Most LLC members are not considered employees, so no Social Security or Medicare taxes are taken out of their paychecks. Instead, most LLC owners must pay these fees directly to the IRS rather than as business payroll taxes, which are known as "self-employment taxes" when paid by a small business owner.
As an LLC, S-Corp, or partner in a partnership, you need to know how to reduce your self-employment tax. This article discusses ways to avoid or reduce this devastating tax.
What Are Self Employment Taxes & Who Needs To Pay Them?
Self-employment tax is a tax on gross income from self-employment in business. It consists of part of social security and part of Medicare taxes.
You should know that any net income from self-employment is subject to the self-employment tax if your total net earnings from all passive activities are $400 or more.
If your net earnings from self-employment are less than these amounts, you do not have to pay any self-employment taxes.
However, if your total business income from self-employment is more than these amounts, some of your income will be subject to both Social Security and Medicare taxes.
Tips to Reduce Self Employment Taxes
If you are self-employed, chances are you have fallen prey to the mistaken notion that because you get a paycheck, your business is automatically set up as an S corporation.
That means that there is no separate tax on the income of the business.
This is wrong! The income of the business gets passed through to your individual returns, where it is counted as income and consequently taxed.
This means that if you do not set up your business as a corporation, the self-employment tax will apply to all of your business revenue. If you fail to take action now, your business could be paying out well over 50% of taxable income!
You can avoid this debacle by setting up your business as a corporation. There are many ways to do this, and you can use an attorney or other professional to make sure the process runs smoothly.
Increase Your Business Expenses
As a self-employed person, one way to avoid paying taxable income is simply to reduce your net income from self-employment.
You can do this by increasing the business expense that is allowed as a deduction against your income.
The downside of this approach is that you will have less money from which to pay yourself, but at least you won't have to pay self-employment tax on it.
Note that increasing business expenses does not reduce FICA taxes.
These are federal insurance contributions, and they continue to apply to all monies earned by the corporation and its employees.
You can talk to your accountant or financial adviser about ways to reduce self-employment taxes. Many accountants are not familiar with the issues surrounding LLCs and S-Corps, so you may need to do some research on your own as well.
Change Your Business Structure or Form
If you are currently in the process of incorporating, check with your attorney to make sure that they have set up all your final papers.
You might be able to switch from an LLC or S-Corp and still reduce or eliminate self-employment taxes. This is another case where talking with a tax professional really pays off!
Look For Deductions in Other Areas
You might be able to reduce the amount of your self-employment income tax by changing business expenses.
You can take deductions on items not only directly related to running your business but also depreciation or loss on investments in other areas.
These can be reflected in tax deductions in the:
- Vehicle Use
- Internet & Phone Bills
- Start-Up Costs
Take Advantage of Tax Cuts
Some tax credits reduce your tax liability dollar-for-dollar, so it makes sense to pursue them.
Take advantage of all the ones you qualify for. Look at:
- Child and dependent care credits
- Earned income credit (EIC) and business mileage credit (Milesharing Program - see sidebar)
- Investment tax credit
- Renewable energy credits
- Savers' credit for low-income individuals
- Work opportunity credit
- Working families with children
These tax credits can be taken against your self-employment tax income as well as your earned taxable income from employment.
Invest in Eligible Retirement Accounts
Contributions to a traditional IRA can reduce your taxable income. This may even help you qualify for the EIC if you do not earn enough money to take advantage of it.
Many entrepreneurs neglect to save for retirement, but everyone will need to retire sometime, and good financial planning is just as important as good tax planning!
Invest in a Health Savings Account (HSA)
This is a qualified savings account that can be used to pay for certain medical expenses while you are still employed and also after you retire.
You can invest money in an HSA, take deductions on contributions, and use the money tax-free to pay for deductible medical expenses if they exceed your annual deductible amount.
The amount of your annual deductible depends on whether you have an individual or family plan.
By investing in Social Security and Medicare, you can both provide for your future financial security and reduce the amount of money that must be paid out in taxes.
You can also enjoy tax benefits even if you don't have a reasonable salary because the benefits apply to everyone, regardless of income.
Make Donations to Charity
You can deduct charitable donations made in cash or property. If you donate your old computer to a child in need, the donation is deductible even if you could not sell it for much money at an auction because it has no resale value.
The same would be true of any clothing donations. You may not be able to get much for it at a yard sale, but it still has value to someone else.
The services that you provide as a volunteer for a non-profit organization are also deductible by the amount of time you put in and travel expenses incurred while providing those services.
What Happens if You Don’t Pay Self-Employment Taxes?
You will have to pay the taxes later when you file your return. If you owe too much, you will be subject to interest and penalties on the unpaid balance.
Can I Be Exempt from Self-Employment Tax?
The self-employment tax law specifically excludes certain groups from having to pay this tax, such as:
- Employees of other members of their family or household.
- Government employees and ministers (not available if you claimed the EIC).
- Certain foreign agricultural workers and certain household employers and crew leaders.
Is It Better to Be Self-Employed or LLC?
If you set up a business as an LLC, this means you are running it as a separate legal entity and not as a sole proprietorship. This offers no tax benefit, and it is more difficult to manage.
How to Reduce Self Employment Tax...
To summarize, the self-employment tax is a payment you have to make if you are working outside of the social security system.
The good news is that there are many legal ways to reduce the amount of this tax, some even offering significant savings on your income taxes, all while ensuring that you can continue to enjoy a comfortable retirement when you finally decide to quit working.