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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I've delved deep into the intricate world of taxation, and let me tell you, the article you've shared touches upon some critical aspects that can significantly impact one's financial strategy. Having navigated through the complexities of self-employment and taxation, let's break down the key concepts discussed.
S-Corp Taxes: When you're self-employed, the burden of Social Security and Medicare taxes, collectively known as self-employment taxes, falls entirely on your shoulders. But here's the interesting twist—structuring your business as an S-corporation provides a strategic way to potentially lower these taxes. It's a move that demands attention from the IRS, given its potential impact on overall tax liability and net income.
Self-Employment Taxes: Regardless of your employment status, Social Security and Medicare taxes are inevitable. When you work for someone else, you only foot a portion of these taxes, with your employer covering the rest. However, being self-employed means taking on both the employee and employer portions, typically totaling 15.3 percent.
S-Corp Distributions: Opting for an S-corporation allows you to categorize your income into salary and distribution. While self-employment taxes apply to the salary portion, the distribution portion is subject only to ordinary income tax. The savvy allocation of income between these categories can lead to substantial savings in self-employment taxes.
Risks of S-Corporations: Now, the IRS has its eyes on S-corporations due to the potential for abuse. Allocating too little income as salary might trigger an audit, emphasizing the importance of designating a "reasonable" amount as wages. The definition of "reasonable" can be a bit hazy, but pushing it too far risks not only an audit but also penalties and interest on any back taxes.
Additional Costs for S-Corporations: While the allure of saving on self-employment taxes is undeniable, don't overlook the additional costs associated with S-corporations. From start-up expenses to ongoing legal and accounting fees, there's a financial commitment involved. Some states tack on extra fees and taxes, such as California's minimum annual tax of $800 for S-corporations.
In conclusion, the article paints a picture of a tax strategy that can be a double-edged sword—potentially reducing self-employment taxes but carrying its own set of financial implications. Always a pleasure to discuss these intricacies!
