Self-employment offers many freedoms and opportunities. But you may be surprised to discover that your tax bill will be much higher when you work for yourself. Self-employed people must pay self-employment taxes, which can come as a shock to your budget. You may be able to reduce the amount of tax you pay by setting up a limited liability company (LLC) or a corporation.
Understanding self-employment tax
When you are an employee, you pay part of your Social Security and Medicare taxes and your employer pays the other part. When you're self-employed, the same total amount is owed for Social Security and Medicare, but you're required to pay all of it yourself, in addition to your regular income taxes. This is called the self-employment tax. Self-employment tax applies to sole proprietors, members of a partnership, and members of a disregarded LLC (a one-member LLC that chooses to be taxed as an individual).
For the 2020 tax year, self-employed people pay 12.4% of their income toward Social Security and 2.9% of their income toward Medicare, for a total of 15.3% in self-employment taxes. This applies only to the first $137,700 of income (in 2021 that amount will increase to $142,800). You'll pay an additional Medicare tax of 0.9% on any income in excess of $200,000. Self-employment tax must be paid quarterly.
Being taxed as an LLC
If you set up an LLC, you have some options when it comes to LLC self-employment taxes:
- Disregarded LLC. If you create an LLC with one member and do not elect to be taxed as a corporation (see below), then you will still continue to pay self-employment tax as an LLC. Your tax liability for self-employment tax does not change.
- LLC taxed as an S-Corporation. As an LLC you can elect to be taxed as an S-Corporation. If you choose this option, you will not pay self-employment tax.
Being taxed as a corporation
If you form a corporation, you can incorporate as a C-Corporation or as an S-Corporation.
- C-Corporation. As a C-Corporation, you will pay corporate income tax on what the corporation earns and then you pay income tax on any salary you pay yourself. Because you are an employee, you do not pay self-employment tax, but the corporation pays the employer's portion of those taxes.
- S-Corporation. An S-Corporation is called a pass-through entity. The corporation itself pays no income tax at all. You can use the funds earned by the corporation to pay yourself in two ways. First, you can pay yourself a salary. As an individual, you will pay self-employment tax only on the salary you pay yourself, not on all the funds your corporation earns. You can then pay yourself other amounts as a distribution from the S-Corporation and not have to pay self-employment tax on those funds. This is where the savings come in. By separating the income earned by the corporation into two separate methods of payment to you as the individual, you avoid self-employment tax on funds paid as a distribution. Note that you have to elect to be taxed as an S-Corporation for this to apply. Otherwise, you will automatically be classified as a C-Corporation. These benefits apply if you are an LLC that chooses to be taxed as an S-Corporation as well.
Choosing to set up your business as an LLC or corporation can reduce the amount of self-employment taxes you will have to pay.