How Sole Proprietors Can Minimize Their Self-Employment Tax Burdens
Four Strategies for Managing the Self-Employment Tax
When you’re working as a sole proprietor, you are both the employer and the employee. While it’s a business model that can offer you the benefits of flexibility and control, there are also important self-employment tax implications.
Consider, for example, that all workers must pay into Social Security and Medicare. For typical workers, this means they split that cost with their employers, each paying 7.65% of the employee’s eligible wages. Sole proprietors don’t have the benefit of splitting the cost with an employer, meaning they must pay both halves – 15.3% of earned income. This is referred to as the self-employment tax, and there’s quite a bit you should know about it – both to follow the letter of the law, and to minimize your tax burden as a sole proprietor.
Calculating the Self-Employment Tax
For the tax year 2020, this tax totals 15.3% on the first $137,700 of net income, plus 2.9% on net income greater than that amount. Note that net self-employment income is your income after deducting business expenses.
Included within the 15.3% tax rate is a 12.3% Social Security tax and a 2.9% Medicare tax. For purposes of this tax, self-employment income includes any income from self-employed business activities (Schedule C), farming activities (Schedule F), the self-employed earnings of a partner (Schedule E), or work as a clergy member or employee of a religious organization.
The next step in calculating your self-employment tax is to multiply your net self-employment income by 92.35%, as the IRS allows you to subtract 7.65% as a business expense. So, essentially, the IRS is taking into account the part of Social Security and Medicare taxes that are a deductible business expense for employers. In this way, the IRS attempts to equalize the tax treatments between wage employees and those who are self-employed.
You will calculate your self-employment tax using Schedule SE Form 1040 or 1040SR. It’s important to note that you are responsible for paying this tax even if you are already receiving Social Security and Medicare benefits.
Tips for Reducing Your Self-Employment Tax
When you’re operating your own business, paying the full self-employment tax can certainly feel financially burdensome. While it is difficult to avoid paying it entirely, there are four useful strategies for reducing the amount you owe:
Strategy #1: Increase Your Business Expenses
This strategy is a guaranteed way to lower your self-employment tax burden. Increasing your business-related expenses, such as rent and equipment, will reduce your net income and have the corresponding result of reducing the amount of taxes you owe. This is important because regular deductions, like the standard deduction or itemized deductions, don’t reduce your self-employment tax. The same goes for deductions for health insurance, SEP-IRA contributions, and solo 401(k) contributions – none of these will reduce your self-employment tax. They only impact the federal income tax.
It may be possible to lower your net income using a Section 179 deduction. This allows you to deduct the cost of certain fixed assets used for your small business. This move impacts both the self-employment tax and your income tax, so it’s best to speak with a tax professional to determine whether you qualify.
Strategy #2: Increase Your Tax During Loss Years
This is a strategy that self-employed individuals can only use five times during their lifetimes (with the exception of farmers and fishermen, who may use it more often). If you’re facing a tax year in which you lost money – that is, your expenses were greater than your income – you can use a special method called the “optional method” to increase your self-employment tax. You may need to do this in order to maintain eligibility for Social Security or disability benefits, and it may also give you a credit toward future tax years. The rules and regulations for using this method are available in the IRS instructions for Schedule SE.
Strategy #3: Form an S-Corporation
Since the self-employment tax applies specifically to earned income, forming an S-corporation may help you circumvent some of the tax burdens. When you form an S-corp and have clients or customers pay the S-corp instead of paying you directly, that is not yet considered income you have earned. You would pay yourself a certain percentage of your corporation’s earnings as a salary, and the remaining balance as dividends. The salary portion would be subject to the self-employment tax, but the dividends would not be. So, using this strategy allows you to reduce your net self-employment income by whatever percentage you paid yourself as dividends.
Strategy #4: Utilize the QBI Deduction
Although the above strategy makes forming an S-Corp attractive, there is also a great advantage to remaining a Sole Proprietor: getting the QBI Deduction. This is a 20% deduction on 100% of your net income, as opposed to an S Corp where you only get the deduction on the net income after deducting your salary. If you’re considering converting to an S Corp, you should work with your tax professional to carefully calculate if the reduction in Social Security taxes will outweigh the decrease in your QBI deduction. If you convert to an S Corp, you should also do the calculation to determine how much salary to pay yourself in order to maximize your 199A deduction. It can be a complex calculation, so be sure to partner with a professional in determining whether this is the right move for you.
Additional Self-Employment Tax Considerations for Sole Proprietors
Any of the above strategies may reduce your self-employment tax bill, but determining the best one for you can be challenging. This is especially true because the best strategy for your income may change from year to year as tax rates and your income levels change.
To ensure you’re always filing your taxes correctly – and being as tax-efficient as possible – it’s best to seek guidance from a tax professional. Those who specialize in self-employment will be particularly helpful in managing your self-employment tax strategy as circumstances and tax law change over time.