Entity selection, reasonable compensation, retirement plan design, depreciation, and the long-arc moves that lower a lifetime effective rate.
Tax planning for an owner-operator is mostly the discipline of doing four or five things in the right order, on time, with documentation. This guide is organized around those things — not around the IRS publication list.
Lays out the structural decisions (entity, compensation, retirement plan) that determine your effective rate, and the operational decisions (deductions, estimates, year-end timing) that fine-tune it. Each section ends with a worksheet or decision aid you can bring to your next planning meeting.
It doesn't replace a CPA who knows your books, your spouse's W-2, and the deal you're about to close. The tax code rewards specifics, and specifics live in your own records — not in a guide.
First time through: read sections 01–03 cover to cover, skim the rest, and earmark the worksheets at the end of each section. After that, this is a reference. Pull it down in October to plan, in January to file, and any time you're contemplating a structural change.
The owners who pay the least in tax aren't doing anything clever. They're doing four boring things on time, every year, with a paper trail.— Ring Tax planning principle
Most owners think of entity selection as a legal choice. It is. But it's also the single largest determinant of how you'll be taxed for the life of the business. The wrong entity can cost five points on every dollar of profit — for decades.
The federal tax code recognizes five practical entity classes for the closely-held firm. They are not equally useful at every stage of a business; they are not equally useful for every owner; and they convert into one another only at specific moments, under specific rules. The chapter that follows walks each one — what it taxes, what it shields, what it costs to run — and ends with a decision framework you can apply to your own situation.
| Entity | How it's taxed | SE tax exposure | Owner pay mechanism | Best fit |
|---|---|---|---|---|
| Sole proprietor | Schedule C — flow-through | All net profit | Owner draws | Side income; pre-revenue |
| Partnership | Form 1065 — flow-through | All ordinary income (general partners) | Guaranteed payments + K-1 | 2+ active owners |
| LLC (default) | Disregarded or partnership | Same as above | Owner draws | Liability shield without entity tax |
| S-Corporation | Form 1120-S — flow-through | Only W-2 wages | Reasonable W-2 + K-1 distributions | Net profit ~$60k–$400k |
| C-Corporation | Form 1120 — entity-level (21%) | Only W-2 wages | W-2 + dividends | Retained earnings; pre-IPO; specific fringe needs |
The LLC is a state-law liability shield. For federal tax it is whatever its members elect — disregarded (one owner), partnership (multi-owner), S-Corp, or C-Corp. "We're an LLC" tells your CPA almost nothing about your tax picture.
A sole proprietorship is the default for any individual earning business income who has not formed an entity. It is reported on Schedule C of the 1040. The taxpayer and the business are the same legal person, which means no liability shield, no separate return, and no separate EIN unless one is requested for payroll.
What it taxes. All net profit is subject to ordinary income tax and self-employment tax (15.3% up to the Social Security wage base, 2.9% Medicare above it, plus 0.9% Additional Medicare for high earners). There is no entity-level income tax. There is no mechanism to split income with the entity itself.
What it costs to run. Almost nothing. No separate return. No payroll. Modest bookkeeping. A business bank account and reasonable records are the only operational overhead.
Where it breaks down. Two places. First, liability: a sole prop offers zero protection against the business's creditors. Second, self-employment tax: at any meaningful profit, the 15.3% SE tax becomes the dominant cost and an S-Corp election starts to pay for its own complexity.
A partnership is two or more persons or entities carrying on a business for profit. It files Form 1065 and issues a Schedule K-1 to each partner; the partnership itself pays no tax. General partners pay SE tax on their distributive share; limited partners generally do not, though "limited partner" is a tested factual question and the IRS has narrowed the definition.
Partnerships are the only entity that can have an unlimited number of classes of equity, special allocations of profit and loss, and basis adjustments under §754. That flexibility is why real estate, professional services, and private investment funds run on them. It is also why a partnership return is the most complex of the five forms.
The S-Corporation is a tax election, not an entity form. A corporation or an LLC can elect S status by filing Form 2553. The entity then files Form 1120-S and passes profit through to shareholders on K-1s. Up to 100 shareholders, all of whom must be US individuals (with limited exceptions), and only one class of stock.
The reason an S election dominates the small-business tax conversation is one structural fact: only W-2 wages paid to owner-employees are subject to FICA / Medicare. Distributions of profit beyond reasonable compensation are not subject to employment tax. For a profitable business with one or two owners doing the work, that delta can be five to ten points of effective rate.
| Net profit (before owner pay) | Sole prop SE tax | S-Corp est. FICA on $50k salary | Annual savings (gross) | Net after $1,500 admin |
|---|---|---|---|---|
| $60,000 | $8,478 | $7,650 | $828 | ($672) |
| $90,000 | $12,717 | $7,650 | $5,067 | $3,567 |
| $150,000 | $19,646 | $7,650 | $11,996 | $10,496 |
| $250,000 | $23,464 | $7,650 | $15,814 | $14,314 |
Illustrative only. Assumes a defensible $50,000 reasonable salary; QBI, retirement contributions, and state tax not modeled.
An S-Corp shareholder-employee must be paid a wage that reflects the value of the services performed. Treating all profit as distribution is the single most common audit trigger for small S-Corps. Section 03 covers how to set and document a defensible salary.
A C-Corporation is the only common entity that pays income tax at the entity level — currently a flat 21% federal rate. Profits distributed as dividends are then taxed again at the shareholder level (qualified dividend rates of 0 / 15 / 20%, plus 3.8% NIIT for high earners). This is the "double taxation" you'll hear about, and it is why C-Corps fell out of fashion for closely-held service businesses.
The C-Corp is not extinct, however. It is the right structure in four cases: (1) you intend to raise institutional capital or go public; (2) the business will retain substantial earnings for reinvestment rather than distribute them; (3) the owners need access to certain tax-free fringe benefits (group health, §125 plans for owner-employees, §127 educational assistance) that are limited or unavailable to S-Corp 2% shareholders; and (4) you anticipate qualifying for the §1202 Qualified Small Business Stock exclusion on exit.
Stock in a domestic C-Corp acquired at original issue and held more than five years may qualify for an exclusion of up to $10 million (or 10× basis) of gain on sale. The corporation must be in an eligible trade or business, have gross assets under $50 million at issuance, and meet active-business tests. For founders building toward a sale, this is one of the largest preferences in the code.
If the business legitimately needs to retain capital — to build inventory, fund equipment, or weather working-capital swings — the 21% C-Corp rate may be lower than the marginal rate the shareholders would pay on flow-through income. Retained earnings can also fund growth without triggering shareholder tax, until distribution.
The IRS has a tool against C-Corps that retain earnings beyond reasonable business needs purely to defer shareholder tax: a 20% accumulated earnings tax. The safe harbor is generally $250,000 ($150,000 for personal service corporations), with documented business reasons supporting anything above.
A practical sequence for choosing or changing your entity. Walk the tree top to bottom; stop at the first match.
The right entity at $40,000 of profit is rarely the right entity at $400,000. Conversions are routine — but each has a window, a form, and a cost.
Form an entity (corp or LLC) and file Form 2553 within 2 months and 15 days of the desired effective date. Late-election relief is available under Rev. Proc. 2013-30 for up to 3 years 75 days late if all shareholders consent. Transfer business assets and liabilities to the new entity under §351 — generally tax-free if the contributors control the entity afterward.
A partnership cannot directly elect S status. Common path: liquidate the partnership into a corporation under §351, or "check the box" on an LLC partnership to be taxed as a corporation, then file 2553. Watch for built-in gains and §704(c) allocations on contributed property.
Revoke the S election by filing a statement with the IRS, signed by more than half the shareholders. Revocation can be retroactive to the start of the year if filed by the 15th day of the third month. After revocation, you cannot re-elect S status for five years without IRS consent.
File Form 2553. Watch the built-in gains tax (§1374): appreciated assets held at conversion remain subject to a 21% corporate-level tax if sold within five years. Watch also accumulated earnings & profits from the C years — distributions during S years above the AAA balance can be taxed as dividends.
For owners with real estate, intellectual property, or multiple lines of business, a single entity is rarely the right answer. The most common patterns:
The operating company leases real estate from a separate LLC owned by the same principals. Rents are deductible to the OpCo; the PropCo accumulates depreciation and appreciation. Watch self-rental rules (§469) and reasonable rent.
A parent LLC or S-Corp owns subsidiaries, each with its own liability profile and possibly its own state footprint. Useful when one line of business is materially riskier than another.
An IP-holding entity (often in a state with no income tax) licenses trademarks or processes to operating subsidiaries. Heavily scrutinized; requires arms-length royalties and economic substance.
A common pattern for partnerships: a manager S-Corp provides services to one or more LLCs. The S-Corp pays the principals W-2 wages; the LLCs pay management fees. Allows employment-tax planning across multiple operating LLCs.
Available in some states. One LLC, multiple internal "series," each with its own assets and liabilities. Federal tax treatment is unsettled and varies by state; consult before relying on it.
Asset-protection and estate-planning structure; the operating entity is owned by a grantor trust. Tax neutral during grantor's life; powerful at death.
Multi-entity structures must reflect real economic activity. Every entity needs a bank account, its own books, its own contracts, and arms-length intercompany pricing. Otherwise the IRS will collapse them under §482 (transfer pricing) or general substance doctrines.
An S-Corp without payroll is an audit waiting to happen. An LLC without an operating agreement is a lawsuit waiting to happen. An entity without its own bank account is neither an entity nor a shield.— Section 02 takeaway
A one-page diagnostic. Complete it before your next planning meeting.
An S-Corp shareholder-employee must be paid a salary that reflects the value of the services performed. The Service has reasonable-comp authority to recharacterize distributions as wages and assess back FICA, penalties, and interest. Most adjustments come not from being too low — they come from being undocumented.
Courts and the IRS rely on a multi-factor analysis. The factors that matter most:
What does the owner actually do? How many hours per week? Sales, operations, executive — or all three? A working CEO earns more than a passive owner.
What does the market pay for that role, in your industry, in your geography, at your firm's size? BLS, RC Reports, Salary.com, industry surveys, and recruiter data are admissible.
Was the salary so low that the firm couldn't have hired a replacement? Was it so high that it stripped the firm of working capital? Either tail invites scrutiny.
Running a profitable S-Corp with no W-2 to the working owner. The IRS finds these through 1099 mismatches, real estate filings, and state employment filings. Recharacterized distributions trigger FICA on the entire amount, plus a 100% penalty under §6651 in some cases.
There is no single "right" answer; there is a defensible range. The practical approach is to anchor on market data and adjust for facts specific to the firm.
List every function the owner performs and the percentage of time on each: sales, account management, production, operations, finance, HR, technology. Treat the owner as a department, not a title.
Pull market salary data for each function in your geography. Build a blended salary weighted by hours. A working owner who is 40% sales, 30% operations, 20% finance, 10% HR is not paid as a CEO — they are paid as a composite.
Salary scales with firm revenue and headcount. A $3M firm pays its working CEO more than a $300k firm. Below a certain profitability, paying the owner the market rate would zero out the business — that is a legitimate downward adjustment, documented.
Board minutes adopting the salary, with attached job description and salary study. Re-approve annually.
| Firm revenue | Net profit | Likely defensible salary range | Notes |
|---|---|---|---|
| $150k | $80k | $35k – $55k | Owner is primary producer |
| $400k | $200k | $70k – $110k | Mix of production and management |
| $1M | $400k | $120k – $200k | Manager / executive role |
| $3M | $700k | $180k – $300k | Replacement cost of CEO talent |
Ranges are illustrative; actual defensible figures depend on industry, geography, role, and documented comparables.
Once the W-2 is set, the rest of the owner's economic draw flows as K-1 distribution of profit. The mechanics matter: distributions are not wages, are not subject to withholding, and must come from accumulated profit, not borrowed capital.
Treat distributions as a quarterly discipline, not a checkbook reaction. The typical cadence: estimate profit through quarter end, retain working-capital cushion (often 1.5× monthly opex), distribute the balance. Equal among shareholders by ownership percentage.
Reimburse the owner-employee for home office, mileage, cell phone, internet, and other ordinary business expenses through a written accountable plan. Reimbursements are deductible to the corporation and non-taxable to the owner — not wages, not distributions. The plan requires business connection, substantiation, and return of excess advances.
There is no IRS rule fixing a salary-to-distribution ratio. "60/40" or "1/3 / 2/3" rules of thumb are heuristics — sometimes useful, never authority. Document the salary on facts, not on ratios.
Tax-advantaged compensation that doesn't run through the W-2. Treatment varies by entity — particularly for S-Corp shareholders owning more than 2%.
| Benefit | C-Corp owner-employee | S-Corp 2%+ shareholder | Partnership / SP owner |
|---|---|---|---|
| Health insurance premiums | Tax-free | Added to W-2; SE health deduction available | SE health deduction (above the line) |
| Group term life (≤ $50k) | Tax-free | Taxable to shareholder | Not deductible |
| HSA contributions | Tax-free | Added to W-2; deduction on 1040 | Personal deduction |
| Dependent care assistance (§129) | Up to $5,000 tax-free | Available to non-2% employees | Available to non-owner employees |
| Educational assistance (§127) | Up to $5,250 tax-free | Available to non-2% employees | Available to non-owner employees |
| Adoption assistance | Tax-free (with limits) | Taxable to shareholder | Not deductible |
| Working condition / de minimis | Tax-free | Tax-free | Personal expense |
| Retirement plan | Fully deductible | Fully deductible | Fully deductible |
A shareholder owning more than 2% of an S-Corp is treated like a partner for fringe-benefit purposes. Most benefits that would be tax-free to a regular employee are either taxable or available only via personal deduction. This is a recurring source of W-2 corrections — particularly for health insurance.
An accountable plan is a written reimbursement arrangement that lets a business pay or reimburse employees for business expenses without those payments becoming taxable wages. For an owner-employee, it is the cleanest way to move legitimate business spending from the personal side of the ledger to the corporate side.
S-Corp shareholders cannot deduct unreimbursed employee business expenses on their personal returns. The accountable plan is the only mechanism to deduct items like home office or business mileage. Without one, those expenses are simply lost.
A board resolution adopting an accountable plan, with an attached reimbursement procedure (form, receipts policy, monthly cadence) is sufficient. Reimbursements run through accounts payable, not payroll. The plan is not filed with the IRS; it is produced on request.
| Function | Hours / week | % of role | Market salary | Weighted |
|---|---|---|---|---|
| Sales / business dev. | ||||
| Production / delivery | ||||
| Operations / management | ||||
| Finance / accounting | ||||
| HR / admin | ||||
| Technology / IT | ||||
| Total / blended salary | 100% |
A defensible salary isn't the highest number you can stomach — it's the number you can explain in one paragraph, with one survey, and one board minute.— Section 03 takeaway
| Form | Purpose | Cadence | Due |
|---|---|---|---|
| Form 941 | Quarterly federal payroll tax return | Quarterly | Last day of month following quarter |
| Form 940 | Annual federal unemployment | Annual | Jan 31 |
| State withholding return | State income tax withheld | Varies (monthly / quarterly) | State-specific |
| State unemployment return | Quarterly SUI / SUTA | Quarterly | State-specific |
| W-2 / W-3 | Annual wage reporting | Annual | Jan 31 |
| 1099-NEC | Non-employee compensation | Annual | Jan 31 |
Withheld payroll taxes are trust funds — held by the employer for the IRS. Failure to deposit them on schedule triggers a 100% personal penalty against the responsible person (§6672), and the corporate veil does not protect against it. Use a payroll service.
A small-business retirement plan is the single largest pre-tax shelter most owners will ever use. The choice among plan types depends on three things: how much you want to shelter, how many employees you have, and how much administration you'll tolerate.
| Plan | 2026 contribution limit | Employer match | Best fit | Admin cost |
|---|---|---|---|---|
| Traditional IRA | $7,000 ($8,000 50+) | — | Personal supplement | None |
| SEP-IRA | 25% of comp, up to $70k | Employer only | Solo or few employees | Low |
| SIMPLE IRA | $16,500 + $3,500 catch-up | 3% match or 2% non-elective | 10–100 employees, simple needs | Low |
| Solo 401(k) | $70k (or $77.5k with catch-up) | Self-funded | Owner-only or owner + spouse | Moderate |
| Safe Harbor 401(k) | $70k combined | 3–4% mandatory | 10+ employees, full-featured | Higher |
| Defined Benefit / Cash Balance | Actuarial — $100k–$300k+ | Employer-funded | 50+ owner with consistent profit | High |
2026 figures projected from IRS inflation adjustments and the SECURE 2.0 super catch-up; verify against current IRS notices before contribution.
SEP / SIMPLE are easy and cheap. The 401(k) family is moderate and lets you contribute much more on a lower salary. DB / Cash Balance is complex and powerful — for owners 45+ who can commit to $80k+ contributions for several years.
A Simplified Employee Pension is an employer-funded plan. The employer contributes a uniform percentage of compensation for every eligible employee — including the owner. There is no employee deferral mechanism.
A 401(k) covering only owner(s) and their spouse. Combines employee deferrals with employer profit-sharing, allowing far higher contributions at lower compensation than a SEP.
Up to $23,500 (2026), plus $7,500 catch-up at 50+, plus $11,250 "super catch-up" at 60–63. Can be traditional or Roth.
Up to 25% of W-2 (corp) or 20% of net SE earnings (sole prop). Always pre-tax.
$70,000 (2026), or $77,500 with 50+ catch-up, or $81,250 with super catch-up.
| Plan | Employee deferral | Employer contribution | Total |
|---|---|---|---|
| SEP-IRA | — | $30,000 (25%) | $30,000 |
| Solo 401(k) — under 50 | $23,500 | $30,000 (25%) | $53,500 |
| Solo 401(k) — 50+ | $31,000 | $30,000 (25%) | $61,000 |
| Solo 401(k) — 60–63 | $34,750 | $30,000 (25%) | $64,750 |
The employee deferral portion can be designated Roth. The employer profit-sharing portion can also be Roth as of 2024, but most providers require it to be made into a separate Roth account at the participant's election. Roth Solo 401(k)s are powerful for high-income owners who expect higher rates in retirement.
A spouse who is a bona fide employee of the business can be included. Each spouse has their own contribution limits, doubling household-level shelter capacity.
A Savings Incentive Match Plan for Employees. Designed for businesses with 100 or fewer employees. Cheaper than a 401(k); contribution limits are lower.
A 401(k) that satisfies the IRS nondiscrimination tests automatically by making a mandatory employer contribution: either a match (typically 4% of comp on a 100%-up-to-3% / 50%-on-next-2% formula) or a 3% non-elective for all eligible employees.
In a standard 401(k), highly-compensated employees (HCEs, including most owners) are limited in how much they can defer based on what rank-and-file employees defer. In small businesses where the owner is the only meaningful saver, the HCE deferral cap can drop to near zero. Safe Harbor short-circuits this — the owner can defer the full $23,500 regardless of what others contribute.
A Safe Harbor 401(k) costs $1,500–$3,500/yr in plan administration plus the mandatory employer contribution. Generally pays for itself when (a) you have employees who would constrain a non-Safe-Harbor plan, and (b) the owner is contributing the maximum.
A defined benefit (DB) plan promises a specific benefit at retirement; the contribution required to fund that promise is calculated actuarially. A cash balance plan is a hybrid: it looks like a 401(k) account balance but funds an actuarial benefit. Both allow much larger annual contributions than defined-contribution plans — especially for older owners.
The contribution is not limited by a percentage of pay. It is limited by what's needed to fund a $280,000+ annual lifetime benefit (the §415 limit). For a 55-year-old owner with 10 years to retirement, that can mean $150,000–$300,000 of deductible contribution per year — on top of a 401(k).
Plans skewed heavily toward an older owner still must satisfy nondiscrimination. The actuary will calculate a contribution for staff — typically 5–7% of compensation in a stacked design. Model that cost into the decision.
Owner age 45+, net profit consistently above $400k, employees few or paid modestly, and a clear horizon of 5+ years of strong earnings. The reverse — young owner, inconsistent profit — almost always points back to a Solo 401(k).
The plan you set up at $200k of profit is rarely the plan you'll want at $800k. Plan to upgrade every five to seven years.— Section 04 takeaway
| Plan | Establish by | Fund by | Annual filing |
|---|---|---|---|
| SEP-IRA | Extended due date of return | Extended due date of return | None |
| SIMPLE IRA | Oct 1 of plan year | 30 days after wage (deferrals); due date of return (employer) | None |
| Solo 401(k) — pre-tax deferrals | By 12/31 of plan year for deferrals; due date of return for employer portion | Deferrals: payroll period; employer: due date | 5500-EZ if assets > $250k |
| Safe Harbor 401(k) | By 12/31; notice 30 days before plan year | Per payroll for deferrals; due date for employer | Form 5500 |
| Cash Balance / DB | 12/31 of plan year (extended for SECURE 2.0) | 8½ months after plan year-end | Form 5500 with Schedule SB |
(1) Employer Roth contributions permitted. (2) Solo 401(k) elective deferrals can now be made up to the extended return date for the first plan year. (3) Super catch-up of $11,250 for ages 60–63 starting 2025. (4) Mandatory Roth catch-up for high earners (≥$145k) is now in effect.
Every business deduction in the code rests on a four-word phrase: ordinary and necessary. Ordinary means common and accepted in your trade. Necessary means helpful and appropriate, not indispensable. Most disallowed deductions don't fail this test — they fail the substantiation that proves it.
The activity must be a real trade or business — profit motive, regularity, business-like conduct. Hobbies don't qualify under §183.
Common in your industry; helpful in earning income. Lavish or extravagant is not "necessary."
Documented as to amount, date, business purpose, and (for travel / meals / vehicles) the parties involved.
If the expense produces a benefit beyond the current year, it must be capitalized and depreciated — not deducted in full.
§183 disallows losses from activities not engaged in for profit. The safe harbor: a profit in three of five years (two of seven for horses). Outside the safe harbor, the IRS uses a nine-factor facts-and-circumstances test. Document the profit motive — business plan, separate accounts, hours, expertise.
Available to anyone using a portion of their home regularly and exclusively for business. For S-Corp owners, it must run through an accountable plan — not Schedule A.
| Method | How it's calculated | Maximum | Best for |
|---|---|---|---|
| Simplified | $5 / sq ft of qualified office space | $1,500 (300 sq ft) | Small offices, simple homes |
| Actual expenses | Business % × (mortgage interest, taxes, utilities, insurance, repairs, depreciation) | No cap | Larger offices, higher home costs |
Square footage of the office divided by total home square footage. A 200 sq ft office in a 2,000 sq ft home is 10% — and 10% of every household cost flows through.
The actual method requires depreciating the business portion of the home. When you eventually sell, the depreciation taken (or that should have been taken) is "recaptured" as ordinary income, regardless of the §121 home-sale exclusion. Many owners prefer the simplified method to avoid this complication.
Two methods, both requiring a contemporaneous mileage log. The choice is generally made the first year and locked in (with limited ability to switch later).
Set annually by the IRS (67¢/mile for 2024, projecting upward). Covers all operating costs — fuel, maintenance, insurance, depreciation. Add separately: parking, tolls, financing interest (business portion).
Business % × (fuel, insurance, repairs, registration, depreciation or lease payments). The percentage is business miles over total miles.
| Scenario | Standard mileage | Actual | Better choice |
|---|---|---|---|
| Low-cost economy car, high miles | Strong | Weak | Standard |
| Expensive SUV / truck, modest miles | Weak | Strong | Actual |
| EV / hybrid (cheap to operate) | Strong | Weak | Standard |
| Leased luxury vehicle | Weak | Strong (subject to lease inclusion) | Actual |
Heavy vehicles (GVWR > 6,000 lbs) — qualifying SUVs, trucks, vans used > 50% for business — can be substantially expensed in year one. Light vehicles are capped by the "luxury auto" depreciation limits under §280F. The often-cited "G-wagon write-off" is the §179 + bonus combination on a heavy SUV.
Apps (MileIQ, Everlance, TripLog) make this painless. Backfilling at year-end is the most common audit weakness — courts have rejected reconstructed logs more than once. Track miles in real time.
For most owner-operated S-Corps, the cleanest answer is to own the vehicle personally and reimburse business mileage through an accountable plan. Corporate ownership creates personal-use income, complicates depreciation, and makes the vehicle a creditor target. Talk through before titling.
| Type of meal | Deductible | Notes |
|---|---|---|
| Business meal with client / prospect | 50% | Substantiation: who, where, when, business purpose |
| Meal while traveling overnight for business | 50% | Per diem option available |
| Office snacks & coffee | 50% | Previously 100%; reduced after 2017 TCJA |
| Company-wide social events (party, picnic) | 100% | Must include all employees |
| Meals for the convenience of the employer (on-site) | 50% | Limited; previously 100% |
| Entertainment (sports tickets, golf) | 0% | TCJA eliminated; meal portion if separable is 50% |
Travel away from your tax home, overnight, for business is generally fully deductible: airfare, lodging, ground transport, baggage, business-related telecom. The trip must be primarily for business. A mixed-purpose trip allocates personal days as non-deductible.
For every meal or travel item, write the business purpose on the receipt (paper or photo) within 24 hours. "Lunch — Q3 review with K. Martinez, Acme Co." A receipt without that note has lost half its evidentiary value.
The two acceleration mechanisms that let a business deduct the cost of equipment in the year placed in service instead of over a 5- to 7-year depreciation schedule.
Acceleration is not always optimal. If you're in a low-bracket year (startup loss, sale year, low revenue), regular depreciation may produce higher lifetime value. The decision is bracket-arbitrage: deduct in your highest expected marginal year.
If business use drops below 50%, accelerated depreciation is recaptured as ordinary income. Sale or disposition of the asset also triggers recapture to the extent of prior depreciation.
Most business property is depreciated under MACRS (Modified Accelerated Cost Recovery System). The class life depends on what the asset is.
| Class | Examples | Recovery period | Method |
|---|---|---|---|
| 3-year | Special tools, certain race horses | 3 years | 200% DB |
| 5-year | Computers, autos, light trucks, R&D equipment | 5 years | 200% DB |
| 7-year | Office furniture, fixtures, most machinery | 7 years | 200% DB |
| 15-year | Qualified improvement property, land improvements | 15 years | 150% DB |
| 27.5-year | Residential rental real estate | 27.5 years | Straight line |
| 39-year | Non-residential real estate | 39 years | Straight line |
Property is generally treated as placed in service mid-year, taking half a year's depreciation in year one. If more than 40% of the year's qualifying property is placed in service in the last quarter, the mid-quarter convention applies — depreciation is calculated by quarter, which can substantially reduce year-one deductions.
For a business owning real estate, a cost segregation study identifies portions of a building that qualify for shorter recovery periods — 5, 7, or 15 years instead of 39 — by classifying them as personal property or land improvements. The result: accelerated depreciation, often a 5–7% basis acceleration to year one.
Generally pays for itself on commercial property with a basis above $750,000. Most useful for newly acquired or recently constructed buildings; possible (via §481(a) catch-up) on properties held for years.
A deduction of up to 20% of qualified business income from a pass-through entity. Available to sole proprietors, partnerships, S-Corps, and certain trusts. One of the largest preferences in the code for owners — and one of the most heavily limited.
Above the thresholds, SSTBs lose the QBI deduction. SSTB includes health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing — and any trade where the principal asset is the reputation or skill of the owner. Notably not SSTBs: engineering and architecture.
Deduction limited to the greater of: 50% of W-2 wages paid by the business, or 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property.
Below the thresholds: maximize QBI. Above the thresholds: for non-SSTBs, increase W-2 wages and qualified property to lift the cap. For SSTBs, push taxable income below the threshold via retirement contributions and timing — the QBI deduction can be the largest single benefit of a Solo 401(k) contribution.
Since 2022, domestic R&D expenditures must be capitalized and amortized over 5 years (15 for foreign). The R&D credit under §41 is separate and still available. Many businesses underclaim it because they don't think of routine product or process development as "research."
Sole proprietors, partners, and 2%+ S-Corp shareholders can deduct health, dental, and qualified long-term care premiums for themselves, spouses, and dependents. Above the line. Limited to earned income from the business.
A workaround for the SALT cap: a pass-through entity elects to pay state income tax at the entity level, deducting it as a federal business expense. Available in 36+ states; details vary. Often the single largest deduction available to a partnership or S-Corp owner.
Generally limited to 30% of adjusted taxable income, but exempt for small businesses with average gross receipts under ~$30M.
Up to $5,000 deductible in year one, with the remainder amortized over 180 months. Costs above $50,000 phase out the immediate deduction.
Up to $5,000 immediate deduction; remainder amortized over 180 months.
Business bad debts are ordinary deductions when they become worthless. For accrual basis taxpayers; cash basis taxpayers had no income to write off.
Premiums for business insurance — liability, professional, property, workers' comp, key person — are fully deductible. Life insurance premiums where the business is beneficiary are not deductible.
Deductible if it maintains or improves skills required by the present business. Not deductible if it qualifies the taxpayer for a new trade.
The deductions owners most often miss: PTE elections, R&D credit, accountable plan reimbursements, home office for S-Corps (via reimbursement), §1202 stock planning, and depreciation methods on real estate (cost seg). A planning meeting that surfaces even one of these often pays for the year.
A self-audit. If you can't answer "where is the documentation," the deduction is at risk.
| Deduction | Claimed? | Method | Documentation |
|---|---|---|---|
| Home office | Y / N | Simp / Actual | Sq ft + utility bills |
| Business mileage | Y / N | Std / Actual | Mileage log |
| Meals (business) | Y / N | 50% / Per diem | Receipts + purpose |
| Travel | Y / N | Actual / Per diem | Itinerary + receipts |
| Cell phone | Y / N | Business % | Carrier statement |
| Internet (home) | Y / N | Business % | Carrier statement |
| Professional dues | Y / N | — | Receipts |
| Continuing ed. | Y / N | — | Receipts |
| Equipment (§179 / bonus) | Y / N | §179 / bonus / MACRS | Invoices, place-in-service date |
| Health insurance | Y / N | SE deduction | W-2 Box 14 / 1095 |
| Retirement plan | Y / N | Plan type | Plan documents + custodian statements |
| State PTE | Y / N | State-specific | State return + entity election |
| R&D credit (§41) | Y / N | Form 6765 | Project documentation |
| QBI deduction | Y / N | 199A worksheet | QBI calculation + SSTB analysis |
Most "missed deductions" aren't hidden in the code. They're hidden in receipts no one wrote a purpose on, miles no one logged, and elections no one made by their deadline.— Section 05 takeaway
Self-employment tax is the equivalent of FICA for someone who is both the employer and the employee. It funds Social Security (12.4% to the wage base) and Medicare (2.9% all the way up, plus 0.9% Additional Medicare on high earners). For sole proprietors and active partners, it applies to every dollar of net business profit.
An S-Corp shareholder pays FICA only on W-2 wages, not on the K-1 distribution of profit. The same $200,000 of profit, paid as $80,000 of wages and $120,000 of distribution, generates ~$12,240 of FICA — versus $26,262 of SE tax. Savings: ~$14,000 per year. That is the central case for the S election.
The "limited partner" exception to SE tax has been heavily tested. Active LLC members and limited partners who materially participate generally cannot rely on the exception. Recent Tax Court cases (Soroban, Denham, others) have aggressively expanded what counts as material participation.
If you owe more than $1,000 of tax after withholding, the IRS expects you to pay it quarterly. Underpayment generates a non-deductible penalty calculated at the short-term AFR plus 3% — currently ~8% annualized. It is not enormous, but it adds up, and it is entirely avoidable.
You avoid the underpayment penalty by paying, through withholding and estimates, the lesser of:
| Period | Income earned | Estimate due |
|---|---|---|
| Q1 | Jan 1 – Mar 31 | April 15 |
| Q2 | Apr 1 – May 31 | June 15 |
| Q3 | Jun 1 – Aug 31 | September 15 |
| Q4 | Sep 1 – Dec 31 | January 15 (following year) |
Q4 bonus payroll with elevated federal withholding can cure a year of underpayment penalty in one paycheck. Works for the owner-employee whose spouse also has wages — coordinate withholding across both employers.
Classifying workers correctly is the single biggest payroll-tax risk for a small business. Misclassification triggers back FICA, federal and state unemployment, penalties, and potential personal liability under §6672.
Does the company control or have the right to control what the worker does and how? Training, instructions, set hours, defined methods all point to employee.
Is the worker reimbursed for expenses, supplied with tools, paid by hour vs. project? Significant investment in own tools and unreimbursed expenses lean contractor.
Written contract; benefits; permanency; whether the work is a key aspect of the business. A multi-year relationship doing the core work is hard to call contracting.
Many states use the "ABC test" — stricter than the federal test. Under ABC, the worker is an employee unless all three: (A) free from control; (B) work outside the usual course of the business; (C) customarily engaged in an independent trade. California (AB 5), Massachusetts, and New Jersey are notably aggressive.
If reclassified, the employer owes back FICA (both halves), federal unemployment, state unemployment, and penalties of $50 per missed W-2 plus 1.5% of wages (or 3% if 1099 wasn't filed). The §3509 reduced-rate program can mitigate for unintentional misclassification — but only if 1099s were filed.
The progression a typical owner-operator follows from sole prop to multi-employee S-Corp. Each rung has a distinct payroll posture.
Payroll is one of the few areas where the IRS will pierce the corporate veil and come after the responsible person personally. Don't shortcut deposits.— Section 06 takeaway
When this year's marginal rate will be lower than next year's, defer income and accelerate deductions. When next year's will be lower, do the opposite. Most owners reflexively defer; the right move depends on the forecast.
Tax planning is rarely about one year. The right Q4 move minimizes tax across two or three years combined — particularly when a sale, retirement, or major income event is on the horizon.
With the standard deduction at ~$30,000 for MFJ, many taxpayers no longer itemize annually. Bunching — making two or three years of donations in one year and taking the standard deduction in off years — recaptures the lost deduction. A donor-advised fund (DAF) lets you fund the deduction now and grant out over years.
Donating long-term appreciated securities directly to a charity avoids the embedded capital gain and delivers a deduction at fair market value. The most efficient form of charitable giving for an investor with concentrated, low-basis stock.
For owners over 70½, a direct IRA-to-charity transfer of up to $108,000 (2025, indexed) counts toward RMD without being included in income. Better than itemizing because it reduces AGI — which affects Medicare premiums, Social Security taxability, and NIIT.
The 2017 TCJA capped the SALT deduction at $10,000. The pass-through entity (PTE) tax election lets a partnership or S-Corp pay state income tax at the entity level, deducting it on the federal return as a business expense. The owner then receives a credit on the state return for tax paid. Net effect: full deduction of state income tax, bypassing the cap. Available in 35+ states.
Most states require an annual election by a specific date (March or June, in most). Missing it costs the deduction for the year. Calendar it; the savings are typically thousands of dollars per owner.
A business loss that exceeds other income for the year creates a net operating loss. Post-2017, NOLs may be carried forward indefinitely but cannot be carried back, and the use is limited to 80% of taxable income in any future year. NOL carryforwards survive the year of the owner's death only in limited circumstances.
Selling investments at a loss to offset gains. Short-term losses first offset short-term gains; long-term losses offset long-term gains. Excess losses offset up to $3,000 of ordinary income per year; the remainder carries forward. Wash sale rules disallow losses if you repurchase the same or substantially identical security within 30 days before or after.
A business with a loss produces "negative QBI" that reduces the QBI of other businesses or carries forward. Net negative QBI across all activities carries forward indefinitely to reduce future QBI.
For non-corporate taxpayers, business losses are limited to ~$305,000 single / $610,000 MFJ (2025, indexed). Losses above the limit become NOL carryforwards. This affects high-income owners with active real estate or investment-related operating losses.
A loss year is a planning opportunity: accelerate Roth conversions (cheap in low-bracket years), recognize gains in low-bracket children's accounts (kiddie tax permitting), reset basis on appreciated property by sale-and-repurchase from a related entity (watch §267).
A state can require an income tax return whenever the business has "nexus" with that state. Historically this meant physical presence; today it can mean an employee working remotely, a property location, or sales above a threshold.
An income tax return apportioning income to the state. For pass-throughs, the owner generally files a non-resident return too.
Registration, collection, and remittance. Triggered by economic nexus (Wayfair) in most states.
Employer registration; income tax withholding for resident state of each employee.
SUTA registration in the state where the employee performs services.
One remote hire in a new state typically creates four obligations: income-tax withholding, unemployment registration, workers' comp policy (most states), and (often) corporate income-tax nexus. Run the analysis before extending the offer.
When a business operates in multiple states, income must be allocated among them. Most states use a formula based on three factors: property, payroll, and sales.
| Factor | Numerator (in state) | Denominator (everywhere) |
|---|---|---|
| Property | Avg. value of owned + 8× annual rent | Same, total |
| Payroll | Wages paid in state | Total wages |
| Sales | Sales sourced to state | Total sales |
Most states have moved to a single-sales-factor formula, weighting only sales for apportionment. The result favors businesses with property and payroll in one state and sales nationally — manufacturers, technology companies. It disadvantages services businesses with concentrated payroll and statewide sales mix.
For services, "where the sale is sourced" varies: some states source to the location of the service performed (cost-of-performance); most now source to the location of the customer (market-based). Sourcing rules are the single biggest variable in service-business state tax.
If a state is not taxing the sale, some origin states "throw back" the sale into their numerator. Eliminating throwback is a major state-tax planning move for manufacturers in throwback states.
PTE elections vary by state and may not be coordinated. Mismatches between state PTE taxes and credits can create traps — particularly for owners with income from PTE states living in non-PTE states. Run the multi-state PTE analysis before the year ends.
When the same owners control multiple entities, transactions between those entities are scrutinized. The code has a dozen related-party provisions; four matter most for closely-held groups.
Losses on sales between related parties are disallowed. The buyer's basis is increased; the loss is preserved until the property is sold to an unrelated party. Common trap: selling appreciated business equipment from one S-Corp to another at a loss.
An accrual-basis entity cannot deduct an accrued expense to a cash-basis related party until the related party includes it in income. Affects timing of compensation, interest, and rent between related entities.
The IRS can reallocate income, deductions, or credits between related entities to reflect arm's-length pricing. Most relevant for IP licensing, management fees, and intercompany loans. Documentation of the arm's-length basis is the defense.
Self-rental income (you own real estate that you lease to a business you also own) is recharacterized as non-passive — meaning losses from other passive activities can't offset it. Major trap for owners with rental real estate they also operate from.
For QBI, controlled-group rules, retirement plan testing, and SE tax, related entities may be aggregated. Two S-Corps under common ownership may need to be combined for plan testing purposes — see "controlled group" and "affiliated service group" rules under §414.
For every intercompany transaction: a written agreement, an arm's-length pricing basis (comparable, cost-plus, or external), and recurring evidence (invoices, payments). Without these, the IRS treats the transaction as a sham.
| State | Reason for nexus | Income tax filed? | Sales tax filed? | Payroll registered? |
|---|---|---|---|---|
| Y / N | Y / N | Y / N | ||
| Y / N | Y / N | Y / N | ||
| Y / N | Y / N | Y / N | ||
| Y / N | Y / N | Y / N | ||
| Y / N | Y / N | Y / N |
The state tax system was designed for businesses in one state. Almost no business is in one state anymore. Treat multi-state compliance as a separate workstream, not a footnote.— Section 08 takeaway
In a sale of a business, the seller generally wants stock; the buyer generally wants assets. The same business sells for the same headline price either way — but the tax consequences shift hundreds of thousands of dollars between the two parties. Understanding the difference is the first step in negotiating the second.
A buyer wants assets because (a) they get a stepped-up basis in each asset, with depreciation and amortization opportunities, and (b) they avoid inheriting unknown liabilities (tax, litigation, employment). An asset purchase creates immediate deductions; a stock purchase produces only future deductions when the stock is sold.
A seller wants stock because (a) gain is long-term capital gain at 20% (plus 3.8% NIIT), and (b) only one level of tax applies for an S-Corp; for a C-Corp, an asset sale creates double taxation (entity-level corporate tax + shareholder-level dividend or gain).
| Structure | Seller tax | Buyer benefit | Typical use |
|---|---|---|---|
| Stock sale (S-Corp) | Single layer, mostly LTCG | Carryover basis | Clean, modest premium for seller |
| Stock sale (C-Corp) | Single layer, LTCG | Carryover basis; §1202 if seller eligible | Founders selling QSBS |
| Asset sale (S-Corp) | Mix: ordinary recapture + LTCG | Stepped-up basis, immediate amortization | Most small-business sales |
| Asset sale (C-Corp) | Double layer (21% + LTCG) | Stepped-up basis | Avoid if possible |
| §338(h)(10) election | Treated as asset sale for tax | Stepped-up basis | Compromise: legal stock sale, tax asset sale |
For S-Corp sales, the §338(h)(10) election lets the buyer treat a stock purchase as an asset purchase for tax. An F-reorganization restructure before the sale can produce the same effect with more flexibility. Both are standard tools in M&A — but require pre-sale planning.
An installment sale spreads gain recognition over the years the seller actually receives payment. For larger sales, the deferral is meaningful — both for cash flow and for keeping the seller out of the top bracket in a single year.
Each payment is part return of basis, part gain. The "gross profit ratio" is gain ÷ contract price; that fraction of each payment is taxable. Interest on the deferred portion is reported separately as ordinary income.
The buyer's note becomes an asset of the seller. Default risk is real; senior secured position with collateral on the operating company is the norm. The seller may also lose access to the §121 exclusion or step-up planning for the deferred portion at death.
Earnouts (contingent payments) are common in middle-market deals. Treatment is complex: payments are allocated between principal and imputed interest, gain is recognized as payments are received, and the maximum-payment assumption affects basis recovery. Negotiate documentation that supports your preferred treatment before the deal closes.
A federal exclusion of up to $10 million (or 10× basis) of gain on the sale of qualified small business stock. The single largest gain-exclusion provision in the code for entrepreneurs. Often overlooked because it requires structural decisions years before exit.
Up to the greater of $10 million or 10× the taxpayer's adjusted basis. Stock acquired after Sept 27, 2010 is 100% excluded; earlier shares are 50% or 75% excluded (with AMT implications).
The $10M cap is per taxpayer per issuer. Gifting shares to non-grantor trusts established for family members can multiply the exclusion across multiple "taxpayers." This is sophisticated planning and requires careful execution well before sale.
If the 5-year holding period isn't met, gain on QSBS can be rolled into new QSBS within 60 days under §1045, preserving the eventual §1202 treatment. Useful when an exit comes earlier than planned.
If you're operating as an S-Corp but anticipate a large exit, evaluate converting to C-Corp early enough to bank a 5-year holding period. The math is brutal: a $10M gain saved from 23.8% tax is $2.4M — typically dwarfing the cost of C-Corp double taxation during the holding period.
An Employee Stock Ownership Plan is a qualified retirement plan that invests primarily in employer stock. For owners, an ESOP is a buyer of last resort with extraordinary tax characteristics — particularly for 100% S-Corp ESOPs, which pay no federal income tax.
Mature companies (10+ years), strong cash flow, owners wanting to preserve culture and employees, no obvious external buyer. Setup costs run $80k–$250k; annual administration $25k–$60k.
Transferring the business to children or other family members. Multiple paths:
Annual exclusion ($18,000 / donor / donee in 2024), plus lifetime exclusion (~$14M federal). For appreciating business interests, transfer early to remove future appreciation from your estate.
Sell business interests to an intentionally defective grantor trust (IDGT) for a promissory note. Removes appreciation from your estate; grantor pays the income tax (a further wealth transfer).
Grantor Retained Annuity Trust. Transfers appreciation above an IRS hurdle rate (the §7520 rate) without using gift exemption. Works best when assets outperform the hurdle.
Pool family assets in an FLP with senior generation as general partner; transfer LP interests at valuation discount for lack of control and marketability. Heavily scrutinized; documentation matters.
Basis is the seller's investment in the entity for tax purposes. Sale price minus basis equals gain. Maximizing basis before sale (legitimately) reduces gain. Common basis builders:
Inherited assets get a basis step-up to fair market value at death. For an owner with a high-basis-difference business, holding until death eliminates the gain entirely. The estate tax may apply above the exemption — but for most owners, the income-tax-free step-up is the dominant benefit.
For gift / sale / restructuring transactions: a qualified appraisal supports the valuation reported on the gift return and starts the statute of limitations. Without it, the IRS can revalue for years afterward.
Buyer and seller must agree on Form 8594 — how the purchase price is allocated across asset categories. The categories carry different tax rates: cash (no gain), inventory (ordinary), depreciable assets (recapture + LTCG), goodwill (LTCG, 15-year amortization for buyer). Negotiate the allocation; do not leave it to the closing date.
The most powerful exit planning happens 3–5 years before close. Entity structure, C-Corp election timing for §1202, basis posture, retirement plan design (to absorb deductions in the sale year), and family ownership structure are all settled long before the buyer is identified.
The hardest part of selling a business is what to do with the money. The second hardest is realizing you should have structured for the sale a decade ago.— Section 09 takeaway
The IRS audit rate for small businesses is low — but conditional probability matters. Certain returns get pulled at multiples of the base rate. Knowing which ones lets you decide whether the position is worth the attention.
The IRS uses an undisclosed "Discriminant Information Function" score to flag returns. The score weighs deviations from norms for similar returns. A single outlier rarely triggers an audit; a pattern often does.
What you want sitting in a single folder, organized by tax year, for every year still within the statute of limitations.
| Type | Description | Typical scope |
|---|---|---|
| Correspondence audit | Mailed letter requesting documentation for specific items | 1–3 line items |
| Office audit | In-person meeting at IRS office | Multiple items; one tax year |
| Field audit | IRS examiner visits your business / advisor's office | Broad scope; multiple years possible |
| State audit | State revenue agency; income, sales/use, or payroll | Varies by state and tax type |
The IRS generally has three years from the later of filing or due date to audit. Six years if >25% of gross income was omitted. Unlimited for fraud or unfiled returns. Hold records accordingly — see G.06 Record Retention Guide.
A Notice of Deficiency (CP3219N or similar) gives 90 days to petition Tax Court. Miss it and the assessment becomes final, payment is due, and your remedy shifts to refund litigation. Calendar the date the moment the letter arrives.
This guide addresses federal income, payroll, and self-employment tax for closely-held business owners operating in the United States. It covers structural choices (entity, compensation, retirement plans), operational deductions, and transactional events (sales, exits, family transfers). State income tax is referenced where it materially changes the answer. International tax, complex estate planning, and industry-specific regimes are out of scope.
Primary sources: Internal Revenue Code, Treasury Regulations, IRS Revenue Rulings and Procedures, Tax Court memorandum and regular decisions. Secondary: BNA portfolios, AICPA publications, and IRS publications and instructions. Specific section references are inline where helpful; a complete bibliography is available on request.
Inflation-adjusted figures (contribution limits, thresholds, mileage rates) are stated as 2026 projections where the indexed amount has been published, and as the most recent published figure otherwise. The Service publishes annual revenue procedures with final figures each November; consult the current notice before relying on a number.
It is not tax advice. It is not a substitute for engagement with a qualified tax professional who knows your specific facts. Every example is illustrative; every threshold is current as of publication but subject to legislative change. Bring this guide to your advisor, not in place of one.