If you’re one of the millions of Americans who make a living as sole proprietor (maybe a freelancer, consultant, independent contractor), you might be wondering where so much of your hard-earned money went at tax time. In particular, first time freelancers are often surprised by the hefty self-employment taxes.
While there’s no way you can legally get around paying taxes, there are certain strategies you can employ to minimize what you owe. You may have heard that changing your business structure from a sole proprietorship or partnership can help you lower your self-employment taxes. And if you’re thinking about starting a business this year, you have an opportunity to start off right with a formal business structure.
We’ll break down the details here (but keep in mind, this is just a general overview and it’s smart to counsel a tax advisor or CPA about your own situation).
Why do you have to pay self-employment taxes?
The self-employment tax is how sole proprietors and partners in a partnership pay their social security and Medicare payroll taxes. Employers and employees typically split these taxes (i.e. each may pay 7.65% of eligible wages for the tax). But when you’re self-employed, you’re on the hook for both contributions.
The actual self-employment tax rate can fluctuate – the rate was reduced for 2011 and 2012, but it’s now back to its regular level for the tax year 2013. This means that all things being equal, you could be paying more in self-employment tax next year.
How does your business structure affect self-employment tax?
When you form an S Corporation or an LLC that’s taxed as an S Corporation, you’re able to split the profits of your business into two payment types: your salary and S Corporation distributions. You must pay social security/Medicare tax (that’s an employer’s version of the self-employment tax) on the salary portion, but you don’t have to pay social security/Medicare taxes on the distributions. So let’s say your business earned 80,000 in profit for the year. If you pay yourself 60,000 in salary and take 20,000 in distributions, you just pay the social security/Medicare tax on the 60,000.
If you’re thinking ahead, you might wonder why you can’t just make your salary 5,000 and then take 75,000 in distributions. That would really be lowering your taxes. However, the IRS states that you need to pay yourself a “fair and reasonable” salary. And this is monitored very closely. You have to pay yourself a fair market rate for whatever job you do for the business. But even with this, sole proprietors and small businesses can often reduce their overall taxes this way.
If you have a sole proprietorship or partnership and you’re making more in profit than whatever your “fair and reasonable” salary would be, it could be smart to form an S Corporation or an LLC that’s taxed as an S Corporation.
Is there a downside?
Once you’ve created a formal business structure like the S Corporation or LLC, you’ve got to run your business at a higher administrative level than with the sole proprietorship. There’s more paperwork and compliance formalities to meet. If you’re concerned about being overwhelmed with formalities, then you should opt for the LLC and elect to be taxed as an S Corporation. Generally speaking, the LLC entails less paperwork and formalities than a corporation (like the S Corporation).
The opportunity to lower your taxes is just one of the reasons why you should consider the LLC or S Corporation for your business. Perhaps even more importantly, both of these business structures will help separate your personal assets from the business, so you don’t have to risk your own savings or property should your business run into 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. As the self-employment tax rate is set to rise back to the pre-2011 levels, this is a good time to act.