Throughout its history, America has been the land of self-made men and women. But regrettably, America’s self-employed must contend with a unique burden every April 15: the self-employment tax. In addition to federal, state and local income taxes, simply being self-employed subjects one to a separate 15.3% tax covering Social Security and Medicare. While employees “split” this rate with their employers, the IRS views an entrepreneur as both the employee and the employer. Thus, the higher tax rate.
The following six tips will help ensure that you do not pay a cent more in self-employment tax than the law requires.
Form an S Corporation
The self-employment tax applies only to what the IRS calls “earned income.” That is, money paid to you as a salary or wage. It does not, however, apply to dividends (or “unearned income.”) The way to receive business income in the form of dividends is to create an S corporation. Nothing changes except that your clients or customers now pay the corporation instead of you directly. Instead, you begin withdrawing a salary from the corporation – but not a full salary. By paying 60% to yourself in the form of salary and 40% in the form of dividends, you will exempt that 40% from self-employment taxes.
As MyMoneyBlog explains in its comprehensive breakdown of the S corp strategy, “the difference between $90k salary vs. $50k salary/$40k dividends is $6,000 a year” in tax savings!
Subtract Half of Your FICA Taxes From Federal Income Taxes
Entrepreneurs are also eligible to deduct half of their self-employment taxes from their federally taxable income. Using the above example: let’s say you owe $7,650 in self-employment tax, which is 15.3% of the $50,000 salary your S corporation paid out. You can now, in turn, deduct $3,825 (which is half of $7,650) from your federally taxable income of $50,000. This way, the IRS can only tax $46,175 of your salary instead of the entire $50,000. While it does not reduce your self-employment tax, it reduces the total amount of tax you pay by lowering your taxable income.
Deduct Valid Business Expenses
The IRS allows business owners and entrepreneurs to deduct all “ordinary and necessary” business expenses. Here, “ordinary and necessary” is the operative phrase. You cannot take a trip to Hawaii and write it off, for instance, unless you genuinely went there to work. You can, however, deduct anything used to generate your income: office space, supplies, advertising costs, business travel, even a pro-rated portion of your mortgage and utilities (if you maintain a home office.) Therefore, if you rack up, say, $10,000 in business-related expenses during the year, you can reduce your taxable income from $50,000 to $40,000. Your self-employment tax obligation will now be 15.3% of $40,000 (which is your net income) rather than $50,000 (which is your gross.)
Deduct Health Insurance Costs
One substantial tax advantage the self-employed have over employees is the ability to deduct health insurance costs. As About.com explains, you can “deduct the full cost of health insurance you purchase for yourself, your spouse, and/or your dependents” so long as you had a net profit for the year. Like the business expenses above, deducting your applicable health insurance costs reduces your taxable income for that year, thereby reducing the total dollar amount of taxes paid.
Defer Income to Avoid Higher Tax Brackets
Another creative but perfectly legal way to reduce your self-employment taxes is to defer income. As a self-employed person, you can choose whether to get paid now or later. While it might seem foolish to delay receiving income, consider the following scenario. Let’s say that even after taking every legally permissible deduction, you are still on pace to have received $36,000 in net income during the 2010 tax year. By arranging to be paid even $2,001 of that in January 2011 rather than now, your 2010 income will be taxed only at the 10% and 15% income tax rates. None of it will be taxed at the 25% rate, as would any amount of salary between $34,000-$82,400.
Bargaineering has helpfully published the marginal income tax brackets for 2010 here. Be mindful of them and consider whether it might objectively make sense to defer some of your income. If you don’t need it right away, deferring income is an excellent way to reduce both your income taxes and self-employment taxes.