Effective Strategy for Small Business Owners to Mitigate Self-Employment Tax Liability

Those who are self-employed generally are subject to higher Medicare and Social Security taxes, which together are alternately referred to as self-employment taxes.  Someone who has employee status pays only a portion of self-employment taxes, but self-employed individuals pay the entire amount of self-employment taxes.  This issue is particularly important because the expiration of the payroll tax holiday means that the total amount of self-employment tax reverts from 15.3 percent back to 13.3 percent with the expiration of the payroll tax cut.

While self-employment tax imposes a heavier tax burden on small business owners than if they were employees, this higher tax burden can be mitigated by selecting an S-Corp as one’s business form.  Someone who is self-employed can use this strategy to reduce tax liability based on the same level of net income.  When structuring your business as an S-Corp, a portion of revenue can be divided between distribution and salary.  Although the portion of revenue designated as salary will still be subject to self-employment tax, the portion designated as a distribution will be subject to ordinary income tax.  This can result in substantial saving because of the reduced employment tax burden.

If you are interested in converting your business to an S-Corp or initially forming your business as an S-Corp, you should seek legal advice from an experienced tax attorney because there is a potential risk associated with this strategy.  The IRS scrutinizes S-Corps more closely because of the potential for abuse.  While this is a legitimate tax planning strategy, the division of revenue between salary and distribution must be reasonable.  If the business generates a million dollars in income after other expenses and only $40,000 is allocated to salary, this may trigger an IRS inquiry because the amount of self-employment tax avoided.  The fundamental principle is that the amount designated as salary must be “reasonable.”

Admittedly, this is a fuzzy concept, but a knowledge tax attorney can provide guidance regarding what might satisfy this standard given your unique circumstances.  While this can result in a significant reduction in the amount paid in self-employment tax, the benefit of this strategy may be undermined if it is not done correctly because it may expose the taxpayer to liability for underreported income, penalties and interest.

There are other costs associated with S-Corps, but a knowledgeable tax attorney can provide information so that you can make an informed decision about whether the self-employment tax savings justify the risk and costs associated with an S-Corp.  We offer a free initial consultation so call us today at 504-302-4949 or email us

Seeking Innocent Spouse Relief for Tax Liability Arising from a Joint Tax Return

Most married couples select “married filing jointly” for their federal income tax filing status because it will typically result in a reduced tax liability.  Despite this financial advantage, filing a joint tax return also has a disadvantage because you are financially responsible for any unpaid tax, penalties and interest if there are inaccuracies when you sign a joint tax return.  Even if your spouse owns a business that generates all of your household income, the IRS can pursue its harsh enforcement penalties and seek the entire amount owed from you.

When signing a joint tax return, you should carefully review every line of the tax return to confirm its accuracy.  If you are not involved in a spouse’s business and have separate bank accounts, you may have no idea that the information on the joint tax return is inaccurate because of an inadvertent error or intentional misrepresentation by your current or former spouse.  The Internal Revenue Code is designed to protect a spouse in this type of situation, but this exception to joint and several tax liability is extremely narrow so it is difficult to qualify.

The conditions that must be met to qualify for innocent spouse relief include:

  • The understated tax liability is a result of an error by the spouse of the requesting party, such as undisclosed income, inapplicable credits and deductions or underreported earnings.
  • The party seeking innocent spouse relief did not know and did not have reason to know that the return underreported tax liability when the return was signed.
  • It would be unfair to impose liability for the tax on the requesting party under the surrounding circumstances.

There are a few nuances that impact eligibility under the above criteria.  If a spouse was aware of the understated tax under the second criteria above but not the extent of the underpayment, the taxpayer may qualify for partial relief for responsibility for the unpaid tax.  The IRS will also consider whether the party seeking relief benefited from the underreported tax obligation in the form of a more affluent standard of living and whether the parties who signed the joint return were later separated or divorced.

The IRS may also grant two other forms of relief beyond innocent spouse status: (1) relief by separation of liability and (2) equitable relief.  Relief by separation of liability involves allocating the unpaid tax liability between the spouses.  This form of relief may be authorized if the parties are separated or no longer married or the parties were not members of the same household during the year covered by the tax return.  If the IRS is able to establish that the party requesting this form of relief had actual knowledge of the erroneous information on the tax return or colluded with his or her spouse, this form of relief will not be granted.

When neither innocent spouse status nor relief by separation is an option, a spouse may seek equitable relief.  When there has not been any fraud, the taxpayer may be granted relief based on fairness.  The factors that the IRS may consider in assessing whether relief is appropriate may include economic hardship, separation and divorce and other factors bearing on the unfairness of imposing liability on the requesting spouse.

If you are facing tax liability based on a joint return and have questions about innocent spouse status, you should contact experienced tax attorney Paul Grego.  We offer a free initial consultation so that we can evaluate your eligibility for tax relief and explain your options.  Call us today at 504-302-4949 or email us.