Reducing the Burden of Self-Employment Taxes: A Case Study

The Problem

Self-employment can be rewarding, but the tax system often feels like a punishment. In addition to Federal and State taxes, self-employed individuals face a 15.3% self-employment tax. This rate, meant to cover Social Security and Medicare contributions, places a heavy burden on small businesses. At our practice, we regularly see hardworking taxpayers with 1099 income who owe over $10,000 in self-employment taxes each year. The root of the issue? Bad planning.

Take, for example, a client we worked with last tax season. He ran a bathroom tile business and earned $120,000, documented on a 1099. The problem? The 1099 listed his Social Security number in the Recipient TIN box. This meant that all income was reported directly to him as an individual, exposing him to significant self-employment taxes.

After deducting business expenses, we reduced his taxable net income to $80,000. Still, his self-employment tax bill was jaw-dropping:

$80,000 × 15.3% = $12,240.

This could have been avoided with better planning.

The Solution

The key to minimizing self-employment tax lies in how your business is structured. By incorporating your business and electing to be taxed as an S Corporation, you can significantly reduce your tax burden. Here’s how:

1. Incorporate Your Business: Set up a corporation or an LLC and elect S Corporation status with the IRS. This changes how your income is taxed.

2. Pay Yourself a Reasonable Salary: As an S Corporation owner, you’re required to pay yourself a salary that’s “reasonable” for the work you perform. This salary is subject to the 15.3% payroll tax.

3. Distribute Remaining Profits: Any income beyond your salary can be distributed to you as a shareholder. This portion isn’t subject to self-employment tax.

If our tile contractor client had come to us earlier, we would have structured his business this way. Let’s compare the numbers:

• Under Sole Proprietorship: $80,000 × 15.3% = $12,240 in self-employment taxes.

• Under S Corporation:

  • Reasonable Salary: $40,000 × 15.3% = $6,120 in payroll taxes.

  • Distributions: $40,000 × 0% = $0 in self-employment taxes.

  • Total Tax: $6,120.

Savings: $6,120.

Take Action Now

This strategy isn’t retroactive. To take advantage of the benefits of an S Corporation, you need to act during the tax year. Waiting until tax season can cost you thousands of dollars unnecessarily.

If you’re self-employed and facing a hefty tax bill, it’s time to rethink how your business is structured. Consult with a tax professional to explore incorporating your business and making the S Corporation election. A little planning now can lead to significant savings later.