A lot of self-employed individuals get upset around tax time when their accountants tell them they owe an extra 15.3% in tax. It can be a bit of a gut punch to those just expecting to pay income tax.
Unfortunately, income tax does not cover FICA—Social Security and Medicare. An employee generally splits those taxes with the employer. However, anyone operating a business as a sole proprietor, general partnership, or an LLC (not electing corporate treatment) gets stuck paying the whole nut. It also hits folks who have been misclassified by their employers, and those professions with special exemptions, like real estate agents.
As a general rule, 92.35% of your net earnings from self-employment is subject to Self-Employment tax. Your net earnings are equal to your gross revenues less ordinary and necessary trade or business expenses.
The 15.3% figure is the combination of 12.4% for social security and 2.9%. The social security tax only covers the first $117,000 of combined wages, tips, and net earnings. The 2.9% for Medicare has no such limit.
So how do you avoid it? Easy:
- Form a corporation or an LLC
- File an election to be treated as an S corporation
- Pay yourself a reasonable salary
- Pay payroll taxes on your salary—FICA and FUTA
- Take earnings in excess of your salary as distributions, free of payroll tax
Ok. It is easier said than done. It also does not avoid the taxes entirely. It only avoids FICA on any earnings over your salary, which are taken as distributions instead of salary.
The trick is determining what your reasonable salary should be. The IRS can re-characterize a distribution if it decides your salary was unreasonably low. See Rev. Rul. 74-44. This can get expensive, especially with penalties. To measure reasonableness, they will look at all the facts and circumstances of your situation. This can include industry standard rates, your education and experience in the industry, the ratio of your salary to gross earnings, your salary compared to that of any employees you may have, and anything else relevant to your business.
In one recent Tax Court decision, Sean McAlary, a real estate broker, paid himself a salary of $24,000 when he had gross receipts of $518,189 and net income of $231,454. Sean McAlary Ltd, Inc. vs. Commissioner, T.C. Summary Opinion 2013-62, pg. 16. Based on market conditions, labor statistics, and McAlary’s relative inexperience in the industry, the court decided that $83,200 was a reasonable salary for his position.
If you had McAlary’s earnings this year and paid yourself the court-deemed reasonable salary, it would translate into a savings of roughly $4,191.20 in social security tax and $3,785.89 in Medicare. The savings would have been greater had a lower salary been reasonable, but that is still a nice little raise.
What is reasonable can seem a little bit arbitrary, so it would be wise to get an opinion from a tax advisor when deciding on a salary. Such advice can evidence reasonable cause and good faith, and avoid penalties. Id. at pg. 18. However, do your due diligence when selecting an advisor, and document it.
There are other costs and considerations to forming and maintaining an entity. Depending on your state and city, you may have franchise taxes to pay. For instance, California charges a 1.5% tax on the net income of S corporations, with a minimum tax of $800. On the other hand, Washington has no income tax and B&O would remain the same. Tax preparation costs may increase since you’ll need to file federal and possibly state corporate income and employment returns, but you should also save on your individual return since you no longer have a schedule C.
Remember, you will also get all the added benefits of having an entity, including limited liability. While it is not a strategy for everyone, any prudent business owner should give it serious consideration.