Tax season is here, as is the dreaded fear of having to owe too much in taxes (or the joy of knowing you’ll get tax refunds).
The Tax Cuts and Jobs Act of 2017 significantly reduced the corporate income tax rate from 35% to a 21% flat rate and reduced the personal income tax bracket threshold at all levels of income wage earners.
Many of these tax breaks expire in 2025, though corporate income tax cuts were made permanent for resident corporations, unlike the personal income tax brackets slated to revert to pre-TCJA rates on January 1, 2026. With 99.9% of all U.S. companies being small businesses (there are 32.5 million), the expiration of TCJA will become a challenge for many business owners.
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Whether you’re a small-business owner or sole proprietor paying self-employment taxes, it is everyone’s goal to minimize tax exposure — legally.
How to minimize tax exposure
It is common to fear increased taxes when trying to maximize your return on investment. ROI is the performance ratio assessing the efficiency of your business investments against net income.
Hardy Desai, founder of Supple, says, “The higher the net income, the higher the tax base for your income tax dues. It is safe to say that, generally, (taxable) net income and tax dues are directly proportional to each other.”
However, the U.S. tax code includes tax deductions, tax breaks and tax credits that small-business owners can use to legally minimize their tax exposure while maximizing their ROI.
1. Offer and set up a 401(k).
In terms of tax breaks and tax deductions, we cannot rule out the option of taking advantage of defined-contribution plans like 401(k)s.
For business owners with employers, not a lot know that offering a 401(k) to your employees aren’t just expenses per se — they’re deductible expenses from your taxable income to reduce your tax exposure, as your employer contributions are considered part of employee benefits.
Brooke Webber, head of marketing at Ninja Patches, adds, “The better news about business owners offering a 401(k) is that deductible expenses related to the contribution aren’t limited to the portion of your contributions. The costs of managing the contribution plan, including administrators, bookkeepers and consultancy fees, are also deductible expenses that you can include to lower your taxable income.”
Self-employed individuals can also set up a solo 401(k) plan through online or traditional brokers, or a financial services company, for retirement preparation and to take advantage of potential tax savings in the process.
Tax-savings-wise, the issue with 401(k)s is the question of “when" is the best time to get taxed for these retirement contributions. The 401(k) comes in two types — traditional and Roth — with the traditional 401(k) receiving pre-tax contributions, while the Roth 401(k)’s contributions are after-tax, which means you won’t be taxed later when you withdraw your money.
Generally, many experts recommend opting for Roth 401(k) or Roth conversions, which is understandable because, after all, it is better to pay taxes now and enjoy tax-free withdrawals later, especially when you might expect a higher income bracket in retirement. Across-the-board tax increases may also affect taxability and tax dues for future withdrawals.
Michael Maximoff, co-founder and managing partner at Belkins, says, “The instability of tax increases and regulations made us decide to offer Roth options to our employees who want to feel secure about tax-free withdrawals later on.”
However, in the context of maximizing ROI and minimizing tax exposure now, a traditional 401(k) gives you the leverage of paying lower taxes for each year of contributing to the plan by deducting pre-tax 401(k) from your taxable income, but treating withdrawals as ordinary income taxable with that year’s applicable tax brackets.
Let’s say you earn an income of $100,000 a year and contribute $20,000 of your income to a traditional 401(k) plan. This means you will be taxed on only $80,000 instead of $100,000 for the year.
Note: For 2024, individuals can contribute up to $23,000 to their 401(k), an increase of $500 from the 2023 limit of $22,500.
The real dilemma in choosing which 401(k) plan ultimately boils down to which point in time you wish to be taxed — today or later. It is also important to consider the tax effects and economic changes when postponing tax payments on defined-contribution plans like 401(k).
2. Leverage tax credits.
While tax deductions lower your tax base, tax credits are deductions from your final tax due.
The Inflation Act of 2022 provided new and extended tax credits and deductions for individuals, businesses, tax-exempt entities and government entities.
Some of these tax credits include:
- Clean vehicle tax credits. Tax credits up to $7,500 are available for qualified electric vehicles (EV) or fuel cell vehicles (FCV), subject to use conditions and adjusted gross income requirements.
- Home energy tax credits. Tax credits up to a maximum of $1,200 for qualifying improvements made to a residential structure. Claiming these tax credits for structures not used for residence is not allowed. Residential clean energy credits are also available for those who use renewable energy sources for up to 30% of their improvement expenses with no limit.
- Work Opportunity Tax Credit. Tax credits for businesses employing individuals from targeted groups for up to their first and second year of salaries.
- Research Activities Credit. Tax credits are available for businesses that devote research and development costs to a product's improvement, efficiency and performance, contributing to economic benefits.
Morgan Taylor, co-founder of Jolly SEO, says, “Inclusivity and equal opportunities for all job seekers must be, and should be, a priority for organizations of all types and sizes. We believe the IRS is taking the right step in supporting targeted groups by giving tax credit benefits to businesses employing them, which is a win-win situation.”
Many more tax credits are available for individual and corporate business owners as outlined on the IRS website.
3. Make charitable donations.
One of the most popular tax minimization strategies businesses lean toward is charitable contributions. Aside from societal contributions, charitable cash contributions to qualified organizations allow business owners to claim up to 60% of their adjusted gross income (AGI) through 2025. When donating property, the property's fair market value is used as the basis.
Taxpayers with charitable donation deductions must itemize them on Schedule A of IRS Form 1040.
According to Jerry Han, CMO at PrizeRebel, “Favorable tax treatments for charitable organizations benefit both the donor and donee. The donee gets funds, while the donor can benefit from tax deduction benefits. However, some tax regulations, like the TCJA, have disadvantaged charitable deduction benefits for donors — thereby discouraging donors from choosing itemized deductions and opting for standard deductions instead.”
Is minimizing tax exposure illegal?
A good number of people have asked me whether minimizing tax exposure is illegal — it is not.
This may have come from the misunderstanding of tax avoidance and tax evasion, both similar in concept yet different in execution.
Conceptually, tax avoidance and tax evasion have the same goal — minimize your taxes. Both have overlapping methods for lowering taxes. What may seem like tax avoidance initially can come off as tax evasion once abused.
For example, certain research and development (R&D) costs can qualify as tax credits to lower income tax liability, typically at 6% to 8% of a company’s R&D costs. However, inflating tax credits by manipulating documentation to qualify as R&D tax credits to pay lower income tax is considered tax evasion.
Shawn Plummer, CEO of The Annuity Expert and a Kiplinger Building Wealth contributor, says, “The thin line between tax avoidance and tax evasion is the intent to deceive regulatory authorities and manipulate data to pay lower taxes. Tax fraud or tax evasion is a criminal violation resulting in up to five years of imprisonment or a $500,000 fine.”
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This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.
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