How Do Self Employment Taxes Work?
Self employment taxes consist of Medicare and Social Security taxes. Self employed business owners must pay at least 15.3 percent of their earnings to cover these obligations, since they have no employer to withhold a portion of these taxes.
Reduce Self Employment Taxes with a Corporation or LLC
In general, sole proprietors and partners usually pay periodic self employment taxes on their entire share of the company's profits. However, the Internal Revenue Service (IRS) taxes employees of corporations (and Limited Liability Companies taxed as corporations) differently.
A corporation pays its share of employment taxes and withholds certain required income and employment taxes from employees' salaries. Corporations and their workers pay these taxes only on the reasonable salaries paid to employees, not on the total profits of the corporation. Executed properly, this strategy may reduce self employment taxes.
John, a sole proprietor, has a net income of $60,000. He pays $9,180 in self-employment taxes:
$60,000 x 15.3% = $9,180
John forms a corporation. He pays himself a reasonable salary of $40,000 and leaves the other $20,000 in the business for future expansion. He pays Social Security and Medicare taxes only on his salary, for a total of $6,120:
$40,000 x 15.3% = $6,120
By incorporating, John saves $3,060 in self-employment taxes.
Remember, the IRS still taxes profits not deducted as salaries at corporate tax rates. Your accountant can help you determine a strategy that will result in the greatest overall tax savings for your business.
incorporate.com does not offer tax advice or assistance, and our services should not substitute for those of an accountant. Please consult your tax advisor for specific guidance regarding tax benefits specific to your business.