Do you want to know why small business owners get so many tax loopholes, deductions, and credits?
Two words: economic growth.
Small businesses account for a massive 44% of total US economic activity, according to the Small Business Administration. They are the engines powering prosperity.
Two-thirds of net new jobs come from small companies. This provides income enabling people to spend and circulate money.
So it’s no surprise that the government wants to incentivize this type of behavior. And they do so by providing tax loopholes to business owners.
There’s over 70,000 pages in the tax law. Some tax rules are black and white. Others are gray.
And the IRS is aware of everything in between. But are you?
By taking full advantage of small business tax loopholes, you can avoid overpaying on taxes and keep more of your hard earned money.
So let’s look at some of the most popular small business loopholes to help you accomplish this.
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Tax Loophole #1: Converting Personal Expenses Into Business Deductions
Unlike employees, the IRS allows business owners to write-off almost anything as long as the expense has a business purpose.
Which means that if any of your personal expenses have a business purpose, you may be able to write-off a portion of those expenses from your business taxes.
Section 162 of the tax code allows deducting all ordinary and necessary expenses to operate your business. Business expenses reduce taxable income.
Lower taxable income = lower taxes.
So with careful tax planning, you may be able to classify many personal costs as business activities to make them deductible.
Here are some popular scenarios:
- Working from home? Deduct a portion of rent, utilities, internet, etc. tied to your office space with the home-office deduction.
- Driving for business? Deduct your business miles with the standard mileage rate or actual vehicle expenses
- Conducting business while on vacation? Deduct related costs like airfare, hotel, and expenses by meeting the IRS criteria for business travel.
- Talking about business during meals? Deduct a percentage of the cost with the business meals deduction. Make sure to keep receipts and document who you met with.
With documentation proving business purpose, the IRS allows business owners to deduct these expenses.
Entrepreneurs enjoy a nice tax advantage deducting business expenses before paying taxes. This allows you to pay less taxes and keep more cash in your business.
Here is a simple example:
Let’s say your business earned $100,000 in revenue. And you have $50,000 in business expenses.
In this case, you would only pay tax on the remaining $50,000 after deductions instead of the entire $100,000 your business earned.
Employees can’t do this. Their tax is taken first, leaving less take-home pay. They cannot deduct most of their work-related expenses.
Business owners can and pay less tax as a result, which make tax deductions so beneficial.
But tax deductions are just one piece of the puzzle. Keep reading to uncover more ways to minimize your tax bill.
Loophole #2: Avoiding Self-Employment Tax
As a small business owner, self-employment (SE) tax for Social Security and Medicare can be a huge burden.
W-2 Employees are also burdened with this tax.
But as a business owner, you can minimize this a large portion of this tax.
Here is how:
First, claim all possible business deductions to reduce your net taxable income. The lower your profit, the lower the SE tax.
Next, you can elect S-Corp status for your business structure instead of a sole proprietorship or partnership.
S-Corporations do not pay any self-employment tax.
Instead, you would be required to take a W-2 salary that is subject to social security and medicare taxes.
But now, your distributions from the S-Corp will not be subject to any self-employment tax.
And you can set a W-2 salary for yourself that is much lower than your S-Corp profits, as long as that salary is “reasonable”.
Here is a simple example:
If you earn $150,000 as a Sole Proprietor, you would be subject to almost $23,000 in self-employment tax.
But if you switched to an S-Corp and paid yourself a $60,000 W-2 salary, you would save $13,820 in taxes!
Here is the breakdown:
Operating as a sole proprietor, LLC, or partnership means paying self-employment tax on 100% of your net business income.
Whereas as an S-Corp, you could reduce your exposure to this tax by 50-70% in most cases.
As you can see, the ability to avoid self-employment tax can save you thousands of dollars in taxes.
But be sure to consult a tax professional before making a switch, as there is much more to consider.
Loophole #3: Sheltering More Income in Retirement Accounts
Another major tax loophole for entrepreneurs are supersized retirement accounts with large contribution limits.
Business owners can use accounts like Solo 401Ks and SEP IRAs to contribute almost 10x more than individuals with traditional IRAs.
For example, in 2023, you can only put $6,500 into a regular IRA. But with a Solo 401K, you can contribute up to $66,000!
Every dollar you contribute reduces your current taxable income. Then your savings compound tax-free over time.
If you’re fully funding a Solo 401K up to the $66,000 limit, you’ll be able to erase $66,000 of taxable income for the year.
At a 25% tax rate, that’s $16,500 in immediate tax savings. Plus, your funds grow tax-free for decades.
Loophole #4: The Augusta Strategy
Would you rent your personal residence to your business to save on taxes?
You can with the Augusta Strategy.
This has two primary benefits:
- The business can pay you to rent your personal residence for an event. The expense it pays you is tax-deductible.
- The income is tax-free to you for up to 14 days in a tax year. Under tax code Section 280(a), rentals under 14 days avoid being taxable personal income.
To use this strategy, there must be an actual business purpose for using your home.
Whether it be for a board meeting, employee training, or content creation – there has to be a business purpose for the expense.
Secondly, you must establish a reasonable rate to charge your business for the rental.
A tax planner can help you put this together.
Here is a simple example of how the Augusta Strategy works:
Let’s say your home could reasonably rent for $500 a day.
If your LLC rents it for a one-day retreat and deducts the $500 fee.
If it rents it for 14 days, it could pay and deduct $7,000 in fees.
Then you avoid paying income tax on the rental fee by keeping the term under 14 days.
The result? You’ve successfully passed a deduction for a day’s worth of home expenses through to your business. Completely legal.
While powerful, the Augusta Strategy must be done right to comply with IRS rules. Here are some recommended steps to consider:
- Choose a date for a business meeting at your home.
- Pick a reasonable 1-day rental fee based on comparable meeting venues.
- Create a contract between your business and yourself documenting the rental terms.
- Hold an actual business meeting on that date. Take meeting notes to prove business purposes.
- Create an invoice from yourself to your business for the 1-day rental fee and pay it from company funds.
Loophole #5: Claiming the QBI Deduction
Here’s a juicy tax loophole for small business owners: the Qualified Business Income (QBI) deduction.
This allows deducting up to 20% of your net business income if structured as a sole proprietorship, partnership, LLC, or S-Corp.
You net $100,000 income. Take the 20% QBI deduction. Your taxable income is now just $80,000.
At a 25% tax rate, you’ve just saved $5,000 in taxes from this one deduction.
The catch is your income must come from a “qualified” trade or business to qualify:
The IRS rules to qualify for QBI are rather broad.
They specifically exclude specified services from the deduction, which they define as businesses that rely on the reputation of the owner.
This would exclude many health, finance, law, and accounting professionals from qualifying.
But when reading the fine print, many service businesses still fit within exceptions to claim the QBI.
For example, there are income limitations that would allow your business to qualify for the deduction EVEN if you operate as a specified service business.
Most CPAs and tax professionals don’t know this but it’s literally in the QBI instructions.
The key is ensuring your business structure and revenue sources fit within the QBI deduction rules. Or leverage exceptions if you’re in a specified service area.
With careful tax planning, you can often qualify even in specified service areas.
So don’t automatically assume you’re excluded. Strategically structured, the QBI deduction can benefit many types of small service businesses.
If you do qualify, you can deduct the lesser of:
- 20% of your net business income
- 50% of W-2 wages or 25% of wages plus 2.5% of qualified property purchase price.
Now, if you earn too much income, you may run into issues with the QBI deduction.
As of 2023, the QBI deduction phases out above $18,000 for single filers or $364,000 joint. And eliminates entirely above $232,000 single and $464,000 joint.
But creative planning can sometimes still make you eligible despite high earnings.
For example, say your business earns $500,000 in income. As a married filer, that exceeds the phase-out threshold.
Normally you’d be disqualified from the deduction with income that high. However, strategic entity structuring may allow you to take the deduction anyway.
For instance, you could create a separate corporation that provide services to your company to shift some of your income to another entity.
Then you could pay that company for its services, which is deductible, to lower your income to qualify for the deduction.
Even with high income, strategic planning can help qualify for substantial QBI deductions.
The Bottom Line On Small Business Tax Loopholes
As a business owner, your financial success hinges on keeping profits high and expenses low. And make no mistake taxes are a major expense.
That’s why fully utilizing small business tax loopholes and strategies is so crucial. Legally minimizing your obligations directly translates to increased profits.
However, to fully take advantage of small business tax loopholes, you must be proactive about your tax strategy. You need an intentional strategy such as:
- Diligent tracking of all business expenses to maximize deductions
- Developing the best entity structure to avoid unnecessary taxes
- Sheltering money in retirement accounts offering higher contribution limits
- Using creative tactics like the Augusta Strategy
- Evaluating eligibility for the 20% Qualified Business Income deduction
- Using a CPA that fully understands the tax code to help you maximize your tax savings
Trying to navigate loopholes alone quickly becomes an exercise in frustration. The regulations are impossibly dense.
Work instead with specialists intimately familiar with the intricacies of small business taxes. Let them handle the complexity on your behalf.
Our team can can optimize your tax obligations through diligent planning and preparation. Our expertise is unmatched. We have:
- Years assisting small business owners specifically
- Deep knowledge of regulations, loopholes, and strategies
- Bespoke guidance tailored to your unique situation
- Ongoing support translating tax code complexity into bottom line savings
If you are interested in a plan that is guaranteed to reduce your taxes, apply to become a client today.