3 Strategies Early-Stage Founders Can Implement Today To Reduce Taxes

By the end of the 10 minutes it will take for you to read this article, you’ll be equipped with specific information valued at least $10,000 - potentially multiple millions if your company grows tremendously.

Most entrepreneurs consider tax a secondary concern, which is understandable given that tax only matters if you’re generating profit. However, this mindset frequently leads to ignoring tax entirely, unintentionally violating federal and state laws, and missing out on legitimate tax savings that could have kept more cash in their business or their pockets.

This article aims to equip entrepreneurs with a handful of tools they can deploy immediately to reduce their next tax bill. Your future self will thank you if you implement only one or two of these strategies.

None of these strategies involve enormous complexity or sketchy loopholes; on the contrary, most of these are generally simple and described in depth on the IRS’s website. The reason most people don’t take advantage of them is because they don’t want to dig through the intimidating Tax Code or don’t see the ROI in investing the time to understand each of the many applicable concepts.

This is entirely fair. For this reason, I mostly avoid domain-specific terminology and technical processes in favor of a plain English overview of each strategy.

Strategy #1: Reduce Your Personal Expenses, Maximize Your Business Expenses

Amazon's Approach to Tax Efficiency

Did you know it took nine years for Amazon to show a full-year profit? Taken at face value, that single fact could lead one to conclude that Amazon was a failing company until some miracle breakthrough catapulted it to become one of the biggest companies in the world.

However, the astute entrepreneur may dig deeper and recognize that Jeff Bezos founded Amazon in 1994 and was first included on the Forbes List four years later in 1998. Surely he did not become one of the wealthiest people in the world by owning and operating a company consistently losing money!

What do the underlying facts tell us about how Amazon has shown little to no profit for the majority of its lifetime, and yet its owners have become tremendously wealthy? Many good decisions led to the success of Amazon. But one of the most impactful decisions they consistently made is that they were absolutely relentless about reinvesting cash back into the business instead of paying themselves gargantuan amounts that would have been taxed at the highest rate.

This is why they showed no profit in a traditional accounting sense - they generated little to no profit because the cash that could have been distributed as profit (and consequently taxed) was consciously reinvested into building a better product, expanding their infrastructure, capturing new markets with products like Amazon Web Services, and strategic acquisitions.

A few years after making these investments, the money invested was worth 5, 10, and sometimes 100 times more than its value when they could have distributed it to the owners.

Benefits of Reinvestment

By the time these investments were bearing fruit, the company had grown so much that cash was being produced that a significant distribution to the owners would have little effect on the business, or they could sell now high-value shares at the much lower capital gains rate. A little bit of patience goes a long way.

During the early stages of your business, by focusing on capital allocation instead of cash distributed to yourself, you dramatically reduce your tax burden by delaying the realization of your profits, which, while you’re waiting patiently, compound in size.

Utilizing Net Operating Losses (NOL)

A similar strategy is to reduce your taxable income by applying Net Operating Losses (NOL) carried forward from prior years. The basic underlying rule is this: you can apply the net operating losses you incurred this year to your taxable income in future years.

You might be wondering, “Why on earth would I want my company to lose money?” Think about how this rule combines with the rule previously described: you can aggressively reinvest into your business to the point you generate losses now, and then when those investments generate substantial profit in the future, you can reduce the amount you're taxed by applying your operating losses from today.

There are a few limitations to this rule (for example, the NOL can be carried forward up to 20 years), but none of the limitations should dissuade you from at least considering how you can implement this strategy into your business - the overall gain is quite substantial. This strategy is particularly useful for startups and businesses in cyclical industries that experience predictable fluctuations in profitability.

Strategy #2: Take Advantage of Lesser-Known Tax Deductions and Credits

The government provides a catalog of tax-reducing mechanisms that, when combined and applied strategically, can be used to meaningfully reduce your tax burden with little headache.

These are relatively straightforward: a deduction is subtracted from your income so you don’t pay tax on it, and a credit reduces the amount you owe by subtracting the credit amount from your total tax liability. Here are a handful of particularly useful options for entrepreneurs:

Standard Deduction

Almost everyone applies the standard deduction without even realizing it, so I’m mentioning it first and then quickly moving on to lesser-known reductions. Depending on the year, every taxpayer can deduct about $13,000 from their income. Yes, it’s that simple.

Home Office Deduction

If you use part of your home, apartment, or other “dwelling,” including an RV or a boat, exclusively and regularly for business, you may be able to deduct the cost attributed to that portion of the space from your income. For example, if you live in a 3,000-square-foot apartment in New York City that costs you about $5,000 per month to rent (a steal for NYC!), and your home office takes up 20% of the space of your apartment, you could potentially deduct 20% of the cost of your apartment from your income. Here, could deduct $12,000 from your net income.

Qualified Business Income Deduction

This deduction allows most business owners to deduct up to 20% of their income attributable to their business. There’s a catch: the deduction does not apply if your income is above about $180,000, so it’s use is mainly targeted to first-time founders or newer service businesses. For example, let’s say Entrepreneur Edward recently started a graphic design business that generates $250,000 per year in gross income and $75,000 per year in business expenses. His net qualified business income (QBI) would be $175,000, so the QBI deduction allows him to deduct 20% of that from his income, giving him a $35,000 deduction to apply to his taxable income.

Higher Education Credits

Are you paying for your or your child’s education? You may be eligible for the American Opportunity Tax Credit, a credit of up to $2,500 available for the first four years of higher education. Because this credit is generally unavailable for individuals with greater than $80,000 per year in gross income (or $160,000 for married couples filing jointly), it’s another reduction of particular use to first-time founders who need every ounce of cash to get their business off the ground.

Note: For individuals earning less than about $60,000 per year in gross income, you could also potentially qualify for the Lifetime Learning Credit for costs associated with post-secondary education or courses related to improving your marketable skill-sets.

Clean Energy Investments

If you buy a new electric vehicle, you can claim up to $7,500 of tax credit simply for investing in an electric future. This is partly why you may have seen a lot of car manufacturers marketing new electric vehicles. Relatedly, you can get a tax credit for 30% of the cost of installing solar panels on your home. For example, if installing a solar panel roof costs you $20,000, you’ll get a $6,000 tax credit.

Work Opportunity Tax Credit

You can claim a tax credit simply by hiring workers who generally face barriers to employment. This credit is frequently applied by companies that hire veterans, ex-felons, or long-term unemployed individuals. The credit amount varies, but generally, it's about 25% of first-year wages for employees working at least 120 hours but fewer than 400 hours, and 40% of first-year wages for those working 400 hours or more (subject to certain limitations depending on the group of workers hired).

This credit can add up, especially if you’re a business with a substantial number of workers, like insurance companies, cleaning companies, and other employee-heavy businesses. A similar credit is provided by the Disabled Access Credit, which gives small businesses a credit equal to 50% of the expenses incurred for removing barriers to make their business accessible to persons with disabilities. To optimize this credit, you can implement accessible mechanisms to sell your product to people with certain disabilities, and then claim a credit for the expenses incurred to provide that access.

Charitable Giving

Feeling generous? Gifts under $18,000 are not taxed at all - a major departure from the 40% gift tax rate typically applied (for more information on the estate and gift tax, read our in-depth article here). Additionally, larger cash donations can be deducted up to 60%.

Strategy #3: Structure Your Company for Maximum Tax Efficiency

Choosing the Right Entity

When officially forming their business, entrepreneurs face a plethora of seemingly similar options without a clear description of the implications of choosing each type of entity. And choosing the wrong entity seems like it could result in doomsday sometime in the future. Should you pick the LLC or the C-corp? But S-corp sounds interesting…and what’s this limited liability partnership? With all of these acronyms, it's no wonder the entity formation process is generally confusing!

Here’s a fun fact: most of your options only exist because at some point in history they might have been a useful option, and the only reason they’re still an option is because the law hasn’t gotten around to updating it. Here’s a simple heuristic: If you’re just starting out, choose a Limited Liability Company (LLC) because it dramatically reduces your legal risk and is treated as a pass-through entity, meaning you generally don’t get hit with a bunch of additional taxes beyond what you pay yourself.

There are certain instances where you may want to form a C-corp (like you get to put “Inc.” at the end of your company name), but the cost is that all income will be taxed at the corporate tax rate of 21%. Then, when you distribute profits to yourself, you get taxed again in your individual capacity. That’s why you hear people talk about “double taxation” when discussing corporations. When the time comes when it might make sense to become a corporation (for example, if you conduct business around the world), consider exploring headquartering your business in a corporate-tax-friendly jurisdiction like Ireland or Dubai.

Forming Your Entity in a Business-Friendly State

Next, you want to form your entity in a business-friendly state. You’ll occasionally hear arguments about which state is the best state to form your company, but the reality is there are a handful of great options for you to choose from. For example, you could form your LLC in Wyoming, which has no corporate or personal income tax, few regulations compared to other states, strong privacy laws for business owners, and some asset protection. Or you could choose Nevada for most of those same reasons. Other great options include Delaware, Texas, and South Dakota.

Conclusion

You now have a conceptual understanding of the various mechanisms you can use to efficiently mitigate your tax burden. Of course, this was a very high-level overview and each of these concepts is simplified. When you implement these strategies, conduct additional research on each concept or consult with a specialist who will understand your business so you correctly apply each strategy.

You are now lightyears ahead of 99% of entrepreneurs when it comes to understanding taxes applicable to you and your business!

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