Self-Employment Tax Optional Methods

If you are self-employed you are no stranger to taxes. The three most common taxes for the self-employed are self-employment tax, federal income tax, and state income tax. Self-employment tax is 15.3% for the first $106,800 of earned income and 3.9% for all earned income above $106,800. It is a significant tax that should be considered in tax planning. Self-employment tax is assessed to a particular type of income called earned income or compensation income. Unearned income is not subject to self-employment tax. The individual facts and circumstances of your case will determine your strategy for minimizing your total tax liability, not just your self-employment tax. A basic understanding of what having earned income and paying self-employment tax entitles you to is necessary. The main benefit of having income subject to self-employment tax is becoming eligible for social security benefits. Social Security Administration requires you have a certain number of quarters as one of the criteria for eligibility for social security benefits and disability benefits. Individuals can earn up to four quarters per year by having at least $4,200 in self-employment income. The Conservation and Energy Act of 2008 set some major changes to the optional methods of computing self-employment tax. These changes specifically effect farmers and self-employed taxpayers whose self-employment income is less than $4,200 or even a loss.

There are two optional methods for self-employed individuals to choose from. In essence what this election does is qualify the taxpayer for up to four credits of Social Security benefit coverage for each tax year. The taxpayer would otherwise not qualify for lack of enough earned income. Let us take a look at two different approaches, one for taxpayers seeking to minimize their self-employment tax and one for those looking to maximize their total tax savings.

For example, one taxpayers' case may indicate a need to minimize his/her self-employment tax. Some tax planning strategies to convert earned compensation income or earned income into unearned income are as follows:

  1. Pay rent to the owner at the maximum allowed.
  2. Take distributions or pass-through income from a Sub S corporation.
  3. Establish fringe benefit plans
  4. Establish qualified derred compensation plans and retirement plans
All of these strategies transform earned income to unearned income and thus are no longer subject to self-employment tax, a savings of potentially 15.3%.

For other taxpayers it may be more beneficial to try and increase the self employment tax. You may want to do this to qualify for social security benefits or qualify for several tax credits. There are three major benefits from electing the optional methods:
  1. Qualify taxpayer for social security benefits.
  2. Generate a higher earned income credit.
  3. Generate a higher child care credit.
Case Study: Mr. and Mrs. Smith in 2007 reported a loss of $2,000 on his schedule C and were happy they did not owe any federal taxes. They explain that Mrs. Smith actually works in the business, but has not received any wages for the services as an employee because of the additional administrative chores and payroll taxes involved with payroll. The Smith's have two children. Proper tax planning would reveal a different approach. One approach may consist of paying Mrs. Smith a reasonable wage for her work performed in her husband’s business. Let’s assume a reasonable wage for Mrs. Smith is $10,000. The sole proprietorship would then have a loss of $13,300(the original $2,000 loss plus $10,000 in payroll and an additional $1,300 in payroll taxes). In addition let’s have Mr. Smith elect the optional method for computing self employment tax. Their return would now show a refund of $4,346.
Calculation of Total Savings
Earned Income Credit$4,590
Self Employment Tax-$244
Payroll Taxes-$1,800
Net Savings$2,546

*In addition to a total savings of $2,546 both taxpayers would receive 4 eligible quarters and receive 4 credits for social security.

I hope this illustrates that self-employment tax planning is not just beneficial for high income taxpayers but all taxpayers.

Written by Nicholas B. Sutton, CPA

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