HUGE Tips to Save Your Agency Money at Tax Time
We sat down with Bryan Nguyen, CPA to discuss a number of topics around accounting and tax planning specific to digital agencies.
Let’s get into it!
- 0:48 – Is there anything unique about agency taxes?
- 2:40 – Should agencies work with a firm to handle their bookkeeping?
- 4:09 – Should an agency hire a full-time accountant?
- 7:30 – What’s the best legal structure for agencies?
- 12:23 – How can agencies reduce taxable income? Agency specific tax deductions?
- 17:20 – Can you apply personal expenses to the business?
- 22:08 – What are common myths regarding tax deductions (cars, meals, etc)?
- 27:08 – How can beginners know about the value of accounting?
- 28:49 – What accounting and tax software do you recommend for agencies?
- 31:52 – What’s the best use of cash from a tax perspective?
- 38:50 – Cash and accrual accounting for agencies?
- 48:55 – What kind of financial ratios should we be looking at?
- 51:43 – What percentage of revenue should an owner take as salary from the company?
Is there anything unique about agency taxes?
It has to do with the way our economy has transformed from being a brick-and-mortar space to an online business world and digital marketing agencies are no exception to that.
Most of the agencies I work with tend to work remotely and use technology for client servicing. The way you work has changed and it has created a shift in the kind of expenses you incur. Most old school practitioners in the accounting space are just not up to date with that type of practice.
With agencies, an understanding of services offered, types of expenses incurred, clientage, labor force location, etc makes it quite different from other types of small businesses.
Should agencies work with a firm to handle their bookkeeping?
They can work with someone who does both. Like we do a combination of accounting, finance and tax strategy. For a lot of agencies, it is probably easier to have everything done by one person.
Should an agency hire a full-time accountant?
What we have noticed is that a lot of agencies, even up to the $2 million mark do not have full-time accounting resources on their staff.
They prefer to focus their investment on the service delivery aspect of their business and leave the administrative aspect off to the side.
For a lot of smaller companies, it does not make sense to hire a full-time accountant. But at the $2 million mark, the processes and operations become quite sophisticated and that is when they should hire an accountant internally.
What’s the best legal structure for agencies?
When you start, your focus is on client acquisition. If you are this new you should not apply for a separate legal entity or try to acquire one.
Once you have a couple of clients then you should think of having some kind of legal protection. At that stage, people will not take you seriously unless you have a legal structure like a Limited Liability Company (LLC).
LLC is the most common structure because it is the most flexible. It will grant you limited protection up to a certain point. It is the go-to de-facto standard in the agency world.
In the earlier stages, if someone is doing less than about a hundred thousand dollars a year in profit they should leave their classification as the default. The default classification for anyone who has an LLC is that they own a hundred percent.
At over a hundred thousand I will look at some more numbers and identify some tax savings opportunities if you choose to go with the S corporation status.
S corporation is just a tax classification for your company that says that it is an entity separate and distinct from you that reports all the income and passes it on to you as the chair-hold.
The key distinction between an S corporation and a distinct entity is that with an S corporation you are not subject to self-employment tax on your shareholder income.
For example, you make a hundred thousand dollars a year from your agency and if you are a sole proprietorship you will pay self-employment tax on that amount.
Self-employment taxes can be up to 15.3%. So on a100k that will be fifteen thousand three hundred dollars which is quite a lot.
But if you are an S corporation you would pay zero tax in that regard.
How can agencies reduce taxable income? Agency specific tax deductions?
When you get a deduction, that does not mean that you are “getting” it. In fact, it is still going out of your pocket.
If you spend a dollar, you are not getting a dollar back from the government. You might be getting 20 cents back or 30 cents or 40 cents depending on what your tax rate is.
A deduction reduces your reported income on your tax return. A reduction in your overall taxable income means that you will pay less tax.
The goal is to maximize your deductions as much as possible, which means lowering your taxable income and reducing your tax liability.
In business, your expenses run in parallel to what you can claim as a deduction.
So if you make a hundred and fifty thousand dollars in revenue from clients, and you spend fifty thousand dollars to support that revenue then your profit is a hundred thousand dollars. This will carry over to your tax return whether you have an S corporation or a sole proprietorship. This is a deduction in a nutshell.
As a CPA accountant, I make sure that you are recording everything on your books to capture all your expenses and that you are deducting everything allowable under the tax law.
For example, if you are a sole proprietor and you work from home, in the eyes of the law you can claim a tax benefit for that.
Can you apply your personal expenses to the business?
There has to be some kind of internal accounting process that allows you to submit receipts for expense reimbursement either through the payroll system or through a bank transfer.
Many accounting software allow you to do that, for example, Expensify which allows you to apply for reimbursement from the business.
Now the business is paying money out of its bank account to reimburse you. It is getting mapped to meals and entertainment and then when tax time comes it is now a deduction at up to 50% off because you can only claim 50% of that.
But remember not everything is tax-free. For example, there is an entire category called fringe benefits, so if you are paying for things like gym memberships or car usage for an officer then such expenses are not tax-free.
What are some common myths regarding tax deductions (cars, meals, etc)?
If you are leasing a vehicle, there is a concept in the tax world called Auto Lease Inclusion.
It cuts the number of deductions that a company is entitled to on a lease expense. If you are getting company car benefits, that is no different than getting paid by the company. For all accounting purposes, it is a bonus calculated by the percentage use of the vehicle determined by mileage.
How can beginners know the value of accounting?
My recommendation to beginner agency owners is that they should try doing their accounting themselves.
One of the most valuable things to learn is to understand numbers and even simple bookkeeping like doing your own books in QuickBooks can help a lot.
The basic stuff is pretty easy to learn. It will make you a better business owner. Also, when it is time to pass on that responsibility to someone else you will have a fundamental understanding of how it works and you will manage them properly.
What accounting and tax software do you recommend?
What is the best use of cash from a taxation perspective?
My philosophy is that if you have an actual purpose to spend that money then you should go ahead and invest.
But never spend money that you were not planning on spending just to lower your taxes
Cash and accrual accounting for agencies?
A cash-based system of accounting means that you recognize income and expenses when the cash comes into your bank account. In this system, you will not recognize revenue until you are paid by a client. On the flip side of things, you will not recognize expenses until you have paid your vendors.
Accrual accounting is different. It provides for matching when it is earned, not necessarily when it is paid. So maybe in the case of an agency you might have a contract that starts in September. You might have done three months of work but you have not been paid yet. Technically you have done work for it and you have met the terms of a part of your contract so in theory, you should record some kind of revenue on that.
You should not choose the accrual basis unless it makes sense for your business.
For anyone with less than $5-10 million in revenue, it is not worth exploring unless there is some special financial need for it.
I would recommend that you keep it on a cash basis because you do not want to pay taxes on the cash you do not have.
What financial ratios should an agency be looking at?
In terms of profitability and KPIs (Key Performance Indices) for a service-based model, the important one is the Labor Efficiency Ratio.
That ratio is revenue to labor cost. It is important because your agency is mostly driven by labor, the team that you have. A higher labor efficiency ratio means that you are getting a better return on your dollar for your team members.
So if you have a 3:1 labor efficiency ratio, that means for every three hundred dollars coming in you only spend a hundred dollars on people and you get two hundred dollars in profit.
If you want to measure the efficiency of your business you need to factor in the true cost of what it would cost to replace yourself.
So if you are a business owner doing CEO level work and you value your salary at $150,000, maybe you are paying yourself only $100 because you want to grow your business. In this case, you have not captured the true cost of your labor. That has to be factored in for an accurate analysis.
What percentage of revenue should an owner take as salary?
It depends on the agency and what level of revenue you are doing. I hesitate to peg it to a percentage of the revenue because that could be dangerous especially if you are at the lower levels or very high levels.
The range is probably based off of what is livable, like what you can live off of and what the market rate is.
You can check market rates on any recruiting website to know the cost of employing you as a person.
If I have to give a percentage to it, I will say that you want your labor cost to stay within 50 percent of the revenue.