This is a guest post by Eric Rosenberg, a full-time freelancer and blogger at Personal Profitability. Eric writes about personal finance and entrepreneurship at InvestmentZen, his own blog, and other sites around the web.
When I started writing about personal finance online in 2008, I had no idea where it would take me. Here I am nearly a decade later and writing about personal finance is my full-time job! Earning as much as I have online, I have picked up a few tax tips as well. None were as valuable to me as changing my business to an S-Corp, which I did when I went full-time in April last year. Read on to find out why I did it, how much I’ve saved, and if it makes sense for you.
Business Structures and Taxes
When I started my online money making adventure, I started working under my own name. Any time you earn money outside of a job with an employer, you are considered a sole proprietorship by default. This means that you are personally liable for any legal issues or claims and count all income and expenses on your personal tax return.
Eventually I started to make enough money that I thought it was worth filing as an LLC. Registering as an LLC was very easy and only costs $50 in Colorado. I filled out the form myself online and was operating as a business, Narrow Bridge Media, LLC, by the end of the day.
Like a sole proprietorship, single member LLC taxes are reported on your personal tax return. In both cases, you use Schedule C to report your business earnings and expenses. An LLC offers legal benefits over a sole proprietorship but as far as taxes go, they are pretty much the same thing. As I started earning more and more each year, reaching $40,000 from my side hustle in 2014, I noticed that my tax bill was going up too.
The big downside of self-employment as far as taxes go is self-employment tax. When you have a job of any type, both you and your employer are required to pay income taxes on your earnings. You see the taxes you pay deducted from each paycheck, with a true up due in April. You don’t typically see, however, that the employer is paying quite a bit in taxes as well.
As a business owner, you are required to pay both sides of the income tax equation. You pay your own income taxes from your personal earnings and have to pay the employer part of the taxes. This is known as the self-employment tax.
Self-employment tax adds up fast. If you earn $40,000 in a year, your self-employment tax is $5,652. If you make $100,000, you would pay $14,130. The FICA, or Social Security, component is limited to $14,694 per year, but the Medicare component does not have a cap.
How S-Corps Lower Taxes
When I quit my job in April, I knew that I would earn well over $40,000 in 2015. At the end of the year, it came out closer to $100,000 in revenue. Looking forward to increased earnings, I wanted to take steps to limit my tax liability. I found that S-Corps were the right way to do that in my situation.
An S-Corp is a type of corporation that acts somewhat independently. Think of it as a step up from an LLC. In some cases, an LLC can be taxed as an S-Corp. Because I was moving states at the same time, I decided to just register as an S-Corp from the start effective April 1, 2016. Starting on that date, the business became Narrow Bridge Media, Inc.
When the business became an S-Corp, I became its first employee. Now, rather than just keeping everything my business earns, I get a paycheck every Friday. I have to pay self-employment tax on every dollar I earn through my paychecks, but any income I earn above that is taxed at my regular income tax rate which is lower than the self-employment tax rate.
For this to work, I have to follow some special IRS rules. I have to pay myself a “reasonable” paycheck amount for someone doing the work that I do. As a content writer, I did some research and found $35,000-$40,000 per year to be common, so that is what I used for my paycheck. Any additional earnings are considered dividends, not employment earnings.
I did some math to estimate how much this would save me on my 2016 taxes, which I have yet to file, and found I would save around $6,000-$8,000. That is huge! Even with the costs of registering an S-Corp in California and dealing with payroll, this was still a no brainer.
Does an S-Corp Make Sense For You?
If you earn income on the side or are self-employed, you may be wondering if this makes sense for you. It very well might, but it doesn’t in all situations. In general, if you are making around $40,000 or more per year, it is worth looking into. If you find this too confusing or complicated, speak with a local small business accountant to find out what makes the most sense for your own unique situations.
For me, running my business as an S-Corp has been great. There were no operational changes to my business, but I am saving money on every dollar I earn over $35,000 per year. That is something anyone can get on board with! Sorry Uncle Sam, but I’m keeping as many of my hard earned dollars as I can.
It may work for you as well. If you have any self-employment income, it is certainly worth a look. Who knows, maybe you’ll save even more than me on your 2017 taxes thanks to reducing your self-employment taxes!