How to Plan for and Minimize the Self-Employment Tax
All workers have to pay Social Security and Medicare, but in the case of an employee, he and his employer would split the cost. They would each pay 7.65% of eligible wages. But an independent contractor is both the employer and the employee so a self-employed person must pay both halves—or 15.3% total. This is referred to as the self-employment tax.
How It Breaks Down
The 15.3% self-employment tax is composed of a 12.4% Social Security tax on the first $128,400 of net self-employment income for the year 2018 and a Medicare tax of 2.9% on all net self-employment income. (For more on the IRS’s self-employment tax rules, check some further reading on the self-employment tax.)
The IRS calculates the self-employment tax rate as a percentage of net earnings from self-employment: 12.4% for social security and 2.9% for Medicare taxes
The $128,400 ceiling is called the "Social Security wage base." It represents the maximum amount of income from wages and net self-employment income that's subject to the Social Security tax. This base increases a little each year to adjust for inflation.
Net Self-Employment Income Defined
Net self-employment income consists of income from self-employed business activities (Schedule C), farming (Schedule F), the self-employed earnings of a partner (Schedule E), and clergy and employees of churches and religious organizations. It's income after deducting business expenses, such as furniture, building repairs and purchased inventory.
You would next adjust your net self-employment by multiplying it by 92.35% or subtracting out the 7.65% as a business expense. The adjusted 92.35% takes into account the part of the Social Security and Medicare taxes as a deductible business expense for employers.
Self-employed taxpayers are permitted to deduct the employer’s portion of Social Security and Medicare taxes—7.65%—on their own tax returns.
When you subtract this 7.65% from 100%, it comes out to 92.35%. This reduction in the base amount of income that's subject to the self-employment tax along with the above-the-line deduction available to self-employed taxpayers for the employer portion of the tax helps equalize the tax treatment between self-employed persons and employees.
Increase Your Business Expenses
The only surefire way to reduce your self-employment tax is to increase your business-related expenses. This will reduce your net income and correspondingly reduce your self-employment tax. Regular deductions such as the standard deduction or itemized deductions won't reduce your self-employment tax.
Above-the-line deductions for health insurance, SEP-IRA contributions, or solo 401(k) contributions will not reduce your self-employment tax, either. These deductions only reduce the federal income tax.
You might want to consider one tactic when you're preparing your tax return—the impact of taking the Section 179 deduction or bonus depreciation for fixed assets. This will impact both your income tax and the self-employment tax, so you might want to speak with a tax professional to find out if you qualify.
Increase Tax During Years with Losses
It sometimes happens that a taxpayer actually wants to increase his self-employment tax in order to maintain eligibility for Social Security retirement or disability benefits.
In general, people need at least 40 Social Security credits over their lifetimes to be eligible for retirement benefits and at least five years of credits out of 10 to be eligible for disability benefits.
Self-employed people who are facing a year in which they have lost money—their expenses were greater than their incomes—or a year in which their incomes are significantly lower can use a special method to increase their self-employment tax. This is called the "Optional Method" and the rules are spelled out in the Instructions for Schedule SE.
Self-employed persons who are not farmers or fisherman are limited to using this optional method only five times in their lifetimes.
Consider Forming an S-Corporation
This might seem a little extreme, but it should save you some tax dollars if you do it right. The self-employment tax applies specifically to earned income. If your clients or customers pay your S-corp, not you directly, that's not earned income to you—yet.
But you need to pay your personal bills, right? You need earned income. So divvy up those payments and pay yourself a percentage of them as a salary and the balance as dividends. The "salary" portion is earned income and is therefore subject to self-employment tax. But dividends aren't subject to self-employment tax, so you've reduced your net self-employment income by whatever percentage you took as dividends.
This can be admittedly tricky so you might want to enlist the help of a tax professional to get it right. Also, make sure you stay current with each year’s self-employment tax rates and income subject to these rates as they often change annually.