To understand how debt can reduce the taxes of your company, we first have to understand how taxes work.
Consider this case: Tax rates on profit in your state are 20%. So, if you earn an annual profit of $1000, you will have to pay 20% to your state for their welfare services. It would amount to $200.
However, companies who do smart business can avoid paying a 5th of their profit by different tactics. In this blog, we will discuss how various types of debt can significantly reduce your taxes while staying within the ambit of the law.
- Making lemonade with bad lemons
Bad customers can be a headache. You have to keep following them to collect your payment, and most of them simply delay it until they can. In worst cases, you might even feel compelled to slap them with a court order to get your money back.
But, it doesn’t mean that you can’t use these bad customers to extract a benefit or two for your business.
If these customers haven’t paid money, you can use them to reduce taxes on your profits. The debt that is owed to you from clients or customers is called as bad-debt. Bad debt is any amount that you were not able to recover from the customer by the end of the year. Here is what the IRS says about it.
Bad debts include:
- Loans that are given to clients and suppliers
- Sales to customers on a credit
- Business loan guarantees
You will need to have an accrual account method for calculating profit for this method to work. Because if you are using a cash accounting method, your profit will not include the sales and order record.
It would mean that you can’t avoid taxes on the sales that were not even recorded in the sheet. In the accrual account method, you record the sale when the order is completed, even if you have not collected the payment from the customer.
In this case, if you don’t get the payment by the end of the year, this amount will be recorded in bad-debt. Each tax form has a section for mentioning bad debts, and you can mention the amount you are owned in that specific column.
- Calculate debt for the whole year (the amount that your customers/clients have not paid you within the financial year) and mention it in the tax form
- Now deduct the amount owed to you from the profit. Tax is deducted on the total profit you earned through sales. Deducting the debt amount from the profit will reduce the amount of tax you will have to pay.
2. Giving Loan to Your Company
Another way to reduce the tax on the amount of profit you make is by giving a loan to your own company. Here is how the whole process works:
You will register a company and then give a certain amount of money to it as a loan, not as an investment. This is good-debt. Whenever a company makes a profit, it will have to return a certain amount as a loan installment.
This amount can be deducted from the company’s profit sheet as debt. So, the company won’t have to pay any taxes on the loaned installment. Similarly, you will receive the loan with interest rate free of tax because there is no tax on receiving a return of your loaned amount.
Similarly, some companies avoid taxes completely by showing that they are under debt. It means whatever profit they make is given to the creditor for the repayment of the loan.
With zero profit or a profit below a certain level, companies are not entitled to pay any amount in taxes in the United States. Although this is not an illegal practice because it is well within the permitted tax rules, but it is unethical.
3. Using Tax Havens to Reduce Taxes
Another trick to avoid taxes is by using a subsidiary in a tax haven. Let’s say a company is based in the US. The company owners will set up a finance company in a tax haven like Panama or Cayman Islands.
They will use this off-shore company to lend money to its subsidiary in the United States. So, if the company earns profit, it has to pay the loan installment to the finance company in the tax haven.
This way, it has to pay only a reduced amount of tax. However, since both companies belong to the same owner, he makes a profit on both of them while filing reduced taxes on both companies. In this case, one company will act as a creditor, and the other will act as a debtor.
4. Bank Loans
Like we said earlier, interests paid to the lenders can be deducted in the yearly company taxes. Most companies prefer to take loans from banks instead of getting more shareholders on board because it reduces the amount of payable tax.
If they were to pay shareholders dividends at the end of each month, that dividend value would be accounted for in the yearly tax on the revenue. However, interest payments are not accounted for in the annual taxes.
This amount is calculated through a formula called the after-tax cost of debt. Since the interest rate reduces the taxes of the company, the final amount equates to a much lower number.
5. Staying legal and not evading taxes
When companies take more loans than necessary, government authorities come in action. The best way to not evade taxes is to get quotes from various banks about their lending rates.
Let’s say if the banks are fine with lending the company money for a 5% return, the company should get the money from the shareholders at the same interest rate. This will mean that the company is not borrowing money from shareholders at an above-market interest rate, and not trying to dodge taxes.
Bottom-line
Yes, taxes don’t apply to the debts of a company. Companies can use this loophole to their benefits. We have mentioned a few tactics that the companies can use to reduce taxes they have to pay on profit while staying within the legal cover.
