Legal Ways to Lower Your Business Tax

Where can a small business legally cut its tax?

A small business should first check the income and expenses already in its books, then compare deductions, credits, and elections against the owner's total tax return. A deduction lowers taxable income; a credit reduces tax, but neither is useful without meeting its conditions and keeping proof (IRS: business credits and deductions).

Use this order: reconcile sales and costs, identify assets placed in service, estimate owner income, check retirement contributions, then test credits and state elections. A purchase made only to create a deduction still costs the business money. If books are behind, catch them up before planning.

Am I deducting every business expense I can?

Business expenses generally must be ordinary and necessary for the work, and the business must be able to show what it bought and why. Review overlooked costs such as supplies, professional fees, business insurance, and the business share of phone or internet service; separate personal costs from business costs (IRS: Publication 334; IRS: records to keep).

For a self-employed person's home office, regular and exclusive business use generally applies, with limited exceptions, and the space must meet a qualifying business-use test. For a car you own, compare actual costs with standard mileage in its first business-use year: claiming Section 179 or bonus depreciation rules out standard mileage for that car later. Keep a mileage log; commuting and personal trips do not become business travel because the vehicle belongs to the business (IRS: Publication 587; IRS: Publication 463).

An employer can reimburse an employee's documented business costs under an accountable plan if the costs have a business connection, the employee accounts for them, and excess advances are returned. This matters when an S corporation owner pays company costs personally; a flat allowance without those steps can become wages (IRS: Publication 463).

Can I write off equipment and vehicles in the year I buy them?

Qualifying equipment may be deducted when it is placed in service, through Section 179 or bonus depreciation. Buying an asset is not enough: it must be ready and available for business use, and personal use, vehicle caps, and other limits can reduce the deduction. A car subject to listed-property rules needs more than 50% qualified business use for Section 179 or bonus depreciation; a later drop to that level or below can trigger recapture (IRS: Publication 946).

Immediate expensing lowers an asset's tax basis, so a later sale may produce taxable gain or depreciation recapture. A vehicle whose business use later falls can also trigger recapture. For pass-through owners, an allowed expense can shrink qualified business income and its related deduction (IRS: Publication 946; IRS: Form 8995 instructions). California does not adopt federal bonus depreciation, so a California return can have a different deduction and basis (California FTB).

Do I qualify for the qualified business income deduction?

An owner of a sole proprietorship, partnership, or S corporation may qualify for a federal deduction of up to 20% of qualified business income. C corporation income, employee wages, and income not effectively connected with a US trade or business do not qualify. The final deduction can be smaller because of taxable income, prior qualified losses, business type, wages, or business property (IRS: qualified business income; IRS: Form 8995 instructions).

Check this deduction after business expenses and depreciation are computed. An owner who materially participates in a qualified business may qualify for a $400 minimum deduction when aggregate QBI from active businesses reaches $1,000 (26 U.S.C. 199A(i)). The deduction can reduce income tax but does not turn an unsupported expense into a valid one; California does not adopt the federal qualified business income deduction (IRS: Form 8995 instructions; California FTB).

How much can an owner's retirement plan shelter?

Pretax deferrals and deductible employer contributions can lower current income tax; Roth deferrals do not. The amount depends on plan type, compensation, other plans, and eligible employees (IRS: Roth accounts). For an S corporation owner, contributions are based on W-2 wages, not distributions (IRS: S corporation retirement contributions). A self-employed person's contribution is calculated from adjusted net earnings, not simply multiplied by Schedule C profit (IRS: Publication 560).

For one employer's plan, do not add the 401(k) deferral limit to the total employee-and-employer limit: deferrals count toward that total, apart from eligible catch-up contributions. SEP contributions are employer-funded and have a separate compensation calculation (IRS: contribution limits; IRS: SEP limits).

Plan deadlines differ. A SEP can generally be set up and funded by the return due date, including extensions. An employer can also adopt a new qualified plan by that date and treat it as adopted on the last day of the year, which allows employer contributions for that year. Most 401(k) deferral elections require action by year-end. A sole proprietor with no employees who adopts a new 401(k) after year-end can make first-year deferrals by the unextended return filing deadline (IRS: Publication 560; IRS: SEP questions; IRS: plans adopted after year-end).

Would an S corporation election lower my self-employment tax?

An S corporation's pass-through profit generally avoids self-employment tax, while a working shareholder must receive reasonable wages subject to employment taxes. The IRS can reclassify distributions as wages if pay for services is too low; payroll, state taxes, and filing costs also matter (IRS: S corporation compensation). A corporation with a nonresident alien shareholder cannot make the election, and an existing election ends when the corporation stops qualifying, for example when a shareholder becomes a nonresident alien (IRS: S corporation eligibility; 26 U.S.C. 1362(d)(2)); see the guide for owners abroad. See when an S corporation election pays off and how to set owner salary.

Can paying family members or owner health insurance lower tax?

Pay to a family member is deductible when the person actually works for the business and pay is reasonable for that work; keep job, hours, and payroll records (IRS: Publication 334). Family relationship affects payroll taxes, so use the family employment guide before changing pay.

Owner health insurance can also produce a deduction, but the route differs for a sole proprietor, partner, and S corporation shareholder. See owner health insurance deductions before recording premiums or reimbursements (IRS: S corporation medical insurance).

Does my state's pass-through entity tax election help?

A qualifying state tax paid by a partnership or S corporation can be deductible at the entity level for federal purposes under IRS guidance. Whether the election helps an owner depends on the state's payment deadline, owner credit, and the owner's full federal and state returns (IRS: Notice 2020-75). See the pass-through entity tax election guide for the state-by-state decision.

Which tax credits can a small business claim?

Credits are available for specific activities, not for being a small business in general. Match each credit to its activity, employee and expense records, and required form; the same cost may not support both a full deduction and a credit (IRS: business credits).

A business meeting the research credit's gross-receipts and business-age tests may elect to apply some credit against employer payroll tax using Forms 6765 and 8974. The election is due by the original income tax return's due date, including extensions; a partnership or S corporation makes it at the entity level (IRS: Form 6765 instructions).

The retirement startup credit cannot be claimed alongside a deduction for the same startup costs. The research credit's reduced-credit election under section 280C, in Item A of Form 6765, changes the related expense deduction; it must be made on a timely filed original return, including extensions, and cannot be made or changed on an amended return, so calculate both before filing (IRS: startup credit; IRS: Form 6765 instructions).

What can I still do before year-end?

Before the tax year closes, reconcile the year-to-date profit and loss statement and payroll, review asset purchases that can actually be put to business use, and check plan elections and state deadlines. For a cash-method business, paying a deductible bill may move a deduction into this year, but a prepayment is not automatically deductible now; accrual-method timing follows different rules (IRS: Publication 334; IRS: Publication 560).

Gather the last filed return, current profit and loss statement, balance sheet, payroll reports, mileage and home-office records, asset purchase dates, and retirement plan documents. If a business loss is expected, check whether the owner can use it before buying assets solely for a current deduction.

Which tax-saving schemes does the IRS warn business owners about?

The IRS warns against fabricated credits, inflated withholding, and claims based on misleading tax tips, including a bogus broad self-employment tax credit. A real business cost still needs records and an eligible tax rule; a preparer's promise does not shift responsibility for the return (IRS: Dirty Dozen).

An accuracy-related penalty can be 20% of the part of an underpayment caused by negligence or a substantial understatement. Review aggressive deductions and credits against primary rules before filing (IRS: accuracy-related penalty).

Example

Illustrative only; all amounts are US dollars, and no tax is computed. A sole proprietor has $200,000 in sales, $80,000 of documented operating expenses, and a $20,000 machine bought for the business and placed in service before year-end. If the machine qualifies for full first-year expensing, business profit before owner retirement contributions is $100,000. That is Schedule C profit, not necessarily QBI: the deductible part of self-employment tax and eligible owner health insurance and retirement contributions attributable to the business can reduce QBI (IRS: qualified business income). The machine deduction may lower both taxable business income and the qualified business income deduction; a state return may depreciate the machine differently.

Different for you?

• You are changing entity type or expect profit far above what you need to spend: compare an LLC with a C corporation and get tax preparation help before an election.
• You own an S corporation and plan distributions: check reasonable owner salary before taking cash out.
• You have a loss rather than profit: see business loss limits.
• Your state offers an entity-level tax election or you operate in several states: use the state election guide and get tax preparation help before its deadline.
• Your business owns rental property: use rental property tax rules for those expenses.
• Year-end is near and you are choosing purchases, retirement contributions, or credits: bring your last return, current books, payroll, and planned purchases to tax preparation.