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
Very informative piece. Thanks for sharing this with us. I’ve definitely bookmarked this post for future reference.
I really wish there were more ways to minimize self employment taxes because every year on April 15th the IRS reminds me how much I have to pay them.
Great piece, Nellie. Thanks so much for writing about this topic in a clear and concise way. This is the golden take-away for me:
“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.”
That’s great advice for up and coming small businesses that aren’t at great risk for liability and would consider forming as an LLC purely for tax reasons.
Hi Beth – thank you so much for reading my post and for the kind comment! Glad the information was useful for you! If you ever need any assistance, feel free to reach out! – Nellie
I’m self employed in the UK, and find that the same question needs addressing here too, though I get wonderful support and advice from a VAT Consultancy firm in Cambridgeshire who offer VAT advice and support from individuals through to charitable organisations.
I’ve found it particularly helpful incorporating into a limited company in the last six months in regards to lowering self employment tax.
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Hi Sam, Thank you for reading my post and commenting! Glad to hear you’ve found the information similar to what you have been told from your consultancy firm! – Nellie
Great info. I wish there were no taxes.
Keep in mind that you could greatly reduce your SS benefit at retirement if forming an LLC to pay out dividends and not compensation.