Being self-employed has many benefits. After all, most jobs won’t let you wear your bunny slippers to work. There are also some drawbacks, though. Most self-employed individuals work much more than a standard 40-hour workweek, for example, and there is the dreaded tax situation.
Anyone who has ever collected a paycheck is aware that Uncle Sam takes his portion of the proceeds first. In addition to state and federal income tax, U.S. employees have to pay FICA taxes, otherwise known as Social Security and Medicare.
When an employer pays employees, the employer picks up half of the tab for these contributions, currently 7.65 percent of the gross earnings. The employee pays the other half. There are to main benefits to this arrangement: one, employees only have to pay half of the FICA tax, and two, the payments are spread out over the course of the year, so come tax time, there isn’t a significant bill for that particular tax. A traditional employee may still be on the hook for income taxes, if her or she did not have enough tax withheld, or had other income during the year, but the FICA taxes are always paid up come tax time.
For a self-employed individual the situation is much different. Because there isn’t an employer to split the bill with, self-employed individuals are required to pay the entire bill for the FICA tax — 15.3 percent of his or her gross income, a tax known as the self-employment tax. The law requires self-employed individuals to make estimated payments on their taxes, including self-employed tax, quarterly, which can make tax time slightly less painful — but there are some ways that you can significantly reduce your self-employment tax bill even more.
Choose the Right Corporate Structure
Entrepreneurs have to pay self-employment tax on top of federal, state, and local taxes — and that extra 15.3 percent can add a hefty amount to the overall tax bill. However, the way that you structure your business can make a difference in how you are taxed.
If your business is set up as a sole proprietorship, partnership, or LLC, then your tax bill is calculated based on the amount of income earned by the business; in other words, the business’s income is treated as personal income. However, if you set up your company as an S Corporation, or an LLC and elect to file taxes as an S-Corp, you can save money on self-employment taxes. .
As an S-Corp, your company pays you a reasonable salary — for example, $40,000 when you have $100,000 in earnings. You will only pay self-employment taxes on the $40,000; in other words, you have reduced your self-employment tax bill from $15,300 to just over $6,000. You will still have to pay corporate taxes on the company’s earnings, but you can elect to take the remainder of the company’s earnings as a distribution from the corporation, which may save you a substantial amount of self-employment tax.
Now, there are some drawbacks to an S-Corp. For example, the corporate taxes can eat in to profits, and it’s not always beneficial to every business. Businesses also need to file the paperwork to become an S-Corp by February 15 of the year in which they plan to file as that type of entity. It’s best to consult with a qualified tax professional to determine the status that works best for you.
Other Tax Reduction Strategies
Because self-employment tax is calculated based on adjusted gross income, it’s important that you take every tax deduction that you are entitled to. Keep meticulous records related to your business expenses so you do not forget to include any. Oher strategies for reducing your bill include:
Deferring income. You do have the option as a self-employed person to defer some of your income until the next tax year. This is a useful strategy if you are within a few thousand dollars of the next highest tax bracket; by deferring some of those earnings until January, you can pay less income tax now. Talk with your tax professional about how to go about doing this.
Deduct self-employment tax from your income. While not necessarily lowering your self-employment tax burden, you can reduce your overall tax bill by deducting half of your self-employment tax from your federally taxable income. In other words, if you pay $6,120 on your $40,000 salary, you can deduct $3,060 of that from your income — making your taxable income $36, 940 instead. This can make a big difference in your bill.
There is no way to avoid paying self-employment taxes altogether, but you should not pay more than your fair share. Work with your tax advisor to determine the best strategy for your business, and tax time will be slightly less painful.