If you are like most, tax time is the least enjoyable time of year. You spend all year long working hard to earn your way through life only to have to fork over a portion of your earnings to the government, either throughout the year or throughout the year AND again the following April – assuming you underpaid. For most high income earners, with tax liabilities greater than $100,000 a year, deductions – let alone credits – are harder and harder to find. Sure if you are a business owner you are afforded a few more opportunities to deduct some additional expenses against your income; but unless a majority of your income is generated from passive source – which can be deducted against passive losses – there are fewer opportunities to offset active, or earned, income. That is, until 2005… wait you thought I was going to say now?? Nope. Of course this begs the question, why has your advisor (i.e. financial and tax) not shared this concept with you?
Before we dive into the details let’s outline the benefits of tax credits, the different types of tax credits, and how they can put money in your pocket. To be clear, the tax credits I will outline in this article are probably different than what you have used in the past; they affect your taxes much the same way. For example, if you have children then you most likely have taken a child tax credit in the past.
The way you need to think about tax credits should be viewed as an offset to taxes owed versus as a reduction to your taxable income. Using a credit against the tax you owe allows you to take a dollar for dollar adjustment. In other words, $1 of tax owed can be completely offset by $1 in credits which results in $0 in taxes owed. On the other hand, if you have $1 of income and have $1 in deductions then only a percentage of your deduction offsets the $1 of income. For high income earners this could amount to 35% of the $1 in deductions, which would result in a hypothetical $0.65 of taxable income and in turn would lead to approximately $0.23 in taxes owed (not taking into account other deductions). In essence, the credit could significantly reduce – if not eliminate – your tax liability; whereas you would need significantly more deductions (than credits) to offset 100% of your income.
Knowing the breakdown, and importance, of a credit versus a deduction should highlight the value of maximizing credits. However, credits tend to be offered to low income households as a way to reduce their tax liability AND keep more income in their pocket. This is the reason why high income earners are not afforded many tax credits. The government’s view, high income earners can afford to pay their share of taxes and therefore do not need tax credits. However, there are a few loopholes that high income earners can legally exploit because this group has something only they can offer… disposable cash flow.
Types Of Tax Credits For Entrepreneurs & Executives
For those with experienced accountants the tax credits you are used to are mostly mainstream. Tax credits like the child tax credit, the Lifetime Learning Credit, American Opportunity Credit, Retirement credit, Adoption Credit, and Nonrefundable tax credits are fairly common and used throughout the early years of one’s life. Early in your career, depending on your income, your accountant may have told you your income fell below the income threshold to qualify for one, or more, of these respective tax credits.
Let me state that again, your income has to fall below a threshold to qualify for those credits. Once you surpass the threshold you’re done… no more credit… you pay more tax. This is why the following tax credits are more valuable to Entrepreneurs and Executives.
For high income earners the following tax credits are available, if you know how to access them:
- Investment tax credits (ITCs)
- Historic rehabilitation tax credit (HTC)
- Low-income housing tax credit (LIHTC)
- New market tax credits (NMTC) program
For those not familiar with these tax credits it is important to know, those with free cash flow – or the ability to control estimated tax payments – can take advantage of these tax credit programs. How? The “secret” comes down to who you make your payment to and when you make the payment. In other words, if you owe $100,000 in taxes to the IRS but your employer deducts your taxes from your paycheck throughout the year then you need the free cash flow to redirect toward one of the aforementioned programs during the taxable year to then receive the credit from the government the following filing season. This credit will lead to a massive refund the following year.
On the other hand, if you make estimated payments then you can direct a portion of what would be paid to the IRS to one of the aforementioned programs and therefore do not need to wait to file the following year.
Let’s walk through an example…
Each of the aforementioned credits comes with different tax benefits so I am not going to dive into each in this article. Instead I will walk through the Investment Tax Credit because it is easier to understand. However, before I do I need to point out these programs come with specific upfront, and possibly ongoing, requirements AND the tax laws supporting these programs can change. Lastly, these are not credits you simply check a box on your tax return to obtain. You have to locate a partner, complete due diligence on the project, perform regular activities, meet the IRS qualifications, and make the corresponding contribution.
The Investment Tax Credits are typically associated with energy projects. For decades the government has offered these tax credits to individuals and corporations as a way to invest in renewable energy. For individuals this can be seen when you install a solar panels on your roof, install energy efficient appliances in your home, or purchase an energy efficient car. Unfortunately, each of these projects requires an investment in them to receive a credit back AND the credit received is not usually equal to, or in excess of, the amount contributed. For example, if you invest $10,000 in energy efficient appliances you may receive up to 30% of the purchase price (plus any state credit) in the form of a credit on your taxes.
Alternatively, if you manage a corporation that invests in energy projects you are eligible to receive the same type of credit (up to 30%) plus any depreciation of the equipment you installed. Depending on the project this could create up to 90% of the invested amount in tax credits and deductions. However, for businesses to invest in these projects they typically need funding – provided by a bank OR by individual investors. This is where being a high income earner with disposable cash flow, or having the ability to redirect estimated payments can come in handy.
For corporations seeking individual investors there is an added benefit to investors. In many cases when a person purchases an energy appliance for their home they cannot depreciate the cost, unless they purchase it for an investment property. If you do depreciate the asset it typically has to be done over a period of time (as defined by the IRS). However, when you become an investor in a corporate energy project you can tap into a benefit where the corporation exchanges your investment for accelerated upfront tax credits, and deductions, that are stretched out over a shortened period of time – with the bulk being received in year 1.
If that wasn’t enough of a benefit, corporations can stack projects which then stacks credits for the individual investor. For example, if a corporation invests in a Historic Rehabilitation project that also qualifies in a Low Income Housing area and also installs equipment that meets the Energy credit requirements can stack credits and deductions. This can offer the investor an opportunity to maximize the first year tax credits/benefits AND any amount not used can be carried over to future years thus reducing future income tax liability. Since the credits are received through a partnership with a corporation the tax credits, and deductions, are not bound by income limits – as other tax credits are – which means your tax liability could drop significantly.
I should note, the tax credit offset previously mentioned can be applied to passive income or active income. Think of rental income versus what you earn from an employer. Passive income is generated from activities you “set and forget” whereas active income is something you are managing regularly – with “regularly” being a flexible term. You can read more about it on the IRS’s website. The net result, if you want to use the tax credit to offset employment income you need to participate “actively” in the aforementioned projects.
So how do you pursue these tax credits? Simple.
Work with your advisor/accountant to review this concept and how this strategy could benefit you. Next line up real estate, energy, or other development partners. Then complete sufficient due diligence on the developers and the projects they are working on. Once you feel comfortable with your future business partner you will need to hire an attorney to advise you on the process and review/draft legal documents. Finally, you will need to complete the necessary steps for these projects to qualify as an offset to active income. Once you do this… you could start saving tens of thousands, hundreds of thousands, or even millions of dollars – actual savings are dependent on your projected tax liability – as early as this year!
OR….
Should you not want to perform the work mentioned above, or do not have the time to do the work mentioned above, consider working with our team of consultants. We will work with your accountant to understand the strategy, we work with developers we have already completed due diligence on, we have reviewed their prior – and current – projects, and we will help you understand the steps needed for these tax credits to offset your active OR employment income. Schedule time below…