A sole proprietorship is an unincorporated business where the individual owns the business assets directly and has the unlimited personal liability for any debts, claims, or other obligations associated with the business. The profit from a small business operated as a sole proprietorship is reported on Schedule C of the business owner’s personal income tax return and is subject to both income and self-employment taxes.
The income tax rate varies depending on the amount of taxable income from all sources computed on the taxpayer’s personal income tax return. The self-employment tax rate is a combination of the Social Security tax of 12.4% and the Medicare tax of 2.9%. The combined tax of 15.3% is assessed on net earnings from self-employment (i.e. profit reported on Schedule C of a taxpayer’s Form 1040) up to $117,000; only the Medicare rate of 2.9% is assessed on net earnings above $117,000. One half of the total self-employment tax assessment is allowed as a deduction when computing the taxpayer’s taxable income.
Tax planning is essential for reducing your self-employment taxes on your business income. In fact, lowering your self-employment income can reduce not only your self-employment tax, but also your income tax and the additional 0.9% Medicare tax imposed by the Affordable Care Act that you may also owe. Some tax planning strategies the sole proprietor may want to consider include:
- Renting real estate from the sole-proprietor’s spouse – If the spouse is the 100% owner of the real estate and a fair market rent is charged to the Schedule C business, the business owner’s self-employment income is reduced by the rent paid. The spouse reports the rent income on Schedule E, but real estate rental income is not subject to the self-employment tax.
- Timing the collection of business income – Since the 12.4% Social Security portion of the self-employment tax is only assessed on the earnings (self-employment income plus wages) up to $117,000, collecting business income in years where you have already reached the $117,000 threshold, can save the taxpayer the Social Security portion of the self-employment tax.
- Employing the owner’s children – Since a child’s earned income is not subject to the kiddie tax regardless of age and since a child’s earned income is often taxed at a lower rate than their parents, paying the owner’s child a reasonable wage for work actually performed in connection with the business will reduce both self-employment and income taxes by reducing self-employment income.
All tax planning strategies to reduce your self-employment income require careful recordkeeping and supporting documentation. Contact Flexible Accounting Services of the Triangle today and allow us to assist you in developing and supporting tax plans that will reduce your self-employment tax liability.