Income Diversification: How Businesses Should Invest for Multiple Income Streams

As a business owner, you likely have a primary income stream. If you have a store, your primary revenue comes from the people who walk through your store and buy things. Similarly, if you’re an accountant, your income comes from people who use your services to keep their books in check.

When you have excess profits, there’s an adage that says that you’re supposed to reinvest those into the business. That’s true. However, only investing in your single income stream leaves your business with a crucial vulnerability. A downturn in the market or a sudden lack of demand for your services or products could result in a significant revenue catastrophe. Instead, a more prudent approach is to have multiple streams of revenue – preferably some that have tax advantages as well!

Here’s how you can diversify your income and save on taxes!

Invest in Stock, Bond, and Other Securities Markets

At first, this point might sound obvious, but it’s genuine: invest some of your business’ profits in securities. The stock market has returned an average of 6-7% annually. It is hard to beat those returns in other investment categories while passively investing. Bond markets have all forms of investment types – from the very risky bonds that have double-digit gains to the very safe US Treasury Bonds that have a low yield but are a beautiful place to park excess cash. Other security markets, like precious metals, have their benefits as well, like being able to hedge against a national recession.

Investing in the stock market has other benefits aside from its past ROI. For starters, economic downturns can impact small businesses in unexpected ways. As we saw with COVID-19, for example, the government shuttered restaurants, shops, hairstylists, and other companies. While this was a unique situation, it highlights the importance of businesses not relying on one revenue stream. If those small businesses held some stocks or bonds that paid dividends and had growth potential, the owners could use that to help keep the business afloat.

Another benefit of investing is that it helps if you have more cash than is FDIC-insurable. The FDIC guarantees deposits of up to $250,000, but if you have $500,000, you can keep $250k in the bank and put the other $250k in stocks or Treasury bills.

Park Excess Loan Money

Quality businesses with a history of doing well often have access to very low-cost lines of credit and loans. For example, your business might own a building that you could put as collateral for a line of credit at minimal interest.

If you don’t need the excess money from that line of credit or loan, one option, instead of letting it sit in a bank account, is to invest it instead. Consider the following hypothetical scenario. Let’s suppose you gained access to a $50,000 line of credit at 3% interest. For the sake of argument, let’s say that it amortized over ten years, so the monthly payment was $482.80.

Now, let’s suppose you took that $50,000 and put it in an ETF (exchange-traded fund) that tracks the S&P500 (SPY is one such ETF). For the sake of argument, let’s assume you did this in 2010, and now it’s 2020, so you’ve just paid off the loan. Including the interest, you’ve paid $57,936.45. However, depending on when you bought the ETF in 2010, it was around $100. Now, it’s $300.

Instead of letting that line of credit go to waste, had you invested it in the stock market, you would have made nearly $100,000 in profit over ten years. For most businesses, an extra $100,000 would be amazing!

Of course, the standard disclaimer that past returns are not indicative of future gains applies here. There’s no telling what the market will do in the future, but if the past is any guide, then putting lower-cost loans into equities is something that is most definitely worth considering.

There Are Tax Advantages As Well

There are some tax advantages when investing in stocks, bonds, and other equities.

For starters, investing in state bonds can often be tax-free at the federal, state, and local levels. Of course, you’d need to check with a tax professional to ensure that the specific ones you’re buying are tax-free, but they do exist.

Investing in stocks also has the benefits of capital gains tax as opposed to regular income tax. Note that this does not apply to C corporations, but S corporations and LLCs enjoy this benefit since they are pass-through entities. For entities that can take advantage of these lower rates, the savings can be significant. Capital gains are 0% at the lowest level, 15% if the recipient has a taxable income between $40,000 and $441,450, and 20% if the person’s income exceeds the $441,450 threshold.

So, in the previous example, the business took the $50,000 loan and sold the stock in 10 years for $150,000. From a tax perspective, if this were an LLC, the interest spent on the loan (~$7,000) would have been tax-deductible (there are some limitations on this, but it can offset certain types of income). The $100,000 sale would have been long-term capital gains, which would have only had a 15% or 20% tax. The interest is tax-deductible under certain circumstances, and the profit is tax-advantaged. It’s hard to beat that kind of arrangement!

C Corporations Do Get Some Breaks

While a C corporation cannot receive the benefits above, they do get some breaks. The biggest one that a C corp gets is the Dividends Received Deduction (DRD). The Tax Cuts and Jobs Act of 2017 made this deduction slightly worse than before, but it’s still valuable.

The DRD aims to eliminate the problem of triple taxation. Let’s say company A owns stock in company B. Company B declares a dividend. Company B pays tax on the income and pays out dividends in that after-tax money. Company A receives that dividend, and that’s taxable income. Then if Company A pays that out to shareholders as dividends, shareholders also have to pay tax on that money! Entities pay taxes on the same funds three times: at the shareholder level, Company A, and Company B.

However, in reality, this isn’t what happens. The DRD lets the corporation deduct some of your dividends. If your corporation owns less than 20%, then it can deduct 50%. Between 20% and 80%, your company can deduct 65%. If you have 80% ownership of the company, you can deduct 100%.

So, let’s say you put $100,000 in McDonald’s as an investment for your corporation. It declares a dividend that amounts to a $1,000 payment. Your business owns less than 20% of McDonald’s, so you would receive a tax deduction of $500. Therefore, your net income would be $500. At a tax rate of 21%, you’d only pay $105 in taxes (a 10.5% effective tax rate).

If your dividends are not qualified or you have an AGI of at least $39,376 as a single person or a married AGI of $78,751, the minimum tax you’ll likely pay is 15%. That percentage is the capital gains tax (which is also for qualified dividends) that filers pay above those AGI levels. If you fall into that category, you technically save on income taxes investing through your C corp than you do when you invest personally. Note, there are some potential caveats to this scenario, so you should always consult with a tax professional to ensure that your situation works as you would expect!

Diversification of Income Is Key

Diversifying your income streams is critical to the success of your business. Whether your business is a store that sells widgets or a holding company for real estate investments, consider all the ways to diversify your portfolio. In particular, consider the benefits of investing in stocks, bonds, and other equities. There are quite a few unique tax advantages and deductions that you can use to maximize your profits and minimize your tax burden.

Additionally, if you find yourself with access to inexpensive loans, you may wish to consider putting that money into equities rather than letting it sit idly. While there’s no crystal ball to predict the future, you can often use that low-cost money to make quality investments that will net you more in the long term.