Small Business Taxes - How to Pay Less Self-Employment Tax

If you fall into one of these three categories, this article is for you: 1) you own a sole proprietorship; 2) you are a partner in a partnership; or 3) you are the owner of a limited liability company being taxed like a sole proprietorship or a partnership.

What do these three types of business owners have in common? They are all faced with the dreaded self-employment (SE) tax on the profits of their business.

If you're new to the world of small business taxes, here's a quick review of self-employment tax. Sole proprietors and those taxed like sole proprietors (i.e. partnership partners and LLC owners who have not chosen to be taxed like a corporation) must pay 15.3% of their business profit in SE tax to the federal government. This consists of 12.4% social security tax and 2.9% Medicare tax. In effect, it is the self-employed person's version of the employee/employee federal payroll tax of 15.3%.

But here's where frustration begins to rear its ugly head: employees and employers each pay one-half of the 15.3%. The self-employed person must pay the entire 15.3%.

So what's a self-employed person to do? There's one particularly effective strategy to legally reduce self-employment tax: choose to be taxed an "S" corporation.

Here's how it works. In 2009, the self-employed person pays SE tax on the first $106,800 in profit. Let's assume you make $60,000 profit this year (sales minus expenses). You must pay SE tax on the entire profit, so your SE tax will be $9,180 ($60,000 x .153).

But if you choose to be taxed like an "S" corporation, you can legally reduce the SE tax by structuring your compensation as a combination of wages or salary (which you must do now that you are being taxed as a corporation) and a profit distribution payment. Assuming that you can pay yourself reasonable compensation of $35,000 salary, only that salary will be subject to the 15.3% SE tax (which will now be called "payroll tax" rather than SE tax). The remaining $25,000 in profit can still be paid to you whenever you like, but it will not be subject to payroll tax, because only wages/salary are subject to payroll tax in a corporation.

End result: the payroll tax on $35,000 will be $5,355. Compare that to the $9,180 in SE tax and you legally reduce your taxes by $3,825.

Two important caveats: First, note that it is only SE tax (or payroll tax) that is reduced. This strategy does not reduce income taxes, because regardless of the entity (self-employed or corporation), the entire $60,000 will be subject to income tax.

Second, now that you are paying yourself wages/salary as an employee of a corporation, the corporation must do all the paperwork that comes with payroll. You must issue yourself bona fide paychecks (which means that withholding calculations must be done). You must also file all the required federal, state and local payroll tax returns, and make all the required federal, state and local payroll tax payments. This can be quite a mountain of paperwork and you should probably outsource these payroll tasks. This will result in a new expense to hire an accountant or bookkeeper to do payroll, but most small business owners in this situation still come out way ahead.