Being self-employed has its perks, you don’t have to go to an office, answer to a boss or wear a suit every day. But self-employment does have a major downside: self-employment tax.
New business owners, freelancers and consultants are often shocked at how much of their income is eaten up by the self-employment tax.
Depending on your situation, you may be able to reduce self-employment taxes by forming a corporation or a limited liability company.
What Is the Self-Employment Tax?
If you are someone else’s employee, your employer pays half of your Social Security and Medicare taxes, and the other half is taken out of your paycheck. But if you are self-employed, you must pay all of your Social Security and Medicare taxes yourself. This is what is known as the self-employment tax.
For 2014, the Social Security tax is 12.4 percent of your income, and the Medicare tax is 2.9 percent of your income. You pay Social Security tax only until your income reaches $117,000.
There is no Social Security tax on the portion of your income that is greater than that. You pay Medicare tax on all your income, and there is an additional .9 percent Medicare tax on wages that exceed $200,000.
If you are a sole proprietor, a partner in a general partnership, or a member of an LLC that is taxed as a disregarded entity, you will pay self-employed tax. You must calculate self-employment tax and income tax and make quarterly estimated tax payments to the Internal Revenue Service, or you could be subject to fines and penalties.
An online self-employed tax calculator can help you estimate your taxes.
How Corporations and LLCs Are Taxed
Corporations are taxed differently than individuals and partnerships. The IRS automatically treats corporations as C corporations, which means the corporation pays corporate income tax on its earnings, and its owners (called shareholders) also pay personal income tax on amounts they take home.
Many small business corporations choose to be taxed as S corporations. An S corporation does not pay corporate income tax. Instead, its shareholders report the company’s income on their personal tax returns.
An LLC can be taxed as a disregarded entity, meaning it is taxed in the same way as a sole proprietorship or partnership. An LLC can also elect to be taxed as an S corporation.
How Can a Corporation or LLC Help Me Avoid Self-Employment Tax?
If you are a sole proprietor, partner, or LLC that’s a disregarded entity, you’ll pay Social Security and Medicare taxes on your share of your company’s entire net income.
If you are an S corporation or an LLC taxed as an S corporation, you will pay Social Security and Medicare taxes only on the salary you pay yourself, not on the rest of your business profits.
To understand how an S corporation can save you money, let’s suppose you have a two-person general partnership that owns a small clothing store and has $400,000 in profits. Your self-employment taxes on your $200,000 share of the profits will be $20,308.
Now let’s suppose you form an S corporation and you and your partner each take a reasonable salary, which you determine is $80,000. You and your business will pay Social Security and Medicare taxes of $12,240 on your salary, but you will not pay those taxes on your share of the remaining business profit. That’s a tax savings of more than $8,000 for each partner.
So does that mean you can pay yourself a salary of $1 for the year and avoid Social Security and Medicare tax altogether? No. You must pay yourself a reasonable salary for the work you perform. If you don’t you can be audited or be subject to other actions by the IRS.
How to Elect to Be Taxed as an S Corporation
You can form either a corporation or an LLC by filing the appropriate paperwork with the secretary of state or other designated agency in the state where your business is located.
If you do nothing further, the IRS will automatically tax your corporation as a C corporation that pays corporate income tax. It will automatically tax your LLC as a disregarded entity whose owners pay self-employment tax on all its earnings.
If you want to be taxed as an S corporation, you must file additional forms with the IRS. If your business is a corporation, you must file form 2553. If your business is an LLC, you must file form 8832. It’s always a good idea to consult with a tax professional to make sure you’re choosing the best tax status for your business.
Self-employment taxes can be a big burden for small business owners. You can’t avoid them altogether, but forming a corporation or LLC and taking advantage of S corporation taxation may save you thousands of dollars each year.