Self Employment Taxes: Why You Need a Personal CFO
If you run your own business, whether as an entity registered with your state or as an informal sole proprietorship, you must pay self-employment tax on at least a portion of the business income. Self-employment income drives up your tax bill, but you can reduce—or even eliminate—it. Read on to find out more about self-employment tax.
Self-employment tax may cost you more money at tax time than you realize. Can you reduce that part of your bill?
Self-employment tax defined
If you earn a salary or wages reported on a W-2, you know that part of the withheld amount goes to Social Security (box 4) and Medicare (box 6). Your employer withholds these amounts and submits them to the Internal Revenue Service (IRS) for you. These amounts usually equal 6.2 percent (Social Security) and 1.45 percent (Medicare) of your salary or wages, (unless you earn a substantially high amount), for a total of 7.65 percent. Those amounts represent your—the employee’s—portion; additionally, your employer pays an equal amount, doubling the total contribution to Social Security and Medicare on your behalf to 15.3 percent of your salary.
The Federal Insurance Contributions Act (FICA) mandates these deductions from salaries and wages. The amounts collected help fund Social Security and Medicare. The idea is you pay into these systems over the time you work so that you can withdraw from them during retirement.
Self-employed (Schedule C) income
If you earn income reported on a Schedule C (that is, not from salary and wages, capital gains, rent, interest, dividends, or other passive activities), this income usually comes without anything withheld. This presents two problems from the perspective of the IRS: first, you did not make your share of the FICA contributions; second, your employer—even if that’s you!—didn’t make the matching contributions on your behalf either.
Self-employment tax corrects these problems. If you reported net income on a Schedule C, attached to your Form 1040, you should also see a Schedule SE.
Calculating your self-employment tax
Schedule SE walks you through the calculation of your self-employment tax (you can see the 15.3 percent figure on line 5), but the concept is generally easy:
- You figure 15.3 percent of your net income (revenues minus deductible expenses). This is your self-employment tax.
- You deduct one-half of that figure (your employer gets to deduct its half of your FICA withholding, so you get the same privilege) from your business income.
- You calculate your income tax as normal.
- You add the self-employment tax to your income tax.
This works out to you paying closer to 14 percent of your business net income as your self-employment tax thanks to the one-half deduction the business takes.
Do this now: if you earned Schedule C income, look at your 1040 line 57. If your self-employment tax exceeds $3,000, keep reading!
Keep in mind: you pay self-employment tax in addition to income tax, so if you derive all (or nearly all) of your income from your sole proprietorship, then add about 14 percent to your income tax bracket. That can make a huge difference, and naturally leads to the next question: Can I avoid or reduce my self-employment tax?
Avoiding/reducing your self-employment tax
You have two main options for reducing your self-employment tax:
- Stop being self-employed, or
- Elect a tax-advantaged entity for your business.
If a single source provides your self-employed income, usually reported on a 1099-MISC, you could consider negotiating employment. You and your potential employer should evaluate whether you are, in fact, an employee or not. If you should be classified as an employee, your then-employer should report your income on a W-2 and withhold for FICA and income taxes. This makes your FICA withholding the 7.65 percent, with your employer contributing the other 7.65 percent, cutting your FICA tax liability in half!
You must consider all the financial implications of this change in the arrangement before agreeing to a status switch. This will reduce your monthly take-home pay due to withholding; however, you should avoid a large tax bill for the year due to eliminating self-employment and having withholding. You may negotiate additional deductible benefits from your employer, such as retirement plan contributions and health insurance.
If employment is not possible or preferable, you can elect a different taxable entity such as an S Corporation. S Corporations allow shareholders (and you can own 100 percent of the shares of your company) to act as both owner and employee. In effect, your company will pay you a salary.
This means you—as a company owner—must arrange for withholding from your employee salary. The company withholds the employee portion of the FICA tax and pays (and subsequently deducts) the employer portion. (I recommend using a payroll service, such as Gusto (accountant link) or the payroll service in your online bookkeeping software. Let me know if you want help with this.)
Thanks for reading! In my next post, I’ll give more details on using S Corporation status to reduce your self-employment tax. I’ll specifically cover how to determine your salary and distributions. If you found this post useful, please share it with your social media communities! If you would like to discuss this or any other financial matters—including taxes, retirement, financial planning, or starting and running a business—schedule a FREE consultation with JWellsCFO, your Personal CFO!