Okay, so you started your own professional practice. Congratulations and welcome to the joys (and challenges) of business ownership. I should know, I’m an owner of a financial planning practice myself.
Speaking of challenges, we need to talk about taxes. At least some basics.
Before we start, you should know that there are all kinds of taxes – income tax, excise tax, sales tax, use tax, payroll tax, etc. at the federal level, state level, city level, and so on.
For this article, we’ll focus on federal taxes (as in the U.S. government). You know the kind you pay to the IRS. Specifically, we’ll discuss self-employment tax, a type of payroll tax.
Sound boring? Yeah, I know. But read on. You’ll be glad you did.
How is Your Business Set Up?
First step in navigating through the self-employment tax maze is knowing how your business is set up.
For federal tax purposes, there are three types of business entities:
A corporation comes in two flavors: C corporation and S corporation.
Microsoft is a C corporation, so is Amazon, and so is Berkshire Hathaway. But that doesn’t mean only big companies can be a C corporation. You can set up your practice as a C corporation, too.
That being said, most small corporations are formed as an S corporation. We won’t get into why, but let’s just say that it’s infinitely easier for an owner to move money in and out of an S corporation than it is with a C corporation.
Hey, wait a minute, you say, my practice is an LLC (limited liability company). Isn’t LLC another type of entity?
No. Not for federal tax purposes.
It’s because LLC is a legal entity permitted under a state law. But for federal tax purposes, an LLC must choose to be taxed as one of the three entity types listed below:
Look familiar? Yep, we are back to the three entity types again.
So, if your practice is an LLC, find out how it’s taxed for federal tax purposes.
Now that we’ve covered business entity types, let’s talk about self-employment taxes.
Remember before you started your business, you used to get paychecks? You grumbled that your take-home pay too small compared to your total pay?
It’s because your employer withheld taxes (and some other things like health insurance). The difference your gross pay and withholdings was your take-home pay.
Among otheE things, your employer withheld FICA tax from your pay. The FICA tax has two components: Social Security and Medicare.
Social Security Tax is calculated at 6.2% of your pay. Medicare Tax is 1.45% of your pay. So the total FICA tax is 7.65% of your pay.
Well, what you maybe didn’t know is that your employer also paid 7.65% of your gross pay. So, between you and your employer, Uncle Sam collected 15.3% of your pay (7.65% times 2).
Now that you are a business owner, in a way, you are both the employee and the employer. So, you are on the hook for 15.3% – both the employee and employer portions.
Before we move on, there’s one more thing you should know about FICA tax. There is a limit on income that’s subject to Social Security Tax. The limit changes every year, but for 2021, the amount is $142,800.
So, for example, let’s say you make $162,800 in 2021. That’s $20,000 more than the 2021 limit. Your Social Security Tax is calculated on income up to $142,800, but not beyond that amount. The $20,000 above that limit is not subject to Social Security Tax.
For the above example, the calculation for Social Security Tax is $142,800 times 6.2% = $8,853.60. That’s it. It stops there no matter how much more income you earn.
There’s no such income limit for Medicare Tax. It’s 1.45% of all of your income.
Self-Employment Tax for a Sole Proprietorship and Partnership
If your practice is a sole proprietorship or a partnership, you don’t pay yourself paychecks. Your total business net income after expenses is your “paycheck.”
That income is called self-employment income.
Your self-employment tax is 15.3% of your self-employment income. That’s 7.65% times 2 and it covers for the employee and the employer.
Of course, if you are a partner of a partnership, you’re responsible for only your share of income.
Self-Employment Tax for a Corporation
Calculating self-employment tax is little different for a corporation.
If your practice is set up as a corporation, you actually get paychecks from your corporation.
So the employee portion of FICA tax (7.65%) is withheld from your paychecks. And the corporation pays its share of FICA tax (7.65%). In all, between you and your corporation, 15.3% is paid in total. This is exactly like it was when you worked for someone and got paychecks. Except this time, you’re the owner of your corporation (employer).
Have you noticed another difference?
With the sole proprietorship and partnership, you pay self-employment tax on all your income. But with the corporation, you pay the tax only on your paycheck.
So, if your business regularly generates a healthy profit, you might save some money on Medicare Tax by setting up your business as a corporation.
As you can see, as a business owner, you have a lot to deal with on the tax front. It’s time to establish a lifelong bond with a good accountant.
We do not provide legal or tax advice. Readers should consult their own legal or tax advisor. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. There is always the risk that an investor may lose money. A long-term investment approach cannot guarantee a profit. Investors should talk to their financial advisor prior to making any investment decision. This information is intended for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.