Reducing Self Employment Tax
What is self-employment tax?
Self-employment tax is Social Security and Medicare taxes for self-employed individuals [not including income tax]. Unlike employees whose employers pay half of their Social Security and Medicare taxes, and the other half is withheld from their paychecks at a rate of 7.65% of income, people who work for themselves are responsible for making estimated tax payments of both the employee & employer portion of the tax, essentially paying 15.3% of net income. This tax is ultimately an enormous burden on an entrepreneur’s profits. However, the requirement to pay only comes into effect if net profits exceed $400.
How to reduce self-employment tax?
A common way of reducing SE tax is by deducting, from income, all ordinary and necessary expenses incurred while operating your business. In addition, those proprietors who use the accrual basis method of accounting can also prepay expenses for the current year, as these expenses would be reported when accrued rather than when paid. In essence, the goal is to reduce net income as much as possible, and the outcome will be a reduction of your self-employment tax.
Another way of reducing SE tax is by deferring income. This technique would only be beneficial if the business owner uses the cash basis method of accounting, as income would be reported when cash is received. For instance, if an entrepreneur has had a very profitable year that is not expected to continue in the following calendar year, it might make sense to defer additional year-end receipts of earnings to the next tax year. This method would limit the amount of profits reported, thus reducing SE tax owed for the current tax year.
SE tax can also be reduced by forming an S-Corporation. For S-Corps or LLCs taxed as an S-Corp, self-employment tax will be paid on earned income only. In other words, the salary you pay yourself. The tax is not applicable to unearned income i.e. dividends, profit distributions or other forms of passive earnings. This is a very creative way of reducing the tax since you can pay yourself out of the business’s profits and either take the remaining profits as a distribution, or leave it in the business. This is worth noting however, the salary you pay yourself must be reasonable for your profession. Otherwise, you may put yourself at risk for an IRS audit or other actions.
To provide an example of how an S-Corp is taxed, suppose your business has a net income of $50,000. If you are a sole proprietor, partner in a partnership, or an LLC considered as a disregarded entity, you would be taxed on the entire net income, thus owing $7,650 for SE tax. On the other hand, if your business is setup as an S-Corp or a LLC taxed as an S-Corp, and you pay yourself a salary of $30,000, you would then owe $4,590 for SE tax. The remaining $20,000 in profits can then be taken as a profit distribution or retained in the business, free of SE tax. The general idea here is to have a low salary, based on industry standards, and distribute or retain the remaining income.