If you’ve been self-employed or are starting as a self-employed individual, you’ve probably have come across the dreaded SELF-EMPLOYED TAX. Getting paid in full is not as fun as you thought once it comes to tax time. So what is the Self-employed Tax, it basically both the employee and employer portion of Social Security and Medicare taxes. On the cuff, it would seem that you get paid less than if you were an employee, however, you are your own boss and you simply have to price your services accordingly or achieve your sales goals accordingly.
Even after you strategize your goals, you reduce your profits with expenses, and you put yourself on a consistent budget to eliminate surprises. The IRS does give you a way to minimize your SE tax and this is to incorporate. Now there are different types of entities your could elect, LLC, LLP, C-Corp, partnership, S-Corp, but for the purposes of minimizing the SE tax we will discuss the most common Pass-through entity, the S-Corp.
The Internal Revenue Service may take a close look at your taxes if you choose this route, as you could end up lowering your overall tax liability while generating the same net income.
If you decide to incorporate as an S-corporation, you can categorize some of your income as salary and some as a distribution. You’ll still be liable for social security and medicare taxes on the salary portion of your income as well as the Employer portion, however, the benefit on is that you’ll just pay ordinary income tax on the distribution portion. Depending on how you divide your income, you could save a considerable amount of self-employment taxes just by converting to an S-corporation.
IRS view of S-Corporations
The IRS tends to take a closer look at S-corporation returns since the potential for misuse is so large. For example, if you make $200,000 in one year but only designate $30,000 of that as salary income, you might trigger an IRS inquiry, since you are avoiding so much self-employment tax. The guiding principle is that you must designate a “reasonable” amount of your income as wages, rather than a distribution. What constitutes “reasonable” can often be a gray area, but if you push the envelope too far, you put yourself at risk for an IRS audit and potentially penalties and interest on any back taxes assessed by the IRS.
S-Corporations have additional costs
While an S-corporation may save you in self-employment taxes, it may cost you more than it saves. As with larger corporations, an S-corporation has both start-up and ongoing legal and accounting costs. In some states, S-corporations must also pay additional fees and taxes. For example, in California, an S-corporation must pay tax of 1.5 percent on its income with a minimum annual amount of $800. This tax is not required for sole proprietors.