Business Structure, the QBI Deduction and Timing Income

Once a business earns steady profit, two questions start to matter more than any single deduction: how the business is taxed, and in which year its income lands. The answers can change a self-employed person's tax by more than every receipt they keep, and they are the subject of a lot of confident advice that ignores the costs. This chapter explains the default treatment of a one-owner business, the 20% qualified business income deduction, when an S corporation election helps and what it costs, and how to time income and expenses across years.

The default: a sole proprietor or single-member LLC

If you start working for yourself and do nothing else, you are a sole proprietor. Forming a single-member limited liability company changes your legal protection, not your federal tax: by default the IRS treats it the same way, as a "disregarded entity". Either way, profit goes on Schedule C, income tax applies at your marginal rate, and self-employment tax applies to almost all of the profit, as chapter 4 explained. A business with two or more owners is taxed by default as a partnership, which works similarly for each partner's share.

This default is simple and cheap. Everything else in this chapter is a way to improve on it, each with costs.

The qualified business income deduction

Owners of pass-through businesses (sole proprietorships, partnerships, S corporations and LLCs taxed as one of those) can usually deduct 20% of their qualified business income. It is taken on the personal return, whether or not you itemize, and it lowers income tax but not self-employment tax. The 2025 law made it permanent.

The deduction is the smaller of 20% of qualified business income and 20% of taxable income before the deduction (not counting net capital gains). Qualified business income is the business's net profit, reduced by the deductible half of self-employment tax, self-employed health insurance and retirement plan contributions. Wages an S corporation pays its owner are not qualified business income.

A single owner whose income is $90,000, all of it qualified business income, has $73,900 of taxable income after the standard deduction and owes $10,970. A deduction of one fifth of that taxable income lowers the tax to $7,718, the same as if income had been $75,220.

Below taxable income of $201,750 for a single filer, or $403,500 on a joint return, the simple 20% rule is all there is. Above those levels, two limits phase in. The deduction becomes limited by the W-2 wages the business pays and the cost of its property, which hurts businesses with no employees. And for a specified service trade or business, such as health, law, accounting, consulting, financial services, performing arts, athletics, or any business whose main asset is the skill or reputation of its owners, the deduction shrinks to nothing over the phase-in range. Engineers and architects are not on that list. Owners near the threshold can sometimes stay under it with retirement plan contributions, which lower taxable income.

The S corporation election

An LLC or corporation can elect to be taxed as an S corporation. The business then pays the owner a salary through payroll, with Social Security and Medicare tax withheld and matched, and the rest of the profit passes to the owner as a distribution. Distributions are subject to income tax but not to payroll or self-employment tax. That is the whole saving: the payroll tax on the part of profit taken as a distribution, 15.3% of it below the Social Security wage base of $184,500 and 2.9% above it.

The catch is that the salary must be reasonable compensation: what the business would pay someone else to do the work you do. An owner who takes a token salary to avoid payroll tax risks the IRS reclassifying distributions as wages, with back taxes, interest and penalties. Industry pay surveys, job listings for similar roles and the hours you work are the usual evidence.

The election also brings costs and side effects that often go unmentioned.

• Running costs. Payroll every pay period, quarterly payroll returns, a separate business tax return (Form 1120-S) due in March, usually a bookkeeper or preparer, and in some states an entity-level tax or minimum fee, plus state unemployment insurance.
• A smaller qualified business income deduction. The salary is not qualified business income, so the 20% deduction applies to less.
• Smaller retirement contributions. A solo 401(k) employer contribution is 25% of W-2 salary, so a lower salary means a lower contribution.
• A smaller Social Security benefit. Benefits are based on earnings that paid Social Security tax, and distributions do not count.
• Less flexibility. Distributions must be in proportion to ownership, and moving property out of an S corporation can trigger tax.

The saving grows with the gap between profit and a reasonable salary. For a business whose profit is close to what the owner's work would cost to hire, there is little to gain and the costs remain. A preparer can model your numbers; the 1099 vs W-2 calculator shows the payroll tax difference between being paid as a contractor and as an employee.

Multi-entity structures. Some advisers recommend owning your building or equipment in a separate LLC and leasing it to your business, or splitting one business into several. These can be legitimate, for liability or estate reasons, but the rent must be at market rates, rental income from your own business is generally not passive income, and the qualified business income rules treat related businesses together in several ways. Arrangements sold mainly to multiply deductions tend to fail when the IRS looks at their substance.

Timing income and deductions

Because tax rates rise in steps, the same total income costs less when it is spread evenly than when it is bunched into one year.

A single filer who earns $150,000 one year and $50,000 the next pays $24,734 plus $3,820. Earning $100,000 in each year instead costs $13,170 twice, less in total for the same income. The strong year reaches the 24.0% bracket; the even years stop at 22.0%.

Most small businesses use the cash method, which taxes income when received and deducts expenses when paid. That gives some control near year end:

• To defer income, invoice late-December work in January, as long as you have not already received the payment or had it made available to you. Money received in December is income in December, even if you deposit it later.
• To accelerate deductions, pay deductible bills and buy needed equipment before December 31. Equipment must be placed in service by year end. Prepaying expenses generally works only for benefits that end within 12 months and do not extend beyond the next year.
• Reverse both if you expect a higher rate this year than next: a big contract coming, a spouse returning to work, or a change in the law.

Lower-income years open other moves: realizing long-term capital gains in the 0% band (chapter 6) or converting part of a traditional IRA to Roth at a low rate. The Roth conversion calculator shows the tax cost of a conversion at your income. Employees whose 401(k) plans allow after-tax contributions and in-plan conversions can also use the mega backdoor Roth calculator to see how much extra Roth saving the plan allows.