The formation of a corporation or limited liability company can help self-employed people lower their tax burden.
There are few ways to completely sidestep having to pay self-employment tax. There are, however, three effective strategies you may apply to lessen your overall self-employment tax liability.
As a self employed person, you get to set your own hours and pursue your own interests. However, you could be taken aback by how much higher your tax bill ends up being when. The self-employment tax is complicated to avoid in most cases. However, there are three excellent options available to lessen your self-employment tax liability.
The independence and possibilities of self-employment are vast. While working for yourself, you may find that your tax liability increases significantly. Self-employment taxes are a necessary evil for those who choose to work independently, but they may be a financial shock to those who aren’t prepared for them. Establishing a corporation or limited liability business (LLC) may help you pay less in taxes.
Your work for yourself. People who are self-employed are expected to contribute self-employment taxes, which can come as a financial jolt. Establishing a corporation or limited liability business (LLC) may help you pay less in taxes.
Understanding Self Employment Tax
Your employer will pay a portion of your Social Security and Medicare taxes, but you will be responsible for paying a portion of these costs yourself. If you’re in business for yourself, you’ll also have to cover your fair amount of federal income taxes, as well as those for Social Security and Medicare. This is an obligatory tax for the self-employed person. Self-employed individuals, including sole proprietors, partners, and members of disregarded limited liability companies, must pay self-employment tax. In 2020, self-employed individuals will pay 15.3% of their income in self-employment taxes, including 12.4% to Social Security and 2.9% to Medicare. In 2019, this threshold is set at $137,700 and will increase to $142,800 in the year 2021. There is a 0.9% Medicare surcharge for anyone with yearly incomes over $200,000.
Self Employed Tax Calculator
Being Taxed as an LLC
The self-employment taxation of a limited liability company (LLC) can be handled in a few different ways.
Ignored the LLC. When forming an LLC with only one member, self-employment tax is still due unless the LLC chooses to be treated as a corporation (more on this below). As a self-employed person, your tax responsibility remains the same.
LLC is treated as an S company for tax purposes. If you form an LLC, you have the option of being taxed as an S company. If you go this route, you can avoid paying SE tax.
Being Taxed as a Corporation
There are two possible types of incorporation for a business: “C” and “S” corporations. A corporation’s primary functions are to generate income or loss, organize those funds for taxation, and then distribute the remaining funds to the company’s shareholders. When a company earns money, that money is taxed by the company, and when the company pays out dividends, the money is taxed by the shareholders. Because of this, a double taxation situation has been created.
C Corporation
Any profits made by your C Corporation will be subject to corporate income tax, and any salary you take out will be subject to personal income tax. You avoid paying self-employment tax as an employee, but the company still foots the bill for its share.
If a company’s shareholders are taxed independently from the company itself, the company is said to be organized as a C corporation (or C-corp). The most common type of company, known as “C” companies, must pay taxes on their business revenue as well. As a result, business earnings face double taxation, as they are levied both on the company and on the individual.
Other business forms, such as S corporations and limited liability companies (LLCs), also shield firm assets from individual shareholders but do so in legally and fiscally distinct ways from C-corporations. B-corporations, also called benefit corporations, are a relatively new business structure that differs from C-corps in their stated mission, level of responsibility and transparency, and the way in which they are taxed.
S Corporation
A pass-through entity describes an S company. There is zero corporate income tax. You have two options for taking a cut of the company’s profits. You may start by giving yourself a wage. When filing as a person, you will only be required to if you are self-employed, you must pay self-employment tax on the money you take out of the firm as salary. Therefore, if you decide to cash out some of your S-Corporation shares, you won’t have to pay any self-employment tax on that sum. In this approach, expenses are cut down significantly. Payroll withholding for a sole proprietorship while receiving a distribution of cash can be avoided by splitting the corporation’s revenue into two payments to you as an individual. Keep in mind that this only applies if you want to be taxed as an S company. If you don’t meet these requirements, you’ll be categorized as a C company. These advantages are also available to limited liability companies that elect to be taxed as S corporations.
Establishing your company as an LLC or corporation may allow you to pay less in self-employment taxes.
The self-employment tax solely applies to earning employed income. If customers or clients pay your S-corp instead of you personally, that money is not yet considered earned income.
Your S-corporation is now ready for you to start drawing a salary and dividends. Self-employment tax applies to “salary” or “earned” income. Self-employed individuals pay tax on their net income at the regular income rate, but dividends are not taxed. 5
The formation of an S-corp or the development of some other strategy to decrease your self-employment tax can be difficult. The best course of action may change from year to year as self-employment tax rates and the categories of income subject to these rates evolve. Avoid making costly mistakes by seeking the advice of a tax professional who has dealt with people in your shoe before.