W2 employees have limited deductions, but business owners can turn spending into deductible expenses. Passive or non-passive status controls whether losses offset other income. Active involvement and smart structuring can reduce total tax. You can take simple steps today to move from passive to non-passive, and to plan ahead.

Why W2 employees often pay more

W2 income is taxed at ordinary rates, and your employer covers most costs meaning you cannot deduct many of your own costs. You have few levers to reduce your taxes. Your main options are retirement contributions and itemized deductions. These options help, but they are limited.

For an overview of how W2 income is taxed and what deductions apply, see the official IRS guidance on Taxable and Nontaxable Income, it’s a reliable reference for understanding what’s included in gross income and what’s not.

Why business owners often pay less

Business owners can convert ordinary spending into deductible business expenses. They can time income and deductions, use Real Estate Professional Status, S-Corporation planning, cost segregations and other different tools throughout the year which give them more control over tax outcomes.

Passive versus non passive income

Passive income includes rental income and business income when you do not materially participate. The passive activity rules limit losses, and passive losses do not offset W2 wages or any other non-passive income. Passive losses carry forward until you have passive income or sell the activity.

Non passive income comes from a trade or business when you materially participate. Non-passive losses can only offset other non-passive income. One clear test is five hundred hours of work in the activity during the year. There are other tests, but the five-hundred-hour test is simple to use.

Real Estate Professional Status

Real Estate Professional Status is a special rule. You must spend more than half of your personal service time and at least seven hundred fifty hours in real property trades or businesses. You must also materially participate in your rentals. If you meet these rules, your rental losses are non-passive. Those losses may offset W2 wages or business profits, and this can create large tax savings when combined with cost segregation and bonus depreciation.

How high earning W2 taxpayers can start offsetting income

Become active in your investments. Choose one business or real estate project where you will put in real time and make decisions. Track your hours and tasks and aim to meet a material participation test.

Partner in a business or real estate project. Take an operating role, manage budgets, approve vendors, oversee renovations, and lead marketing or operations. The goal is real involvement so that your share of income and losses is non-passive.

Use strategic deductions. If you run a business, use an accountable plan for reimbursements. Set up retirement plans with high limits and use a Health Reimbursement Arrangement when your entity type allows it. For rentals consider cost segregation to front load depreciation. If you qualify for Real Estate Professional Status, these deductions may reduce non-passive income.

Choosing the right entity

Many profitable service businesses use an S Corporation. This can reduce self-employment taxes. How it works: You pay yourself a reasonable salary. You take the rest as distributions. You must run payroll and keep books clean, and when done correctly, this can lower total tax while staying compliant.

Cost segregation in plain language

A cost segregation study separates a rental property into components with shorter depreciation lives, allowing you to write off those portions more quickly. This results in larger deductions in the earlier years. If you qualify for Real Estate Professional Status or materially participate in a short-term rental, these deductions can offset W-2 income or business profits. If not, they can be used to offset passive income or carried forward to future years.  

🎥 Watch: High W2 Wages? Here’s How to Keep More of Your Money

Documentation and discipline

Good records are not negotiable. Keep a time log. Save receipts and invoices. Use separate bank accounts for each activity. Clean records are used to support your tax return and reduce audit risk. Clean records will also help you make better decisions during the year.

A simple action plan

Step one. List your top income sources and label each as W2, passive, or non-passive.
Step two. Choose one activity to make active this year and set a five-hundred-hour target.
Step three. Meet with a tax professional to plan S Corporation pay and retirement options.
Step four. For rentals order a quick feasibility check for cost segregation.
Step five. Start a time log and a simple expense system today. Small daily habits create large results.

Risks and guardrails

Tax rules are strict. Track hours and keep proof.
S Corporations require reasonable compensation. Do not guess.
Cost segregation creates large deductions now and smaller ones later. Plan for depreciation recapture on sales.
State rules may differ. Plan for every state where you work and invest.

Final takeaway

The tax code rewards ownership and active participation. If most of your income is W2, you have fewer levers. When you become a business owner or an active investor, you gain tools to lower your taxes. Start small, get involved, document your time, choose the right structure, use proven strategies, and keep more of what you earn.

A Guide We Offer You: What You Can Claim With Individual Tax Credits: Tax credits available to individuals and families, including clean vehicle credits, education, and child-related incentives.
👉Download Now to see which credits you can claim this year.

FAQs

What is family payroll?
Family payroll is when your business pays wages to your children or your spouse for real work performed. The work must be ordinary and necessary for business. Wages must be reasonable for the age and the job. You must keep timesheets, job descriptions, and payroll records.

Can I pay my child and get a deduction?
Yes when the child performs real work and is paid a reasonable wage. In many cases wages to a child under eighteen from a sole proprietorship or a partnership owned only by the parents, are not subject to federal payroll taxes when under the standard deduction. Your facts and your entity type matter. Keep good records.

Do I issue a W2 or a 1099 to a family member?
Use a W2 for an employee. Do not use a 1099 to avoid payroll taxes. Misclassification creates penalties. When in doubt, use payroll.

How much can I pay my child?
Pay a reasonable market rate for the work. Use local wage data or quotes. Track hours and tasks. Document the rate and the rationale. Reasonable pay is the key.

What about child labor laws?
You must follow federal and state child labor laws. Choose age-appropriate tasks. Follow hour limits during school days and non-school days. Keep written permission when required.

Do I need a separate bank account?
Yes. Pay wages from a business bank account. Have your child deposit wages in his/her bank account. Avoid cash. Keep things clean.

How do I document hours?
Use a simple timesheet. Record date, task, start time, end time, and total hours. Keep supervisor approval. Save these records with payroll files.

How does an S Corporation change things?
An S Corporation can reduce self-employment tax when you pay a reasonable salary and take distributions. It also changes payroll tax rules for family wages. Plan the structure with your tax professional before you start payroll.

Can I deduct family travel and auto expenses?
Yes when travel and auto expenses are ordinary necessary and business related. Keep mileage logs for auto. Keep itineraries, agendas, and receipts for travel. Mixed trips need a clean split between business and personal days.

What is cost segregation and why does it matter?
Cost segregation separates rental property into different categories as shorter life assets. This accelerates depreciation. For long-term rentals, when paired with Real Estate Professional Status these deductions may offset non-passive income. Without that status, they offset passive income or carry forward. For short-term rentals all you need to show is material participation, and these deductions may offset non-passive income.  

How does Real Estate Professional Status work with family payroll?
They are separate strategies. Real Estate Professional Status changes the character of rental losses. Family payroll shifts income to family members and creates deductible wages in the business. Both require good records and compliance.

Final Takeaway

The tax code rewards ownership and active participation. If most of your income is W2, you have fewer levers. When you become a business owner or active investor, you gain tools to lower your taxes. Start small, get involved, document your time, choose the right structure, and use proven strategies to keep more of what you earn.

Want Help Setting This Up?

Reach out to INVESTOR FRIENDLY CPA® for expert guidance on turning your business and family into a tax-smart, wealth-building team.

We help with:

• Customized family payroll plans

• IRS-compliant job descriptions and documentation

• Payroll setup for children and spouses

• Entity structuring and long-term wealth strategies

• Guidance on travel, auto, and business expense compliance

Toll-Free: 1-800-522-6091
Website: www.investorfriendlycpa.com

Schedule a FREE Consultation Today and take the first step toward smarter tax planning.