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How Can I Reduce Taxes for My Small Business Thumbnail

How Can I Reduce Taxes for My Small Business

Business Taxes Entrepreneurship Small Business Owner

As a CPA for owners of self-employed and closely-held businesses, we often get the question on how a small business owner can reduce taxes. Have no fear! This white paper outlines key tax and financial planning strategies for two critical phases of the business: the ongoing operation and pre-exit phase, and the post-exit phase. Implementing these strategies can help you increase your firm’s revenue, build deeper connections with your clients, and reduce your clients’ tax bills.

For savvy business owners, minimizing tax liability is an important component of maximizing profitability and preserving wealth. Beyond standard deductions and credits, a suite of sophisticated tax planning strategies can unlock significant savings on both the business and personal fronts. These advanced techniques, while often complex and requiring expert guidance, can yield substantial financial rewards.

This blog post outlines several such strategies for two critical phases of the business: the ongoing operation and pre-exit phase, and the post-exit phase.

Phase 1: Continued Business Operations & Pre-Exit Planning

During the primary operational phase of a business, the strategic focus is on maximizing current tax deductions, accumulating wealth efficiently, and establishing a solid foundation for an eventual exit. The following strategies are instrumental in achieving these goals:

Retirement & Wealth Accumulation

  • Qualified Retirement Plan with a Defined Benefit/Cash Balance Plan: This powerful combination allows for significantly higher tax-deductible contributions than a 401(k) alone. A cash balance plan, a type of defined benefit plan, is particularly attractive for high-income owners nearing retirement, as it allows for accelerated, tax-deferred savings.
  • Individual Retirement Arrangement (IRA): A fundamental tool for personal retirement savings, both traditional and Roth IRAs offer tax-advantaged growth. For business owners, SEP and SIMPLE IRAs provide straightforward, low-administration options for themselves and their employees.
  • Health Savings Account (HSA): An HSA is a triple-tax-advantaged vehicle: contributions are tax-deductible, funds grow tax-free, and withdrawals for qualified medical expenses are also tax-free. It serves as both a healthcare spending account and a long-term investment vehicle.

Risk Management & Business Continuity

  • Key-Person Life Insurance: This strategy protects the business from financial loss resulting from the death of a crucial owner or employee. The death benefit provides the company with the necessary liquidity to navigate the transition, hire a replacement, or pay off debts.
  • Cross-Purchase Buy-Sell Agreement: Funded with life insurance, this agreement ensures a smooth ownership transition in the event of an owner's death, disability, or retirement. Each owner purchases a policy on the other owners, and upon a triggering event, the proceeds are used to buy out the departing owner's interest. This provides a stepped-up basis for the remaining owners.
  • Micro-captive Insurance Company: For businesses with unique and substantial risks, a micro-captive (an insurance company owned by the business) can be a sophisticated risk management tool. Under Section 831(b), eligible captives can receive up to $2.85 million in annual premiums (for 2025) without being taxed on the underwriting profit, paying tax only on investment income.

Income Tax Reduction

  • Section 199A Qualified Business Income (QBI) Deduction: This deduction allows owners of pass-through entities (sole proprietorships, partnerships, S corporations) to deduct up to 20% of their qualified business income, subject to certain limitations for specified service trades or businesses and high-income taxpayers.
  • Management Fee Arrangements: For business owners with multiple entities, establishing a formal management fee structure can be a powerful tool. A C corporation, for instance, can provide management services to a related pass-through entity (like an S corporation or LLC). The pass-through entity deducts the management fee, reducing its taxable income. The C corporation pays tax on this fee at the corporate rate, which is often lower than the individual owner's marginal tax rate. This strategy effectively shifts income to a lower tax environment. However, the management fees must be for legitimate services rendered and be set at a "reasonable and necessary" market rate to withstand IRS scrutiny.
  • Section 125 Cafeteria Plan: This plan allows employees to pay for certain qualified benefits, such as health insurance premiums, with pre-tax dollars, reducing both the employee's and the employer's payroll tax liability.
  • Self-Employed Health Insurance Deduction (Section 162(l)): Self-employed individuals can deduct 100% of their health and qualified long-term care insurance premiums for themselves, their spouse, and dependents as an above-the-line deduction.
  • Pass-Through Entity Tax (PTET) Deduction: Now enacted in most states, the PTET is an optional entity-level tax that allows partnerships and S corporations to pay state income tax on behalf of their owners. This converts a state tax payment, which is subject to the $40,000 to $10,000 SALT deduction limitation on individual returns (depending on the taxpayer’s AGI), into a fully deductible business expense at the federal level.
  • The Augusta Rule (Section 280A): This provision allows a homeowner to rent out their primary residence for up to 14 days per year without having to report the rental income on  their personal tax return. A business owner can rent their home to their own business for legitimate business purposes, such as board meetings or company retreats. The business can then deduct the rental payments as a business expense, while the owner receives the income tax-free. The key is that the rental rate must be reasonable and in line with fair market value for similar event spaces, and the business use must be well-documented.

Phase 2: Post-Exit from the Business

The sale or transfer of a business is a pivotal financial event. The focus shifts to minimizing the tax impact of the transaction and strategically managing the proceeds to support the owner's long-term financial goals.

Tax-Efficient Exit Strategies

  • Section 1202 Qualified Small Business Stock (QSBS) Exclusion: This is one of the most powerful tax incentives for small business owners. If specific criteria are met, including a five-year holding period and the business operating as a C corporation, sellers can exclude up to 100% of the capital gains from the sale of their stock, up to the greater of $15 million (for 2025 and 2026) or 10 times their basis in the stock.
  • Qualified Opportunity Fund (QOF) Deferral (Section 1400Z-2): Business owners can defer capital gains from the sale of their business by reinvesting the gain portion of the proceeds into a QOF within 180 days. The gain is deferred for 5 years, or until the QOF investment is sold. On the fifth anniversary date of the investment in the QOF, a 10% basis step is achieved. If the QOF investment is held for at least 10 years, the appreciation on the QOF investment itself is permanently excluded from capital gains tax (i.e., there is a full step up in basis).
  • Donor Advised Fund (DAF) Contribution: For charitably inclined owners, donating a portion of their business interest to a DAF before a sale is finalized can be highly advantageous. This strategy can provide a current fair market value tax deduction and eliminate the capital gains tax on the donated portion of the business. Please note that because of H.R. 1 (colloquially referred to as the “One Big Beautiful Bill Act” or “OBBA”) corporate charitable deductions are reduced by a floor of 1% of taxable income and are capped at 10% of taxable income.
  • Employee Stock Ownership Plan (ESOP): Selling the business to an ESOP can provide significant tax benefits to the selling owner. Under Section 1042, if the ESOP owns at least 30% of the company post-sale, the seller can defer capital gains by reinvesting the proceeds into qualified replacement property (QRP), such as stocks and bonds of U.S. operating companies.

Family Succession & Wealth Transfer

  • Gifting and Selling to Family Members: For owners who wish to keep the business in the family, a combination of gifting and selling can be an effective strategy. Gifting portions of the business over time can utilize the annual and lifetime gift tax exclusions to reduce the owner's taxable estate, which will be $15 million per individual beginning in 2026. The remaining interest can then be sold to a family member, often through an installment sale to spread out the tax impact and provide the owner with a steady income stream.
  • Grantor Retained Annuity Trusts (GRATs): A GRAT is an estate planning tool that allows a business owner to transfer appreciating assets, such as company stock, to beneficiaries with minimal or no gift or estate tax. The owner (the grantor) transfers assets into an irrevocable trust and receives an annuity payment for a set term. Any appreciation in the assets above a specific IRS interest rate (the "hurdle rate") passes to the beneficiaries tax-free at the end of the trust term. If the assets do not appreciate as expected, they are simply returned to the grantor. The primary risk is that if the grantor dies before the end of the trust term, the assets may be included in their estate.

Conclusion

By working with a CPA financial planner, business owners can potentially realize substantial tax savings, enhanced wealth accumulation, and a more secure financial future for their business and their family. A comprehensive and forward-looking approach is key to navigating the complexities of business ownership and achieving long-term financial success.

Important Considerations for All Sophisticated Strategies:

  • Professional Guidance is Non-Negotiable: The strategies outlined above are complex and subject to strict IRS regulations. Attempting to implement them without the guidance of experienced tax attorneys, CPAs, and financial advisors is highly discouraged and can lead to significant penalties.
  • Economic Substance is Key: All transactions must have a legitimate business purpose beyond just tax avoidance. The IRS can disregard transactions that lack economic substance.
  • Documentation is Crucial: Meticulous record-keeping is essential to substantiate the legitimacy of these strategies in the event of an IRS audit. This includes formal agreements, meeting minutes, and market-rate analyses.

By exploring these and other advanced tax planning opportunities with a team of qualified professionals, business owners can proactively and legally minimize their tax burdens, freeing up capital for reinvestment, growth, and personal financial goals. The landscape of tax law is ever-changing, making ongoing review and adaptation of these strategies a critical component of long-term financial success.