Whether you just started or have been self-employed for years, your mind is constantly with your clients - finding new ones and making sure existing ones are happy. It is so easy to become self-employed (send your first invoice, and Voila!) and it’s so easy not to think about tax and your business structure.
Well, as we all know, every decision in our lives has tax consequences, operating a business especially! The type of entity you establish for your business sets the “tax tone” for the business and has a big influence on your eventual tax bill. Even if you are incorporated as an LLC – don’t stop reading now. Let’s examine the differences between two common entities in an effort to help you decide which is best for you.
Food for thought…income tax is separate from self-employment tax. Self-employment tax is the contribution for Social Security and Medicare taxes, accumulating to 15.3% based on 2016 rates. As an employee of someone else, you are only responsible for 50% of this cost; while your employer is responsible for the other 50%. Being self-employed makes you responsible for 100% of this cost.
The Sole Proprietorship is the default business type. Not making a choice about your entity type defaults you to Sole Proprietor status. Even if you form an LLC, if you are the only member of the LLC you will still default to Sole Proprietor status for federal tax purposes. As a Sole Proprietorship, you will file your taxes claiming your business on Schedule C of form 1040 (your personal tax return form) and you will pay income tax on the income produced by the business you created and self-employment tax calculated at 15.3% of the income towards Social Security and Medicare.
With an LLC, you may be able to save some of the self-employment taxes by electing to become an S-Corporation. Under this election you are required to take a reasonable salary and pay self-employment taxes on the salary, but the rest of your business income is subject only to income tax, not self-employment taxes! By splitting your income between a salary and ordinary business income you can save thousands of dollars every year in self-employment taxes!
Risks of Electing S-Corporation
Please be aware that reasonable salary is not well defined by the IRS, and therefore can be misunderstood. If, for instance, your company makes a profit of $150,000 yet you only take a salary of $35,000.00, this may trigger an IRS audit and result in penalties, interest and the tax owed; as this could be seen as an act of tax avoidance.
Unlike other topics we cover and tips we provide in this blog, S-Corporation is the most complicated one, and we strongly advise you to contact us or other tax professional before you move forward.