimes it depends on the business’s shareholder agreements
  • Tips for paying yourself:
    1. Include yourself in the budget
    2. Think about what you really need
    3. Assess your worth
    4. Keep tabs on business performance
    5. Factor in benefits

Entrepreneurs know that it’s too easy to forego their pay just to keep a business afloat. But most of us can’t afford to work for free or at a significant discount, at least not for long. It’s essential to know how to pay yourself while still effectively managing a business budget.

You can implement strategies to start paying yourself a living wage as an owner while still focusing on boosting the business’s bottom line. Here’s some essential info about paying yourself smartly and tips for getting started.

Salary versus owner’s draw

First, some clarifications: A true salary is when you get a set paycheck each pay period, as you would if you were a regular employee. The nice thing about a salary is that you don’t have to worry about taking taxes out since they’re withdrawn automatically from each paycheck. And you know you can count on a set amount of money every pay period. However, not all business types allow owners to take a typical salary.

An “owner’s draw” is when an owner withdraws funds from the business to use strictly for personal costs. These can be set up to be taken on an as-needed basis or regularly. The benefit of an owner’s draw is that you have more flexibility in what you get paid and can base these payments on how the business is performing.

“Distributive share” is another term to know. These are any owners’ shares of income, whether a credit or gain. These are treated differently when tax time comes around. Sole proprietors and single-member LLCs can withdraw business money, and it isn’t included on their tax returns. But partners, multiple-owner LLC members, and S corporation shareholders record their distributive shares on their tax return on Schedule K. 

Note that the way income is distributed in partnerships and LLCs will vary based on the business agreements.

Choosing the right business structure

As touched upon, whether your business is a sole proprietorship, C or S corporation, partnership, or LLC will matter when figuring out how to pay yourself. Let’s walk through what each business structure looks like as far as payment:

  • Sole proprietors are not employees and do not technically have the paycheck/salary option. Sole proprietors can draw money from the business to get paid, and no taxes are proactively withheld.
  • Partnerships: Partners cannot receive a salary because they cannot be both partners and employees. Partners receive distributive shares from the business and record them on their tax returns. The partnership agreement will govern how profits are distributed.
  • LLCs: Members of LLCs also do not take a salary as an employee. Single-member LLCs treat draws like a sole proprietor does, and multiple-member LLCs like a partnership.
  • C corporation: Shareholders must take a salary. They may also take dividends if allowed, but sometimes profits are put back into the business instead.
  • S corporation: Shareholders must take a salary. Sometimes shareholders have to pay self-employment taxes, but they could take distributions as part of their compensation to avoid these taxes since distributions come from income that was already taxed.

A few other tax considerations: C corporations are doubly taxed, meaning the corporation pays taxes on net profit, and shareholders pay taxes on the income they receive from dividends.

Pass-through entities, which can be sole proprietorships, S corporations, LLCs, or partnerships, pass profits directly to stakeholders, who then report income on their personal tax returns. Pass-through entities do not pay corporate income tax exactly like C corporations usually do.

Tips for managing your business budget and paying yourself

It may just be a temporary reality that you won’t be able to take much from your business until it gets off the ground. You have many expenses to cover, and managing cash flow the right way can make or break the business. Here are a few tips when you’re trying to figure out how to pay yourself:

1. Include yourself in the budget

It’s easy for business owners to pay themselves only when the business is performing well, and what you get paid can vary a lot using this method. You’ll have much more control over your personal income and thus your personal budget if you factor yourself into the budget from the beginning. 

2. Think about what you really need

Carefully consider what you really need to get paid right now on a personal level. This is where you should start when including a salary in a business budget. At the very least, pay yourself enough to get by. Outline your basic living expenses each month, including food, housing, bills, and others that are absolutely necessary. Make sure you can pay yourself at least this much.

3. Assess your worth

When determining how much you need to get paid, compare what you got paid at your last job, if applicable, and what you would be getting paid if you worked for someone else doing the same tasks.

4. Keep tabs on business performance

Say you pay yourself a consistent amount each month to cover your basic living expenses. Make sure that if your business starts doing great financially, you also begin to think about paying yourself more. Include this salary in forecasts and consider increasing pay each period, if applicable.

5. Factor in benefits

Just because you’re not a “regular” employee doesn’t mean you don’t need the same benefits. Write down everything required, including health and dental insurance, retirement savings, and anything else that is a must. Make sure these costs are factored into pay when you decide on a number. 

Work with tax professionals to create the right plan

Sometimes these details are overwhelming, and you need assistance from the experts. The team at Provident CPA and Business Advisors can assist you with understanding the type of business structure to create, any tax implications, smart growth strategies, and more.

Contact Provident today to learn more about our services.

Why and When an IRS Audit Could Happen to You

While uncommon, certain red flags increase the risks of receiving an IRS audit

It’s unlikely the IRS will audit you anytime soon. For the 2019 fiscal year, the organization only audited 0.45% of American taxpayers, a number equal to about one in every 220 people. One reason for this dip was a reduced budget for the IRS, as its 2018 allowance was about 20% lower than in 2010 when adjusted for inflation. 

However, the Biden Administration is looking to increase the IRS’ operating budget once again in a move that could see the number of people audited increase significantly. In 2010, 1.11% of taxpayers received audits, and a return to those numbers isn’t out of the question once the Internal Revenue Service has greater funds at its disposal. 

Of course, the odds of being audited depend on various financial factors, including income and tax reporting habits. Here’s a look at some things that could increase or decrease the odds of ending up on the receiving end of an IRS audit.

Making a mistake

Perhaps the most common reason people are audited is for making a mistake on their taxes. Even a simple error like a typo on your social security number or a simple math miscalculation could throw off an entire return, triggering an audit in the process. 

The good news is that you can typically fix a mistake quite quickly as long as you have the supporting documentation on hand. However, you’ll still have to deal with the hassle of the audit, so it’s best to avoid errors wherever possible.

High expenses or deductions

If you’re writing certain business expenses off, always keep receipts handy. Excessive travel, meal, and entertainment expenses could trigger an IRS investigation because there’s often a thin line between personal and business expenses. For example, if the IRS sees trends in your business expenses that don’t particularly match up with your company’s practices, they might ask for supporting documentation.

Claiming deductions that seem excessive for your income level could also raise suspicion. For example, if you make about $100,000 per year but claim $30,000 in charitable donations to reduce taxable income, you might be audited. 

Schedule C losses

Businesses are supposed to make money, so the IRS will want more information if you have losses on a Schedule C every year. A company should turn a profit three out of every five years at a minimum. If it fails to do so, the IRS considers the business a hobby, which changes the tax structure. 

You are permitted to have the occasional lousy year in business. But if you lose money consistently, you could have to explain it to the IRS and modify filings.

Missing some income

Generally, all income for regular employees should appear on a W-2. However, there are situations where individuals receive money for additional projects, side hustles, and other opportunities that won’t show up there. Those taxpayers have to fill out a 1099 form that reports this extra income to the IRS. An audit is likely if the government finds out about this income and you don’t claim it. 

Real estate losses

Property owners must be careful about reporting a loss when renting a home or office to a third party. The gist is that real estate is a passive activity, according to the IRS, so the amount of loss you can claim is limited. There is an exception, though, if you can prove that you’re a real estate professional. Qualifying as a professional involves working more than 750 hours per year in the industry. 

Underpayment

Failing to pay enough on your tax bill by the deadline can get you audited. The statement has a due date, but you can seek an extension by filling out Form 9465 with your return and agreeing to pay on an installment plan. Basically, if you can’t afford to pay your taxes, the IRS will demand to know why and may investigate your financial situation more thoroughly.

High income

While all of these situations could cause the IRS to audit you, the single biggest reason for these investigations is a high income. In 2015, for example, 8.16% of all individuals making over $10 million per year were audited. It doesn’t stop there, as an additional 4.39% of those earning between $5 million and $9.99 million were subject to investigations, too. 

Individuals making $1 million to $4.99 million in that year had a 2.39% chance of an audit, as did 1.13% of people with incomes between $500,000 and $999,999. 

Joe Biden’s American Families Plan includes $80 billion in additional funding for the IRS, most of which will be used to audit high earners in the coming years. Officials believe this plan could raise over $700 billion in additional tax revenue from these wealthy individuals over the next decade, so carefully planning their tax situations is an essential part of doing business.

Get tax planning and minimization assistance

You don’t want to overpay on your taxes. At the same time, it’s essential that you claim all your earnings and don’t give the IRS any reason to go after you. The best step is seeking a qualified tax planning and minimization service to legally keep more of your hard-earned money without running into issues with the government. 

Provident CPA & Business Advisors offers holistic business guidance to help our clients build great businesses and achieve financial freedom. We also provide proactive tax minimization services, ensuring you can reduce this expense legally and ethically. Contact Provident CPA & Business Advisors today for more information.

Tax Record Essentials for Gig Workers

Gig workers have unique responsibilities for organizing their tax records and paying quarterly balances on time.

Life as a gig worker can be pretty good. After all, you’re usually your own boss, and you can set a schedule that fits in with your lifestyle.

However, there are some challenges, including filling out invoices, collecting payments from clients, and making sure you have enough money on hand to pay your estimated taxes. You don’t have an employer to deduct taxes for you either, leaving you on your own to report all income when tax season arrives.

Here’s a look at some tips gig workers should follow throughout the year to streamline tax season.

What is gig work, exactly?

Before all else, it’s a good idea to define gig work. Keep in mind that it’s a broad definition that covers many different jobs, but in short, it generally means you’re paid for your goods or services without being considered a full-time employee. 

Jobs that count as gig work include delivery driver, online salesperson, short-term rental landlord, or any contract or freelance worker. Renting out your car or equipment or providing a service like babysitting could also count as gig work. It’s estimated that over half the U.S. workforce could be involved in the gig economy by 2027.

If you aren’t on the payroll but are receiving financial compensation for your goods or services, it’s gig work that you’ll have to pay taxes on once you make at least $400. You’re also responsible for making all contributions to Medicare and Social Security, which a traditional employer splits with employees.

Records you need to keep

Streamlining the tax process involves keeping adequate records throughout the year. Organizing these documents can save you money come tax season because doing so will also include an accurate summary of expenses.

  • Expenses: You can use your business expenses to reduce the amount owed. Save all receipts so you have proof of these expenses if the government audits you after filing. You might need to fill out Publication 463, Publication 535, Publication 587, or Section 199A, depending on the type of business you’re operating. These expenses reduce taxable income and can make your overall bill far lower.
  • Income: It’s also essential to keep a detailed record of all your income, of course—and the government will eventually find out about it. Even income that doesn’t show up on your Form 1099 or W-2 must be reported because you’ll owe tax on it. It’s a good idea to collect and keep your sales receipts and note all these amounts to the IRS to avoid later complications.

The more detailed information you keep updated, the less time it’ll take you to submit accurate tax records when the time comes.

Paying your taxes

It’s a good idea to pay taxes quarterly rather than waiting until the end of the year, and the IRA requires minimum quarterly payments that are based on income or the prior year’s tax bill. Any gig worker making over $1,000 per year who does not pay quarterly estimated taxes on time is subject to a penalty fee unless they pay 90% of their total taxes within that year or “100% of the tax shown on the return for the prior year, whichever is smaller.”

You can submit these quarterly taxes using Form 1030-ES. This document allows you to estimate how much you owe based on your quarterly income and expenses. It doesn’t have to be exact, but remember you’ll have to pay the difference at the end of the year if you don’t make sufficient quarterly payments. And any total under the IRS minimum is subject to a penalty. 

Filing a return

As a self-employed gig worker, you may have to fill out Form 1040 or Form 1040-SR, depending on your age. 

When filling out your documents, make sure you don’t forget Schedule SE, which is Self-Employment Tax, and Schedule C, Profit or Loss from Business. If you fail to include some self-employment income, Form 1040-X allows you to amend a return.

Start early and engage professional tax planning services if necessary

One of the best things you can do when reducing your tax bill is to begin the planning process immediately. Many gig workers don’t start thinking about taxes until the last minute, which leads to them paying far more than they would have with a good strategy. You’re likely entitled to deductions that you don’t even know about, so seeking professional assistance is often a good idea. 

The team at Provident CPA and Business Advisors helps businesses grow profitably through better business and tax strategies. Contact us to learn more.

A Basic Guide to the SEP IRA

A SEP IRA can be a smart retirement plan option if you want higher contribution limits, flexibility, and tax advantages. Here’s how they work.

Key takeaways:

  • SEP IRAs are flexible retirement savings options, especially helpful to business owners with few or no employees
  • SEP IRAs have high contribution limits: $58,000 for 2021
  • Only employers can contribute to employees’ SEP IRAs
  • Business owners can change contribution amounts each year, but percentages must be the same for themselves and all their employees
  • Tax advantages include tax-deferred investments and contribution deductions

Self-employed workers and business owners often must establish a more involved tax planning strategy to maximize credits and deductions and comply with all IRS requirements. It can be challenging to find the right retirement option that will help you contribute enough each year and lower your tax burden. 

The simplified employee pension (SEP IRA) could be the right option. Let’s cover how this plan works, who qualifies, and the key tax advantages.

What is a SEP IRA?

The SEP IRA is an individual retirement account that business owners and self-employed workers can create. Employers decide how much to contribute to each employee’s plan, and they can take advantage of a tax deduction for these contributions. For employees, any contributions their employer makes to their SEP IRA are 100% vested right away, which is a big benefit for them as well.

Many business owners decide to go with the SEP IRA because these accounts have high annual contribution limits. Contributions can’t be higher than the lesser of 25% of a worker’s compensation or $58,000 in 2021. Compare these amounts to traditional IRA limits, which are $6,000 for 2021 or $7,000 for those 50 and older.

Unlike other employer-sponsored retirement plans, the SEP IRA doesn’t require certain startup and operating costs, as administrative expenses are low. 

This is also an attractive option because employers can take a break from making contributions if the business is going through a rough patch. Each year, the employer can decide how much or whether they want to contribute. They can lower and raise contributions amounts year-over-year as needed. This flexibility helps smaller business owners offer a retirement savings option without being locked in each year.

Essential eligibility requirements for SEP IRA participants are as follows:

  • They are at least 21 years old
  • They have worked for the employer for at least three years of the last five years
  • They earned at least $600 in compensation in the previous year

An employer must provide access to the SEP IRA if a worker meets these requirements. But individual employers may opt to use “less restrictive requirements, for example age 18 or three months of service, to determine which employees are eligible.” In all cases, the employee owns and controls their account and can make decisions about retirement investments.

A critical note about SEP IRAs is that if you contribute for yourself as the business owner, you’re required to have proportional contributions for each of your eligible employees. In other words, the contribution rate must be the same for you and all of your workers. So, the SEP IRA is usually best for business owners who have few or no employees.

Other facts about SEP IRAs:

  • There isn’t a catch-up contribution for people age 50 or over, as with traditional IRAs.
  • Minimum distributions are required starting at age 72.
  • Early withdrawals before age 59 ½ are subject to a penalty of 10% and are taxed as income.
  • The SEP IRA may be combined with a Roth or traditional IRA.
  • Employees cannot make contributions—only employers.

SEP IRAs are easy to set up and manage, so they’re great options for small business owners and self-employed workers looking for a more flexible retirement savings alternative. The SEP IRA is available to businesses of any size.

SEP IRAs and taxes

As with traditional IRAs, investments within each employee’s SEP IRA grow tax-deferred until they retire, and withdrawals are then taxed as regular income. Contributions and earnings to SEP IRAs can be rolled over tax-free to other retirement plans and IRAs.

There’s not a Roth option for SEP IRAs, in which contributions are taxed now instead of in retirement. However, as mentioned above, a SEP IRA can be combined with a Roth IRA if desired. 

When tax time rolls around, you can deduct the lesser of your SEP IRA contributions or 25% of compensation, though there is a limit on compensation: $290,000 in 2021. For self-employed workers, the deduction amount is 25% of net income.

In sum, SEP IRAs provide: 

  • A low-administrative-cost retirement savings option
  • Several tax advantages, including tax-deferred investments and contribution deductions 
  • Flexibility that is especially helpful to small business owners who want the ability to decide how much to contribute each year

Where to turn with questions

Choosing the right retirement savings strategy for your business can be a big part of your overall growth plan. You always need to understand tax implications and the pros and cons for both you and your employees. 

When you have questions about the best tax planning and business growth approach, contact the team at Provident CPA and Business Advisors. We help you establish the best tax-advantaged strategies that put your business on the right path for a successful future,

Contact us to learn more about our services.

How to Measure Profitability vs Profit in a Business

Profit and profitability are two separate concepts. Here’s how they differ and how to start measuring.

Key takeaways:

  • Profitability is a metric that tells you if your business is viable, and it’s a measurement used by investors
  • Profit is the dollar amount of net earnings in a given period
  • Measure profitability by assessing gross and net profit, operating profit, margin ratios, return on assets, and other calculations

Metrics keep your business running. Without visibility into performance, it’s impossible to know what areas need improvement, where the organization excels, and how things are likely to go in the future. Key performance indicators (KPIs) from sales to finance to HR tell you a lot about the state of the business, in the moment, and the past and future.

One of the most important metrics to determine the viability of your business is profitability. Many business owners use the terms profit and profitability interchangeably. But while they are related and both have to do with business accounting, there are key differences to be aware of when you’re starting to measure them. 

Here’s a deep dive into profitability, how it differs from net profit, and steps to take to measure this important metric.

What is profitability?

On a basic level, profitability tells you whether or not you are making money, or a profit. Positive profitability is, of course, one of the biggest goals of a business so that it stays viable and continues to grow.

What’s tricky about profitability, however, is that it goes beyond simply looking at a dollar amount at a given time. Properly measuring it requires looking at several metrics that analyze each aspect of the business and how each contributes to the organization’s overall success. 

Profitability measures a company’s ability to succeed or fail financially. It asks, is the business getting a return on investment? Is it efficient? Is it sustainable? Thus, profitability takes things a step further from just measuring profit.

Profit versus profitability

Even if a company sees a profit in a given month or quarter, it doesn’t necessarily mean that the business is profitable long term. Profit is a set number representing income minus expenses—the money left over after everything is paid. (Note that net profit could also be a net loss if profits are in the negative.)

While companies aim to make a tangible profit, profitability measures things relative to whether the scope of profit aligns with the size of the business and future concerns.

Both profit and profitability are taken into account to determine how a business is performing, but profitability is a deeper analysis of whether resources are being used correctly and if the model is sustainable. Profitability is a measure that investors use, for example, to determine a company’s worth.

How to measure profitability

So, how do you measure profitability? There are a few tactics you can use.

Let’s first look at the basic calculations to have on hand. You need to know your gross profit (net sales minus cost of goods or services sold); your operating profit (the sum of operating costs subtracted from gross profit); and your net profit (the sum of operating profit and income, minus additional expenses and taxes).

Margin or profitability ratios can tell you more about the company overall. You can convert the above metrics into ratios by taking the following steps:

  • Gross profit margin ratio = (gross profit/sales) x 100
  • Operating profit margin ratio = (operating income/sales) x 100
  • Net profit margin ratio = (net income/sales) x 100

You can also measure the return on assets, which is a crucial step in determining profitability. It tells you the percentage of profit you’re making compared to your assets, or valuable property. To find this number and a return on investment, perform these calculations:

  • Return on assets = (net income before taxes/assets) x 100
  • Return on investment = net profit before tax/net worth

Next, assess your profit per client. This helps measure how valuable each customer is and what the averages are. Here are a couple of formulas to help you figure it out:

  • Gross profit per project = total project fees – project expenses
  • Hourly wage = gross profit per project/hours spent

Your goal should be to increase that hourly wage.

These tactics can help you get an overall sense of the viability of the business, which is essentially its profitability. While related to net profit, these metrics tell a bigger story of success or failure rather than the monetary amounts in the period you’re measuring.

Where to turn when you have business strategy or tax questions

The good news is that there are concrete steps any business can take to increase profitability and grow. When you need assistance streamlining your organization, work with the team at Provident CPA and Business Advisors. We are a team of experienced professionals who helps businesses just like yours create better strategies for long-term success and growth.

Contact Provident today to get started.

A Basic Guide to the Roth IRA: Tax Pros and Cons

The Roth IRA is a tax-advantageous option for retirement savings. Learn how it works and who should use it.

Key takeaways:

  • Pros:
    • Tax-free withdrawals.
    • Withdraw contributions for any reason at any time without paying tax.
    • Money grows tax-free.
    • Make contributions at any age.
    • No income limits on conversions.
    • Lots of investment options.
    • No required minimum distributions.
  • Cons:
    • No upfront tax benefit.
    • Big tax bill if converting a lot of funds.
    • No tax benefit if your tax rate is lower in the future.
    • Must wait five years to start taking tax-free withdrawals.
    • Maximum contribution of $6,000 is pretty low.
    • Can’t contribute if you are married, filing separately, and make $10,000 or more.

Individual retirement accounts (IRAs) are savings plans provided by banks and other financial institutions that give you a few tax benefits. They’re easy to set up and maintain, so they’re one of the most popular retirement savings options. There are a few types of IRAs, including traditional, Roth, SEP, and SIMPLE. Depending on your situation and goals, there are pros and cons to each of these retirement accounts

Let’s take a closer look at one of the most popular types of IRAs: the Roth IRA. Here is your guide to what it is, the pros and cons, and who might benefit the most from this approach.

What is a Roth IRA?

A Roth IRA is a retirement savings option for individuals, similar to a traditional IRA except for how it’s taxed. These accounts allow you to take tax-free withdrawals when you’re in retirement and receiving the income. This is a big benefit since you don’t have to worry about paying income tax when you could be in a higher tax bracket, relieving a significant financial burden. 

This setup means, however, that the contributions you make now are already taxed, as they’re not tax-deductible like with a traditional IRA. Traditional IRA contributions are usually made with pretax dollars, and you have to pay taxes on the income when you withdraw it in retirement. 

Contributions to a Roth IRA can come from regular contributions, spousal IRA contributions, conversions, rollovers, or transfers. You cannot contribute anything but cash (earned income), so no securities or other assets qualify.

The pros and cons of Roth IRAs

First, let’s review the pros of Roth IRAs:

  • You get tax-free withdrawals.
  • Withdraw contributions for any reason at any time without paying tax.
  • All the money invested in the Roth IRA grows tax-free.
  • You can make contributions at any age when you’re earning income.
  • You can convert a traditional IRA into a Roth IRA with no income limits.
  • You have many investment options, including money market, CDs, mutual funds, stocks, bonds, or ETFs.
  • There are no required minimum distributions in retirement.

Next, the cons:

  • There is no upfront tax benefit—contributions are made with income that has already been taxed.
  • If you have a lot of funds to convert to a Roth IRA, you’ll have a pretty hefty tax bill the year you convert.
  • If your tax rate is lower in the future, you don’t see a significant tax benefit.
  • You have to wait five years to start taking tax-free withdrawals.
  • The maximum annual contribution of $6,000 is pretty low.
  • You can’t contribute if you are married, filing separately, and make $10,000 or more.

To that last point: something many married couples overlook is that you can’t contribute to a Roth IRA if you make over $10,000 and you are married filing separately. If you earned less than $10,000 and lived with your spouse during the applicable tax year, you can contribute a reduced amount. But, it still may make sense to go with a different retirement plan.

Carefully weigh these pros and cons to understand if a Roth IRA is best for you. Compare this type of account with a traditional IRA or a 401(k), both funded with pretax dollars.

Who should use a Roth IRA?

You should consider opening a Roth IRA if you expect to be in a higher tax bracket when you’re in retirement than you’re in now. This means that you’ll ultimately pay less in taxes on the income. Some people also decide to go this route just so they won’t have to worry about paying taxes later, whatever their situation may be. A Roth IRA helps you be proactive about a tax-free future.

Also, it’s important to note that you can’t contribute to a Roth IRA if you make over $140,000 if a single filer and $208,000 for joint filers. So, if you’re above these limits, unfortunately, you have to consider another option.

As touched upon above, there are limits on what you can contribute each year, too. For 2021, the limit is $6,000 if you’re under 50 and $7,000 for taxpayers older than 50. So, if you plan on saving more than these amounts each year, the Roth IRA may not be for you. Or, you’ll need to combine this investment with another retirement plan. (In comparison, a 401(k) allows you to contribute up to $19,500 for 2021).

Getting help from the experts

A Roth IRA can be a very wise choice for many who meet the income requirements and who want to take advantage of tax-free withdrawals in retirement. However, carefully consider all your options.

When you have tax-related questions, contact the team at Provident CPA and Business Advisors. We help you plan to pay the least amount of taxes legally possible. 

Reach out to Provident CPA and Business Advisors today.

What Is a Capital Expenditure and What Are the Tax Implications?

Capital expenses are large purchases required to keep a business growing. Here’s what you need to know about these costs, including the tax implications. 

Key takeaways:

  • Capital expenditures are long-term investments like technology upgrades or significant equipment purchases
  • These purchases are recorded on the balance sheet since they’re investments, not everyday operational costs
  • Capital expenditures are not directly taxable, but depreciation can be deducted each year over the asset’s useful life
  • Tracking these purchases helps a business understand returns on investment and how they relate to business growth

Part of running a business is taking all the right steps to record financial transactions and keep track of cash flow, tax impacts, and ROI. Some aspects of bookkeeping will be straightforward, like tracking the everyday costs of running the business. In contrast, others can be more complicated, like major equipment purchases that are investments into future growth.

This guide will walk you through what capital expenditures are and how they work when maintaining financial records and paying taxes.

What are capital expenditures?

Capital expenditures include the purchases made by a business on long-term physical assets and property that improve capacity or efficiency. These assets could be real estate, equipment, machinery, technology, and the like. In accounting, an expense is considered a capital expenditure if its life is more than one accounting period (one year) or if the asset improves upon an existing asset, like an efficiency upgrade to a building, for example. 

These expenditures are usually made for business projects or investments that support the business so that it can continue its operations, improve the way it delivers services, or continue growing its revenue. Generally, capital expenditures are costs to maintain a business’s operations or expenses that lead to future growth.

Sometimes capital expenditures need to be made on a fixed asset, which may include upgrading a machine or improving something about the business’s property. These payments are more like investments instead of regular expenditures. In other words, capital expenditures are expenses that the company capitalizes, whereas operating expenses are short-term costs that support day-to-day operations.

Note that expenses associated with normal, everyday repairs and maintenance on assets are usually not considered capital expenditures.

How are capital expenditures recorded?

To fully understand capital expenditures, you also need to learn how to record them on your financial documents. Best practice states that if a piece of equipment or other asset has a useful life for under a year, it’s expensed on the income statement and is not considered a capital expenditure. A true capital expenditure is recorded on the balance sheet and is regarded as an investment, something that leads to long-term business health and growth. 

After a large asset is purchased and incorporated into your workflows, it will depreciate for the rest of its life. Depreciation expenses are recorded on the income statement.

Capital expenditures and taxes

Unlike operational expenses, capital expenditures usually aren’t fully tax-deductible in the year the purchase was made. Instead, the depreciation they experience can be deducted over the life of an asset.

For example, if you purchase business equipment that costs $500,000 and will last five years, you may be able to deduct $100,000 in depreciation each year of its useful life. Like other business deductions, depreciation can reduce a business’s tax burden significantly. 

There are exceptions to this rule, however. For example, IRS Section 179 allows businesses to fully deduct the expense of some qualifying capital expenditures in the year they are purchased.

Why are capital expenditures important?

Businesses record financial information for a variety of purposes, from forecasting to presenting to investors to assessing current profits. Keeping track of capital expenditures also has a vital role in the overall financial health of a company. These purchases usually have significant impacts on the organization’s future and can also affect current cash flow, as they are expensive. While they require large upfront expenditures, they are meant to have long-term benefits and payoff.

Capital expenditures are notably crucial for businesses in industries like telecom and manufacturing. These types of organizations usually put a lot more investment into expensive equipment to see bigger payoffs. But a variety of small businesses also routinely make significant purchases that qualify.

Recording these payments helps a business track how much it is investing in improvements or new assets linked to growth.

Capital expenditure challenges to be aware of

The process of recording this kind of spending and correctly forecasting its impact on the business isn’t always as straightforward as you might like. These expenses are larger and often more complex than other costs. Thus, the accounting process surrounding capital expenditures takes a bit more effort and planning.

Another challenge is accurately predicting investment outcomes. While any capital investment should bring financial benefits, sometimes losses are incurred when unforeseen circumstances arise, whether something goes wrong with an asset or a problem arises that’s unrelated to the expense but impacts its use nonetheless. There is always at least a little uncertainty about the future when making capital expenditures, and all businesses can do is project the impact and outcome to justify the purchase.

Provident CPA and Business Advisors can help

Our team of experts helps businesses like yours get on the right track for long-term success. We can help you understand best practices for accounting and business planning so that you have the visibility and knowledge necessary to succeed.

Contact our team of business strategy and accounting professionals today to get on top of capital expenditure reporting and your business’s tax obligations.

8 Quick Tips for Better Business Cash Flow

How can you find the right balance for optimized cash flow? Start with these eight tips.

Key takeaways:

8 tips for better cash flow:

  • Maintain visibility
  • Be prompt with payments and invoices
  • Be on the lookout for changes
  • Try renegotiating
  • Reevaluate your invoicing practices
  • Cut unnecessary costs
  • Use accounting software
  • Consider a line of credit

Cash flow management continues to be a sore spot for many business owners. And failing to monitor and optimize cash flow can lead to big problems, now and in the future. These considerations are especially important after the economic downturn over the last year, with business closures, layoffs, remote work, and other severe business impacts. 

Cash flow describes the funds being transferred in and out of your business: the rhythmic movement of money. It measures all your income and expenses over a given period and tells you if you have any profit left over. Cash flow management is a crucial component of managing your business and ensuring it is stable and prosperous.

Fortunately, you can get on top of any issues with the right solutions. Here are eight quick tips for optimized cash flow:

1. Maintain visibility

The first step toward better cash flow is staying on top of it. You should always know everything coming in and out—all sources of income and all business expenses. This is an ongoing process that needs regular attention, so put a simple yet thorough process in place that works for you and your team, whether it’s using an online platform or just a spreadsheet. Create a budget and monitor for any issues you come across when sticking to it.

2. Be prompt with payments and invoices

It’s easy to become annoyed with clients when they’re dragging their feet on payment. Try tightening your payment terms, but also remember that you should send your invoices as soon as services are complete. Encourage promptness in the payment process by being prompt yourself. Don’t wait to pay your own bills, either, as this can create a dangerous cycle, and you can quickly get behind.

3. Be on the lookout for potential changes

Once you start tracking and monitoring cash flow regularly, you’ll get a sense of when something might change, even if numbers aren’t your strong suit. There will always be ups and downs we can’t predict, but still many we can. So pay attention to the market and do your research. For example, start tracking which seasons are great for your business and which may cause a cash flow crunch and plan accordingly.

4. Try renegotiating

Take a look at current contracts and see if you can renegotiate with your vendors. Are you getting the best deal? Are you paying a fair price for your business rental? Are there other service providers you could work with instead that are more affordable? Try leveraging whatever you can to get a better deal or rate. This may include negotiating better terms with long-term vendors based on an excellent payment history and consistent business.

5. Reevaluate invoicing practices

The reason payments aren’t coming through fast enough could be because of your workflows, not necessarily your payment terms. How long does it take for you to generate and send an invoice? Try using digital tools that make it much faster to perform these tasks. Make sure you don’t have a pile of invoices somewhere waiting to be sent or processed.

6. Cut unnecessary costs

Always be on the lookout for places to cut back, especially if you see worrisome patterns in your cash flow. It may be time to let go of a space you’re paying rent for but not using, for example, especially if you work primarily remotely now. Many subscriptions are started and rarely, if ever, used. Go through all of the expenses to see if there’s anything that’s just not worth the payment anymore, like software or professional services. Cut back wherever possible. 

7. Use accounting software

Staying on top of cash flow requires regular monitoring, organization, and some math. To make this process easier, try using an accounting software platform that tracks business transactions, generates reports, sends invoices at the press of a button, and helps make predictions for the future. The software can save you time, ensure accuracy, and increase visibility regularly. When a process is simpler, you’re more likely to do it.

8. Consider a line of credit

Finally, consider getting a line of business credit. Even if you’re not doing poorly right now, credit can protect you in the future if you have a cash flow problem. Many small businesses decide to do this long before they need it, just so they have peace of mind moving forward. 

Work with a business advisor

When you find you’re having a cash flow issue, another option is working with a business advisor who can help identify problems and put better practices in place. Talking to a professional is a good idea, even if you haven’t hit a roadblock yet. Asking for guidance now helps ensure you’ll stay on the path to long-term success. 

The team at Provident CPA and Business Advisors helps businesses grow profitably through a better business strategy. We also specialize in minimizing taxes for business owners and walking our clients through the best tax planning strategies.

Contact the team at Provident CPA and Business Advisors to learn more.