Self-employment tax can be a significant burden on small business owners and freelancers. The tax, which funds Social Security and Medicare, can add up to 15.3% of your net income. That’s a considerable amount of money that could be better invested in your business or personal savings. However, there are ways to minimize or avoid self-employment tax legally. In this article, we’ll explore some of the strategies you can use to keep more of your hard-earned money.
Before we dive into the tips, let’s briefly discuss what self-employment tax is and who needs to pay it. Self-employment tax is a tax that applies to individuals who work for themselves and earn more than $400 a year. This tax covers both the employer and employee portions of Social Security and Medicare taxes. For 2021, the self-employment tax rate is 15.3% on the first $142,800 of net income and 2.9% on any net income above that amount.
1. Incorporate your business
One of the most effective ways to reduce self-employment tax is to incorporate your business. By incorporating, you become an employee of your own company, and you can pay yourself a salary. As an employee, you’ll only pay Social Security and Medicare taxes on your salary, not on the business’s entire net income. The remaining profits can be reinvested in the company or paid out to shareholders as dividends, which are subject to a lower tax rate than self-employment tax.
2. Elect S corporation status
If you’re already incorporated, you can elect S corporation status to further reduce your self-employment tax liability. An S corporation is a pass-through entity, which means that the business’s income is passed through to the shareholders, who report it on their individual tax returns. As an S corporation shareholder, you only pay self-employment tax on your salary, not on the business’s profits. However, to qualify for S corporation status, you must meet certain eligibility criteria, such as having no more than 100 shareholders and only issuing one class of stock.
3. Maximize your deductions
Another way to reduce your self-employment tax liability is to maximize your deductions. As a self-employed individual, you can deduct a variety of business expenses, such as office rent, equipment purchases, and business travel. These deductions reduce your net income, which in turn reduces your self-employment tax liability. Keep detailed records of your expenses and work with a tax professional to ensure you’re taking advantage of all eligible deductions.
4. Contribute to a retirement plan
Contributing to a retirement plan can also help you reduce your self-employment tax liability. Self-employed individuals can contribute to a variety of retirement plans, such as a solo 401(k), SEP IRA, or SIMPLE IRA. These contributions are tax-deductible and reduce your net income, which in turn reduces your self-employment tax liability. Plus, contributing to a retirement plan can help you save for your future while reducing your tax burden.
5. Hire your family members
If you have children or other family members who can assist you with your business, consider hiring them. You can pay them a reasonable salary for their work, which reduces your net income and your self-employment tax liability. Plus, your family members can earn income and gain valuable work experience. However, be sure to follow all tax and employment laws and keep accurate records of their work and compensation.
Self-employment tax can be a significant burden on small business owners and freelancers, but there are ways to minimize or avoid it legally. Incorporating your business, electing S corporation status, maximizing your deductions, contributing to a retirement plan, and hiring your family members are just a few of the strategies you can use to reduce your self-employment tax liability. Work with a tax professional to determine the best strategy for your unique situation and ensure you’re following all tax laws and regulations.