I often get asked about self-employment taxes, and if there are ways to reduce this cost of doing business with structures that subject taxpayers to this level of tax. Depending on the type of business and a few other factors there may be a solution that allows for a reduction in tax costs. As a review, income that is generated by conducting your business as a sole proprietorship (or through a wholly-owned limited liability company (LLC), think single-member LLC, is subject to both income tax and self-employment tax.
The self-employment tax is imposed on 92.35% of self-employment income, so if you earned $100,000 in self-employment income then $92,350 of that income would be subject to self-employment taxes. That $92,350 would be taxed at a 12.4% rate for social security up to the social security maximum ($118,500 for 2016; $127,200 for 2017) and at a 2.9% rate for medicare. In our example the $92,350 would cost approximately $14,130 in self-employment taxes. An additional 0.9% medicare tax is imposed on income exceeding $250,000 for married couples ($125,000 for married persons filing separately) and $200,000 in all other cases. No maximum tax limit applies to the medicare tax.
Similarly, if you conduct your business as a partnership in which you are a general partner, in addition to income tax you would be subject to the self-employment tax on your distributive share of the partnership’s income. On the other hand, if you conduct your business as an S corporation you will be subject to income tax, but not self-employment tax, on your share of the S corporation’s income.
An S corporation is not subject to tax at the corporate level. Instead, the corporation’s items of income, gain, loss, and deduction are passed through to the shareholders. However, the income passed through to the shareholder is not treated as self-employment income. Thus, by using an S corporation, you can avoid self-employment income tax.
There is a catch, however, in that IRS requires that the S corporation pay you reasonable compensation for your services to the S corporation. The compensation is treated as wages subject to employment tax (split evenly between the corporation and the employee), which is equivalent to the self-employment tax. If the S corporation does not pay you reasonable compensation for your services, IRS may treat a portion of the S corporation’s distributions to you as wages and impose social security taxes on the deemed wages. There is no simple formula regarding what is reasonable compensation. Presumably, reasonable compensation would be the amount that unrelated employers would pay for comparable services under like circumstances. There are many factors that would be taken into account in making this determination. However, done properly this strategy can generate tax savings upwards of 15.3% on a portion of your earnings. Returning to our example of $100,000 of taxable income, using an s-corporation structure, and paying “reasonable wages” of $60,000, the net savings in self-employment taxes would be approximately, $4,950.
Choice of entity is a very important decision, and while taxes play a role in this decision, that should not be the sole reason for picking any one type over another. Please call or email me if you would like to discuss the practical aspects of conducting your business through an S corporation and how much the S corporation would have to pay you as compensation. You may find the tax savings well worth the change in structure!