Self-Employment Tax: What is it and how to legally limit how much you pay!

If you are self-employed and making profit through earned income you are subject to self-employment tax. The amount of the self-employment tax bill often comes as a surprise to small business owners, especially if they have not planned diligently through the year. Luckily, there are ways to limit your self-employment tax liability.

What is “self-employment tax?”

Self-employment tax refers to taxes paid for Social Security (at a rate of 12.4%) and medicare (at a rate of 2.9%). The self-employment tax rate of 15.3% is IN ADDITION TO your normal income tax rate.

When you work for an employer, your employer pays half of this tax liability on your behalf- the portion your employer pays for you is referred to as the “payroll tax.” When you work for yourself, you are treated as employer and employee and you are liable for the entire 15.3%.

Self-employment tax applies only to earned income. Generally speaking, earned income is money received by you in exchange for goods or services sold. For instance, as a lawyer, I sell my services to clients and my income from those services is earned income. On the other hand, if you receive payments from tenants for rent on an investment property- that income is considered unearned income and not subject to self-employment tax.

The rate of 15.3% is due on every dollar of earned income up to $176,100.00.

How can we limit self-employment tax liability?

From a legal perspective, the first thing you can do to significantly reduce your self-employment tax liability is to properly structure your business to take advantage of tax planning strategies.

Both LLCs and sole proprietors (including d/b/a) are treated by default as “disregarded entities" meaning the income passes through to the individual owner. When talking about self-employment tax, pass through taxation is disadvantageous to the individual because every dollar of income earned by the business is considered as earned by the individual and subject to the 15.3% self-employment tax. There are situations where pass through taxation is a benefit- however your earned income should be funneled through a pass through entity.

Structuring your business to separate the business from the individual is important from the standpoint of asset protection and tax strategy. For tax purposes, we achieve this separation by choosing to be taxed as a corporation where the owner of the business is a paid employee of the business earning reasonable compensation. The reasonable compensation includes salary paid as wages, which is only a portion of that compensation. The business owner, as the employee, only has to pay self-employment tax on the salary portion of their compensation.

Choosing the right business formation and structuring it properly from a tax perspective can open a world of tax planning strategies. Limiting self-employment tax is one of those tax strategies that can pay off year after year.

Conservatively, a person earning $100,000 a year can save a minimum of $10,000 a year in taxes by doing the bare minimum of simply choosing the right legal entity to limit self-employment tax. The savings only increase as you employ other tax strategies. Imagine the possibilities if small business owners are able to keep this money in their own bank accounts.

It is important to remember that tax planning and business formation are fact dependent and whether a particular strategy is right for you is dependent on your circumstances. It is always advisable to work closely with an attorney and tax planning professional who can guide you through these steps. Contact our office to review your business structure and see if you are taking advantage of tax saving strategies.