Reducing taxable income is an important part of running a small business, and there are two key ways to do it.
1. Open a Retirement Plan
First, you can open a retirement plan, such as a SEP-IRA, SEP 401(k), SIMPLE IRA, or SIMPLE 401(k). Qualified retirement plans such as these benefit employees and employers alike.
Although each plan works differently, any contributions you make as an employee are excluded from your taxable income. The money you put into a plan grows tax-deferred until you retire. Then, distributions and earnings will be included in your taxable income.
If you’re an employer, your contributions to qualified retirement plans are generally deducted from your business’s income.
2. Use the New Tax Law
Additionally, thanks to the Tax Cuts and Jobs Act of 2017, which went into effect in January 2018, there’s another way to reduce your business’s taxable income.
The new law allows pass-through entities (business entities that are not taxed at the entity level) to take a deduction of 20% against their business income. This essentially reduces the effective top rate on pass-through entities’ income by roughly 10 percentage points over pre-2018 tax law.
Of course, nothing that involves taxes is ever easy. Claiming the new 20% deduction requires navigating a tangle of barely comprehensible requirements and limitations that make it far from accessible to small-business owners. For example, single filers who earn less than $157,500 and married filers who earn less than $315,000 may take the deduction regardless of their field of business. However, after taxable income passes those thresholds, individuals operating service businesses, such as doctors, lawyers, and financial advisors, may not be able to take the deduction.
A financial professional can help you determine which of these options is best for your business.