I understand. No one enjoys paying tax. That’s why small business tax planning is so important.
As a self-employed business owner, you must take advantage of all legal tax deductions. There are many ways for you to lower your tax liability. You just might not be aware of how to do it.
Your CPA possibly helps you with your tax return. However, most CPAs and tax preparers don’t do a great job with tax planning. They’re very good at doing tax returns, but often they’re so busy that they don’t go out of their way to look for tax planning ideas for clients.
The goal of this post is to spell out some tax planning ideas that you can use to reduce your taxable income. There generally is not one big silver bullet. But if you put these together, you have a good chance of cutting your tax bill in half, if not more!
As you know by now, we are huge fans of cash balance plans. But we do get involved in other tax structures from time to time.
Most of the planning ideas we will discuss in this guide are complex. They’re not run-of-the-mill vanilla strategies that many tax practitioners preach. In fact, I assume you’ll know very little about most of the strategies we will discuss.
As a result, many of these strategies can be more expensive to implement and may not be suitable for your business. But my goal is to bring these strategies and structures to your attention and let you review and discuss them with your CPA. You decide what works best for your business.
This post will briefly discuss other structures available to some of our clients. Each client situation is unique, so discuss and review these strategies with your CPA. Not only do these structures save on income tax, but many of them offer estate tax benefits and asset protection as well.
Our tax planning generally broken down into 10 different categories:
- Entity Structuring
- Retirement Planning
- Spouse & Children
- Health Insurance and Medical
- Fringe Benefits
- Tax Credits
- Special Structures
- Special Deductions
- Real Estate & Investments
- Estate Planning
Entity structure is the first step in tax planning. You can have a relatively simple structure or a very complex one. Simple structures can be flexible and easy to understand but not tax efficient. But if you implement multiple entity structures, it might only make sense if you’ve got very high business income.
The sole proprietor is the most straightforward tax structure. Single-member LLCs fall under a sole proprietorship. These entities file Schedule C to your personal tax return.
While these entities are not very tax efficient, they can be suitable for many small businesses or companies with limited operating profits.
Sole proprietorships can also use certain fringe benefits that are not available to S-Corps, such as fringe benefits and certain medical reimbursement accounts.
One significant tax benefit of an S-Corporation is its pass-through taxation structure. Unlike C-Corporations, where the company is taxed separately from its owners, S-Corps pass through their income, losses, deductions, and credits to the shareholders.
This means that the company’s profits and losses are reported on the individual tax returns of the shareholders, and the income is only taxed at the individual level. By avoiding double taxation at both the corporate and individual levels, S-Corporations can potentially reduce the overall tax liability for the business owners.
Another advantage of S-Corporations is the potential for self-employment tax savings. In a sole proprietorship or partnership, business owners are subject to self-employment taxes on their entire net income. However, with an S-Corporation, only the wages or salaries paid to the shareholders who are actively working in the business are subject to self-employment taxes.
The remaining profits distributed to shareholders as dividends are not subject to self-employment taxes. By structuring the income distribution appropriately, business owners can potentially reduce their self-employment tax liability and save on taxes.
With the highest tax bracket being 37%, it can go along way to have some income up-streamed into a C corporation and be taxed at only 21%. You can also make the shareholders of the C corporation, children, grandchildren, or other related parties.
You want to make sure you have a reasonable basis for many of these decisions on the C Corp. But this can reduce not only your tax liability, but also limit estate tax.
Consider adding a C-corporation that is managed within your family. This can allow you to take advantage of certain fringe benefits that are not available with a typical S-Corporation structure.
Here are a couple of advantages:
- Owner/employees receive tax-free fringe benefits, like medical expense reimbursement, daycare, college, and educational funding.
- Any remaining taxable income is shifted to the 21% tax bracket.
Your S-Corporation would make a tax-deductible management fee payment to the C-corporation. Then the C-Corporation would hire employees who could take advantage of the tax-free fringe benefits.
Partnerships are the most flexible tax structure. The only problem is that they’re not very tax efficient.
They work great for real estate entities and other passive activities, but they’re usually not the best for operating businesses that are subject to employment taxes.
One of our favorite structures to implement is establishing your main operating company as a partnership. Because of the flexibility to allocate the income differently from the partnership, you can divert some of the income to a C Corp. or S Corp. This can give you the best of all worlds.
A flexible operating entity that can divert most of your income to an S corporation (saving employment taxes) and take advantage of a lower tax bracket and the fringe benefits of a C Corp. It can be a win-win.
Trusts often come up in the small business tax planning process. Many people think that trusts can be used to lower income taxes. Unfortunately, this is generally not the case.
Trusts are typically used for asset protection and estate planning purposes. Trusts can be revocable or irrevocable. Revocable trusts are often used for probate avoidance and can be amended. An irrevocable trust generally cannot change after the trust agreement is signed. Because you have transferred assets from your estate, there may be transfer tax benefits with an irrevocable trust.
We will touch on trusts later in the estate planning section. But for most small business owners, income tax planning with trusts is normally not done.
Qualified retirement plans are our favorite tax planning tool. You can stash away money into retirement and get a tax deduction for doing so. It’s a true win-win.
Most business retirement strategies revolve around a solo 401(k) or a SEP IRA. These are great plans and should be considered in lower tax brackets. But if you make over $300,000 annually, you may need more than these plans allow for your desired retirement contribution.
What if you would like to contribute $75,000 to $400,000? Then you might have to think outside the box. Traditional retirement structures won’t work. There are other retirement plans for business owners looking to put a nice chunk into retirement and lower your tax bill.
Mega Backdoor Roth
You may be aware of the Backdoor Roth. This strategy works great but doesn’t allow you to get a large amount into retirement. But the “Mega” Backdoor Roth works a little differently. It combines tax deferral with after-tax contributions. That’s why it’s so powerful.
The structure itself is rather straightforward. It uses a customized solo 401(k) plan document to make an “after-tax” contribution. This brings the total annual contribution for a year up to the yearly limit. These amounts can qualify for tax-free rollover to a Roth IRA.
The opportunity to make after-tax contributions isn’t a new strategy. But recent IRS guidance makes these contributions much more attractive.
Cash Balance Plan
A cash balance plan is a unique retirement structure that allows business owners to make significant retirement contributions. You can think of it like a 401(k) plan on steroids. Annual contributions often can exceed $400,000.
A cash balance plan is sometimes called a hybrid retirement plan because it has characteristics of defined contribution and defined benefit plans. The calculation is similar to a defined benefit plan, but amounts are stated in dollar amounts that are presented similarly to a 401(k).
These plans are the best option for small business owners looking to move up from a solo 401(k) plan. It comes down to tailoring the plan to meet the small business owner’s needs.
Defined Benefit Plan with Prior Service
My guess is that you have heard of a defined benefit plan. But you still probably don’t know how they work. You may have a family member receiving payments under a plan from a large company they worked for. That’s because large businesses traditionally offered these plans. But the good news is they can also work for the small business owner.
Defined benefit plans aim for a large payout (or payment stream) at retirement. You can make significant tax-deductible contributions because the final benefit amount can be as high as $3.4 million.
These plans can sometimes work better than cash balance plans for younger business owners because of lower discount rates. But there is also one great strategy to turbocharge the plan contributions. It’s called “past service” or “prior service.”
Plans can be customized so they provide for employee compensation earned in prior years. You can make a one-time contribution for this past service during the year the plan is set up. This can result in an additional 50% contribution over the normal contribution. Think of it as a “catch-up” contribution.
The good news is that you can combine the above strategies into one super-sized structure. This usually takes the form of a solo 401(k) with the Mega Backdoor Roth option. Then it is combined with a cash balance plan or traditional defined benefit plan. You can then tack on a “prior service adjustment” if you want.
At the end of the day, this strategy can enable someone to contribute as high as $500,000 in just one year! But you must be careful. There are IRS restrictions and limitations when combining retirement plans. So, you must do your homework.
Spouse & Children
Being a small business owner offers you tax planning opportunities for your spouse and children. This can allow you to take tax deductions at the business level while minimizing the tax implications to your family members.
Hiring Your Spouse
As a business owner, you can hire your spouse to perform specific business duties. Employing your spouse can increase potential fringe benefits and provide extensive tax advantages.
In fact, hiring your spouse and paying them a relatively lower wage can often result in a retirement contribution of twice the payroll. This is because the spouse can contribute to both a 401k plan as well as a defined benefit plan. Depending on your entity structure, your spouse can also take advantage of other fringe benefits.
Hiring Your Children
You also can pay your children from the business and take a tax deduction. As long as the W2 compensation is less than $13,850, your child does not have to file a tax return.
Hiring your children creates earned income. This means they qualify to contribute to a Roth IRA. You can fund the maximum amount to the child’s account each year based on the total income earned or $6,500 (whichever is lower).
While these contributions are not a tax deduction, they allow you to fund your child’s retirement tax-free. In addition, the account can be used for college or a first-time home purchase.
Research & Development (R&D)
Research and Development (R&D) tax credits have emerged as a valuable tax strategy for businesses engaged in innovation and technological advancement. These credits are designed to incentivize companies to invest in R&D activities by providing tax benefits.
Many people think that R&D tax credits are just for tech companies. This is not the case. R&D tax credits are available to almost any company or entity structure that incurs certain costs while developing new or improved processes or products.
One of the primary benefits of R&D tax credits is the potential reduction in tax liabilities. Companies can claim tax credits based on a percentage of qualifying R&D expenses, including wages, supplies, and contract research costs. By offsetting a portion of these expenses against their tax liabilities, businesses can significantly reduce their overall tax burden.
R&D tax credits can be used to offset the costs relating to research and experimentation for the following:
There are companies that do free studies and will run you an estimate to see if this makes sense. We have seen R&D tax credits work in physician offices and other service-related businesses.
Medical and health expenses
In conjunction with the C corporation it might make sense to set up a section 105 plan. This can allow you to get reimbursements of medical deductions like co-pays and other items.
A Section 105 plan, also known as a Health Reimbursement Arrangement (HRA), is a tax-advantaged benefit plan established by employers to reimburse employees for qualified medical expenses. It allows employers to provide healthcare benefits to their employees in a tax-efficient manner. Here’s how a Section 105 plan typically works:
- Plan Setup: The employer establishes a Section 105 plan, usually with the assistance of a third-party administrator or benefits provider. The plan must be documented in a written plan document that outlines the terms and conditions, eligibility criteria, reimbursement procedures, and other relevant details.
- Employee Eligibility: The employer determines the eligibility criteria for participating employees. Typically, Section 105 plans can cover all eligible employees or be limited to specific groups, such as full-time employees or those who meet certain service requirements.
- Reimbursement Contributions: The employer sets aside funds designated for reimbursing qualified medical expenses incurred by eligible employees and their dependents. These contributions can be made on a pre-tax basis, meaning they are excluded from the employee’s gross income for federal income tax purposes.
- Qualified Medical Expenses: Section 105 plans can reimburse a wide range of qualified medical expenses, as defined by the Internal Revenue Code (IRC) Section 213(d). These expenses include medical, dental, and vision care costs, prescription medications, co-pays, deductibles, and other eligible healthcare-related expenses.
- Expense Reimbursement: When an eligible employee incurs a qualified medical expense, they submit a reimbursement request to the plan administrator. The request typically includes documentation, such as receipts or invoices, supporting the expense. The plan administrator reviews the request for compliance with the plan’s terms and conditions and processes the reimbursement accordingly.
- Tax Advantages: One of the main benefits of a Section 105 plan is the tax advantage it provides to both the employer and the employee. For the employer, contributions made to the plan are generally tax-deductible as a business expense. For the employee, reimbursements received under the plan are typically tax-free, meaning they are not subject to federal income tax, Social Security tax, or Medicare tax.
- Plan Compliance: Employers must ensure their Section 105 plans comply with applicable laws and regulations, including the Employee Retirement Income Security Act (ERISA), the IRC, and the Affordable Care Act (ACA). Compliance requirements may include plan document maintenance, participant disclosures, non-discrimination testing, and annual reporting obligations.
Section 105 Medical Reimbursement Plan
These plans allow for tax-free medical reimbursements. The company is able to deduct these reimbursements directly on their tax return.
A section 105 plan can work with the C-Corp fringe benefit structure above. But it also works excellent with sole proprietors.
A sole proprietor must legitimately employ a spouse involved in the business. The employed spouse is treated as any other employee, with the business owner offering medical benefits as part of the employee’s compensation package. A spouse doesn’t need to work for the company with a C-Corporation.
It’s important to note that while Section 105 plans can be a valuable tool for providing healthcare benefits, they must be implemented in compliance with the relevant regulations. It is advisable to consult with a qualified benefits professional or legal advisor to ensure proper plan design and administration, as well as compliance with applicable laws and regulations.
There are fringe benefit programs for C-corps that should be considered.
This IRS code section provides that a captive that qualifies to be taxed as a U.S. insurance company can exclude insurance premium income of $2.6 million annually. This is a great option for a high-income business with many employees.
Captive insurance has become a tax strategy among businesses looking to manage risk and optimize their tax position. It involves the formation of an insurance subsidiary, known as a captive, to provide coverage for the risks of its affiliated entities. While the primary purpose of captive insurance is risk management, it also offers significant tax advantages.
One of the key tax advantages of captive insurance is the deductibility of insurance premiums paid by the affiliated company. As long as the premiums are determined at arm’s length, and the coverage is legitimate, the IRS recognizes them as ordinary and necessary business expenses. This deduction reduces the parent company’s taxable income, resulting in potential tax savings.
Captive insurance companies often accumulate surplus funds from premiums not immediately needed to cover claims. These accumulated funds can be invested, providing additional income streams and potential investment gains. If structured correctly, the income generated within the captive can be taxed at a lower rate than the parent company’s ordinary income.
When structured and operated appropriately, captive insurance offers businesses various benefits beyond risk management. As a tax strategy, captive insurance enables businesses to optimize their tax positions through deductible premiums, potential tax deferral, and wealth accumulation opportunities.
1202 C-Corporation for Intellectual Property
A little-known part of the tax code allows certain shareholders to exclude qualifying capital gains from taxation. Silicon Valley companies have been using this strategy for years.
Specifically, owners of qualified small business stock that has been owned for at least five years can exclude capital gains of up to $10 million upon the stock sale and up to 100% of capital gains in some situations.
The 1202 corporation holds intellectual property, and your operating entity pays the entity a tax-deductible IP licensing fee for the use of the IP. When the practice is sold, this income stream can then be capitalized for valuation.
Restricted Property Trust
An RPT is an excellent option for business owners who also need life insurance. They get to deduct 70% of the payment and receive tax-free income in retirement.
It works a little like a deferred compensation plan. But you have a minimum annual contribution of $50,000, and you must commit to it for a minimum of five years.
Conservation easements offer several tax advantages for landowners who choose to protect their properties and preserve natural resources. One significant benefit is the potential for substantial income tax deductions. When a landowner donates a conservation easement to a qualified organization, such as a land trust or a government agency, they can claim a charitable contribution deduction on their federal income taxes.
This deduction is based on the appraised value of the easement and represents the difference between the value of the land before and after the easement is placed. By permanently restricting certain development rights, such as prohibiting subdivision or commercial activities, the land’s value typically decreases, resulting in a significant tax deduction for the landowner.
Real Estate & Investments
I think you acquired a building and you should possibly consider a cost segregation study and passive income strategies to be able to offset any passive losses.
When a C-Corporation owns less than 20% of another business, it can exclude 50% of the dividends received from taxation.
The dividend exclusion allows C-corporations to deduct 50% of any qualified dividends received from their stock investments. This helps ensure that the dividends received are only taxed once. As such, there is no double taxation. Before this rule was implemented, C-corporations could be taxed twice. Once on business profits and then again on any qualified dividends.
A dividend exclusion will only apply to companies that are classified solely as domestic corporations. As such, foreign corporations are excluded from this provision. In addition, only dividends received that are distributed by domestic corporations are eligible for this special exclusion.
No small business tax planning guide would be complete without, at least, addressing estate tax. Even though this does not directly tie to income tax planning, many business owners have valuable companies that can create estate tax problems. This is certainly the case with estate taxes looking to revert to old exclusions starting in 2026.
As of January 1, 2026, the current lifetime estate tax exemption of $12.92 million for 2023 will be cut in half and then adjusted for inflation. If you are looking at an estate tax issue in 2026 you might benefit from transferring assets and their related appreciation out of the estate sooner rather than later.
Another essential point to consider is that virtually everything you own will be included in your estate. This includes retirement accounts and even life insurance that is typically tax-free. But there are some ways for you to structure them to avoid estate tax.
There are many trusts that can be considered for estate planning. We don’t have time to address them all, but here are some you can consider:
- Grantor Retained Unitrusts (GRUTs)
- Charitable Remainder Trusts (CRUT)
- Grantor Retained Income Trusts (GRIT)
- Intentionally Defective Grantor Trust (IDGT)
- Irrevocable Life Insurance Trust (ILIT)
- Crummey Trusts
- Qualified Terminable Interest Property (QTIP)
- Dynasty Trusts
- Qualified Personal Residence Trusts (QPRTs)
- Grantor Retained Annuity Trusts (GRATs)
As a successful business owner, you have various tax planning options at your disposal. Hopefully, you will consider these above strategies and see if they can work for you in your situation.