Many tax strategies share the goal of reducing revenue and increasing expenses in order to reduce the ultimate net income of the company. This is good tax planning and we strive to accomplish this with each of our business owner and non-business owner clients. We ensure that our business owner clients are claiming every legitimate expense they can each year to offset business revenue to reduce their income tax liability. We ensure that our non-business owner clients claim all legitimate itemized deductions to reduce their individual tax liability as well.
One tax planning strategy that many of our new business owner clients may not think of is structuring their business operations so as to minimize their social security and Medicare tax liability. When a client becomes self-employed for the first time, one item of sticker shock that so often grips them is the enormous burden that social security and Medicare tax can have on their new operation. They may not understand that as a self-employed taxpayer, they suddenly get the pleasure (sarcasm intended) of paying not only the 7.65% of gross wages that their employer once withheld from their wages, but also the matching 7.65% of gross wages that their employer once also contributed to match their wage withholding before sending the funds on to the Internal Revenue Service. The combined employer and employee percentage for social security and Medicare is 15.3%. That must be paid based on your business net income before we even consider the income tax liability that will also be assessed on that income.
Many factors have a bearing on your ability to structure your business operations to reduce social security and Medicare tax but the most common business entity structure chosen to accomplish this is to elect S-corporation filing status with the IRS. The majority of business owners form a limited liability company (LLC) and then elect S-corporation filing status with the IRS for that entity. Others form an actual corporation and elect S-corporation status for that corporation with the IRS.
Assuming that you employ or contract others to provide services to run your business, the justification for reducing your self-employment tax burden is that a portion of your compensation from your business is payment for services rendered by you and the remainder of your compensation is a return on your investment in the company (compensation for your ownership and risk assumed rather than for your direct labor within the business). The concept is that you pay yourself a reasonable wage for the services you provide within the company (often similar to what you would have to pay an outsider to perform the same duties) and then take out additional net profits of the entity in the form of dividends or distributions. The gross wage you receive would be subject to social security and Medicare tax and the dividends or distributions would not be subject to the self-employment tax. All net income of the business operation would be subject to income taxation at the individual level when it flows through but only the wage portion would be subject to self-employment tax. For those business owners who qualify, they can save themselves thousands of dollars in self-employment tax each year by simply structuring their business operations differently.
If you believe you may be eligible to restructure your business operations to save on self-employment taxes, please contact us to set up an appointment so we can discuss your current situation.