As a business owner, self-employment (SE) tax is how you contribute to Social Security and Medicare – like the FICA tax for employees.
The self-employment tax rate is 15.3% on your net business income. And this obligation can really add up, especially if your business is thriving.
For example, if your net earnings are $150,000, your self-employment tax burden would be about $23,000. That’s a huge chunk.
And unlike employees, you pay both the employer AND employee portion as a self-employed individual. So you get hit with the full 15.3% versus just 7.65%.
Now here’s the exciting part – you can take steps to significantly reduce or even eliminate your self-employment tax burden entirely through strategic planning.
With the right techniques tailored to your situation, you can keep substantially more of your hard-earned income.
But it starts with fully understanding the intricacies of self-employment tax. Let’s dive in!
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What Is Self-Employment Tax?
Many business owners find self-employment tax confusing. But understanding how it works is key to minimizing your obligations.
So what exactly is self-employment tax? At a high level:
- It’s a 15.3% tax on your net business income
- This covers your Medicare and Social Security contributions
- You pay both employer + employee portions since you’re self-employed
Let’s break it down further:
In a typical employer-employee relationship, the FICA tax is split:
- The employer pays 7.65%
- The employee pays 7.65%
This is withheld from the employee’s paycheck. The employer matches and sends the full 15.3% to the IRS.
In contrast to a typical employer-employee split, as a self-employed individual you pay the FULL 15.3% yourself.
You are your own boss and staff. So you bear both halves of the self-employment tax burden.
Once income exceeds about $160,000, the Social Security portion stops applying, so the percentage owed declines.
But in general, expect to pay around 15.3% of your NET business income in self-employment tax. That’s after deductions.
Gross revenue of $500,000 – $150,000 in business expenses =$350,000 net business income.
Self-employment tax would be 15.3% of $350,000. A hefty $53,550 bill!
This double tax duty makes self-employment tax a primary expense for self-employed individuals to minimize.
The first step to avoid self-employment tax: Lower business income
How to Reduce Tax by Maximizing Deductions
Self-employment tax only applies to your NET business income after accounting for all business tax deductions.
So maximizing write-offs directly reduces the income subject to self-employment tax.
Some prime categories to maximize:
- Home office expenses
- Mileage for a vehicle used for business
- Travel, meals, and entertainment tied to business
- Inventory, supplies, software, equipment
- Accounting and legal fees
Carefully tracking and claiming allowable deductions may be beneficial. Missed write-offs directly increase your self-employment tax obligations.
Let’s say your gross revenue is $300,000. You have $200,000 in business deductions.
That leaves $100,000 in profit subject to self-employment tax.
If you forgot $20,000 in deductions, your profit would show as $120,000. You’d owe 15.3% self-employment tax on that higher amount.
The more deductions you legally claim, the lower your income and self-employment tax bill.
Truly mastering small business deductions takes time and expertise. The tax code is enormously complex.
Working with a tax coach may help develop a tailored strategy that leverages every write-off possible. Their guidance can uncover overlooked deductions.
Remember, maximizing deductions directly reduces self-employment tax owed. It’s an essential first step.
But you can also completely avoid large portions of self-employment tax burden. For most owners, the key is electing S-corp status for your business structure.
Avoiding Self-Employment Taxes With an S-Corp
Forming an S-corp opens up a prime avenue for circumventing large portions of your self-employment tax burden.
Here’s how it works:
By default, all your small business income passes through to you personally as the owner. You pay self-employment tax on 100% of it.
But with an S-corp, you can pay yourself a “reasonable” salary equal to maybe 30-50% of profits.
This salary portion remains subject to self-employment tax. But the remaining income is distributed to you as the owner. These distributions are NOT subject to self-employment tax.
S-Corp profits = $200,000
Your salary = $70,000
Remaining $130,000 distributed to you tax-free.
This structure allows avoiding self-employment tax on up to 50-70% of your earnings. The key is keeping your salary aligned with industry averages.
Let’s look closer at corporate vs pass-through income…
Self-Employment Tax on Pass-Through Businesses
By default, income earned via pass-through entities is subject to full self-employment tax.
Pass-through structures include:
- Sole proprietorships
- Any unincorporated small business
The reason they’re called “pass-through” is all profits pass directly to you as the owner and are reflected on your personal tax return.
Let’s look at some examples to see self-employment tax in action for pass-throughs:
Sole proprietor with $100,000 net business income = owes full 15.3% self-employment tax on the entire $100,000. That’s $15,300 owed.
50/50 partnership with $100,000 net income = each partner pays 15.3% self-employment tax on their $50,000 share. So $7,650 self-employment tax each.
The key point: all pass-through income flows to the owners and is subject to full self-employment tax automatically.
However, C-corps and S-corps work differently…
These corporate structures intrinsically avoid self-employment tax, creating planning opportunities I’ll explain soon. The corporate divide between salary and profits is the key.
C-Corps vs. S-Corps
There are two main corporate entity types:
C-Corps – More complex and better suited for large enterprises. Not ideal for small business owners in most cases.
S-Corps – Relatively simple structure with tax advantages tailored to small/mid-size businesses. Popular choice.
Most small business owners don’t need a complex C-corp structure.
C-corps allow you to sell unlimited shares of stock on the public markets. This aggressively raises investment capital from outside investors.
But most small businesses don’t want outside investors. And they don’t want the headaches of managing countless shareholders and complex securities filings.
So C-corps add needless complications for everyday small business owners.
Most small businesses should steer clear of C-corps.
Sure, C-corps let you dodge self-employment taxes. But they stick you with double taxation – from BOTH corporate income tax and personal income tax.
For most owners, the corporate tax burden outweighs the self-employment tax savings.
That’s why S-corps are the ideal structure for many small business owners.
S-corps give you the perks of a corporation with none of the pitfalls:
- Escape self-employment taxes on distributions
- Avoid double taxation – no corporate income tax
- Ownership flexibility of an LLC
- Minimal IRS paperwork
When first starting out, you have a couple options to form an S-corp:
- Organize as a C-corp, then elect S-corp status with the IRS
- You may want to form an LLC, then consider electing S-corp taxation
The second approach is most common for small business owners. An LLC offers initial liability protection and operational simplicity.
From there, you file IRS Form 2553 to choose S-corp taxation. This passes income/expenses through to your personal return.
Alternatively, existing C-corps can elect S-corp status to receive pass-through tax treatment while maintaining current operations.
Self-Employment Tax and S-Corps
Here’s where S-corps really shine for small business owners – enabling you to avoid self-employment tax on your distributions (profits).
As an S-corp, you only pay self-employment tax on “reasonable” W-2 wages paid to yourself as the owner-employee.
Remaining profits are distributed to you tax-free as the owner.
S-Corp profits = $200,000
Your wages = $80,000 → Owe 15.3% self-employment tax
Remaining $120,000 distributed to you, no self-employment tax
This structure allows legally avoiding self-employment tax on up to 50-70% of your earnings. The savings are enormous.
S-corp taxation was created by the IRS specifically for entrepreneurs to minimize obligations and keep more of their income.
However, S-corps have a few extra administrative requirements that sole proprietors and LLCs lack. Here are the key ones:
- File a separate S-corp tax return (Form 1120-S) in addition to your personal return.
- If you work in the business, pay yourself a reasonable market-rate salary.
- Run payroll for yourself as an employee-owner.
- Your salary remains subject to payroll taxes – Medicare, Social Security, etc. The S-corp pays half as the employer.
So you’ll still incur some employment taxes on your salary. But the remaining distributions as the owner avoid self-employment tax.
You reap major savings because self-employment tax only applies to your salary – not total business income.
CPAs often recommend considering an owner’s salary in the 30-50% of profits range. This percentage is considered reasonable by the IRS.
Your S-corp nets $100,000 profit. You pay yourself a 45% salary = $45,000.
Only the $45,000 salary portion is subject to 15.3% self-employment tax.
You avoid self-employment tax on the remaining $55,000 in profits distributed to you as the owner.
In this scenario, the S-corp structure saves you $8,415 in self-employment taxes.
The key is keeping your salary in the justifiable 30-50% of income range based on your role and industry.
Remember – the 30-50% salary guideline is a general rule of thumb. What’s considered “reasonable” depends on your specific situation.
Analyze comparable roles and salaries in your industry. Aim for the market median based on your experience and business services.
Document your methodology thoroughly. Being audited on an unjustifiably low salary causes headaches.
Work closely with your accountant to determine a salary that’s both financially optimized for you and defensible to the IRS.
Minimizing self-employment tax through an S-corp may present a significant opportunity. But it’s only one piece of reducing your overall obligations.
You also need to leverage deductions, retirement accounts, and other strategies to lower federal and state income taxes.
Combined with S-corp planning, these can save you thousands by keeping more of your hard-earned income.
Federal and State Income Tax
When tax time rolls around, your personal income tax bill includes all your small business earnings.
Federal and state governments both take their cut of your net business income.
How do they calculate what you owe? It’s based on progressive tax brackets:
- The more you earn, the higher your tax rate. Makes sense.
- Brackets range from 10% to 37% for federal income tax. State brackets also rise progressively.
- Your total net business income flows through to your personal return, unless you’re structured as a C-corp.
- C-corps pay a 21% flat corporate income tax on earnings. More on corporate vs pass-through taxation later.
The upside is that income taxes are relatively straightforward compared to self-employment payroll taxes.
You can lower your taxable income through business deductions, retirement contributions, mileage write-offs, and other tax planning strategies.
Work with an accountant or tax advisor to maximize these. But set aside an estimated percentage of income to cover what you’ll owe.
Your federal income tax bracket is based on total income from all sources.
Say your small business earns $75,000 net profit one year.
Standalone, that income puts you in the 22% bracket.
But what if you ALSO have:
– $80,000 salary from a day job
– $20,000 rental property income
Now your total taxable income is $175,000.
That bumps you into the 32% federal bracket.
The more you earn, the higher your rates climb. That’s how our progressive tax system works.
Fortunately, you can reduce taxable business income through:
- Standard deductions – $13,850 if single, $20,800 if head of household.
- Business expense deductions – supplies, equipment, mileage, home office, etc.
- Retirement contributions like Solo 401k or SEP IRA
- Accounting techniques like S-corp election to save on self-employment tax.
You can also increase your deductions by itemizing rather than taking the standard deduction:
- Add up business expenses, mortgage interest, charitable giving, medical bills.
- Itemizing often exceeds the standard amounts.
Next, use losses to offset income:
- Claim operating losses against your earnings.
- Roll unused losses forward to reduce future tax bills.
Finally, shift to tax-friendly income sources.
- Municipal bonds avoid federal tax (but not state tax).
- Rental real estate income may allow paper losses for deductions.
- Retirement plan contributions like 401k or IRA reduce current taxable income.
Work closely with an accountant to maximize these techniques. The goal is keeping more of your hard-earned income and boosting your bottom line.
Get Help Reducing Your Tax Bill
With the right strategies, there may be opportunities to legally reduce your taxable income and obligations.
But you have to take action to claim these tax-savers. They don’t happen automatically.
If you miss write-offs, you leave money on the table for Uncle Sam.
Trying to navigate self-employment taxes and loopholes alone can become frustrating. The regulations are dense and complex.
Partnering with specialists may help simplify managing small business tax obligations.
We at My CPA Coach leverage decades of experience assisting entrepreneurs like you.
- Deep knowledge of latest regulations and tax loopholes
- Proven systems to substantially reduce your tax burden
- Ongoing support translating tax code complexity into bottom line savings
At My CPA Coach, we also offer an incredible guarantee – we’ll save you at least 2x your fees through optimized tax strategies.
Between expert coaching and educational resources, you can legally minimize taxes and keep more of your hard-earned income.
Don’t overpay the IRS due to confusion. Knowledge is money when it comes to small business taxes.
Contact My CPA Coach to get clarity, confidence, and control over your tax bill. Start saving today!