Throughout its history, America has been the land of self-made men and women. But, America’s self-employed must contend with a unique burden every April 15: the self-employment tax. Simply being self-employed subjects one to a separate 15.3% tax covering Social Security and Medicare. While W-2 employees “split” this rate with their employers, the IRS views an entrepreneur as both the employee and the employer. Thus, the higher tax rate.
The following five tips will help ensure that you do not pay a cent more in self-employment tax than the law requires and will help you keep your hard-earned money.
1. Form an S Corporation
The self-employment tax applies only to what the IRS calls “earned income” – that is, money paid to you as a salary or wage. There may be reasons to consider forming an S corp to save money, but they need to consider other factors like having to form a board which they don’t have to do under an LLC. Self-employment tax does not, however, apply to dividends (or “unearned income”). The way to receive business income in the form of dividends is to create an S corporation. Nothing changes except that your clients or customers now pay the corporation instead of you directly. You can then withdraw a salary from the corporation – but not a full salary. Your salary should be reasonable compensation based upon the work performed. Once the S-corporation has paid a reasonable salary, you can then make any other payments as distributions. Distributions are not subject to payroll taxes, only income taxes. For example, by paying 60% to yourself in the form of a salary and 40% in the form of dividends, you will exempt that 40% from self-employment taxes.
2. Subtract Half of Your FICA Taxes From Federal Income Taxes
Entrepreneurs are also eligible to deduct half of their self-employment taxes from their federal taxable income. Let’s say you owe $7,650 in self-employment tax, which is 15.3% of the $50,000 salary your S corporation paid out. You can now, in turn, deduct $3,825 (which is half of $7,650) from your federal taxable income of $50,000 as an adjustment to income. The IRS only taxes $46,175 of your salary instead of the entire $50,000. While it does not reduce your self-employment tax, it reduces the total amount of tax you pay by lowering your taxable income.
3. Deduct Valid Business Expenses
The IRS allows business owners and entrepreneurs to deduct all ordinary and necessary business expenses. You can only deduct business expenses to offset your business income. For example, you cannot take a trip to Hawaii and write it off unless you genuinely went there to work. You can, however, deduct anything used to generate your income: office space, supplies, advertising costs, business travel, even a prorated portion of your mortgage and utilities (if you maintain a home office). As an example, if you incur $10,000 in business-related expenses during the year, you can reduce your taxable income from $50,000 to $40,000. Your self-employment tax obligation will now be 15.3% of $40,000 (which is your net income) rather than $50,000 (which is your gross income.)
4. Deduct Health Insurance Costs
One substantial tax advantage the self-employed individuals have over employees is the ability to deduct health insurance costs. You can deduct 100% of health insurance premiums you pay for yourself and your qualifying dependents as a business expense as long as you have a net profit for the year. Like the business expenses above, deducting your applicable health insurance costs reduces your taxable income for that year, thereby reducing the total dollar amount of taxes paid.
5. Defer Income to Avoid Higher Tax Brackets
Another creative but perfectly legal way to reduce your self-employment taxes is to defer income. As a self-employed person, you can choose whether to get paid now or later. While it might seem foolish to delay receiving income, consider the following scenario. Let’s say that even after taking every legally permissible deduction, you are still on pace to have received $47,500 in net income during the 2024 tax year. By arranging to be paid even $350 of that in January 2025 rather than now or before the end of the year, your 2024 income will be taxed only at the 10% and 12% income tax rates.
TurboTax has helpfully published the marginal income tax brackets for 2023 and 2024 here. Be mindful of them and consider whether it might objectively make sense to defer some of your income. If you don’t need it right away, deferring income is an excellent way to reduce both your income taxes and self-employment taxes.
No matter what moves you made last year, TurboTax will make them count on your taxes. Whether you want to do your taxes yourself or have a TurboTax expert file for you, we’ll make sure you get every dollar you deserve and your biggest possible refund – guaranteed.
