If you're self-employed, one way to help avoid higher Social Security and Medicare taxes is to organize your business as an S-corporation.
S-Corp taxes
If you're self-employed, you'll usually have to pay higher Social Security and Medicare taxes, collectively known as self-employment taxes, than if you were an employee of a company. One way to help avoid these higher taxes is to organize your business as an S-corporation. The Internal Revenue Service may take a close look at your taxes if you choose this route, as you could end up lowering your overall tax liability while generating the same net income.
Self-employment taxes
Whether you're self-employed or an employee, you'll have to pay Social Security and Medicare taxes to the government. When you work for someone else, you're only responsible for part of these taxes, while your employer pays the balance. However, if you're self-employed, you have to pay both portions of this tax. The combined employee and employer portions of this tax amount normally amounts to 15.3 percent.
S-Corp distributions
If you organize your business as an S-corporation, you can classify some of your income as salary and some as a distribution. You'll still be liable for self-employment taxes on the salary portion of your income, but you'll just pay ordinary income tax on the distribution portion. Depending on how you divide your income, you could save a substantial amount of self-employment taxes just by converting to an S-corporation.
Risks of S-Corporations
The IRS tends to take a closer look at S-corporation returns since the potential for abuse is so large. For example, if you make $500,000 in one year but only designate $20,000 of that as salary income, you might trigger an IRS inquiry, since you are avoiding so much self-employment tax. The guiding principle is that you must designate a "reasonable" amount of your income as wages, rather than a distribution. What constitutes "reasonable" can often be a gray area, but if you push the envelope too far, you put yourself at risk for an IRS audit and potentially penalties and interest on any back taxes assessed by the IRS.
Additional costs for S-Corporations
While an S-corporation may save you in self-employment taxes, it may cost you more than it saves. As with larger corporations, an S-corporation has both start-up and ongoing legal and accounting costs. In some states, S-corporations must also pay additional fees and taxes. For example, in California, an S-corporation must pay tax of 1.5 percent on its income with a minimum annual amount of $800. This tax is not required for sole proprietors.
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FAQs
If you organize your business as an S-corporation, you can classify some of your income as salary and some as a distribution. You'll still be liable for self-employment taxes on the salary portion of your income, but you'll just pay ordinary income tax on the distribution portion.
How can an S Corp reduce taxable income? ›
How can S corporations reduce their taxes?
- Business vehicle expenses.
- Charitable donations.
- Real-estate taxes.
- Self-employment health insurance.
- Marketing and advertising costs.
- Salaries and employee benefits.
- Business-related travel expenses.
- Professional fees/organizational dues.
The tax benefit for S corporations is that business income, as well as many tax deductions, credits, and losses, are passed through to the owners, rather than being taxed at the corporate level.
Can self-employment tax be reduced? ›
You can accomplish this by seeking to maximize tax write-offs through your business. Maximizing write-offs directly reduces the income subject to self-employment tax. As a self-employed individual, the tax law allows you write-off all ordinary and necessary expenses to conduct your trade or business.
How can an S Corp reduce your self-employment taxes? ›
So, what's the tax benefit of an S Corp? The S Corp advantage is that you only pay FICA payroll tax on your employment wages. The remaining profits from your S Corp are not subject to self-employment tax or FICA payroll taxes.
Who qualifies for the 20% pass through deduction? ›
Deduction for Taxable Income Up to $182,100 ($364,200 if Married) For 2023, the threshold is taxable income up to $364,200 if married filing jointly, or up to $182,100 if single. If your income is within this threshold, your pass-through deduction is equal to 20% of your qualified business income (QBI).
How much can an S Corp save you in taxes? ›
S-Corp election lets you split your profits into “shareholder wages” (subject to 15.3% self-employment taxes) and “distributive share” (NOT subject to 15.3% self-employment taxes). Active owners in an S-Corp must pay themselves a reasonable salary, but realize a 15.3% savings on the rest of their retained profits.
Can an S Corp write off a car? ›
Well, the answer depends largely on who the vehicle is titled to. Vehicle Titled In Corporation's Name. Corporations, S-Corps, and Partnerships may only claim actual expenses for vehicles. Thus, your S-Corp may claim depreciation, fuel expenses, oil expenses, repairs, insurance, and so forth.
Can S Corp losses offset personal income? ›
As such, losses pass directly to shareholders as well. That means shareholders can use losses in an S corporation to offset their personal income, thus reducing their tax liability. However, there's an important caveat here. They can offset losses only to the extent they have basis in the entity.
Why is S Corp better than LLC for taxes? ›
S corporations may have preferable self-employment taxes compared to the LLC because the owner can be treated as an employee and paid a reasonable salary. FICA taxes are withheld and paid on that amount.
The 20% self-employment deduction, also known as a qualified business income (QBI) deduction, is a deduction that allows business owners to deduct 20% of their qualified business income.
Does an S Corp pay less taxes than an LLC? ›
Who pays more taxes, an LLC or S Corp? Typically, an LLC taxed as a sole proprietorship pays more taxes and S Corp tax status means paying less in taxes. By default, an LLC pays taxes as a sole proprietorship, which includes self-employment tax on your total profits.
What is the tax credit for self-employed people? ›
The SETC tax credit is a refundable credit providing up to $32,220 in aid for self-employed individuals affected by the COVID-19 pandemic, including entrepreneurs, freelancers, healthcare professionals, and more.
Am I self-employed if I own an S Corp? ›
Some business owners wonder, "Am I considered self-employed if I own an S Corp?" Owners of S Corporations are "employed by" the S Corporation and receive a salary. This means that strictly speaking, you are not self-employed since you're considered an employee of the company.
Can an LLC be taxed as an S corporation to avoid self-employment taxes? ›
Your tax liability for self-employment tax does not change. LLC taxed as an S corporation. As an LLC, you can elect to be taxed as an S corporation. If you choose this option, you will not pay self-employment tax.
Is it better to be taxed as an S Corp or sole proprietor? ›
Which Is Better: S Corporation or Sole Proprietorship? In the end, an S Corporation may be better than a sole proprietorship if you have a large company and wish to limit your personal liability, want to avoid double taxation, want to raise capital, or want to be able to issue a specific type of stock.
Can my S Corp losses offset personal income? ›
S corporations are "pass-through" entities, meaning income passes through the corporate structure directly to individual shareholders. As such, losses pass directly to shareholders as well. That means shareholders can use losses in an S corporation to offset their personal income, thus reducing their tax liability.
What reduces the amount of taxable income? ›
The standard deduction is a specific dollar amount that reduces the amount of taxable income. The standard deduction consists of the sum of the basic standard deduction and any additional standard deduction amounts for age and/or blindness. In general, the IRS adjusts the standard deduction each year for inflation.
What lowers the amount of taxable income? ›
A tax deduction reduces income subject to tax. For each dollar of tax deduction, the reduction in tax liability is less than a dollar.
What is the 60 40 rule for S Corp salary? ›
The 60/40 rule is a simple approach that helps S corporation owners determine a reasonable salary for themselves. Using this formula, they divide their business income into two parts, with 60% designated as salary and 40% paid as shareholder distributions.
