For many business owners, taxes can feel like a never-ending burden. Running a business is hard enough, and you may often find yourself “doing what you are told” to take care of the taxes. After piling on a rental enterprise on the side, your spouse’s income, or any outside jobs you have, it’s no wonder why taxes can be confusing. Inevitably, this leads to surprising tax bills and missed opportunities. When it comes to proper tax planning, understanding how your income is taxed is the first step to lowering your lifetime tax bill.
Separating Business and Personal Income
Many small business owners may not realize the consequences of mixing their business and personal income. Profits from the business can get mixed in with money outside the business, like other salaries, rental income, income from a spouse, etc. Then, when the time comes to pay taxes, people can feel overwhelmed by paying a large tax bill out of their total income. That is why it is important to plan for business income taxes separately. Having a dedicated business account just for your quarterly tax payments is a great example. Set aside money that is solely responsible for paying taxes on business profits. Not only will this make your quarterly tax payments easier, but it will also improve both your tax planning and cash flow management.
There is a general rule of thumb here: the accounts or assets that generate the income should be responsible for the tax created. Allocating some revenue to a savings account earmarked for taxes is one example. Another example could be selling real estate. Setting aside funds to pay off any capital gains after the sale could smooth over a large tax bill the following April. Even brokerage accounts that generate dividends and interest could apply. If they are large enough, it may be wise to take a distribution for the taxes. This rule does not apply to every situation, but it can prime you to a higher level of “tax awareness” with your income sources.
Additional sources of income can also make the picture more complex. Salary from a spouse or from a second job you may have needs to be accounted for when it comes to taxes. The payroll for these salary positions should automatically withhold taxes for you. While it’s nice that you do not need to save the taxes yourself, it does require a W-2 form come tax time, and that income will be coded differently from your business income. This is why taxes can feel complicated, since your salary income would show up on the 1040 form of your tax return while your business income could show up on multiple other forms (depending on your business structure). This is why a quality accountant is so important, to help you properly file the different incomes you have each year.
Understanding Business Structure
Your business structure is very important when it comes to the filing and taxation of your income. Many times, business owners do not understand the implications of filing as a sole proprietor, partnership, or corporation. Instead, they open an LLC because that is what they were told to do. LLCs provide great legal protection, but they are not tax structures. As a result, owners need to elect (or are defaulted to) one of the other structures for tax purposes. An LLC taxed as a sole proprietor or partnership, therefore, will have different tax implications than electing to be taxed as a corporation.
Businesses filing taxes as sole proprietors or partnerships are considered pass-through entities. This means that the revenue, expenses, and profits from the business pass through the business and “live” on the owner’s personal tax return. This means two things. First, business profits must be recorded on your personal tax return separately from any personal income (as mentioned above). Second, this income is not only included for personal income tax purposes, but there is also self-employment tax required (15.3% of the business income). It becomes quickly apparent why small business owners are motivated to reduce their taxes.
Corporations or LLCs electing a corporation status can complicate matters as well. Sometimes this can lead to more taxes or less, depending on the company. For example, an LLC filing as an S-corporation (which would technically still be pass-through entities) must pay a reasonable salary to the owners who work in the business. Afterwards, any remaining distributions of profits are not subject to the 15.3% self-employment tax. Given the right company and income structure, this could reduce taxes by thousands of dollars. C-Corporations, on the other hand, are not pass-through entities. In 2025, profits are initially taxed at the corporate tax rate of 21%, and then any dividends paid out to shareholders are subsequently taxed again on the individual’s tax return. While the “double taxation” may appear negative at first, some companies and owners can benefit greatly from structuring as a corporation, especially those planning to raise capital, bring on investors, and/or potentially sell the company.
How Small Business Owners Get Taxed
Given all the moving parts, understanding how all income is taxed can help business owners make more informed decisions. Remember, income from pass-through entities is taxed as ordinary income. For federal tax purposes, the business income will be included with any other income outside the business, and then the tax will be based on the total income for the household. The calculation is also affected by capital gains. Capital gains on investments held for over a year typically qualify for lower tax rates (0%, 15%, or 20% in 2025) rather than being taxed at ordinary income rates. For those with a higher marginal tax rate (like 30% plus), it may be beneficial to prioritize long-term capital gains since they may only be taxed at 15 or 20%.
Then, separately, you must address the self-employment taxes, which are Social Security and Medicare. Wage income already accounts for this through payroll and W2 forms, but profits of pass-through entities must pay this tax as well. This will likely show up as additional taxes on your tax return. Combining your self-employment taxes with your ordinary income taxes can be a shock to business owners once they understand this. Instead of the typical tax bracket you are accustomed to, the additional 15.3% tax on business income can significantly increase your tax bill.
Ultimately, after all the income is properly filed, owners naturally want to turn their focus to deductions. On the personal side, the standard (or itemized) deduction is the default option to reduce ordinary income. After that, strategies like contributions to a retirement account could help. On the business side, access to additional deductions can significantly help the tax situation. This could include the qualified business income deduction, retirement plan contributions, home office deductions, mileage, wages, business expenses, and much more.
Taxes Can Be Complicated
At the end of the day, taxes do not have to be a mystery. A larger tax bill is usually a byproduct of more income, which is good. As long as you can create a tax planning strategy to account for your taxes (whether through separate accounts, an organized payroll system, etc.), tax season does not have to be difficult. The different income sources you have and the structure of your business can impact your taxes dramatically. As a result, it is important to understand how each income is taxed and the potential options you have to adjust your tax strategy.
TC Falkner 