Reducing Your Self Employment Tax

The Self Employment tax can take a good chunk of change out of your earnings, but luckily there are legal ways to reduce it for high income earners. If your business (your website, freelancing, etc) generates over $100,000 a year in profit, this article could save you thousands that you’d otherwise pay in self employment tax.

Owners of Sole Proprietors, Partnerships, and LLCs are required to pay self employment tax, but S-Corporations and C-Corporations do not, at least not in the same way. Since C-Corporations are already double taxed and have many more rules and regulations, choosing to turn your business into an S-Corporation can save you quite a bit of money. If you own an LLC you don’t have to close it and open up an S-Corporation to take advantage of this strategy. You can simply elect to have your LLC taxed as an “S-Corporation”, which means you’ll remain an LLC, but for tax purposes, you’ll be seen an S-Corporation.

An S-Corporation or an LLC that elects to be taxed as an S-Corporation, unlike an LLC or Sole Proprietorship, is required to pay its owners a “reasonable salary”. Since your business will be paying you a salary, that means you’ll receive a regular paycheck (I recommend working with a payroll company or if your online bank has a payroll system for business accounts, you can use that), you won’t need to pay self employment tax anymore. The purpose of Self Employment Tax is to collect Social Security and Medicare, and since you’re receiving a paycheck (albeit from your own business) these two taxes will be taken out of your paycheck instead of your total profits.  Now you’ll pay FICA taxes on only your salary rather than your total profits.

Example of Savings:

Let’s say you built a website over the last 5 years that now generates $300,000 a year in total profits and your business is set up as a regular LLC. We’ll use the year 2011 for this example. Self Employment Tax for the year 2011 is as follows:

Social Security: 11,107.20 (10.4% * $106,800, this tax is only assessed on the first $106,800 in income).

Medicare: $8,700 (2.9% * $300,000, This 2.9% is assessed on all income.)

Your self employment tax bill in 2011 would be $19,141 as a regular LLC.

Let’s run that same $300,000 profit number again, but this time as an LLC that elected to be taxed as an S-Corporation. Instead of paying Self Employment Tax, you’ll pay regular FICA Taxes only on your salary, which for this example we’ll say is $75,000. The way FICA tax works is that the employee pays half of the FICA taxes, while the employer pays the other half. Since you own the business and will end up paying both the employee and employer share, there’s no reason to make two separate calculations. FICA taxes in 2011 are 10.4% (It’s the same percentage as the self employment tax, as the self employment tax, as both taxes collect money for the same thing).

Social Security: $7,800 (10.4% * $75,000, this 75k number is your salary)

Medicare: $2,175 (2.9% * $75,000)

Your total FICA tax bill in 2011 would be $9,975 as an LLC being taxed as an S-Corporation. A whopping $9,166 in savings! You saved $9,975 because instead of paying social security and medicare taxes on your entire $300,000 in income, you’re only paying it on your $75,000 salary. Social Security is only taken out of your first $106,800 in income, so the real savings come by exposing less of your income to the medicare tax. The portion of your income that wasn’t taxed by self employment simply becomes a “distribution” and dodges the self employment tax.

A Reasonable Salary

Since paying yourself an incredibly low salary could save you thousands in taxes, the IRS specifically states that salaries paid out in S-Corporations and LLCs elected to be taxed as S-Corporations, must be “reasonable”. Anyone who pays themselves “too much” or “too little” in order to reap a tax benefit could be violating the law. In the above example, instead of a $75K salary, if you used a $25K salary, you’d save even more in self employment tax. A “reasonable” salary would be a competitive salary that you could pay someone else to do the work you’re putting into your business. One major aspect of a “reasonable” salary would be where you live. States with higher incomes would have to pay themselves a higher salary if they want to avoid getting in trouble with the IRS.

Webmasters can save a tremendous amount of money by paying themselves a salary as an S-Corporation or an LLC being taxed as an S-Corporation. This is especially true because once you have a web business going, it doesn’t take too much effort to keep it going, which is why you could justify a $50K salary, and let the rest of your profits “pass through” as distributions, which won’t be hit by the Self Employment Tax, but would of course still be taxable under the Federal and State income taxes.

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