If tax time left you feeling bruised and battered, you are not alone. For self-employed people, writing that check to the IRS can really sting.
Playing catch-up makes it harder for many solo business owners. Though the self-employed are supposed to pay taxes quarterly, many free agents wait until April to pay for the whole year and wind up paying a big bill all at once. Only 16% of independent contractors pay quarterly taxes, even though 80% should, according to new research from Payable, which provides tools for paying independent contractors, 1099 forms, and other services. (The research focused mostly on newer independent contractors, so the figures could be different for the general population of solo business owners).
It’s not surprising that they put it off. Many have to wait months to get paid by their clients, which creates cash flow problems. And higher income free agents are subject to whopping tax bills, with a top tax rate that is now 39.6%.
Now is a good time to start putting changes into place that can lower your tax burden for next year, so you can make your quarterly payments--and wince a little less when you do.
Recently, I spoke with CPA Marty McCutchen in Ft. Worth, Texas, who advises many self-employed people. Here are some strategies he recommends.
Consider paying taxes as an S corporation. “Operating as an S corp is the most tax-efficient way to run a business,” says McCutchen. “If you are a sole proprietorship or single-member LLC, all of your earnings are subject to self-employment tax. If you are an S corp, as long as you are paying yourself a reasonable wage, only that income is subject to FICA. “(Federal Insurance Contributions Taxes, or FICA, are the taxes for social security and Medicare).
That’s nothing to sneeze at: The self-employment tax, consisting of social security and Medicare taxes, was 15.3% on the first $118,500 of wages for 2015, with 12.4% for social security and 2.9% for Medicare, plus an extra .09 percent in Medicare taxes for income above a certain threshold level.
You don’t necessarily have to form an S corporation to be taxed as one. An LLC can elect to be taxed as an S corporation, an option that offers some of the ease of maintaining an LLC with the tax benefits for an S corporation.
However, if you pay taxes as an S corporation, you need to choose a reasonable salary to pay yourself and issue paychecks to yourself with the proper taxes taken out. The IRS has cracked down on professionals who generate high revenues at their businesses and pay themselves a pittance in wages to avoid paying taxes.
“I think what the authorities look for is, say, people who are billing $200,000 and are paying themselves $30,000,” says Gene Zaino, president and CEO of MBO Partners, which provides back-office services for the self-employed out of Herndon, Va. Using reports on salary trends in your industry can be a good place to determine what a fair wage is. “You have to defend your wage as fair if you ever get challenged,” says Zaino.
Plus, if Social Security still exists when it is time for you to retire, you want to make sure you have contributed enough. The maximum amount of earnings subject to taxation for Social Security for 2016 is $118,500.
Once you’ve settled on the right salary, McCutchen recommends using an outside payroll provider, so you don’t make any mistakes. “Don’t try to do it on your own,” he says. “You don’t want to get in any trouble on payroll taxes." Money you take out of the business beyond your paycheck is treated as a distribution and is taxed at the ordinary income rate, without the self-employment tax.
How much do you need to earn annually for this strategy to pay off? McCutchen recommends it only to clients making $100,000 a year or more, to ensure that the savings outweigh added administrative costs. How much will it save you? “A lot of times there can be $5,000 to $15,000 savings,” depending on how much you make," he says. That’s not a giant amount, but it could be tucked away in a tax-advantaged retirement account, providing some additional tax savings.
Hire your spouse. If you do so, McCutchen recommends putting 100% of your spouse’s earnings in a 401(k) plan, so you achieve tax savings from this strategy. A spouse or family member can participate in your solo 401(k) plan if you set one up for yourself. “They are flexible and cheap to maintain,” he says.
If you travel with your spouse on business, hiring your spouse will allow you to get a tax benefit from this. With your spouse on payroll, “you can legitimately say your expenses and your spouse’s expenses are business expenses,” he says.
Put your kids to work. If your children are whizzes at web design or coding—or are simply looking to earn some extra money by handling your clerical work— hiring them can be a smart tax move.
McCutchen recommends having them set up a bank account, which you use as a college fund. Pay them a reasonable wage for the work they are doing, treat it as a business cost, and then have them deposit that money in the bank account.
Let’s say you pay a child $15,000 in a year. The first $6,000 of a child’s earnings are tax-free, says McCutchen. The next $9,000 will be taxed at 10%, he says. (That tax rate increases after the first $15,000). That means your child will pay only $900 in taxes on the first $15,000. That is most likely lower than what you would pay on that income. “It’s virtually tax-free earnings to your child,” says McCutchen. While there is only so much you can expect your children to earn in a year, this approach could help your family make some headway on any tuition bills in your future--and lower your tax bills a bit.
