Being self-employed gives you a unique opportunity to be your own boss. However, this level of freedom comes with great responsibility. For starters, you are called to take charge of your own retirement plan and, of course, pay your own FICA taxes (Social Security and Medicare). This means that you must understand and comply with your federal tax responsibilities. This guide will help you get a pretty good idea of what tax planning should look like for you. We will also share valuable insights and tips to help you minimize your tax obligations.
What is the Self-Employment Tax?
In a nutshell, it is the way the federal government funds Medicare and Social Security benefits. The only case you are not obliged to pay this tax is when you have a minimal amount of self-employment income. The way your self-employment income is calculated varies depending on your business structure. For instance, if you are a sole proprietor, statutory employee, or independent contractor and file Schedule C, your self-employed tax is the net profit listed on your Schedule C (or C-EZ). This must be included on your Schedule SE.
Minimizing your Tax Obligations
1. Choose the Best Business Structure
As it has already become apparent, identifying what business structure best suits your needs is important for the self-employed. This decision will not only determine how much you pay in taxes, but also affect (1) the personal liability you face, (2) the amount of paperwork required, and (3) your ability to raise money. Your individual circumstances will pinpoint the structure that makes the most sense, though. You can choose among the following business entities:
- Partnership – You share the losses and profits of a business with two or more people. This means that you don’t bear the benefit of losses-profits or the tax burden of profits all by yourself. During tax time, each business partner files a Schedule K-1 form that indicates their share of income from the business, tax credits, and deductions. As for the losses, these are passed through to the partners, who report them on their individual tax reruns. On the flip side, each partner is personally liable for the business’ financial obligations. Plus, partnerships require more extensive accounting and legal services than sole proprietorships. Hence, they are costlier to establish.
- Sole Proprietorship – The most common business structure. It offers the owner complete managerial control and is very easy to form. Nevertheless, the owner is held responsible for all their business financial obligations. Tax-wise, a sole proprietorship business owner includes income and expenses from the business on form 1040 (their personal income tax return). The losses and profits are recorded on Schedule C (a tax form) that is then filed along with their 1040. Finally, the Schedule C “bottom-line amount” is transferred to their personal tax return. Worth noting is the fact that your business earnings are taxed once.
- LLC (Limited Liability Company) – It is a hybrid form of partnership that enables business owners to benefit from the advantages of both the Partnership and Corporation forms of business (i.e., owners bear no personal liability, losses and profits are passed through to owners without taxation of the business). LLCs are great entities for tax purposes as they enable owners to enjoy liability protection skipping the double taxation of corporations. They also offer more attractions to business owners than S-Corps (i.e., no shareholder limitations. However, they usually dissolve after 30-40 years.
- C-Corporation (or C-Corp) – It is a legal entity that is separate from the individuals that found the business. A corporation is taxed and held liable for its actions pretty much like a person (liability protection for the owners). This is perhaps the biggest advantage of going for a Corporation business structure – the owner does not have any personal liability. The extensive record-keeping required, alongside the cost to form a corporation, though, are the primary disadvantages. Plus, corporation owners pay a double tax on the earnings of the business.
- S-Corporation (or S-Corp) – You may choose the S-Corp (aka Subchapter corporation) structure that enables losses and income to be passed on individual tax returns (single-level federal tax to be paid). Usually, an S-Corp structure is offered to companies with no more than 75 shareholder returns and provides business owners with the liability protection of a corporation.
The type of business format that best suits your requirements will primarily depend on the following three factors
(1) Record-keeping – How much paperwork is required? Are you up to it? Can you bear the cost of paperwork and record-keeping, along with the costs related to incorporation? Remember that administrative requirements like that can eat up your time, which can, consequently, create costs for the company. But, if you are benefiting from protection from liability and tax implications, a corporation is a good option. In any other case, you would be better off with a sole proprietorship, especially if you own 100% of the business.
(2) Taxation – There are much fewer tax options available to partnership and proprietorship than to corporations. For example, a self-employed that receives a 1099 pays an additional self-employment tax. Those that do not make much is best to choose a sole proprietor business entity. As for those making at least $50,000 and are 1099’d, it would be better to create a corporation business structure, depending on the number of employees, business owners, and the size of the business.
(3) Liability – To what extent do you need to be held legally liable for potential losses related to your business? Can you afford the risk of the potential liability? If not, then a partnership or sole proprietorship may best be avoided.
2. Make Your Estimated Tax Payments on Time
This is a major consideration as it will help you avoid penalties. Ensure you (1) set up estimated tax payments and (2) make the required quarterly estimated tax payments (using Form 1040-ES) to cover both your self-employment tax and income tax liability. Note that you may also need to make estimated tax payments to avoid getting penalties and receiving a big tax bill at the end of the fiscal year. And, don’t forget your periodic tax responsibilities if you have employees (see IRS Publication 15 for more information). The IRS has an automated payment system called EFTPS that you can use for your payments. We strongly advise you to opt for monthly payments as it is easier to stay current than with quarterly payments. This also helps prevent the IRS from penalizing you for not paying your due (quarterly) tax on time.
Tip: You can save taxes by employing family members (not minors), which allows you to shift income to your relative. That way, the business takes a deduction for employee compensation (ensure it is a reasonable amount), which reduces the business taxable income that flows to you.
3. Establish an Employer-Sponsored Retirement Plan
This will not only allow you to take care of your own retirement needs but also provide you with several tax benefits by enabling your business to be eligible for an immediate federal income tax deduction (expenses to fund the plan). Such employer-sponsored retirement plans worth considering are SIMPLE IRA, SEP, SIMPLE 401(K), Keogh plan, and Solo (or one participant or individual) 401(k). Note that until you withdraw earnings and contributed funds, you will not need to pay any federal income tax. IRS Publication 560 has more details about these schemes. You may, however, call us and let us guide you appropriately.
4. Take Advantage of Business Deductions
Your business is entitled to deductions that reduce your taxable income. Make sure you use every single one of the offered deductions to deduct business expenses, including equipment costs, utilities, office expenses, and rent. Just ensure your business expenses are considered necessary, common, and accepted in your business or trade. Also, using the cash method of accounting allows self-employed taxpayers for greater maneuverability at the end of the year.
Tip: You may also deduct self-employed healthcare-related expenses (up to 100% of the health insurance cost you provide for yourself, your dependents, and your spouse). Note that your contributions to HSA (health savings account) are also deductible.
Two Effective Ways to Sidestep the 13.25% Self-Employment Tax
1. Become a Partnership.
The first would be to become a partner and make K1 distributions (aka guaranteed payments) to yourself.
2. Become an S-Corp.
The second option is to become an S-Corp. Whichever business structure you choose will enable you to sidestep the self-employment tax.
Here’s a savings example to get an idea of what we are proposing here:
Let’s assume that you make $100K and write $50K for business expenses. According to the current federal tax laws, you will be called to pay around 20% tax PLUS the 13.25% self-employment tax. As an S-Corp, though, you will NOT have to pay the 13.25% tax – the profit would be a K1 distribution.
- You must file an 1120-S.
- Ownership pulls must be consistent (for example, $5K every month).
- The IRS wants to see one or more W2, which could be yourself.
Make Sure You Do Your Bookkeeping
You may either want to outsource bookkeeping or use platforms like QuickBooks. When it comes to calculating estimated payments and paying the right tax amount on time, bookkeeping with the help of a software or by trusting a reliable and experienced tax accountant makes things far easier.
As you can see, there are legitimate (aka legal) ways to save money on your taxes while being self-employed. It’s simply a matter of planning well, staying on top of things and taking advantage of all possible tax savings strategies.