I came across a fascinating post on Twitter recently. A solo business owner who makes over a million dollars a year broke down exactly what he spends money on. What is the first thing you notice?
He’s paying more than $400,000 in taxes every single year! I don’t know Brett personally but I know lots of Brett’s — incredibly successful independent business owners facing absolutely monstrous tax bills. Between self-employment taxes, state taxes and federal taxes, without smart planning, I’ve seen effective tax rates of over 50% in states like New York and California. This article is a guide on exactly what you should do in his situation to dramatically reduce your tax bill. Results will vary by your personal situation, but if you are fully unoptimized, this guide should enable you to knock off at least 6 figures a year at those numbers.
While there are literally hundreds of strategies for business owners to save money on taxes, I’m going to focus on the five most impactful ones here. I’ll end with a section for miscellaneous tips and strategies where I’ll share a longer list of ideas that may be less impactful, but could still add up. Send this to your CPA! Or if you need a new tax professional, keep reading for my recommendations at the bottom.
Strategy 1: Elect to file your taxes as an S-Corp
The first nasty surprise you typically discover as a business owner is employment taxes. When you have a full-time job, you typically only pay half of social security and medicare taxes, while your employer pays the other half. It’s also automatically deducted from your paycheck so you don’t feel the pain quite as viscerally. But when you work for yourself, you are on the hook for both sides of employment taxes, which could be as much as 15% of every single paycheck! This 15% is in addition to regular federal and state income taxes you owe… which in higher brackets can easily take your overall tax rate over 50%. Filing your taxes as an S-Corporation is the best way of bringing this number down. Here’s how an S-Corp works: An S-Corp bifurcates your business income into two distinct components:
- W-2 salary: A fair market salary that you pay yourself as an employee of the S-Corp. This should be a salary that you would reasonably pay someone else to do the same job as an employee for your business.
- Profit distributions: The remaining income flows to you as profit as the business owner.
The magic of an S-Corp is you only pay employment taxes on the W-2 salary, so this can potentially save you tens of thousands of dollars in taxes. From the original example, without an S-Corp, Brett would have to pay employment taxes on the entire $1M. But if he chose to pay himself a W-2 salary of $200,000, he would not have to pay any employment taxes on the remaining ~$800,000! While most high income business owners are generally better off filing taxes as an S-Corp, there are some important caveats to consider: 1 – Complexity An S-Corp does take more effort to run since you now need payroll and a separate tax return. I tend to think at $100K+ in net income it’s fully worth the additional hassle, but lots of other professionals advertise a lower number. Personally, I would want to save at least a few thousand dollars to make the additional work worth my time. 2 – Have a tax pro run the numbers I would not DIY an S-Corp analysis, since there are a bunch of weird edge cases that a qualified tax professional can correctly identify. As an example, an S-Corp in New York City faces an additional business tax that a pass-through LLC would not. For residents in NYC specifically, the threshold at which an S-Corp is worth it becomes much higher than typical. 3 – Picking the right W-2 salary is important You may be tempted to pick the lowest W-2 salary you can since that would result in the lowest employment taxes. But, this can sometimes have the adverse effect of increasing your overall taxes since it could reduce your QBI deduction! Your retirement plan contributions are also based on the W-2 you pay yourself. We’ll talk more about this soon.
Strategy 2: Hire your spouse and double your Solo 401k contribution
A Solo 401k is the most powerful retirement account in America if you are eligible for it. A quick recap: with a Solo 401k you can get up to a $70,000 tax deduction, invest in any almost asset class, compound tax-free, make Roth contributions and get a tax credit for setting one up. The only thing better than a Solo 401k as a business owner? Two Solo 401k’s. The easiest way for a successful business owner to “double down” on this benefit is to hire their spouse for their business. Assuming you pay your spouse a reasonable enough salary, this would now allow them to also get their own $70,000 Solo 401k tax deduction — and you can collectively as a couple now deduct $140,000 from your taxes every single year If you are over the age of 50, that’s an extra $7,500 each or a $155,000 tax deduction between the both of you.
Strategy 3: Add a cash balance plan for an even bigger retirement contribution
For the truly high income business owners, there is a special type of retirement plan available with an even bigger tax deduction. It’s called a cash balance plan and can potentially get you an annual tax deduction of hundreds of thousands of dollars and pairs very well with a Solo 401k. A cash balance plan is a type of “defined benefit” retirement plan that works backwards from giving you $3.5 million at retirement age. The maximum pre-tax contribution you can make is a somewhat complicated actuarial formula calculated based on:
- Your age
- Your income level
- How much you already have in the plan
- Estimated asset growth rate
They tend to not be worth it until you hit your 30s, but as you get older, it’s not unusual to see a maximum pre-tax retirement contribution of a Cash Balance plan in the hundreds of thousands of dollars! These plans are notoriously painful and expensive to both set up and administer — but if you are making half a million dollars or more every year, the massive tax deduction more than makes up for it. And newer providers are continually making it easier to set one up.
Strategy 4: Have a tax professional calculate the optimal W-2 salary to pay yourself
One of the most important pieces of legislation for US-based business owners came with Trump’s 2017 Tax Cuts and Jobs Act (TCJA). Amongst other things, the TCJA gave business owners of passthrough businesses (like LLCs and S-Corps) an automatic tax deduction of up to 20% called the Qualified Business Income (QBI) deduction. This deduction was supposed to sunset next year, but it’s now looking quite likely that the TCJA will be extended indefinitely! The QBI deduction is a free gift for most business owners, but if you are a high-income earner (roughly ~$190K single, ~$380K married), there are additional restrictions in order to unlock the full deduction. Specifically, the maximum QBI deduction for high income earners can typically be no more than 50% of the total W-2 wages paid by the business. What does this mean for you as a high earning S-Corp owner? You could end up saving more in taxes by paying yourself and your spouse a higher W-2 salary… or at least enough to unlock the full QBI deduction. I’m not suggesting pulling out the calculator yourself as these calculations do get rather complicated. But it is absolutely worth finding a tax professional who can run the numbers for you and optimize your W-2 salary. Getting this number right is alone worth many thousands of dollars every single year.
Strategy 5: Pay your state taxes from your business
The 2017 TCJA gave most business owners and high tax payers all kinds of tax breaks. With one big exception. The TCJA limited the total tax deduction you could claim from paying state and local taxes (SALT) to only $10,000! This is especially painful for residents of high-tax states like New York or California Imagine making $1M in California, paying $100K+ in state taxes to California and only being able to deduct $10,000 from your federal taxes! To make matters even worse, the $10,000 limit is the same whether you are single or married filing jointly with two incomes. This was catastrophic to lots of people in high tax brackets… resulting in most people no longer itemizing deductions (which is needed to claim the SALT deduction) and instead taking the standard deduction. But the individual states came up with an ingenious workaround for business owners. Most of them created an “optional tax” that business owners could pay called the PTET or Pass-Through Entity Tax. This allows you to optionally pay the entirety of your state taxes via your business. This would effectively register the entire payment as a business expense and in effect all your state taxes are now deductible for federal purposes. Genius, right? Every state implements the PTET slightly differently so it’s worth reading up on the requirements for your specific state. But paying this optional tax will end up saving you a lot of money at the highest brackets in high tax states.
You may notice that a lot of these strategies require the help of a tax professional to implement. It’s imperative you find a CPA that is knowledgable about these strategies since it’s too difficult and painful to DIY most of this.
Miscellaneous Considerations
I wanted to focus this article on what I consider to be the five most impactful strategies. But there are a couple of other important things to mention as they can be absolutely vital to get right once your business starts making real money.
Expense Tracking and Bookkeeping
At this revenue level, having quality bookkeeping more than pays for itself. By doing this accurately, you could potentially find more expenses to deduct which would reduce your overall taxable income. Some opportunities worth looking at here: 1 – Home office deduction Being a business owner also opens up more tax deductions that W-2 employees don’t have. If you have a dedicated workspace for the business, you can take the square footage of the workspace, and pro rata deduct it from your rent or mortgage. You could also apply it to furniture, cleaning, utilities etc. 2 – Augusta Rule If you are not taking the home office deduction, you could look into renting your home to your business for a meeting, offsite, team event etc. This allows you to pay yourself a fair market rent from your business. And you can legally do this for up to 14 days a year, and owe zero taxes! 3 – Credit card points If you spend lots of money on ads, OpenAI tokens, building materials or anything really — you can set up a business credit card that gives you a lot of points for those specific expense categories. You could then use those points to travel in style for you and your family, which works out a potentially very valuable untaxed benefit! 4 – Prepaying large business expenses If you are going to have a massively profitable year, you can save money by prepaying software expenses that you would otherwise incur in the next year. This can be a great way of bringing costs forward, temporarily reducing your profitability, while having larger expenses for the next year prepaid.
Other Tax Saving Strategies
There are way too many strategies to list in a single article while maintaining any kind of brevity. But for those of y’all that want to be inspired and dive into your own research holes, here are some other things I’d consider:
- Some strategies for W-2 workers like direct indexing, charitable donations and setting up an HSA would also apply here.
- If you have children, hiring them and paying them under the standard deduction could save some. But more importantly, makes them eligible to contribute to a Roth IRA.
- I would generally recommend also reading The High Earners Guide to a Roth IRA, as a lot of it would still be applicable.
What do you think of this article? Send this to any high earning business owners you know — creators, agency owners, and physicians all typically fall into these categories. I’m planning out content for the next few months, reply to this email and let me know if there are any specific topics you’d like me to cover in the coming weeks!
