Focus on these strategies to minimize the impact of self-employment taxes.
If you’re one of the 20+ million Americans making a living as a sole proprietor, tax time can make you wonder where all of your hard-earned money went. Whether you have been self-employed for decades or this was your first year filing as a solo worker, you’re probably concerned by those hefty self-employment taxes.
If you make self-employed income, you can’t expect to avoid self-employment taxes entirely. However, there are certain strategies you can take to minimize the impact of these taxes. We’ll break down the details here, but keep in mind that like any tax advice you read online, this is general advice only and it’s always smart to speak with a tax advisor about your particular situation.
What exactly are self-employment taxes?
The self-employment tax is how self-employed individuals (i.e. sole proprietors and partners in a partnership) pay their social security and Medicare payroll taxes. If this tax seems higher than what you paid as an employee, that’s because it is. Employers and employees typically split these taxes, but self-employed people are on the hook for the whole thing.
Anyone making more than $400 in self-employment income is required to file a with his or her tax return. This is where you calculate how much self-employment tax you owe.
The self-employment tax rate can fluctuate from year to year. For example, the rate was reduced in 2011 and 2012, but came back up to its regular level for tax year 2013. Keep in mind that you can deduct a portion of your self-employment tax payments (around 50%) on your Form 1040.
Can you lower your self-employment taxes?
Your business structure can affect your self-employment taxes and a CPA/tax advisor may tell you to turn your business into an S Corporation to reduce your self-employment taxes. Here’s why. With an S Corporation (or an LLC that’s taxed as an S Corporation), you’re able to split your profits into two payment types: payment to you as an employee (salary) and to you as a shareholder/owner (distributions). Social security and Medicare taxes are paid on the salary portion, but not on the distributions.
Here’s an example. Let’s say your business brought in $100,000 in net income for the year. If your business is a sole proprietorship, you need to pay self-employment taxes on the whole thing (after multiplying it by 92.35%). However, when your business is taxed like an S Corporation, you could pay yourself $60,000 in salary and then take $40,000 in distributions. In this case, you pay social security/Medicare tax on the $60,000 in salary only.
There are a few caveats to this strategy. First, you’ve got to pay yourself a fair and reasonable salary for the job you do. In other words, you can’t pay yourself $10,000 in salary and $90,000 in distributions and expect the IRS to be okay with that. The IRS does monitor this closely, so you’ll need to make sure your salary reflects a fair market rate.
In addition, keep in mind that by changing your business structure to an S Corporation or an LLC, you will have more administrative obligations than you did as a sole proprietor. However, generally speaking, an S Corporation will have more paperwork and administrative requirements than an LLC. For example, with an S Corporation, you’ll have to hold an annual meeting, take meeting minutes, and record important changes for the business. You won’t need to hold a yearly meeting or record meeting minutes with an LLC.
For this reason, many small businesses prefer the LLC. That’s because it can still be taxed like an S Corporation (and thus give you the benefit of lowering your self-employment taxes), but has fewer formalities than an S Corporation itself.
Lower your reported net profit to lower your self-employment taxes
Beyond changing your business structure, you can also minimize your reported net profit. Your business’ net profit (gross revenue minus deductible business expenses) is used to calculate your self-employment tax. Therefore, by lowering your net profit, you can lower your self-employment tax bill. Make sure to include all allowable business expenses on your Schedule C…business travel, entertaining, office supplies, cell phone bill and web hosting, computer equipment, home office deduction and more.
Make sure your pricing reflects these taxes
The most important way to deal with self-employment taxes is to make sure that your pricing and rates reflect all your costs, including the taxes you must pay. Considering you need to pay the entire Medicare and Social Security tax yourself as a self-employed individual, you should be compensating yourself enough to cover these higher costs.