If you’re self-employed and run your own business, you already know just how much that self-employment tax can hurt. Self-employed people typically pay higher Social Security and Medicare taxes than those who are employees of a company, as they must pay their share as well as their employer’s share. One way to reduce your SE taxes is organizing your business as an S Corporation. Here’s what you should know.
The Self-Employment Tax Explained
When you work for someone else, your employer pays half of your Social Security and Medicare taxes while the remaining half is taken out of your paycheck automatically. When you work for yourself, you are responsible for the full tax amount on your own. When you pay them, they’re known as the self-employment tax.
The self-employment tax varies by year, although the Social Security tax is always higher than the Medicare tax. In 2014, the Social Security tax was 12.4% while the Medicare tax rate was 2.9% (15.3% total). You only pay the Social Security tax on your income up to $117,000, although you must pay the Medicare tax on all income. The Medicare tax rate climbs another 9% for any income exceeding $200,000.
As a sole proprietor or an owner of an LLC, you will pay self-employment taxes. You will be required to calculate your tax rate and make estimated quarterly tax payments to the IRS.
Why Corporations are Taxed Differently
Corporations are treated differently than sole proprietorships in terms of taxes. The IRS automatically treats all corporations as a C Corp, which requires paying corporate income tax on all earnings before the owners (shareholders) pay personal income tax on distributions.
As a business owner, you may qualify for S Corp status, however. If you incorporate your business as an S Corp, you will not pay corporate income tax. Instead, shareholders report company income on personal income tax returns.
If you own an S Corporation (or an LLC that chooses to be taxed as an S Corp), you will only pay self-employment taxes on the salary you pay yourself but not on business profits that you do not distribute to yourself. This can work out to significant tax savings.
For example, imagine a general partnership with $400,000 in business profits. As a partner, you will have self-employment taxes of $20,308 on your half of the profits. If you form an S Corporation and you and your partner receive reasonable salaries of $80,000 each, your taxes will be much lower at $12,240. You will not need to pay self-employment taxes on your share of the remaining profit that is not distributed to you but remains in the company.
You can enjoy S Corp tax treatment by incorporating your business or forming an LLC and filing additional forms with the IRS for S-Corp status. For an LLC, file form 8832. For a corporation, file form 2553. Remember that every business has a unique tax situation. Be sure to discuss the potential consequences of filing for S Corp status with a tax specialist or attorney. If you need to incorporate or form an LLC first, contact a corporate services company for help.