The tax code has over a million words and counting, providing for a long web of cryptic rules, limitations, definitions, and references to other code sections—making it difficult for even experienced professionals to navigate, and near impossible for the curious layman looking for the hint of a loophole.
Large professional firms and in-house tax teams across the Fortune 500 spend tens of thousands of hours annually combing through four core sources of tax rules:
- The Internal Revenue Code itself, written by Congress;
- Regulations that are “promulgated” by the Internal Revenue Service (“IRS”), a technical term for how the IRS interprets and guides others, i.e., taxpayers as well as professionals, to interpret the technical code;
- Written guidance—provided by IRS via technical memos and revenue rulings, amongst other IRS-issued guidance; and
- Case rulings that contain the conclusions and findings from tax court.
Combined, the source data allows for creative interpretation and application of favorably-selected rules of various jurisdictions. This process provides the basis for taking what is referred to as a “defendable position” that reduces or defers tax liability.
In some ways, all tax planning is a series of defendable positions, those taken, those calculated, as well as those miscalculated.
If there is one key takeaway from this post, it is that any business can deploy strategic tax, so long as they have a process to document their position, assess how unique or “creative” their position is, and understand the likelihood of challenge or assessment by the IRS.
Fortune 500 tax and accounting departments have entire teams exploring case scenarios of variables, actual and hypothetical. Such are the resources of large companies, small armies focused on maximizing their cash and limiting or deferring. However, most small-to-medium-sized businesses, or SMBs, don’t have teams of lawyers and accountants on their staff. In some cases, they have just themselves and an accountant they see once a year. Or they are their own accountant. Nonetheless, a carefully designed and reviewed strategy can, in our experience, represent 2X earnings before income taxes (“EBIT”) on a compounding basis when considering taxable exit events.
While Fortune 500 tax strategies may seem out of reach for ordinary businesses, there are key principles and practices in play that can be utilized by any business owner with the same goal. That is if your goals include maximizing cash, and limiting and/or deferring tax liabilities, while managing risk. In this post, Miguel Alex Centeno, managing partner at Tax Hack and a former PwC tax manager, outlines some of the best lessons SMBs can learn from Fortune 500 in the world of finance and tax.
What can SMBs learn from Fortune 500 tax & finance strategies?
The world’s largest corporations use sophisticated tax strategies to minimize their business taxes. Examples include maximizing credits, shifting profits to more favorable tax jurisdictions, and accelerating depreciation, to name a few. SMBs can benefit from many of the same strategies on a smaller scale.
In addition to tax strategies, Fortune 500s employ best practices that allow them to plan and assess risks. These include three practices that any business can employ: (i) forecasting, (ii) documenting accounting and tax positions, and (iii) having a standardized process for assessing risk.
Small business tax strategy basics
Proper tax planning doesn’t have to be complicated. In fact, a lot of the most effective strategies are relatively basic. Here are some of the simplest ways your business can optimize its tax efficiency.
Set your goals & share them with your advisors
Tax planning should start by understanding your time and growth horizon. If you’re a fast-growing startup, minimizing this year’s taxes may be straight forward since you have more deductions than revenue, however, minimizing your tax bill at scale or upon exit will require having an understanding of your profitability or loss and gain on sale down the road.
Knowing company revenue goals and cost structure allows business owners and operators to forecast profits and anticipate opportunities with enough lead time to qualify and engage a tax strategy partner.
Long-term goals are typically harder to manage, as tax laws constantly change. This year’s credits and deductions might disappear in future years, so a great deal of uncertainty starts to creep into the picture over longer time frames. A good tax provider will be able to communicate uncertainties about changing tax rules and provide options that the business can weigh for themselves.
Be sure to set goals that are specific, measurable, achievable, and relevant, also known as “SMART” goals. You should also decide what your business’s priorities are over both the short and long term and their financial implications.
Business owners and operators who can communicate these goals in their financial projections are generally in the top 10 percent of business planners. We often tell our business owners that if they don’t have this skill, it is one worth acquiring or building through an engagement with a fractional Chief Financial Officer. Check with your advisor team to see if this is something they provide.
Knowing whether you are showing a profit or loss in the current and next year will help you determine which tax strategies to employ. For example, many startups that show high investment blitz scaling and show losses, can still leverage net operating loss carryforwards and refundable R&D tax credits against payroll taxes (which they still pay). For high-margin, high-profit companies, deferring taxes through a defined benefit plan may be appropriate.
Well-defined objectives provide goal posts for measuring success and evaluating areas where improvement is needed. They also can help you stay focused on the big picture and keep you in tune with your preferred tax and financial outcomes year-round.
Make meticulous record keeping easier
Bookkeeping is the cornerstone of accounting. Keeping detailed records of your transactions can help you maximize deductions, and it’s the best defense against an unexpected IRS audit, reducing the anticipated risk of adjustments.
Track and document every business expense, including notes about the transactions and their business purpose, using established tools such as Quickbooks, Xero, or Expensify. This will allow you to justify any deductions in the event of an IRS inquiry. For example, receipts for business meals should include the name of the people present, the nature of the business discussed, and other pertinent details. Rather than keeping a stack of receipts, use an expense system that allows you to enter the receipt and required details and do this once or twice a month.
Most large companies keep meticulous records for their purchases and require receipts from their employees for reimbursed expenses—and you should as well by defining a reimbursement policy and system.
Another key part of bookkeeping is cost accounting. That is, the ability to divide financial statements between different customers (to assess profitability), segments, or functional departments. The main benefit is assessing the value of each business segment, but it is also helpful for tax planning purposes. As companies grow, they will divide different parts of the business into separate entities depending on their tax profile for strategic purposes. See Coca-Cola’s structure, where each distribution company is its own entity in each state and separated from the centralized entity which handles marketing and legal. This also has significant implications for sales tax. Since certain states have lower sales tax than others, it’s critical that sales by states be properly divided and recorded. This is also the reason many back office functions get moved to low-tax states, allowing activity (and therefore tax base) to shift to a state like Florida, while only the smallest tax bases are kept in high tax states such as California or New York.
Advanced tax planning strategies
Large corporations also utilize sophisticated tax planning strategies that can significantly reduce and, in some cases, completely avoid taxes altogether. These strategies can be more difficult and costly to deploy, but the benefits can be huge if utilized properly.
The R&D tax credit
A Research and Development credit (26 U.S. Code §41), also known as an R&D credit, can yield substantial tax savings for small business owners. The credit provides dollar-for-dollar tax savings on expenses related to the development, design, or improvement of products, processes, or software.
The R&D credit applies to various activities and business sectors, so many smaller organizations can tap into these benefits too. If you’re producing or refining a product, whether physical or virtual, there’s a good chance you can qualify for an R&D credit even if you’re not a software company.
Though the credit has some limits, it’s largely available to any company that’s actively advancing any kind of scientific or technological developments within your industry.
Many Fortune 500 companies claim this credit every year to offset their otherwise massive tax bills, as there is no set upper limit on the value of the R&D credit each year.
International tax planning & migration
International tax planning and migration is a complicated and expensive tax strategy typically used by large companies who can sell their intellectual property (IP) to a low-tax jurisdiction. Utilizing this strategy starts with a company forming several international business entities. For example, in the case of the Double Irish Dutch Sandwich, companies will set up two companies in the Republic of Ireland, and one in the Netherlands.
Note that this is an extremely complicated tax ploy, so we’ve over simplified here. Once the overseas businesses are established, the company transfers its profits to one of the Irish subsidiaries. A common tactic involves transferring intellectual property, or IP, to the Irish entity. Then, the U.S.-based parent company sends its profits to the Irish subsidiary in the form of royalties for use of the IP, thereby stripping profits that would otherwise sit in the U.S. at 21 percent to the offshore operation.
Next, the first Irish company sends its profits to the Dutch company, which then sends the profits back to Ireland, where they remain with the second Irish company, which often has a special arrangement with the multinational taxpayer.
Irish corporations pay little or no taxes, so this controversial strategy allows companies to maintain their profits through the Irish subsidiary without paying taxes on the income. However, the company needs to keep the profits offshore because they will be subject to US taxes if they return to the domestic parent company.
Google famously utilized this strategy in past years, and the practice drew criticism from many US policymakers. Eventually, Google ended the practice due to the regulatory heat and public outcry.
This strategy is typically utilized by large, multinational corporations, however, having a separate entity to house your IP is a relatively practical strategy. First, it allows the company to legally separate the business so that it can sell its business operations and trademarks, branding, know-how (collectively, IP) separately. This allows businesses to recognize a premium on exit creating two selling prices. In addition, it allows the IP even in the US, to separate some of the income and receive it as “passive” as royalty income. This is taxed at lower rates personally than if it is active income. We recommend SMBs consider this strategy domestically before putting into an international structure.
For SMBs considering deploying international tax planning, the downsides should be considered. First, there are substantial costs associated with setting up a web of overseas shell corporations, and most businesses based solely in the US can’t do much with money that must remain offshore.
Logistical complications put the “Double Irish Dutch Sandwich” out of reach for most SMBs, but it nonetheless provides an interesting example of how some large corporations plan strategically around tax rate differences. For those who have international operations already, international tax planning may be more feasible as cash is already in non-U.S. banks and vendors are already being paid offshore.
Land conservation trusts
In their most basic form, land conservation trust strategies require an entity to place owned land into a protected trust. Then, the company donates the trusted land to the government for environmental preservation purposes. In exchange for the contribution, the donor receives a charitable deduction proportionate to the value of the land at a higher appraisal. Suppose for example that a group of trustees purchase land for $1.0 million and later donated the land at a newly appraised value of $2.0 million. This effectively allows trustees to receive a charitable donation of 2X their cash contribution, while also creating a protected environmental benefit.
Although this strategy is perfectly feasible, businesses should tread carefully and have an advisor that can properly communicate risk. Because land conservation trusts have the potential for fraud and abuse, these transactions can be extensively scrutinized—so make sure you’re following all the rules if you decide to go this route. If your company has unused or unwanted land it’s having trouble offloading, a land conservation trust can be an excellent solution for tax purposes.
Capital gains tax rollover (CGT rollover)
Most business owners have heard of a Section 1031 exchange. This exception allows taxpayers to sell commercial property and put profits into a new piece of real estate without paying capital gains tax on the original sale. The strategy is also used for other types of assets that fall within the limits of CGT rollover. There are strict rules regarding the timing of rollovers, but the tax savings can be substantial.
This tax strategy can be used by companies of any size, but you need to make sure that you are completing all the necessary steps in the required timeframe. Missing a deadline will make the capital gains immediately taxable.
If you unknowingly claim an unqualified Section 1031 exchange, you might not find out about it until years later when you’re blindsided by a massive tax bill. Make sure you cross your T’s and dot your I’s if you decide to use this strategy.
Closing thoughts: what SMBs can learn from Fortune 500 tax planning strategies
Though not every strategy employed by large companies will work on a smaller scale, many of them will. Small companies should monitor changes in tax laws just like their larger counterparts and review how leading companies are mitigating their potential tax expenses.
Small businesses, just like large ones, can reap significant benefits from tax planning. Working with a trusted tax advisor can unearth untapped tax credits and other tax-minimizing moves. Oftentimes, these dedicated professionals pay for themselves in the long run.
Although SMBs don’t typically have a fully-staffed accounting department like their Fortune 500 counterparts, a quality tax advisor can be an equally valuable asset for smaller companies.