I’ve written a more general article on which entity your small business should choose, but let’s dive a little deeper on one of the most common tax planning strategies we use with our clients.
Let’s start by defining what Self Employment (SE) Tax is. According to the IRS website SE tax is a tax consisting of Social Security and Medicare taxes primarily for individuals who work for themselves. Generally, if you have net earnings in excess of $400, you have to pay self-employment taxes. Most of the time this is computed on the individual’s tax return for their Schedule C income (sole proprietor), but SE tax can come into play with partnerships as well.
The SE tax rate is 15.3%, which mirrors the tax an employee and employer would pay for FICA if you worked for someone else. But, you do receive one half of that against your income tax, which is the equivalent to the employer’s portion. This is a deduction against your taxable income for regular taxes, NOT the SE tax.
A common strategy for small business tax planning is to incorporate the business, and elect the S-Corporation election. The business owners working in the business then have to take a salary from the corporation, like a regular employee. This will cause the owner to pay FICA taxes on those wages, which is the same rate as the SE tax (15.3%). However, any profit ABOVE the salary amount is no longer subject to the SE tax. Understand, it is still subject to income tax, but you’ve saved 15.3% from being a sole proprietor (Schedule C)!
Here is an example. Let’s say you have a small business that generates $70k in net income after expenses. As a schedule C sole proprietor, you will pay 15.3% SE tax or $10,700. This is in addition to income taxes (which I’ve excluded from this example). So now, let’s say you incorporate that business and elect S-Corporation status. You take a salary of $35k and pay the FICA tax on that wage equal to $5,350 and have net income of $35k after the salary. That net income is not subject to SE tax, saving you $5,350! Viola!
The more astute of you may be asking, so why not just take no salary and save even more? Good question.
The IRS expressly prohibits it, that’s why. The IRS says that everyone working in the business must be paid a reasonable salary. Ah, so what is a “reasonable salary” you ask? I’ve written another article discussing what constitutes a reasonable salary.
Of course, there are other issues to consider when you’re selecting an entity and tax planning.
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