How to Reduce Taxable Income with a Side Business

Introduction

As an individual taxpayer, it can be disheartening to see an average of 24% of your hard-earned income go towards taxes. But starting a side business offers a brilliant opportunity to trim your taxable income. By becoming an entrepreneur, you unlock possibilities, generate additional income, and enjoy tax deductions on legitimate business expenses. In fact, small businesses accounted for 44% of U.S. economic activity in 2023. Blend personal and business expenses wisely to maximize deductions and minimize taxes. Embrace the audacious spirit of entrepreneurship, pursue your passions, and reclaim control of your financial destiny. With each step, you’ll gain confidence and reshape your life.

How to Reduce Taxable Income with a Side Business (Source : Unsplash)

Why reducing taxable income is important

Reducing your taxable income is a crucial strategy for financial management. In the United States, the average effective federal income tax rate was around 14% for the tax year 2023, according to the Tax Foundation. First and foremost, it can help you save money on taxes. The less income you have to report, the less you will owe in taxes. Additionally, reducing your taxable income can also help you qualify for certain tax deductions and credits that you might not be eligible for otherwise.

In 2023, the standard deduction for a single filer in the US was $12,400, while for married couples filing jointly, it was $24,800, as per the IRS. But saving money on taxes isn’t the only benefit of reducing your taxable income. It can also help you increase your net income, which is the amount of money you take home after taxes. This can give you more financial freedom and flexibility to pursue your goals and dreams.

The benefits of having a side business

Starting a side business can provide a number of benefits beyond just reducing your taxable income. For example –

• Provides a source of additional income that can help you reach your financial goals faster.
• Running a side business can be a great way to pursue your passions and interests while also earning money.
• Offers the opportunity to experience a feeling of self-reliance and empowerment when it comes to shaping your financial destiny.

Reducing taxable income is important because it can help you save money on taxes, qualify for tax deductions and credits, and increase your net income. Starting a side business can be a great way to achieve these goals while also providing additional income, pursuing your passions, and gaining financial independence.

I. Understanding the Tax Code

Gaining a profound grasp of the intricate tax code holds the key to unlocking a treasure trove of opportunities for trimming down your taxable income, particularly if you happen to be a savvy business owner.

The difference between deductions and credits:

Deductions and credits are two ways to reduce your taxable income, but they work in different ways. Here is a table depicting the differences –

Deductions	Credits
Deductions are expenses subtracted from taxable income.	Credits directly reduce the amount of taxes owed.
They reduce the overall taxable income.	They directly reduce the amount of taxes owed.
Deductions are calculated based on eligible expenses.	Credits are based on specific criteria and qualifications.
Example: Earning $50,000 with $10,000 deductions results in a taxable income of $40,000.	Example: Owning $5,000 in taxes with a $1,000 credit results in $4,000 owed.

The types of deductions available for business owners:

Business owners have access to a number of deductions that can help reduce their taxable income. Some common deductions include –

• Home office expenses
• Business travel expenses
• Equipment and supply expenses

Keep in mind that these expenses must be necessary and ordinary for your business in order to qualify as deductions.

How tax brackets work:

The United States has a progressive tax system, which means that people with higher incomes pay a higher percentage of their income in taxes. Tax brackets are used to determine how much income is subject to each tax rate. For example, in 2023, the first $9,950 of income for single filers is taxed at a rate of 10%, while income between $9,951 and $40,525 is taxed at a rate of 12%. This means that if you earn $30,000 from your side business and have no other income, you will owe 10% on the first $9,950, 12% on the amount between $9,951 and $30,000, and nothing on the amount over $30,000.

It’s important to understand how tax brackets work in order to optimize your tax strategy. For example, you may be able to take advantage of deductions and credits to reduce your taxable income enough to move into a lower tax bracket, resulting in significant tax savings.

Read More : How to Report Side Income on Taxes

II. Choosing the Right Business Structure

Selecting the perfect business structure is a momentous choice that wields significant influence over your taxable income. Here are some important considerations when choosing the right business stricture –

The different types of business structures

There are several types of business structures, each with its own advantages and disadvantages. The most common business structures are –  

• Sole Proprietorships
• Partnerships
• Limited liability companies (LLCs)
• S Corporations
• C Corporations

Sole proprietorships are the simplest and most common business structure. They are easy to set up and maintain, but offer no protection against personal liability. Partnerships involve two or more individuals sharing ownership and responsibility for the business. LLCs provide protection against personal liability and offer flexibility in terms of taxation. S corporations and C corporations are both separate legal entities from their owners, but differ in terms of taxation and ownership structure.

Pros and cons of each structure

Each business structure has its own pros and cons. For example,

• Sole proprietorships are easy to set up and maintain, but offer no protection against personal liability.
• Partnerships can provide more resources and expertise, but also have shared liability.
• LLCs offer protection against personal liability and flexible taxation options, but can be more complicated to set up and maintain.
• S corporations can provide tax advantages, but have limitations on the number and type of shareholders.
• C corporations provide protection against personal liability and have no restrictions on the number or type of shareholders, but can be subject to double taxation.

Which structure is best for reducing taxable income

The best business structure for reducing taxable income depends on your individual circumstances and goals. According to IRS data from 2023, there were approximately 1.5 million new LLC formations, showcasing their popularity. LLCs are a popular choice for business owners because they offer protection against personal liability and flexible taxation options. They can be treated as pass-through entities for tax purposes, with over 75% of LLCs electing this taxation method. This means that the business income is reported on the owner’s personal tax return and taxed at the individual tax rate. In 2022, the individual tax rate ranged from 10% to 37%, providing insight into the potential tax benefits. This can be advantageous for reducing taxable income because it allows business owners to take advantage of deductions and credits to reduce their taxable income.

Choosing the right business structure is crucial for maximizing tax benefits and protecting personal assets.

Eva Rosenberg

However, it’s important to consult with a tax professional and/or an attorney to determine which business structure is best for your specific situation. They can provide guidance on the pros and cons of each structure and help you make an informed decision that aligns with your goals.

III. Maximizing Deductions

Maximizing deductions is a vital tax strategy for business owners to reduce their taxable income effectively. By skillfully navigating the intricacies of tax planning, these savvy entrepreneurs uncover the power of deductions to safeguard their resources and optimize their financial success. Here are some common deductions that can help reduce your taxable income:

Home office deductions

If you work from home, you may be eligible for a home office deduction. This deduction allows you to deduct a portion of your home expenses, such as rent, utilities, and insurance, that are used for your home office. To qualify for this deduction, your home office must be used exclusively for business purposes and must be your principal place of business.

Business expenses

Business expenses are costs incurred in the course of running your business. These expenses can be deducted from your taxable income, reducing your overall tax liability. Some common business expenses include rent, utilities, supplies, equipment, and employee salaries. It’s important to keep accurate records of your business expenses to ensure that you can deduct them properly.

Travel and entertainment expenses

If you travel for business, you may be eligible for deductions on your travel expenses. This includes expenses such as airfare, lodging, and meals. Additionally, you may be able to deduct expenses related to entertaining clients or customers, such as meals or tickets to sporting events. It’s important to keep accurate records and receipts of these expenses to ensure that you can deduct them properly.

Maximizing your deductions

To maximize your deductions, it’s important to keep accurate records of your expenses and consult with a tax professional to ensure that you are deducting them properly. Additionally, it’s important to be aware of any changes to tax laws or regulations that may impact your deductions.

One way to maximize your deductions is to take advantage of tax planning strategies, such as deferring income or accelerating expenses. For example, if you have the option to defer receiving payment until the following year, it may be beneficial to do so if you expect your tax rate to be lower in the following year.

IV. Managing Income and Expenses

Managing your income and expenses effectively is essential for reducing taxable income as a business owner. Here are some tips for managing your finances:

Record keeping for tax purposes

Keeping accurate records of your income and expenses is crucial for reducing taxable income. Good record-keeping practices include keeping track of all receipts, invoices, and bank statements related to your business. This will make it easier to claim deductions and ensure that you are accurately reporting your income.

The importance of separating personal and business finances

One common mistake that small business owners make is mixing personal and business finances. This can make it difficult to accurately track income and expenses and can also lead to tax issues. It’s important to have separate bank accounts and credit cards for your personal and business finances to ensure that they are properly managed.

Managing cash flow to reduce taxable income

Managing your cash flow effectively can also help reduce your taxable income. For example, you may be able to defer income until the following year or accelerate expenses to reduce your taxable income for the current year. It’s important to consult with a tax professional to determine the best strategy for managing your cash flow.

In addition to these tips, it’s important to stay up to date with changes in tax laws and regulations that may impact your business. This includes changes to deductions and credits, tax rates, and reporting requirements.

V. Utilizing Retirement Plans

Retirement plans can be a powerful tax-saving tool for business owners. Here are some key things to consider when utilizing retirement plans to reduce your taxable income:

The tax benefits of contributing to a retirement plan

Contributing to a retirement plan can provide significant tax benefits for business owners. According to IRS data, contributions to retirement plans like traditional 401(k)s are often made on a pre-tax basis. For instance, in 2020, the maximum contribution limit for a 401(k) was $19,500, with an additional catch-up contribution of $6,500 for those aged 50 and above. This deduction from taxable income for contributions can substantially reduce your tax burden. In 2021, nearly 58 million Americans were active 401(k) participants, taking advantage of these tax-saving opportunities.

Furthermore, some retirement plans may offer additional tax benefits, as noted by financial experts like Warren Buffett, who highlighted the advantage of tax-free growth or tax-free withdrawals in retirement. These additional benefits can further amplify the advantages of utilizing retirement plans for tax savings.

Types of retirement plans available to business owners

There are several types of retirement plans available to business owners, including:

• SEP IRAs: Simplified Employee Pension Individual Retirement Accounts are easy to set up and allow for contributions of up to 25% of an employee’s compensation or $58,000 (whichever is less) in 2023.
• Solo 401(k)s: These are designed for business owners with no employees other than their spouse. Contributions can be made as both employer and employee, with a total contribution limit of $58,000 in 2023.
• SIMPLE IRAs: Savings Incentive Match Plan for Employees is designed for businesses with fewer than 100 employees. The employer matches employee contributions of up to 3% of their salary, or contributes a flat 2% for all employees.
• Traditional 401(k)s: These are the most common type of retirement plan and allow contributions of up to $19,500 in 2023, or $26,000 for those over age 50. Employers may also match employee contributions up to a certain amount.

How to choose the right retirement plan for your business

Choosing the right retirement plan for your business depends on several factors, such as

1. The size of your business
2. The number of employees you have
3. Your business goals

It’s important to consider factors such as contribution limits, administrative costs, and employee eligibility when selecting a retirement plan.

VI. Other Tax-Saving Strategies

In addition to maximizing deductions and managing income and expenses, there are other tax-saving strategies that business owners can use to reduce their taxable income. Here are some common strategies:

Timing income and expenses

Timing income and expenses can be a powerful tax-saving strategy. For example, if you expect your tax rate to be lower in the following year, you may want to defer receiving income until the following year. Similarly, if you have the option to accelerate expenses, such as by prepaying for supplies or services, it may be beneficial to do so if you expect your tax rate to be higher in the following year.

Taking advantage of carryover losses

If your business incurs a net operating loss, you may be able to carry that loss forward to future years and use it to offset future income. This can be a valuable tax-saving strategy, as it can reduce your taxable income in future years and potentially lower your overall tax liability.

Hiring family members as employees

If you have family members who are involved in your business, hiring them as employees can be a tax-saving strategy. This can allow you to deduct their salaries and benefits as business expenses, reducing your taxable income. Additionally, hiring family members can help ensure that your business remains in the family and can provide valuable employment opportunities.

It’s important to note that while these strategies can be effective for reducing taxable income, they must be used appropriately and within the confines of the law. Consult with a tax professional to ensure that you are using these strategies properly and to determine the best strategy for your individual circumstances.

Conclusion

Reducing your taxable income by starting a side business is a smart way to save money on taxes and gain more financial flexibility.

If you’re thinking about starting a side business to reduce your taxable income, now is the perfect time to take action. With proper planning and execution, a side business can bring both financial benefits and personal satisfaction. Don’t let fear or uncertainty hold you back. Consult with a financial professional to get started on your journey to financial freedom today. They can provide expert advice and guidance to help you make the most of this opportunity. Embrace the chance to save on taxes and improve your financial situation—it’s within your reach!