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Imagine this scenario, you all will hopefully experience: your small business has had its first great year.

Instead of slaving all year just to find out from your accountant that you barely broke even, you know you brought home close to $100k. As you tell your bean-counter the good news his face doesn't seem to share in your excitement. "Did you make estimated tax payments" he asks. Unwittingly you respond, "I made some." And that's when the bomb drops; you hear a number for tax due that is significantly higher than you ever expected to have to pay. The reason: self-employment tax.

Self-employment tax is the tax that covers your contribution to social security and Medicare.  Usually, when you are employed by someone, 7.65% of your gross paycheck is withheld to pay these taxes. Your employer then matches your 7.65% and sends it to the US Treasury on your behalf. The problem is, when working for yourself in a small business, no one is doing this for you. And, unless you are making estimated tax payments during the year, this entire burden comes due April 15th. Because you are all by yourself you end up paying both portions of your social security and Medicare. That ends up being 15.3% of your net earnings. This tax is on top of whatever you owe for regular federal income tax.

Let me tell you how you can substantially reduce your self-employment tax bill.

Self-employment tax is meant to be paid on "earned income." That is, money you earn from working or producing. It is not intended to be paid on passive earnings or earnings from investments. As small business owners, not all of our income is "earned" from our labor. Some of our income comes from the intrinsic value of our businesses. It comes from the good reputation we've made in our cities. It comes from the profitability of our employees.

The problem is when we are sole proprietors or single-member LLCs, all of our income gets reported on a schedule C and it is all considered earned income. We pay 15.3% self-employment tax on every penny. The key to reduce self-employment tax is elect to be taxed as an S corporation (aka S corp). Generally speaking, a business's entity status with the state can be an LLC and the status with the IRS can be S corp. This provides all the legal protection of being and LLC and all the tax benefits of being an S corp.

Let me provide an example of how electing S-Corp status can save you a significant amount of self-employment tax.

(Please note: It is not always most beneficial to elect S-Corp status. You should always consult a tax professional regarding your tax strategies.)

A business owner earns $100k after paying business expenses. Normally, SE tax on these earning would amount to $15,300 (15% of $100k).

Alternatively, the same business owner earns $100k after paying all business expenses and elects to be taxed as an S corp. In this case the business owner can choose to pay himself a salary of $40,000 and take the remaining $60,000 as a distribution from the S corp. Now, instead of paying 15.3% SE tax on all $100k of his earnings, he will only pay SE tax on $40,000 of his earnings. This will bring his SE tax bill down from $15,300 to $6,120. That is a total savings of $9,180! That is a lot of tax savings for making a simple tax election!

There are some important things to consider before making an S corp election for your business.

  • First, the more your business earns, the more an S corporation election can save you. However, if you make less than $40,000 in a year, making an S corporation election may not help you and may even cost you money. If your business suffers a loss while having an S corp election, you will pay SE tax on wages that you would not have had as a sole proprietorship or a single member LLC.
  • Additionally, the salary you choose for yourself (in the example above $40,000) must be reasonable for your industry or profession. In some cases that's $20,000, in some cases that's $40,000, and in some cases it's even higher. The key to reducing SE tax is by having a low salary and distributing the remaining income. However, the salary must be "reasonable." Consult a tax professional for assistance on determining a reasonable salary.

S corporation elections are made on Form 2553 and must be made by February 15th of the year you want the election to take effect (assuming you are a calendar year tax payer and do not run your business on a fiscal tax year).

SE tax can be detrimental to your profits. Consider making an S corporation election and save BIG!

{To ensure compliance imposed by IRS Circular 230, any US federal tax advice contained in this communication is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed by governmental tax authorities.}

Adam Diaz (adam@firstfruitsaccounting.com), a CPA and Owner of First Fruits Accounting, was a contributing member to this blog.