Being self-employed has its benefits, but it also has headaches, especially when tax time rolls around. If it feels like you’re always paying more taxes than you should as a self-employed person, it could be because you actually are.
Self-employed individuals typically pay higher Medicare and Social Security taxes, collectively known as ‘self-employment taxes,’ than employees do. While nobody wants to pay more in taxes just because they’re self-employed, there are some things you can do to reduce the amount of self-employment tax you have to pay.
Organizing your business as an S-corporation could cut your self-employment tax by a good deal. Is an S-corporation right for your business? Let’s take a look.
LLC, Sole Proprietorship, and Self-employment Tax
You’re subject to paying self-employment tax when your self-employed business is set up as a sole proprietorship or a Limited Liability Corporation (LLC). Employees employed by a business split the 15.3% tax that covers Medicare and Social Security combinations, but if you’re self-employed, you’re responsible for all of it.
Even general partnerships aren’t immune to the higher tax rate. If you are in a general partnership, you still pay self-employment tax on your share of the partnership’s income in addition to your federal income tax. However, if your business is set up as an S-corporation, you’ll only be subject to paying income tax on your share of the S-corporation’s income.
S-corporations and Distributions
When your business is set up as an S-corporation, you can assign some of your income as your salary and some as a distribution or profit. In this type of setup, you are not required to pay self-employment taxes on the profit portion of your income, only on the salary.
By eliminating taxes at the corporate level, an S-corporation can reduce your overall tax liability. Income, gains and losses, and deductions are passed through to shareholders in an S-corporation, thereby removing it from self-employment taxation. Depending on how much your business earns (and how much you assign as salary), you could reduce your self-employment taxes considerably.
Salary and Profit
One of the most important things to consider about using an S-corporation for self-employment tax savings is that you must keep your salary designation to a reasonable amount. This ‘reasonable’ compensation is treated as wages, so it’s subject to an employment tax split between the corporation and the employee and equal to self-employment tax.
What Constitutes a Reasonable Salary?
There’s no hard and fast rule about this, and while it can be tempting to split your total income between profit and salary, you need to be careful. The IRS compares your self-assigned salary to the compensation that others would earn in the same field.
If you pay yourself too little in an effort to avoid paying self-employment tax, the IRS is likely to impose a self-employment tax on part of your distributions (profits) instead. Some small business owners opt for a 60/40 split, with sixty percent of the company’s income paid as salary and forty percent as profits.
Unfortunately, the IRS doesn’t offer any solid advice about deciding what makes a salary reasonable. Numerous factors should be considered when determining what constitutes a reasonable salary.
- What are the duties and responsibilities of the employee?
- What experience and training has the employee had?
- How much time is spent working for the business?
- How much do similar roles earn within your industry?
Ultimately, it’s best to speak with your accountant or tax specialist to figure out the best ratio for your business.
Possible Risks With S-corporations
While S-corporations can help you reduce the amount of self-employment tax you pay, they’re not without their risks. The IRS scrutinizes S-corporations more closely than sole proprietorships because there is more room for S-corporations to try and avoid paying self-employment taxes.
In addition to being at higher risk of being audited by the IRS, S-corporations may cost you more money in the form of legal fees and startup costs. However, these costs can vary significantly from state to state, so depending upon where you are and how much your business earns, an S-corporation could be a good option that saves your small business money at tax time.
Trust Us With Your Tax and Accounting Needs
Running a small business is tricky, especially when it’s time to figure out your taxes. There are numerous ways to reduce your tax liability depending on the type of business you operate, but learning the ‘secrets’ to tax savings can be near impossible if you aren’t familiar with the ins and outs of the US tax system.
Lloyd & Hodge know how stressful accounting and taxes are for many small businesses and sole proprietors. We know you’d rather focus on growing your business, and we understand that taxes are something most people would rather not think about.
With proper planning, you can manage your effective tax rate and reduce your costs. Tax planning and restructuring services from Lloyd and Hodge are designed to protect your business’s financial future while maintaining compliance with all laws and regulations.
We can work with you remotely! We use the latest in technology and security so we can handle your accounts remotely without ever needing to make a trip to our office! Contact us today and find out how you can reduce your tax liability and plan for the future of your business.