You are your own boss. You do contract work for whomever you choose, whenever you choose. Your customers’ businesses write you phat checks and you are feeling flush all year. All is good in the entrepreneur hood until the tax man comes around in April. Your 1099 arrives in January and that is where the problem begins. The problem is that no one told you that LLCs and Sole Proprietors pay a whopping 15.3% Self Employment tax on the entire amount on your 1099….on top of your regular income tax! Most self-employed people only find out about this nightmare situation after they file tax returns with 1099s and are then hit with the tax bill. YOU are paying the highest % of tax out there. Thankfully there is an easy way to to stop this gross overpayment of taxes — and it’s still available for 2019 if you have not filed your returns yet. For the sake of your bank account, read on. 

4 Crucial Things to Consider

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Business Formation

If your business is an LLC or Sole Proprietorship, you must pay Self Employment Tax. Why? Since you don’t receive paychecks and don’t pay into Social Security and Medicare, this is how the IRS makes sure that you still do. Self Employment tax is 15.3% on your total net business income. That number is in addition to your regular income taxes. 

EXAMPLE: You receive $100,000 in 1099s, and had $20,000 in expenses. Your net income is $80,000 and you will end up paying $12,240 in SE Tax.  ($80,000 * 15.3% = $12,240). If you fall into the 24% tax bracket for personal income tax, that means you are also going to pay an additional $19,200 ! ($80,000 * 24% = $19,200). That is a ghastly total of $31,440, nearly 40% of your income is now going to taxes. 

Lets say you only receive $20,000 in 1099s, and had $2000 in business expenses. Your $18,000 profit is going to cost you $2,754 in Self Employment taxes. If you are in the 12% tax bracket for personal income tax, that’s going to add $2,160 to your tax bill. That adds up to $4,914, nearly one third of your $18,000 profit is gone.. 

How To Stop Paying Self Employment Tax

First, if your accountant never explained Self Employment Tax to you, you have a problem with your accountant. Now that we’ve not only explained this tax to you, we’re going to tell you exactly how to stop paying it. Turn your business into an S-Corp. Yes, you’ve heard people talk about it but you didn’t really understand and weren’t sure it was right for you. Well chances are, if you are getting those phat 1099s, it’s exactly right for you. Here’s how this goes: when you are an S-Corp owner you’ll be required to pay yourself a portion of your net income through an actual paycheck. Now that you are paying yourself a modest salary based on your accountant’s advice (hopefully not from the bad one) you will also be paying Social Security and Medicare taxes through your paycheck. Now that the IRS is getting their piece of cheese from your paychecks, they no longer subject any of your net income to Self Employment tax!

Example: your S-Corp made $100,000. After expenses you have $80,000. You pay yourself a salary of $45,000 leaving a net income of $35,000. You pay Social Security & Medicare tax on your salary which amounts to $6,885. The $35,000 left as net income is no longer subject to any Self Employment Tax. In the 24% tax bracket, you are still going to pay $19,200 for personal income tax. But now your taxes total $26,085: a $5,355 savings from filing your taxes as an LLC or a sole proprietor. 

NOTE – these example scenarios are very simplistic, but the basic premise is there. The more your income increases, the more you save.

When Should I convert

We recommend that you elect s-corp status at the point that your tax savings more than covers the increase in accounting costs (i.e. the cost of adding payroll). Depending on the business and how expensive your accountant is, this could be as low as $20,000 in 1099-MISC income. There are many additional advantages of being an S-Corporation such as access to pre-tax retirement savings, added deductions for health insurance, a separate set of books providing clear and easily digestible financial information. Also consider this, being on payroll means that you will be “withholding” income taxes each year. Many contractors fall into the trap of not saving any of their money for tax time. With an S-Corp you will be paying yourself a monthly salary with taxes taken out offsetting some of that April tax bill.

Develop a Bulletproof Plan

Now that we’ve talked you into the no-brainer switch to an S-Corporation, it’s time to develop a bulletproof financial plan. ALL of this depends very much on your own personal scenario. This is not a one-size-fits-all situation, many factors are at play, and this is where a pro comes in handy. A professional accountant can ensure S-Corp status is right for you and get you set up on a plan to keep your S-Corp fully compliant with all the IRS rules and regulations. While switching to an s-corp is often the smartest tax move, the “paperwork” is tricky. It is best to hire a professional accountant to take care of the details.  

Takeaway

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The great news for you – it’s not too late to take advantage of these tax savings. A tax professional can change your business formation before you file your taxes on April 15, as long as you act quickly and check a few requirement boxes. Remember, your tax savings should keep more money in your pocket and still cover accounting costs.

Singletrack Accounting saved customers well over $100,000 in 2019. We can absolutely make you a part of that statistic! We live and breathe small businesses and nothing makes us more joyful than saving you money while providing expert accounting and excellent service. We are with you every step of the way. 

To learn about more tax saving strategies read 5 Tax Saving Strategies For Small Businesses

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