Operational Deductions and Family Employment

The mechanical list of business deductions — ordinary and necessary expenses under IRC §162, “Trade or business expenses”, startup costs under IRC §195, IRC §179 expensing and bonus depreciation, the home-office deduction, the R&D credit and IRC §174A expensing — is set out in section “Business Income Deductions” and is not repeated here. Neither is the IRC §163(j) cap on business interest at 30% of adjusted taxable income: a business under the $32 million three-year average gross-receipts test of IRC §448(c), “Limitation on use of cash method of accounting” is exempt from it, which covers nearly every reader; above it, the cap is real and belongs in the financing model. What that list does not cover are the structural moves that turn ordinary operations into tax savings.

Accountable plans

If your business reimburses you or your employees for business expenses incurred personally — a share of home internet, a cell phone, mileage, travel — do it through a formal accountable plan ( Treas. Reg. §1.62-2, “Reimbursements and other expense allowance arrangements”). Under such a plan, with proper substantiation, the reimbursement is a deduction to the business and tax-free to the recipient. Without one, the reimbursement is taxable wages — and because the TCJA suspended the unreimbursed-employee-expense deduction, an S-corporation owner who skips the accountable plan simply loses the deduction.

The Augusta rule

IRC §280A(g), “Disallowance of certain expenses in connection with business use of a home” lets you rent your home for up to 14 days a year without reporting the rental income at all. A business owner can rent their residence to their own company for legitimate business use — a board meeting, a planning retreat — so the company deducts the rent and the owner receives it tax-free. The rate must be defensible with documented comparables (event-venue or short-term-rental quotes), and the meetings must be real and minuted. Inflated or undocumented rates have been struck down in Tax Court; treated with discipline, the provision is sound.

Employing your children

Wages paid to a child for genuine, age-appropriate work are deductible to the business, and the child’s standard deduction shelters those wages from income tax up to the standard-deduction amount (Table 6.1). The kiddie tax does not reach earned income. Two payroll-tax exemptions run alongside, and they have different age limits and the same entity restriction: wages paid to a child under 18 are exempt from Social Security and Medicare under IRC §3121(b)(3)(A), “Definitions”, and wages paid to a child under 21 are exempt from federal unemployment tax under IRC §3306(c)(5) — both only when the employer is a sole proprietorship or a partnership owned solely by the child’s parents. Elect S-corporation status and both exemptions disappear; the corporation withholds payroll tax on the child like any other employee. The standard fix is a family management company — a sole proprietorship or spousal partnership that contracts with the corporation and employs the child — which preserves the exemptions if it does real work at a real fee. Earned income also opens the door to a Roth IRA contribution for the child, converting business profit into decades of tax-free compounding; the documentation standard and the failure modes are in section “Active Income and Custodial Roth IRAs”.

Health insurance for the S-corporation owner

The premiums the company pays for a more-than-2% shareholder are deductible, but only through a specific two-step: the premiums must be included in the owner’s W-2 Box 1 wages (exempt from FICA), and the owner then deducts them above the line as self-employed health insurance under IRC §162(l). Skip the W-2 step and the personal deduction is technically unavailable; run the premiums as a bare corporate deduction and the return is simply wrong. The same wage-inclusion rule sweeps in HSA contributions the S-corporation makes for a 2% owner. This is the most common S-corporation compliance error there is, and the fix is one line of payroll setup in December.

Employing your spouse, and the §105 plan

Hiring a spouse who does genuine work opens a deduction no other structure reaches. A sole proprietorship can adopt a written IRC §105(b), “Amounts received under accident and health plans” medical-reimbursement plan — a one-employee health-reimbursement arrangement — covering the employee-spouse’s family, which includes you. The business then deducts the family’s health premiums and out-of-pocket medical costs as a business expense, reducing income and self-employment tax instead of claiming a personal itemized deduction that rarely clears the 7.5%-of-AGI floor. The conditions are the risk: the employment must be real (timesheets, a market wage, actual duties), the plan must be in writing before any expense is reimbursed, and the structure dies in an S-corporation — IRC §318(a) attribution makes the spouse of a 2% shareholder a 2% shareholder, forfeiting the tax-free treatment. With non-family employees, the plan generally must cover them too; the QSEHRA (section “Business Income Deductions”) is the compliant multi-employee version.

Year-end timing, in both directions

A cash-basis business recognizes income upon cash receipt, not invoice issuance; December work invoiced in the first week of January moves the income a full year, legitimately, with nothing to document beyond the invoice date. On the expense side, the 12-month rule ( Treas. Reg. §1.263(a)-4, “Capitalization rules for intangibles”) lets a cash-basis business deduct prepaid insurance, rent, software, and similar costs now, provided the benefit runs no more than twelve months and not past the end of the following year. Neither move changes lifetime tax; both move income and deductions across a bracket boundary, which is the whole point of timing — and the only way to get it wrong is deferring income into a year whose bracket turns out higher.

The R&D credit against payroll tax

A company that has not yet turned a profit cannot use an income-tax credit, which is why IRC §41(h), “Credit for increasing research activities” lets a qualified small business — under $5 million of gross receipts in the credit year and no gross receipts at all more than five years back — elect to apply up to $500,000 of its research credit a year against the employer share of Social Security and Medicare tax on Form 941, beginning the quarter after the return claiming it is filed. For a pre-revenue software or hardware company paying engineers, this is cash in the year the work is done, not a carryforward. Make the election on Form 6765, “Credit for Increasing Research Activities” with the timely-filed original return — it cannot be made on an amended one — and it is available for five years.