Jane starts a wedding photography business. She is excited since this is what she’s always wanted to do. She already has bookings on most weekends for the rest of the year to keep her busy and hopefully fill up her bank accounts. Jane diligently sets aside 15% of her income. She used an online income tax calculator to determine that will be her effective tax rate. The rest of the income she uses to pay her personal bills and enjoy a well-earned vacation. Fast forward to February when Jane sits down with her tax preparer—she didn’t wait until April because Jane has her life together and likes to be proactive. She knows she made about $80,000 last year after expenses and expects to pay around $12,000 in taxes, and this is the money she has set aside. The tax preparer hands her the tax return and she still owes another $12,000. “How can that be?!” she demands.
The problem Jane is facing is that she only accounted for income tax, and neglected to set aside money for Self-Employment Tax. She is not alone in facing this crisis, and many first-time business owners and independent contractors are in for a shock the first time they file business taxes. This is not an article to discourage people from pursuing their goals, however, but to offer a solution to this all-too-common problem.
Jane should start an LLC or corporation and elect to have it taxed as an S-Corp. This will allow her to save on Self-Employment Tax. The only minor downside is that it will affect her social security check, as it effectively decreases the amount of wages (highest 35 years), which is used to calculate the payout at retirement. If you are worried about this, take those savings and put them in an IRA and you’ll likely be better off.
Below is a general outline and you might want to consult a tax professional or attorney for help. But as a sound starting point, here are the steps you need to take to become a tax-savvy self-employed worker:
1. File your Articles of Organization or Articles of Incorporation in the state you reside. Don’t file in a different state. Contrary to popular belief, that is not going to save you any money on taxes.
2. File Form 2553 with IRS and state treasury departments where applicable. In the eastern half of the USA, it is only NY and NJ residents that need to worry about state S-Corp elections.
3. Determine your reasonable compensation. There are multiple ways to do this, and a good starting point is 40% of your profits.
4. Set up your payroll. The cost of setting up payroll a few years ago used to make this strategy less effective, but full-service payroll processing firms have faced rapid automation and competition, thereby reducing monthly full-service payroll costs to under $50 per month. Don’t fall for cheaper options that are not full-service; you want to ensure your payroll provider will file all necessary forms.
5. Set up your accountable plan and expense report. As an S-Corp, you can reimburse yourself for the use of your home office and your car. Make sure you follow the guidelines in the tax code when determining how much to reimburse yourself.
If Jane would have elected to be taxed as an S-Corp she could have saved over $7,000 in taxes. This might sound too good to be true but this strategy was discussed in Congress when the Tax Cuts and Jobs Act of 2017 was passed. Congress decided to keep this part of the tax code as is and didn’t make any changes to it.
To summarize, electing to have your business taxed as an S-Corp is a great way to save on your Self-Employment Taxes. There are some specific steps to take, but overall, it does not significantly increase the amount of time you need to spend on accounting and taxes. Ideally, you want to do this when you start your business. But if you haven’t, it’s not too late. Now is the time to talk to your tax professional or advisor to determine if this strategy is right for you.