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