The end of tax time typically brings renewed interest in business structures. Fresh from filling out their tax forms, sole proprietors and partners in a general partnership are often concerned about self employment taxes and wonder if there’s a way to legally keep more of their hard earned money.
If you have a sole proprietorship or general partnership, read on to learn if incorporating or forming an LLC for your business can help you reduce self employment taxes. In addition, if you’re thinking about starting a business this year, you have an opportunity to start off right with a formal business structure.
How You Can Lower Your Self Employment Taxes
An Intro to Self Employment Taxes
The self employment tax is an extra tax that self employed business owners, independent contractors and other independents need to pay. Self employment taxes are how sole proprietors (and partners in a general partnership) pay social security and Medicare payroll taxes.
When you’re an employee at a company, you split these taxes with your employer (typically, each pays 7.65 percent of eligible wages for the tax). But when you’re self employed, you’re essentially both the employer and the employee and thus, you’re responsible for both contributions.
Note that self employment taxes were reduced for 2011 and 2012, but are set to rise to the regular level for tax year 2013. This provides added incentive to take a look at your business structure for the years ahead.
LLC and S Corporation: Can They Lower Self Employment Taxes?
The LLC and S Corporation are popular business structures for small businesses, freelancers and entrepreneurs. Many small businesses begin as a sole proprietorship or general partnership and then ultimately transition to an LLC or S Corporation.
Both entities let you “pass through” your taxes. Meaning, the company itself doesn’t pay taxes, but profits and losses are passed on to your personal tax return. This is an important distinction from the general C Corporation that must file its own taxes (and often results in an increase in taxes for the small business owner).
For the S Corporation and LLC taxed as an S Corporation, you’re able to split your profits into two payment types – salary and S Corp distributions. You pay social security/Medicare tax only on the salary portion. This means that if your business made $80,000 in profits and you pay yourself $40,000 in salary and $40,000 in distributions, you only have to pay social security tax on the $40,000 salary.
Sounds good, right? Why not take it a step farther and pay yourself $1,000 in salary and $79,000 in distributions? That way you can really minimize your self employment (social security/Medicare) taxes. However, that type of compensation is not allowed, as the IRS requires you pay yourself a “fair and reasonable” salary and these distributions are watched very closely. You’ll have to pay yourself fair market rate for whatever services you provide to the company. Yet even so, small business owners can often significantly reduce their self-employment taxes by setting up as a corporation or LLC.
For example, if you’re running a sole proprietorship and you’re bringing in more in profit than a “fair and reasonable” salary, then it probably makes sense to form an S Corporation or LLC that’s taxed as an S Corporation.
Bear in mind that with a formal business structure, you’re generally required to operate your business at a higher administrative level than with the sole proprietorship (where there’s no paperwork at all). If you’re concerned about having too much paperwork and legal formalities, opt for the LLC and then elect to be taxed as an S Corporation. In general, the LLC has fewer legal requirements than corporations (S Corporations and C Corporations).
The Other Upside: Protecting Your Personal Assets
While lowering one’s taxes is often the driving force behind incorporating, LLCs and S Corporations offer another significant benefit for the small business. That is, protecting your personal assets.
With a sole proprietorship or general partnership, your own personal savings, property and other assets are at risk to settle any debts of the business. Yet once your business becomes an LLC or S Corporation, it exists as its own entity. This offers a shield between your personal assets and the business, giving you added peace of mind.
While most small business owners I know have little time to spare, I encourage you to take some time and investigate the various business structures. Speak with a tax advisor to learn more about your own personal situation.
As self employment taxes are set to rise back to the pre-2011 levels, it’s smart to act now to get ready for your 2013 taxes and beyond.
Grasping Money Photo via Shutterstock