In addition to federal and state income tax, most business owners must also pay a 15.3% self-employment tax. As you can imagine, this tax is an unpleasant surprise for many new business owners.
Fortunately, there are several provisions in the tax law that allow taxpayers to significantly reduce their self-employment tax. Or, even better, avoid this tax completely.
This posts examines the top ways to reduce self-employment tax, which may result in thousands of dollars in tax savings for business owners.
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What Is Self-Employment Tax?
Self-employment tax is a 15.3% tax on business income up to an annual limit. In 2024, the annual limit was set to $168,600. In other words, self-employment tax assessed on up to $168,600 of your business income.
For example, if your net earnings are $150,000, your self-employment tax burden would be about $23,000.
This tax is paid in addition to federal and state income tax assessed. Together, this can be extremely costly for business owners.
The purpose of self-employment tax is fund Social Security and Medicare programs. For employees, these taxes are automatically withheld from their paychecks throughout the year.
For self-employed individuals, however, these taxes are not withheld. Therefore, the IRS imposes the self-employment tax as a way to collect these taxes from those individuals.
However, as a business owner, you pay twice as much employment tax as employees.
Employees only pay 7.65% of their income toward these taxes while their employer pays the other half. But, because business owners are considered “self-employed”, they must pay both portions of this tax. Hence, the 15.3% tax rate.
Millions of business owners pay this tax without taking advantage of ways to reduce it. As a result, they pay hundreds of thousands more in taxes than other tax-savvy business owners.
The truth is that every business has an opportunity to significantly reduce or completely eliminate your self-employment tax burden entirely through strategic tax planning.
The remainder of this post focuses on the most effective techniques to do so, starting with the basics.
#1 Use The Self-Employment Tax Deduction
First and foremost, self-employment tax is tax deductible. In other words, the self-employment tax you pay will directly reduce the amount of income you report on your tax return.
This simply means that it lowers the amount of income subject to federal and state taxes.
Example: If you earned $10,000 in self-employment income, you would pay about $1,530 in self-employment tax.
Only the remaining amount of $8,470 would be subject to federal and state taxes.
If you were in a 37% tax bracket, this tax deduction would save you $566 per $10,000 in reported self-employment income. Or put another way, you would save $5,660 on $100,000 in self-employment income.
However, while this deduction does reduce your income tax on a federal or state level, it does not reduce your actual self-employment tax burden.
The next method will directly decrease your self-employment tax burden.
#2 Reduce Income Subject To Self-Employment Tax
Self-employment tax only applies to your NET business income after accounting for all business tax deductions.
Therefore, if you find more tax write-offs to reduce your business income, you will report less income and pay less self-employment tax.
You can accomplish this by seeking to maximize tax write-offs through your business. Maximizing write-offs directly reduces the income subject to self-employment tax.
As a self-employed individual, the tax law allows you write-off all ordinary and necessary expenses to conduct your trade or business.
In other words, you can likely write-off any expense that is directly related to helping your business operate. This includes everything from supplies and equipment to employees, contractor, or professional service providers you hire.
To ensure you do not miss any tax write-offs, you should implement a bookkeeping system that properly records your income and business expenses.
However, you may be able to benefit from some less-obvious tax deductions. Many business owners are unaware of the following tax write-offs:
- Home office deduction: which allows you to write-off a portion of your home expenses attributable to your business
- Business vehicle or mileage deduction: which allows you to write-off a portion of your vehicles if used for business
- Business travel deduction: which allows you to write-off travel, lodging, and related expenses for business-related travel
- Business meals deduction: which allows you to write-off business meals with business contacts
- Self-employed health insurance deduction: which allows you to write-off your family’s health insurance premiums under your business
- Depreciation deduction: which allows you write-off a portion of your business assets each year
These are some of the most missed tax deductions that almost any business can use if they qualify.
It will be in your best interest to claim all possible tax write-offs, as it will directly reduce your self-employment tax burden. A skilled tax advisor can help you find all available tax write-offs or even create tax write-offs through careful planning.
Here are just some of the ways you can create tax write-offs:
- Hire your children: payments made to any employee or contractor are tax deductible, including family members you employ
- Rent your personal residence: the “Augusta Rule” allows you to rent your personal residence to your business, up to 14 days per year
- Invest in your business: spending money on advertising, research and development, or other areas that can benefit your business is tax-deductible
- Retirement contributions: contributions made to traditional retirement accounts are tax deductible
Remember, tax write-offs reduce your self-employment income and therefore, reduces your self-employment tax.
However, if you still have a large amount of self-employment income, you can make one change to your business structure to avoid this tax completely.
For most taxpayers, this involves electing S-corp status for your business structure. The following section explains this in detail.
#3 Form An S-Corporation
S-Corporations are not subject to self-employment tax.
This is why:
When you own a S-Corporation, you are no longer considered “self-employed”. The corporation itself is a standalone entity. Owners who work for the corporation are typically considered employees.
Owners of S-Corporations must receive W-2 wages for the work they perform for the business as an employee. And they receive dividends or distributions for the ownership they have in the corporation.
On the other hand, when you are not a corporation you are considered a “disregarded entity”. Put simply, the tax law views you and the business as one person. There is no separation between you as the employer or employee of the company, which is why self-employment tax is assessed.
The S-Corporation structure provides this separation and eliminates this tax at the entity level. Instead, employees pay social security and medicare tax through their W-2 wages.
This includes owners who work for the corporation. The tax law requires shareholder-employees take pay themselves “reasonable compensation”, which is subject to employment tax on the employee-level.
By assessing employment tax on employee wages as opposed to 100% of business income, business owners are able to reduce their overall employment tax by over 50-70%.
Let’s say you own an S-Corp with $150,000 in profits and take a $60,000 salary.
You would pay $0 self-employment tax on your business profits and only pay employment tax on your $60,000 salary.
The opposite would be true if you were not a corporation.
If you were taxed as a disregarded entity, you would pay $23,000 in self-employment tax. However, as an S-Corporation, this tax is reduced to about $9,000. That’s almost $14,000 in tax savings.
Instead of paying self-employment tax on all of your business income, the S-Corp status limits the tax to your employee wages. The net difference can compound in massive savings over time.
However, S-Corporations are subject to more rules and requirements which may make this tax status less valuable for some business owners. For a fair comparison, read our full comparison on S-Corp vs. LLC and 15 S-Corp Disadvantages.
Get Help Reducing Your Self-Employment Tax
Navigating the complexities of the tax law can be overwhelming, especially if you are not supported by a tax professional.
If you want a tax plan that is guaranteed to put more money back into pockets, schedule a free consultation with a tax advisor now.
Or if you want to learn the best ways to reduce your taxes, enroll into our step-by-step self-guided course.