There are many steps small businesses can take to minimize their income taxes. Throughout my career as both a practicing certified public accountant (CPA) and an educator, I’ve developed a list of easy-to-use tax tips that I am happy to share.
1. Keep Organized
The most important step to minimizing your small business tax is to make sure you deduct every dollar you spend on business expenses. That means being organized. Tax returns should never be compiled based on a box full of receipts. You’ll never know if you lost a receipt and therefore missed the deduction. Here are some tips to stay organized:
- Have a separate bank account only for business activity
- Use bookkeeping software to track your bank account activity; by tying your expenses to your banking activity, you’ll be sure to capture all expenses
- Prepare your return based on the financial statements generated by your bookkeeping software
- Save receipts by either placing them in a file or attaching electronic copies to the transactions in your bookkeeping software
For more tips to stay organized, see my article on bookkeeping tips for small businesses.
2. Hire a CPA or Enrolled Agent
Almost anyone can sign a tax return as a paid preparer—there are no licensing requirements. Be wary of bookkeepers that want to prepare your taxes. Bookkeeping and taxes are two completely different fields within accounting. While bookkeepers may know where to put your income and expense numbers on the tax forms, being a tax professional is so much more.
CPAs are licensed by individual states while enrolled agents are licensed directly by the IRS. Both are required to meet education requirements, pass an exam, and complete education classes on a continuing basis.
It’s not realistic for you to both manage your business and know everything you should about taxes. Best of all, a tax professional will very likely pay themselves with tax savings. Maybe not every year, or even the majority of years but, at some point over the life of your business, you’ll be very happy to be in the hands of a tax pro.
3. Make Estimated Tax Payments
Small business owners are required to make estimated tax payments on their business income. S corporation (S-corp) owners must estimate the amount of income tax on their business income and submit the payments in four quarterly installments. Sole proprietors and partners must estimate the amount of both self-employment tax and income tax on their business income.
Self-employment tax is 15.3% and is in addition to income tax, which could be as high as 37% in 2022. Needless to say, sole proprietors need to stay on top of their estimated payments or they could fall far behind very quickly.
Generally, estimated tax payments are only necessary when you have income that isn’t subject to withholding, such as business income. However, the amount of the estimated payments is determined by estimating the total tax on your tax return and subtracting any projected withholding. The IRS has great information on paying estimated taxes.
4. Claim the 199A Qualified Business Income Deduction
For tax years 2018 through 2025, taxpayers can reduce their taxable income through the qualified business income (QBI) deduction, which is equal to 20% of income flowing through to their personal returns from a sole proprietorship, partnership, or S-corp.
There are several limitations to the income deduction, but the limitations don’t apply to joint taxpayers with total taxable income of less than $340,100 for 2022 and single taxpayers with total taxable income of less than $170,050 for 2022. Even if your taxable income exceeds these thresholds, you likely qualify for some deduction, but the calculations become more complicated.
5. Pay Wages to Your Children
It’s likely that your children have a much lower marginal tax rate than you do. Therefore, shifting business income to them will save taxes. Assign them chores and duties around your business and pay your children a reasonable amount.
The wages paid to your child save tax on your personal return at your high marginal tax rate, while your child pays tax at their low (often zero) marginal tax rate. This strategy will work for any low-tax-rate individuals to whom you wish to provide money. Instead of gifting them money, assign them business duties and run the payments through payroll.
Sole proprietors and partnerships, where the only partners are the parents of the child, don’t have to pay Social Security and Medicare taxes on wages paid to their child under 18 years old. However, you do need to withhold federal and state income tax, just as you would for other employees.
S-corps must treat the wages of children the same as for any other employee and withhold Social Security and Medicare. While paying children younger than 18 years old is usually a great idea for sole proprietors and partnerships, S-corps need to compare the income tax savings to the additional payroll tax liability.
6. Invest in a Business Building
If you’re currently renting your business property from a third party, consider buying a building to house your business. Business buildings are a great tax shelter because you can deduct the expense of the building while the value of the building actually increases. I call this a “phantom expense”—you’re deducting depreciation related to the building that doesn’t actually exist, thus lowering taxable income. The value of the building is most likely increasing.
If your business is an S-corp, it’s best to buy the building personally and then lease it to your business.
7. Deduct Fixed Assets using Bonus Depreciation or Section 179
Bonus depreciation and section 179 expense are both rules that allow you to currently deduct the entire cost of fixed asset purchases, instead of depreciating them over a period of years. Both provisions have some dollar limitations, but these limitations are high enough that they rarely affect small businesses. There are some important differences in the type of property that qualifies for each provision, but unfortunately, neither provision will allow the current deduction of a building.
8. Claim Home Office Expenses
Many small business owners can deduct the cost of operating a qualified home office. A home office must meet the following rules to qualify:
- The home office must be used exclusively for “business purposes.” It cannot double as a room used for personal purposes, such as a guest room or dining room.
- “Business purposes” are defined as any one of the following uses:
- The office is used to regularly administer or manage the business and the business owner doesn’t conduct substantial administrative or management activities anywhere else.
- The office is used to meet customers, even if administrative and management activities are done elsewhere.
- For structures not attached to the home, like a detached garage or shed, the business purpose rule is satisfied if the structure is used in connection with the business, such as storing inventory.
If you qualify for the home office deduction, you can classify otherwise-personal living expenses as business. For example, you can allocate your rent, mortgage interest, property taxes, and utilities between your personal residence and your home office.
9. Deduct Your Mileage Expenses
Deducting mileage is an easy decision if you regularly drive your personal vehicle for business purposes. At 58.5 cents per mile driven in 2022, the standard mileage rate can very quickly add up to a big tax deduction. In the old days, taxpayers tried to keep manual mileage logs and it was a pretty big hassle. But now there are a large variety of mileage tracking apps that will run in the background of your phone and automatically record the start and stop of each trip. At the end of the day, you just swipe left or right to separate business from personal trips.
Tip: Commuting to and from your business location isn’t deductible as a business trip.
10. Convert Your Sole Proprietorship to an S-corp
The primary tax advantage of converting your sole proprietorship to an S-corp is payroll tax savings. In a sole proprietorship, all of the business income is subject to both self-employment tax, which is the equivalent of payroll taxes paid by employees, and income taxes.
With an S-corp, only W-2 wages and salary paid to the owner are subject to payroll taxes. The business income remaining after owner compensation is subject to income taxes but not payroll taxes.
A common question is when to make the conversion to an S-corp. A good rule of thumb is to make the conversion when you hire employees. Prior to having employees, it’s hard to argue that income from the business is attributable to anything other than the owner’s labor. Therefore, the IRS will argue that all the income of the S-corp should be paid in wages, and you won’t save any payroll taxes. We’ll discuss reasonable compensation more in my next tip.
Bonus Tips for S-corps to Save Payroll Tax
Most business payments between S-corps and their owner have no income tax effect. The S-corp deducts the payment as an expense, which reduces the net income flowing to the shareholder. The payment is taxable to the shareholder, which offsets the reduction in net income. Therefore the overall effect on taxable income is a wash.
However, not all payments are treated the same for payroll tax purposes. Wages paid are taxable for payroll tax purposes, but other business payments, such as interest, rent, and shareholder distributions aren’t. Therefore, you can save payroll taxes by withdrawing money as rent, interest, and shareholder distributions instead of wages.
A. Minimize Your Compensation
As a shareholder/employee, your compensation must be paid through the payroll system and have payroll taxes withheld from it. The way to save payroll taxes is to minimize your compensation while finding other ways to withdraw the cash you need. However—and this is extremely important—you must pay yourself a reasonable salary for the services you’re performing for the business. You can’t intentionally underpay yourself. Determining a reasonable salary is a huge gray area where the IRS and taxpayers are fighting constantly. Be sure you can justify the low salary you pay yourself.
B. Loan Your S-corp Money
If your business needs an infusion of cash, consider loaning the corporation money instead of investing it as equity capital. The corporation will then repay the loan to you plus interest at a reasonable rate. The interest is tax-deductible by the corporation and taxable to you, so you don’t save income tax, but you do withdraw the interest without paying payroll taxes. Be sure your loan is documented with a promissory note that has a reasonable interest rate.
C. Lease Real Property to Your S-corp
A good general rule to follow is to not own real estate inside a corporation. Instead, own the real estate personally, or in a single-member limited liability company (LLC) if you’re concerned about liability protection. Then rent the real estate to your S-corp at a profit. Then, you’re able to withdraw the rent from your corporation without paying payroll taxes. As with all these strategies, make sure the dollar amounts of any contracts are reasonable.
D. Take a Shareholder Distribution From Your S-corp
The simplest way to take money out of your S-corp without paying payroll tax is to take a shareholder distribution. It’s neither deductible by the S-corp nor taxable to you, so it has no income tax consequences. However, excessive shareholder distributions could cause the IRS to question whether your compensation is high enough given the success of the company.
Another problem with taking a shareholder distribution—and the reason you need tips B and C—is that if the company is struggling, a shareholder distribution may not be reasonable. However, if the company has a signed promissory note (tip B) or lease (tip C) with you, then they’re justified―which is required legally―to make payments to you regardless of how they’re performing. This ensures your payments from the S-corp will continue to be reasonable and can be counted on to pay your living expenses.
Good tax planning and saving on your taxes starts with being organized and having a solid bookkeeping system to produce accurate financial statements. That way, you aren’t depending on a box of receipts to determine your deductions. Once you’re organized, hire a tax pro to help you sort through the myriad of tax deductions that might be available to your business. Finally, as your business grows and you hire employees, you should consider converting to an S-corp for considerable payroll tax savings.