Self-employment taxes tend to be one of the biggest challenges for freelancers, startups, and anybody working from home or on a business of their own and are usually subject to higher Social Security and Medicare taxes. However, one great way to deal with these taxes and make them more manageable is by setting your business as an S Corporation. This way, the IRS will look at your taxes from a different perspective, which could result in lowering the amount of taxes you would pay as self-employed.
One of the most relevant advantages of filing as an S Corporation is that it can help us reduce the amount of FICA taxes that we pay, which include Social Security and Medicare taxes. When we file our taxes as self-employed, we must cover the entire amount of FICA taxes, yet when we are employees, our employers cover a part of that. When we file as S Corp, though, we can report a part of our annual gross revenue as a net profit as long as we take a portion of the AGR to cover our salary. This way, instead of paying the 15.3% of FICA taxes from our profits, only the part of our salary is subject to taxes, and the rest net profit will be taken as a distribution from the business.
Working as an S Corp allows us to classify a portion of our income as our salary, and another portion as a distribution. As we mentioned above, the portion that is meant to cover our salary will still be subject to self-employment taxes, while the portion that qualifies under distribution will be subject to ordinary income tax. Therefore, this is a great way to lower our FICA tax balance, which could end up representing a significant reduction.
On the other hand, we must be cautious when we are filing as an S Corporation since this type of incorporation will make the IRS take a closer look at our income tax return. S Corps structures have been used to abuse the system and avoid self-employment tax, which will result in a more careful review. Therefore, we need to make sure we are designating a reasonable amount of our company’s income as our salary so that we don’t end up being subject to an IRS audit. For example, if our business is making an annual gross revenue of $50,000, a reasonable salary would be around $25,000 to $30,000.
It is important to do our corresponding research before deciding to turn our company into an S Corporation, since there may be some additional costs we might not be aware of. For example, S Corps will require legal and accounting costs, both for the start-up and once we have our operations running. Also, some states require S Corps to cover additional taxes and fees, just like the case of California, where S Corps are required to cover tax of 1.5% on its income, with a minimal annual amount of $800.