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M09 · Module 9 of 11

Business & side income

Owning a business, even a side practice that earns alongside a W-2 job, gives you control over how the income is taxed, how you pay yourself, what you can deduct, and how much you can shelter for retirement. This module explains those structural choices and the tax mechanics behind each.

What you’ll take away

  • How a sole proprietorship, an S-corp, and a C-corp are each taxed, and the tradeoffs among them.
  • Why an S-corp owner splits pay between salary and distributions, and what limits the split.
  • How the QBI deduction works and where it phases out, and how a PTET election recovers a deduction the SALT cap took away.
  • Which retirement plans let owners shelter far more than an employee can.
  • How buy-sell agreements, succession planning, and key-person insurance protect the business and the family.

Choosing how your business is taxed

A business has a legal form and a tax form, and they are separate questions: you can run a single-member LLC for liability protection and still be taxed as a sole proprietor, an S-corp, or a C-corp. The wrapper protects your personal assets; the tax election decides how the income is reported and what you owe, and it usually matters more for the bill.

A sole proprietorship (or a single-member LLC, which the IRS disregards by default) reports business profit on your personal return, subject to ordinary income tax and to self-employment tax, the self-employed version of Social Security and Medicare. An employee pays half of those payroll taxes and the employer pays the other half; a sole proprietor is both and pays the full combined rate on net earnings, up to the Social Security wage base of $184,500 (2026), $176,100 (2025) and with no cap on the Medicare portion. You can deduct half of the self-employment tax above the line, but the full rate still applies to every dollar of profit, and it is the cost most new owners underestimate.

An S-corp is an election, not a separate kind of company. An LLC or a corporation elects S-corp treatment, the entity pays no federal income tax, and profit passes through to the owner’s return as in a sole proprietorship. What changes is payroll. An owner who works in the business is an employee of it and must take a salary, which carries payroll tax; profit left over is paid as a distribution, which carries none. That gap is the entire reason owners elect S-corp status. The cost is administrative: payroll filings, a separate return, and bookkeeping clean enough to defend the salary figure.

A C-corp is a separate taxpayer. It pays corporate income tax on its profit at the rate of 21% (2025 and 2026), and when it distributes profit as a dividend the shareholder pays tax again, the double taxation that leads most small businesses to avoid the C-corp. Two things still make one worth a look. Reinvested profit compounds inside the lower corporate rate, deferring the second tax layer. More important for founders, original C-corp stock can qualify as Qualified Small Business Stock, which can exclude a large share of the gain at sale; QSBS attaches only to C-corp stock, so a founder who expects an exit may accept double taxation on operating profit to keep that path open. Its mechanics are covered in QSBS for C-corp founder stock.

There is no single right answer: a thin-margin solo consultant may stay a sole proprietor, a profitable services business often elects S-corp, and a venture-backed startup is almost always a C-corp. The entity-selection helper compares the three under your numbers, showing the framework rather than picking for you; the choice is one to make with a CFP and a tax attorney.

Splitting pay between salary and distributions

An S-corp owner pays themselves in two streams: a salary, run through payroll and subject to Social Security and Medicare tax, and a distribution of remaining profit, subject to income tax but not to payroll tax. Because the distribution escapes payroll tax, owners feel a pull toward a small salary and a large distribution. On a business clearing $300,000, taking it all as salary loads the whole amount with payroll tax, while a reasonable salary plus a distribution of the rest taxes only the salary. Since the Medicare portion has no wage cap, the savings continue even past the Social Security wage base of $184,500 (2026), $176,100 (2025) and can reach five figures a year on a healthy profit.

Reasonable compensation is the constraint that holds the split in place. Tax law requires an owner-employee to be paid a salary comparable to what the business would pay an unrelated person for the same role. Set it too low and the IRS can recharacterize distributions as wages, then assess back payroll taxes, interest, and penalties. Reasonable is judged on facts: the owner’s role and hours, their experience, what comparable positions pay, and how much of the profit comes from the owner’s labor versus from capital or employees. A sole-producer surgeon cannot pay themselves a clerk’s wage.

So the split is a balance. Too high a salary overpays payroll tax; too low invites recharacterization and weakens other things that key off salary, including the retirement-plan contributions below and, in some cases, the QBI deduction. A defensible salary is documented and consistent year to year, and setting the figure is a judgment call for a CFP and a tax professional.

How the QBI deduction works, and when it phases out

Section 199A gives owners of pass-through businesses a deduction of up to 20% (2025 and 2026) of their qualified business income, roughly the net profit from a pass-through (a sole proprietorship, partnership, or S-corp), with some adjustments. The deduction comes off taxable income, so on $100,000 of qualified income it shaves a meaningful slice off the amount taxed.

Above a taxable-income threshold the rules tighten, and the first thing that matters is whether your business is a specified service trade or business. An SSTB is one whose principal asset is the reputation or skill of its people: health, law, accounting, consulting, financial services, performing arts, athletics, and similar fields. For an SSTB owner, the deduction phases out completely once taxable income rises above $403,500 (2026), $394,600 (2025) (married filing jointly) or $201,750 (2026), $197,300 (2025) (single), across a phaseout range of $150,000 (2026), $100,000 (2025), so a high-earning doctor, lawyer, or consultant above the top of that range gets no QBI deduction at all. By design it favors businesses that build or sell things and employ people.

For a non-SSTB above the same threshold, the deduction survives but two activity tests cap it: it is limited to the greater of 50% (2025 and 2026) of the W-2 wages the business pays, or a smaller percentage of wages plus a percentage of the unadjusted basis of qualified property the business holds. These reward businesses that pay employees or own capital, so a manufacturer with a payroll and a plant clears the tests easily while a high-income solo owner with no W-2 wages and little property may find the deduction limited. This connects back to the salary decision: the salary an S-corp owner pays themselves counts as W-2 wages, so pushing it too low to save payroll tax can shrink the QBI deduction.

Below the threshold none of this applies, and the deduction is the straight percentage regardless of SSTB status or wages, so the same business can get a clean deduction at one income and a limited or zero one at a higher income. The QBI deduction estimator runs your numbers through the SSTB question, the thresholds, and the wage and property tests; the moves that follow are for a CFP.

Working around the SALT cap with a pass-through entity tax

Federal law caps the deduction for state and local taxes on a personal return at $40,400 (2026), $40,000 (2025), which strands a large amount of state tax for a high earner in a high-tax state. A pass-through entity tax, usually shortened to PTET, is a state-level workaround that most states with an income tax have adopted and the IRS has blessed.

The mechanism is a shift in who pays the state tax. Instead of paying state income tax personally on the business profit, the owner has the pass-through entity elect to pay it at the entity level, where state taxes are an ordinary business expense not subject to the personal SALT cap. The entity deducts the tax it paid, lowering the profit that flows through to the owner’s federal return, and the owner claims a state credit for what the entity paid, so the income is not taxed twice. State tax that the personal cap of $40,400 (2026), $40,000 (2025) would have stranded becomes federally deductible again, a considerable saving on substantial pass-through income.

The details vary state by state. Some states make the election annually and irrevocably, some grant a deduction rather than a dollar-for-dollar credit, the timing of the payment determines which year the deduction lands, and no-tax states have no PTET at all. PTET also depends on the current SALT cap, so a future change to that cap could reduce or remove its value. Whether to elect, and when to pay, is a state-specific decision to settle with a CFP and a tax preparer who knows your state’s version.

Retirement plans that let owners shelter far more

An employee defers their own salary up to the 401(k) limit and takes whatever match the employer offers. A business owner is both the employee and the employer, controls the plan, and contributes from both sides, which is why an owner can shelter far more at the same income. The right plan depends on profit, the owner’s age, and whether there are employees, and these designs build on the account fundamentals in the account basics owner plans build on.

A solo 401(k) is the workhorse for an owner with no employees other than a spouse. The owner contributes as an employee, up to the deferral limit of $24,500 (2026), $23,500 (2025), and again as the employer, up to an additional share of compensation, with the combined total capped at $72,000 (2026), $70,000 (2025). A profitable solo business reaches that cap far faster than an employee relying on salary deferral alone. A solo 401(k) can also allow Roth and, in some plans, after-tax contributions that open a mega-backdoor path, which connects to coordinating owner-plan contributions with Roth strategies.

A SEP-IRA is simpler: contribution is purely employer-side, a percentage of compensation up to the same overall cap of $72,000 (2026), $70,000 (2025), with no annual filing in most cases. Its weakness shows up with employees, since a SEP generally requires the owner to fund the same percentage of pay for eligible staff as for themselves. For a no-employee owner, a solo 401(k) usually reaches the same cap at a lower profit level.

A cash-balance plan is where the numbers get large, built for an older, high-earning owner with steady profit. It is a defined-benefit pension: rather than capping at a fixed contribution, it targets a future benefit, and the allowable annual contribution is whatever an actuary calculates is needed to fund it. Because an older owner has fewer years to fund the same benefit, the permitted contribution rises steeply with age and can reach several hundred thousand dollars a year, far beyond any defined-contribution limit, and owners typically stack one on top of a 401(k). The tradeoffs are real: it requires consistent annual funding (a pension promise, not an optional contribution), carries actuarial and administrative cost, and obligates a business with employees to fund benefits for them. For a 55-year-old owner of a profitable practice who is behind on saving, nothing else comes close. The retirement plan-design comparator models a solo 401(k), a SEP, and a cash-balance-plus-401(k) stack against your profit and age, with the design routed to a CFP and a plan administrator.

Running business deductions on principle

A real business deduction lowers taxable income, and an owner has access to legitimate deductions an employee does not. The standard is that the expense be ordinary and necessary: common in your line of work and helpful and appropriate to it. Software, professional services, a home office used regularly and exclusively for the business, travel, and the employer share of retirement contributions all qualify when they are genuine business expenses tracked with records.

The discipline is in the line between a real expense and an aggressive game. Deducting a family vacation as business travel or inventing a home office that is really a dining table invites disallowance, penalties, and a costly audit, while good substantiation and separate accounts turn a legitimate deduction into a settled fact. Claim everything you are entitled to and nothing you are not.

Buy-sell agreements, succession, and key-person coverage

A business is often a family’s largest asset, and these tools matter most when it has more than one owner or an owner it cannot easily replace.

A buy-sell agreement is a contract among the owners that sets, in advance, what happens to an owner’s stake on a triggering event: death, disability, divorce, departure, or dispute. It fixes who may buy the departing interest, at what price or valuation method, and on what terms, so a co-owner’s death cannot leave the survivors in business with the heirs or watching the heirs sell to a stranger. It takes one of two forms, a cross-purchase where the remaining owners buy the share directly or a redemption where the business buys it back, and the choice affects the survivors’ tax basis and the funding.

Funding is what makes a buy-sell work, since the obligation to buy a deceased owner’s share is only as good as the survivors’ ability to pay for it, and life insurance is the usual source. In a cross-purchase the owners insure each other; in a redemption the entity insures each owner; either way a death produces the cash to buy at the agreed price, and disability buyout insurance does the same for a triggering disability. Because who owns and pays for the policies has tax consequences, a buy-sell is drafted by an attorney and funded with input from a CFP and an insurance professional.

Key-person insurance protects the business itself rather than the ownership transfer. Many small businesses depend on one person whose departure would damage revenue, a founder with the client relationships or a rainmaker no one can quickly replace. The business owns a policy on that individual, and the payout covers the disruption and the gap until operations stabilize; a lender or investor may require it. Succession planning is the wider frame: who runs the business next, how leadership transfers to a family member or outside buyer, and how the owner converts a lifetime of equity into retirement income. These are legal and personal decisions as much as financial ones, squarely where the platform hands off to a CFP and an estate attorney; see estate planning that coordinates with a business succession.

Putting it together

Owning a business hands you levers an employee does not have. The tax election sets the foundation and its tradeoffs, from self-employment tax to double taxation to the QSBS path only a C-corp keeps open. Inside an S-corp, the salary-versus-distribution split saves payroll tax within the limit of reasonable compensation. The QBI deduction shaves a slice off pass-through income until your income and business type phase it out, a PTET election recovers a state-tax deduction the SALT cap removed, and owner retirement plans shelter far more than any employee can. A buy-sell agreement, key-person coverage, and a succession plan protect the asset and the family at exit. Each is a framework you can now reason about; the moves for your situation are where a CFP comes in.

Connections

This module explains how these strategies work. For what to do in your own situation, the platform hands off to a CFP.