So you took that leap of faith, and started your own business! What does this mean to the typical entrepreneur? For most of us, running your own business means that you are responsible for paying your own individual income tax liability throughout the entire year in quarterly installments. Moreover, payroll taxes aren’t always automatically withheld from a W-2 form as is the case for most traditional employees.
Am I considered self-employed?
If you work for yourself, then it’s probable that you are considered self-employed for tax purposes. However, the tax code is not that simple. Specifically, the tax law characterizes a trade or business that has been defined as “holding one’s self out to others as engaged in the selling of goods or services,” as being self-employed. Furthermore, the trade or business activity must be one that is regular, frequent and continuous as per Revenue Ruling 58-112. Essentially, this means that a one month job, likely will not be considered self-employment income.
Are self-employment taxes treated differently depending on my company’s legal entity?
A self-employed individual can be organized as a proprietorship, a single member LLC, as a partner in a partnership, as a one shareholder S-corporation, or even a one shareholder C-corporation (most typically for foreign taxpayers). Moreover, as proprietor, a single member LLC, or even a partner in a partnership, you are considered both an employer and employee. For the corporations, the entity is the employer, and you are its employee. That is a big difference, as that could mean you either pay self-employment taxes on all your profits, or on some of your profits. This is because a “self-employed” individual is subject to the dreaded self-employment tax on most of the profits from the business, and the owners run no payroll; or the owners elect an amount of salary to compensate themselves and in effect pay the self-employment tax on only the salary received as a W-2 worker/employee of the corporation.
So, could I run a payroll of $10,000 a year, and pay a very limited amount of self-employment tax?
Not exactly. Just because you regulate the amount of payroll the entity will pay you, you do not automatically have a license to compensate yourself an unreasonably low salary. By law, you need to pay yourself an annual salary that has some “basis” behind it. To determine a reasonable salary, one must be able to answer the following questions:
How much are other companies paying for your level of expertise?
You can do this easily by going on job postings search engines like Monster, or Hotjobs, or just reference your last job. See IRS official corporate financial ratio reports.
What is the expected gross revenues your business?
You can only pay yourself what you bring in, not more right? How much does my business profit on a net (income less expenses) yearly basis? i.e., can I pay myself x y and z and still stay in the black? Do you have investment plans for your business in the near future, or have you been saving to finance some sort of expansion? These factors are also very important to consider.
How much time are you committing to rendering services?
Don’t forget to also factor in your actual time spent at which rate, and how often. If you put in a steady 3 hours a day performing emailing, faxing, scanning, printing, receptionist, marketer, etc, it is one story, but if you always spend 50 percent of each, it would be a different story, as these functions would weigh differently out in the open market, right?
What type of work are you performing?
Once you actually establish this plan, don’t forget to document how you came to this determination, so that you can always refer back to your “reasonable basis.” Some pointers to consider when documenting your compensation determination would include factoring in what kind of work you perform on a regular basis. Is it administrative in nature, or is it specialized? Are some of your responsibilities completely unrelated, as in: marketing, office personnel management, time spent a continuing education, etc. Most likely, once you put this down on paper, you will be amazed as to how many hats you wear.
How much in disposable income do you need to support your current lifestyle?
Do you need $3,000, $5,000 or more to cover your monthly living expenses? If you need $2,000 to cover your expenses to just exist, is that enough for you? Do you stick to your budget? Or do you typically end up over exceeding your budgeted spending during the month?
Do you have more tax planning or self-employment tax questions? Contact us at firstname.lastname@example.org