If you make a living as a self-employed sole proprietor, tax time probably makes you wonder where so much of your hard-earned money goes. Freelancers, consultants, and independent contractors are usually shocked the first time they’re hit with the self-employment tax.
You can’t legally avoid paying your taxes…period. However, there are certain things you can do to help minimize what you owe. Here we’ll break down the details of self-employment taxes and how a different business structure can help you lower them. Of course, as with anything you read on the Web, this is a general overview and it’s smart to talk with a tax advisor about your personal circumstances.
What are self-employment taxes?
Self-employment taxes are how self-employed people help fund the Social Security and Medicare programs. Employers and employees typically split these taxes, but when you’re self-employed, you’re on the hook for the whole thing.
Self-employment tax rates can vary year to year. For example, it was lowered for 2011-2012. For the 2013 tax year, it reverted back to its normal 15.3% rate (the breakdown is actually 12.4% for social security and 2.9% for Medicare).
Who has to pay self-employment taxes?
Anyone making more than $400 in self-employment income is required to file a Schedule SE with his or her tax return. This is where you calculate how much self-employment tax you owe. Also, keep in mind that when you’re filling out your Form 1040, you can deduct a portion (between 50-57%) of your self-employment tax payments.
How can you lower them?
The key way to reduce what you owe in self-employment taxes is to change your business structure from a sole proprietor/partnership into a corporation or Limited Liability Company (LLC). When you have a corp or an LLC, you can make an S Corp election and this can help you reduce some self-employment liability. Here’s how:
When you’re a sole proprietor, you owe self-employment tax on the first $113,700 of your SE income (for 2013). With an S Corp election, it’s slightly different. You pay yourself a reasonable salary for the work you do, and then if there are any profits left over, they can either stay in the business or you can take them as a “profit distribution.” Here’s the key point: you need to pay social security/Medicare tax on the salary portion, but you don’t have to pay it on the profit distributions.
Let’s look at an example: Jill is set to earn $100,000 this year in self-employed income. If her business is structured as a sole proprietor, then she’ll need to pay self-employment taxes on the entire amount. However, if her business is an LLC with S Corp election, she will pay SE taxes (or social security) only on $60,000, which in this case, is what she pays herself as a reasonable salary for her job.
Wondering why Jill doesn’t just pay herself $10,000 in salary and then enjoy $90,000 in profit distribution that’s SE tax-free? That’s because the IRS requires that you pay yourself a fair market rate for whatever job you do for the business. And this compensation is checked very closely.
Is there a downside to changing your business structure?
When you have a formal business structure like a Corporation or LLC, you are obligated to manage your business at a higher administrative level than with the sole proprietorship. That means more paperwork and administrative work. If you like to keep things simple and are concerned that all the extra paperwork won’t be worth the tax savings, then consider choosing the LLC with S Corporation election. In general, an LLC has a lot less paperwork and formal management than a corporation. In fact, it won’t be too different than a sole proprietor.
Other ways to reduce SE taxes
Beyond changing your business structure, you should also think about minimizing your reported net profit. For the self-employed, the Schedule C/C-EZ calculates your net profit (gross revenue minus deductible business expenses). This net profit is used to calculate your self-employment tax, so it only goes to follow that the lower your net profit figure, the lower your SE tax bill. Make sure that you’re including all allowable business expenses when filling out your Schedule C, including: office rent or home office deduction, office supplies, business travel expenses and conferences, computer equipment, software, etc.
In addition to helping you lower your SE taxes, the LLC or corporation can also help you separate your personal assets from the business, so you’re not risking your personal savings if your business is sued or runs into financial trouble.
Speak with a tax advisor or do your own research on business structures to decide if the LLC or S Corp is right for you. There’s not much you can do now to have any affect on 2013, but with the New Year quickly approaching, it’s the perfect time to get everything squared away to start the 2014 tax year.
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