How can business owners, the self-employed, and 1099 earners save on income taxes? What are the top tax strategies for business owners, self-employed, and 1099 earners? What kinds of retirement plans can business owners use? Can business owners save on state and local taxes? Where can business owners get tax planning?
By James L. Cunningham Jr., Esq.
Business owners, the self-employed, and people who earn 1099 income should consider specialized tax planning—and truly, even a little planning often goes a long way in figuring out how to pay less taxes on that income.
The types of folks I just listed don’t get paid with regular, W-2 wages. They’re “self-employed,” even if they run a sizable concern. Think business owners, doctors, lawyers, and here in California—movie stars. Some folks in this category, maybe including you, make hundreds of thousands—sometimes millions—more every year than ordinary employees with a regular paycheck.
But higher income comes with higher tax bills, and the math is simple: If you can find income tax reduction strategies, you will increase the amount of earned income you actually keep every tax year.
You would think successful business owners and anyone self-employed would use every tax-saving strategy available to them, but many people just don’t do basic tax hygiene. It’s like washing your hands before you put your contacts in. It’s just basic stuff that should be done that can save you thousands and thousands of dollars through a little smart business planning. But you do need to know what to do, and in many cases, you will need help doing it. That help might come from qualified tax planning lawyers like the kind who work here at CunninghamLegal.
Can We Help Hal and Wanda?
Let me tease this discussion with the example of a nice couple named Hal and Wanda.
Hal and Wanda are business owners who bought a McDonald’s located at 123 Main Street in a California city. The franchise brings in $1 million in profits each year. If Hal and Wanda do nothing and report the $1 million as income, each year they will fork over around $372,000 in federal income taxes to Uncle Sam, plus another $35,000 in state income taxes to California.
That brings their total income tax to $407,000—a whopper of a tax bill!
A little tax planning at the outset could save Hal and Wanda $122,000 in taxes each year. No kidding! Would they need a lawyer to help them to do a somewhat complex maneuver? Yes. Would that maneuver pay off enormously in both the short and long term? We’ll see in Strategy #2, below.
Advanced Tax Planning Is Not a DIY Project
Before we take a look at some income tax reduction strategies business owners, self-employed, and 1099 earners can use to cut taxes, just a word of warning—don’t take this advice and go do a bunch of stuff on your own. This kind of advanced tax planning is complicated, and mistakes get extremely costly. You should assemble your “A-team” of professional advisors including an accountant, a financial planner, and a lawyer with tax-planning expertise. A savvy attorney can help you save hundreds of thousands—if not millions—over the course of your career. Set up a call to learn more about CunninghamLegal’s work in the tax planning field.
Who Counts as Business Owners, Self-Employed, and 1099 Earners?
As I mentioned, the term 1099 earners refers to independent contractors and self-employed people who earn income commonly reported on Form 1099. Traditional examples include independent contractors and freelancers who are not regular employees, even if they work for only one business. If you are self-employed and provide services, your clients may report your income to the IRS on 1099 forms. But if you sell products, your customers most likely will not report your 1099 income. Either way, those earnings operate as 1099 income. You’ve got to report and pay taxes on those earnings as a 1099 earner.
Thanks to the increasing trend toward a “gig” economy, more and more people are filing as self-employed, often with a “Schedule C” on their returns, across the whole spectrum of society. Sometimes that 1099 income is supplemental to their W-2 wages, but the issues are the same.
Trouble is, many self-employed folks and entrepreneurs just starting out don’t bother to really understand their tax options—and if they do, they don’t have the first-hand experience necessary to figure out how to reduce taxes on 1099 income. Often they wind up paying twice as much in taxes as they should! I do not exaggerate. Twice too much is not uncommon!
Here are some basic and not-so-basic income tax reduction strategies—but remember, every case is different. If you want to discover how to reduce income taxes, the content below offers a range of general tax deduction paths that can work according to the current rules and regulations. But for specific solutions, a savvy law professional is required, as they need to get to know your individual goals and situation before creating a strategy.
Basic Strategy #1, Formalize Your Business Structure!
Yes, this is basic. If you are a business owner, start acting like one. Often, business owners will start a business as a “sole proprietor.” Income is reported on Schedule C of the sole proprietor’s personal income tax return (Form 1040). However, although simple, this approach does have drawbacks. For starters, everyone you do business with will have your Social Security Number. If that isn’t bad enough, you are 20 times more likely to be audited with Schedule C income as a Sole Proprietor than if you are reporting that income on a Partnership Return (Form 1065) or Corporate Return (Form 1120). Operating with a formalized business structure gives you added clout in the business world.
Part of going “formal” means keeping good records! Plan and track business meals, trips, conferences, marketing, and ongoing licensing or other continuing requirements carefully so that all expenses that can lawfully be deducted are deducted. This saves you income tax!
Areas often overlooked include:
- Business meals
- Work-related car use
- Phone and internet expenses
- Professional service fees
- Retirement contributions
- Client and employee entertainment
Pay close attention to those areas and consider ways to maximize your business expenses in concert with your CPA. For example, consider deducting your actual auto costs instead of using the simplified method.
Few business owners realize they can also hire their spouses to work for their businesses, deduct their salary, and qualify them for social security benefits! If you hire your kids, you can also contribute to a Roth IRA for them and withdraw the money tax-free to pay for college. Finally, consider supporting charitable organizations with gifts of appreciated property that qualify for deductions.
What sort of business entity should you create? Read carefully through my detailed blog on choosing between types of business structures. Create the structure using a good lawyer, and work closely with a qualified CPA on all these deductions.
Business Income Tax Strategy #2: Carefully Structure Your Business Entity to Minimize Taxes
Remember Hal and Wanda, who bought the McDonald’s restaurant at 123 Main Street? Let’s play out the scenario I teased at the beginning, and see if we can save them taxes on that $1M in yearly profits.
As Hal and Wanda’s attorney, I might suggest they put the land and the building into one entity and the operating business into another—a bit complicated, but worth it. Under this plan, they might put the operating business into an entity taxed as an “S” corporation, say McD Inc.; and the land and building into an LLC taxed as a Partnership, say 123 Main LLC. Under this plan, McD Inc. leases the land and building from 123 Main LLC and runs the restaurant.
That move also simultaneously protects Hal and Wanda, their business, and their assets in key ways I’ve covered in another webinar and blog on using LLCs in real estate.
Under this plan, Hal and Wanda take salaries totaling $100,000 from McD Inc. and dividends of $900,000 from the LLC every year—the same million they took before. But now, Hal and Wanda can deduct $180,000 in income, saving $67,000 in federal income taxes. They can deduct California state income tax, saving $35,000 on their federal return. They also avoid a 3.8% Medicare tax on $900,000, saving another $34k. They will pay an additional California tax of 1.5 percent on the $900,000 dividend, or $14,000, but all told they net $122,000 in tax savings! That takes their tax bill down to just $285,000, and they keep the rest in their pockets.
What If Hal and Wanda Ignore this Strategy?
But hey, maybe Hal and Wanda think this is too much of a hassle. They ignore my advice, and instead, they keep running their McDonald’s as a single business entity.
Well, after a decade, they’ve forked over an unnecessary $1.2 million in taxes! But it gets worse. Shortly after they move to Oregon to retire, Hal passes at age 80, and Wanda sells the McDonald’s franchise as well as the land. Luckily property values have skyrocketed, and the McDonald’s sells for millions more than what Hal and Wanda paid for it. But now Wanda has to pay a huge tax on all that capital gain.
At this point, 10 years after their fateful decision to ignore the two-entities option, and having moved to Oregon (not a community property state) without having the right structures in place, Wanda probably doesn’t even realize that with a little tax planning at the outset to create those two business entities, Wanda would receive a full stepped-up basis for the valuation when Hal passed, and could likely have sold the property without paying capital gains taxes altogether!
Before we move on from Hal and Wanda, let me note that business ownership often entails some kind of real estate ownership—and in the long run, the real estate may become more important than the business itself. California real estate requires careful long-term planning to control property taxes, capital gains taxes, and liability. Work with an expert. You can learn more about CunninghamLegal’s real estate practice here.
As you can see, a little tax planning can go a long, long way—sometimes saving significant money many years after the work gets done. Set up an appointment with us to discuss your particular situation.
Income Tax Reduction Strategy #3: Set Up and Fund the Right Retirement Plan
One key, ongoing tax reduction strategy for business owners, the self-employed, and 1099 earners is to set up and fund a retirement plan—but choosing the right kind of plan for your situation is crucial.
Retirement plans allow you to defer or avoid paying income taxes on part of your income, and often people forget how critical such arrangements are to overall tax planning. Often, people are so used to their employer setting up a 401(k) plan on their behalf, that they may neglect that work when they create their own business—a big mistake, especially as business ownership offers you all kinds of additional options.
What Options Do California Business Owners Have for Retirement Plans?
What kind of options do business owners have for retirement plans? Let’s take a look.
For starters, you need to know that retirement plans come in two basic flavors: defined contribution and defined benefit plans. Then there’s a specialty strategy just for Californians called a Private Retirement Plan, or PRP.
Are retirement plan options needlessly complex? You bet. Does understanding that complexity pay off? Oh yes.
Defined Contribution Plans
Let’s begin with the most common type of plan: Defined contribution. Defined contribution plans limit the amount you can put into your retirement account each year. The amount varies depending on whether you have employees and your age. Here’s a quick overview, valid as of 2024—but remember that the laws and thresholds on these plans change frequently. I can’t go explore all the ins and outs of IRAs, 401(k)s, and so forth, but here’s a summary of options that go beyond a traditional IRA:
- If you have no employees, you can put up to $69,000 per year in a Solo 401(k) until age 50, and $76,500 per year after that.
- If you have employees, you can set up a Simplified Employee Pension Plan, or SEP IRA. You can put up to 25 percent of your income or $69,000 per year into a SEP IRA if you set up a business entity (like a corporation or an LLC) as the employer. If you are self-employed without a business entity employer, you are capped at contributing 20 percent of your compensation.
- Small businesses with 100 or fewer employees can also set up a Savings Incentive Match Plan for Employees, called a SIMPLE IRA. You can contribute $16,000 per year to a SIMPLE IRA if under 50, and $19,500 per year after that. SIMPLE IRAs allow both employers and employees to contribute to IRAs without the startup and operational costs of a conventional retirement plan, making them ideal for small businesses.
You can choose a traditional IRA, SEP IRA, or SIMPLE IRA plan, or roll them into a Roth retirement plan. The difference is when and how the money is taxed. A traditional plan defers but does not avoid income taxes. You put in pre-tax dollars, meaning income that hasn’t been taxed yet. You must take mandatory distributions as you reach age 73 (or 75 after Jan 1, 2033) under the SECURE Act 2.0 (depending on your year of birth) and pay taxes on those distributions when you take them.
Instead, you could contribute after-tax dollars to a Roth IRA, so you’ve already paid income tax on that money. Growth in the Roth IRA account is tax-free. You can also take out withdrawals tax-free. You don’t have to take mandatory distributions out at any time during your life. Instead, you can leave your Roth IRA to someone else, who must take mandatory distributions when they inherit the account. There are other complications with a Roth, however, which you must understand.
Do you need help getting it all straight? Probably. You may also need help protecting these assets from possible predators, creditors, and more. Contact us to discuss your particular retirement plan situation.
In any case, I strongly suggest you download the chapter about IRAs from my book, Savvy Estate Planning. Many retirement account paths eventually lead to IRAs, and I guarantee you don’t know enough about how IRAs operate.
Defined Benefit Plans
If you’re self-employed, it may make more sense for you to choose a Cash Balance Pension Plan, a type of defined benefit plan that pays out benefits based on interest rates and your age. The key advantage of a defined benefit plan is you can put away and defer taxes on much more of your income.
As of this writing, you can contribute pre-tax dollars to a Cash Balance Pension Plan, up to $409,000 annually, for a total of $3.5 million. Any growth is tax-deferred. You must take mandatory distributions the year you turn age 73 (or 75 after Jan 1, 2033) under the Secure Act 2 (depending on your year of birth) and pay income tax on distributions as you take them.
Many physicians, lawyers, and other professionals with high incomes but few employees use defined benefits plans to defer taxes. But please note: Cash Balance Pension Plans require expert care and feeding. They are not for everyone, and mistakes get audits and penalties. Make sure you work with a lawyer, financial advisor, and CPA to set up the right retirement plan for you. Contact us to discuss your particular situation.
California Private Retirement Plan
Hey, Californians! You have an extra option called a California Private Retirement Plan (PRP)—which is much more than a mere “plan.” Under a properly structured PRP, California residents can set aside assets for retirement and keep those assets protected from creditors, even in bankruptcy. You don’t need to include employees or make annual IRS filings, and no restrictions limit the type of investments you can make. A PRP by itself doesn’t save on income taxes, but it can be coupled with other tax strategies to reduce or defer income and capital gains taxes.
You can stack multiple plans on top of each other, but be warned, things quickly get complicated, and a PRP is generally only appropriate for high-income individuals, and it requires a professional to set up and administer the plan.
At CunninghamLegal, we work with our partner TRUST-CFO to set up and administer PRPs. Read more about PRPs here.
Business Income Tax Reduction Strategy #4: The SALT Workaround
California has another special tax-saving strategy for businesses called the State and Local Tax or SALT Workaround (also known as AB 150). Other states with a state income tax have similar workaround laws.
Small business owners can deduct all their California state income tax by setting up certain types of business entities to employ them instead of remaining self-employed.
S-corporations and partnerships with individual members qualify, but not sole proprietorships, C-corporations, or entities with a partnership as a partner, member, or shareholder.
Briefly: When a qualifying business entity pays salary and dividends out to business owners, they can use a discounted flat rate of 9.3 percent to pay their California state income taxes, then deduct those state taxes on their federal income taxes, without being subject to the usual $10,000 limit.
Let’s take Betty, a physician, earning $1 million per year. Betty sets up BettyInc, a professional corporation, and under AB 150, she pays her California state income tax at the discounted flat rate of 9.3 percent. That means she pays $93,000 instead of $116,907, for a savings of $23,907. She can then deduct the $93,000 on her federal taxes, saving an additional $34,410 in federal income tax. That’s a total income tax savings of $58,317!
If Betty takes a salary and pays herself a dividend, she also avoids a 3.8 percent Medicare tax, but pays a 1.5 percent California tax, so her net savings on distributions is 2.3 percent.
Again, this requires a lawyer and CPA working together—it is not DIY! Make sure to consult with your team of advisors before trying to set up a SALT workaround business structure. And schedule a call with CunninghamLegal today.
Business Income Tax Reduction Strategy #5: Business Owner Tax Break
The federal government passed another key tax break for business owners in 2017, geared toward people with business income other than the usual professionals in health, legal, and financial services, or selling their likenesses or endorsements.
The 2017 Tax Cuts and Jobs Act allows small business taxpayers to deduct up to 20 percent of their qualified business income! The deduction is available for sole proprietorships, partnerships, S-corps, and LLCs, but not large C-corporations.
Let’s take Hal, a plumbing contractor, who earns $1M per year. As a business owner, Hal can take a 20 percent or $200,000 deduction, resulting in tax savings of $74,000. That’s a freebie for a business owner! Traditional professionals can also use the deduction, but only if their earnings fall below relatively low-income caps. Consult with your CPA before claiming this on your return.
Income Tax Reduction Strategy #6: Make Sure to Have a Succession Plan
A business succession plan is a vital, often overlooked part of long-term tax planning. Eventually, you will stop working. Five years or more beforehand—maybe even eight—consider professional tax planning before your exit. Give your team enough lead time to take advantage of these income tax reduction strategies. Lack of planning often results in a higher tax bill when you sell a business, making retirement more expensive. I don’t have the space to go into detail about this vital issue here, so please check out our detailed blog on business succession planning, or listen to our webinars on Business Succession Planning: Essential Estate Planning Tips and How to Plan for Business Succession and the Sale of a Business.
Income Tax Reduction Strategy #7: Go Beyond Your CPA for Tax Planning
I suppose I should call this a “bonus tax strategy,” but I think it’s vital.
If you make a lot of money, you likely need more than a CPA. Don’t get me wrong, I love CPAs and none of us could live without them. But CPAs too often look backward not forward—figuring your taxes for reporting well after the basic decisions on tax structures have been made. Advanced Tax Planning is quite a different art, and as I said at the outset, if you make serious money, your personal “A-Team” should include a CPA, an Investment Advisor, and a Tax Planning Lawyer. You should also be talking to your advisors at least once a year, well before the end of each year—I talk to mine quarterly. Tax planning for professionals, the self-employed, and business owners gets very complicated, even for an expert. Don’t skimp on professional help.
I’ve outlined a few key maneuvers here. There are plenty more –but don’t try to do these maneuvers on your own, even if you’re a lawyer! Does this sound like a gratuitous piece of advice? Perhaps, but it may turn out to be the most important of all.
What Do We Do as California Estate and Tax Planning Attorney Specialists?
The lawyers and staff at CunninghamLegal help people plan for some of the most critical times in their lives and then guide them through when those times come. We have offices throughout California with expert estate planning, tax planning, and real estate transaction attorneys. We invite you to contact us for help and advice. We offer in-person, phone, and virtual appointments. Just call (866) 988-3956 or book an appointment online.
A key goal of our practice is client education. We invite you to keep updated with tax laws and regulations, as they often change. Subscribe to our YouTube channel and newsletter. Also, check out our webinars on Key Estate and Tax Planning Issues for Business Owners and Crucial Tax and Retirement Strategies for Business Owners.
We look forward to working with you!
Best, Jim
James L. Cunningham Jr., Esq.
Founder, CunninghamLegal
At Cunningham Legal, we guide savvy, caring families in the protection and transfer of multi-generational wealth.
