How to Reduce Taxable Income With a Side Business Effectively

Earning extra income through a side business can be rewarding, but it also comes with tax responsibilities. Fortunately, there are ways to reduce taxable income legally while running your business efficiently. By taking advantage of deductions and strategic planning, you can keep more of what you earn.

Understanding how to structure your business expenses and contributions can significantly impact your tax bill. Proper planning ensures you’re not overpaying while staying compliant with IRS rules.

Choosing a Tax-Efficient Structure

How you set up your side business affects both your tax liability and income reporting. Many start as sole proprietors because it’s the simplest option, but all profits are subject to self-employment tax, which is 15.3% in 2024. This can add up quickly, especially if your business generates significant income.

Forming a Limited Liability Company (LLC) provides legal protection, but by default, an LLC is taxed like a sole proprietorship unless an election is made. Electing S Corporation (S-corp) status can be more tax-efficient. With an S-corp, you can pay yourself a salary and take the remaining profits as distributions, which are not subject to self-employment tax. For example, if your business earns $80,000 and you take a $40,000 salary, only that portion is subject to payroll taxes, while the remaining $40,000 avoids the 15.3% self-employment tax.

If you have a business partner, a partnership allows income to pass through to individual tax returns, avoiding corporate taxation. However, partners must pay self-employment tax on their share of earnings. For highly profitable businesses, a C Corporation (C-corp) may be worth considering. While C-corps face double taxation—once at the corporate level (21% federal rate) and again when dividends are distributed—they allow more deductions and benefits, such as retaining earnings at a lower tax rate.

Deductible Business Expenses

Running a side business comes with various costs, many of which can be deducted to lower taxable income. Ordinary and necessary expenses directly related to the business qualify for deductions under the Internal Revenue Code. These include advertising, office supplies, travel, and professional services such as accounting or legal fees. Keeping detailed records is essential, as the IRS requires proof of expenses in case of an audit.

Marketing and advertising costs are fully deductible, including website development, social media ads, business cards, and promotional materials. If you spend $5,000 on digital marketing campaigns, that entire amount can be deducted. Similarly, costs associated with maintaining a business website, such as domain registration and hosting fees, qualify as deductions.

Professional development expenses related to improving business skills may also be deducted. If you take an online course or attend industry conferences, registration fees, travel costs, and educational materials can qualify. However, the IRS specifies that the education must maintain or improve skills required for the business and cannot be for a new career. For instance, a freelance graphic designer taking an advanced Photoshop course can deduct the cost, but enrolling in a real estate licensing program would not qualify.

Business-related travel expenses, including flights, hotels, rental cars, and meals, are deductible if the trip has a legitimate business purpose. If a consultant travels to a conference, airfare and lodging are deductible, but additional personal sightseeing costs are not. The IRS allows a 50% deduction on meals during business travel, so if a business owner spends $200 on meals while attending a conference, they can deduct $100.

Vehicle expenses can also reduce taxable income if the car is used for business. The IRS allows two methods for calculating this deduction: the standard mileage rate and actual expenses. In 2024, the standard mileage rate is 67 cents per mile. If a business owner drives 5,000 miles for work-related purposes, they can deduct $3,350. Alternatively, they can deduct a percentage of actual vehicle expenses, including gas, maintenance, insurance, and depreciation, based on business use.

Home-Workspace Costs

Using a portion of your home for business can lead to tax savings through the home office deduction. To qualify, the space must be used exclusively and regularly for business purposes, as outlined in IRS rules. A desk in the corner of a bedroom that is sometimes used for personal tasks would not qualify, but a separate home office dedicated to business operations would.

There are two methods for calculating this deduction: the simplified method and the regular method. The simplified method allows a deduction of $5 per square foot, up to 300 square feet, for a maximum deduction of $1,500. The regular method involves determining the percentage of the home used for business and applying that percentage to eligible costs such as mortgage interest, rent, property taxes, utilities, insurance, and maintenance. If a home office occupies 10% of a 2,000-square-foot house, then 10% of qualifying home expenses can be deducted.

Repairs and maintenance specific to the home office, such as painting or installing new lighting, can be fully deducted. General home repairs, like fixing a roof or replacing an HVAC system, must be prorated based on the percentage of the home used for business. Depreciation on the home’s value may also be claimed, though this can result in depreciation recapture tax when the home is sold, requiring careful planning.

Retirement Contribution Opportunities

A side business creates opportunities to reduce taxable income through retirement contributions. Unlike traditional employment, where retirement plans are often limited to an employer-sponsored 401(k), self-employed individuals have access to multiple tax-advantaged savings vehicles with higher contribution limits.

One option is the Simplified Employee Pension (SEP) IRA, allowing contributions of up to 25% of net earnings, with a maximum of $69,000 in 2024. This plan benefits high earners, as contributions are tax-deductible and grow tax-deferred until retirement. Another alternative is the Solo 401(k), which permits both employer and employee contributions, enabling self-employed individuals to contribute up to $23,000 as an employee, plus up to 25% of net earnings as an employer, with a combined cap of $69,000 ($76,500 for those over 50). The Solo 401(k) also allows Roth contributions, providing tax-free withdrawals in retirement.

Health Insurance Factors

Self-employed individuals, including those running a side business, can deduct health insurance premiums for themselves, their spouse, and dependents. This deduction applies to medical, dental, and long-term care insurance, provided the business generates a net profit and the individual is not eligible for an employer-sponsored plan. Unlike itemized deductions, this is an above-the-line deduction, meaning it directly lowers adjusted gross income (AGI), which can also impact eligibility for other tax benefits.

For those with high medical expenses, a Health Savings Account (HSA) offers additional tax advantages. If enrolled in a high-deductible health plan (HDHP), contributions to an HSA are tax-deductible, grow tax-free, and can be withdrawn tax-free for qualified medical expenses. In 2024, individuals can contribute up to $4,150, while families can contribute up to $8,300, with an additional $1,000 catch-up contribution for those 55 and older. Unlike Flexible Spending Accounts (FSAs), HSA funds roll over indefinitely, making them a valuable long-term savings tool.

Timing of Income and Expenses

Strategically managing when income is recognized and expenses are incurred can optimize tax liability, particularly for cash-basis taxpayers, who report income when received and expenses when paid. By deferring income to the following year or accelerating deductions into the current year, business owners can shift taxable income to a lower bracket.

For example, if a side business expects higher earnings in the current year but lower income in the next, delaying invoicing until January can push taxable income into the following tax year. Conversely, prepaying deductible expenses, such as office supplies or professional memberships, before year-end can increase deductions in the current year. This approach is particularly useful for those nearing income thresholds that affect tax credits or phaseouts, such as the Qualified Business Income (QBI) deduction, which begins to phase out for single filers earning over $191,950 in 2024.