Most self-employed persons know the impact the Internal Revenue Service (IRS) can have on your business. They can often be an unwanted partner, sharing in your profits at rates over 50%. For many, it seems the harder they work, the harder the IRS wants to squeeze. For this reason, I would like to share a few tips to keep more of your money in your pocket, and out of the hands of the IRS.
The first strategy I want to mention is proper entity election. I spoke in a previous article about the different types of entities available to the self-employed. Current tax law allows most small businesses to make an S election and be taxed as an S Corporation. After taking a “reasonable wage” for your services provided to your business, the remaining profits from the S Corporation avoid the 15.3% self-employment tax. In addition, you need to determine if your participation and investment in the business is material enough to be considered non-passive. Or, are you simply a passive investor. If your passive income is defined as such by the IRS, then it is not subject to self-employment tax. On the flip side, losses from passive activity may be suspended but can be used to offset income in future years.
A second strategy is to offer a retirement plan. There are an array of retirement plan options available to self-employed persons and small businesses. For the most part, you will have to offer a plan to your employees if you want to participate in a retirement plan through your business. Contributions on behalf of your employees, and certain funds contributed to yourself through the proper entity, are a business deduction and can reduce your taxable income for both income and self-employment tax. If you have no other employees, you still have retirement plan options available to you. Depending on your entity and income, you can contribute upwards of $60,000 into a retirement plan each year. That $60K contribution is a deduction on your tax return, and limits the IRS’s impact on your business and profits. The retirement plan contribution goes into an account that can be invested and used for your future retirement. Withdrawing from the retirement account will be taxable, but with proper planning, the tax affect will be much less severe in retirement. Think of retirement contributions from self-employed income as a way to park profits in an investment account, out of the hands of the IRS, until the time comes that you will need the funds.
The final strategy to mention is for self-employed parents. Instead of giving your able-bodied offspring free money, make them work for it. While the IRS does not have any age restrictions, your child must be providing a service for your business to count as an employee. If your child is under the age of 18, no FICA taxes will have to be withheld from their wages. The 2022 standard deduction is $12,950. This means if you were to pay your child less than $12,950 to perform services for your business (and they had no other income), no taxes would be owed on their wages. In addition, your business will receive the deduction reducing both taxable income and self-employed earnings. This will open the ability for your child to invest in IRAs. The wages can also be managed in a savings or UTMA account to plan for your child’s future, college or otherwise.
In summary, just be aware that there are many opportunities to limit the IRS’s impact on your hard-earned money, while also planning for your future and the future of those you love. As always, I recommend speaking to your attorney, CPA and CFP® to make sure you are selecting all the right options for yourself and your business.
Published in the Victoria Advocate
Adam Baucom, CPA/CFP® is a Senior Tax Manager for Keller & Associates CPAs, PLLC and an Associate Advisor for KMH Wealth Management, LLC.