Learn about the social security and medicare tax we all pay, called self employment taxes.
We're going to try to cover some really basic information about self employment taxes, since many contractors, self employed people, small business owners and entrepreneurs struggle to understand them.
How much Social Security & Medicare Tax does a small business have to pay?
How do self employment taxes work?
What should we know about self employment taxes for S-Corps vs. LLC's?
We are Reduce My Taxes CPA, Tax & Accounting, and we help small businesses with their bookkeeping & business tax preparation service, with a focus on helping them do everything possible to mitigate and reduce their taxes.
A major part of tax reduction planning concerns S-Corporations, and we want to help people gain an understanding of small business self employment taxes.
Today, we're going to explain how self-employed sole proprietors are subject to social security and medicare taxes.
As a self-employed sole proprietor, you are responsible for paying self-employment taxes, which include both the employer and employee portions of social security and medicare taxes. Unlike employees who have social security and medicare taxes automatically deducted from their paychecks, self-employed individuals are responsible for paying both portions of these taxes.
We will walk you through the basics of Self Employment taxes to help you if you're confused.
You first need to calculate your net earnings from self-employment for the year. This includes all income earned from your business, minus any business expenses and deductions.
Next, you need to calculate the social security tax owed on your net earnings. The current social security tax rate for self-employed individuals is 12.4%. However, this tax only applies to the first $142,800 of net earnings in 2021.
To calculate the social security tax owed, you multiply your net earnings by 12.4%. If your net earnings exceed $142,800, only the first $142,800 is subject to social security tax.
In addition to social security tax, you also need to pay medicare tax on your net earnings. The current medicare tax rate for self-employed individuals is 2.9%.
To calculate the medicare tax owed, you multiply your net earnings by 2.9%.
You add the social security tax and medicare tax amounts together to determine your total self-employment tax owed for the year.
You report your total self-employment tax owed on your personal income tax return. This includes filing a Schedule SE, which calculates your self-employment tax liability.
In conclusion, as a self-employed sole proprietor, you are responsible for paying both the employer and employee portions of social security and medicare taxes. To determine your self-employment tax liability, you need to calculate your net earnings, social security tax, and medicare tax, and report the total amount on your personal income tax return. At Reduce My Taxes CPA, Tax & Accounting, we can help you navigate the tax requirements and minimize your tax liability.
An S-Corporation can help reduce social security and medicare taxes for a typical small business owner earning about $180,000 in net profits each year. Here's how:
As a sole proprietor, the small business owner is required to pay self-employment taxes on all of their net profits, which include both the employer and employee portions of social security and medicare taxes. For a small business owner earning $180,000 in net profits, this would amount to approximately $24,000 in self-employment taxes.
You'll pay social security taxes, at 12.4%, up to the social security limit which is/was set at about $160,000 in 2023.
However, if the small business owner were to form an S-Corporation, they could potentially reduce the amount of self-employment taxes they owe. This is because they could take a salary as an employee of the corporation and only pay social security and medicare taxes on that salary portion. The remaining income, which is classified as a distribution, is not subject to self-employment taxes.
Let's say that the small business owner decides to pay themselves a reasonable salary of $100,000 per year and takes the remaining $80,000 as a distribution. In this scenario, they would only pay social security and medicare taxes on the $100,000 salary portion, which would amount to approximately $15,300 in self-employment taxes. The remaining $80,000 distribution would not be subject to self-employment taxes, which would mean we saved about $8,700 a year.
By using this strategy, the small business owner would save approximately $8,700 in self-employment taxes per year. Think of how dramatically that piles up when invested in a retirement account earning monthly interest, of if you have access to that capital within your business.
It is important to note that the salary portion of an S-Corporation owner's income must be reasonable and in line with industry standards to prevent owners from avoiding self-employment taxes by paying themselves an unreasonably low salary and taking most of their income as a distribution.
In conclusion, forming an S-Corporation can potentially help small business owners reduce their social security and medicare taxes by taking a reasonable salary and distributing the remaining income. At Reduce My Taxes CPA, Tax & Accounting, we can help small business owners understand the tax benefits of forming an S-Corporation and guide them through the process of setting one up.
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