If you have a side hustle, you may be paying up to an extra 15.3 percent in Social Security and Medicare taxes. By setting up an S-Corporation to hold your small business, you may be able to cut those taxes.
What Is an S-Corporation?
An S-corporation is a special type of corporation that avoids paying a separate corporate income tax and double taxation. Instead, an S-corporation’s profits are passed through to your personal income tax return and taxed at your personal tax rate.
The advantage to an S-corporation is that money you take out as dividends is not subject to Social Security and Medicare taxes.
How Side Hustle Taxes Work
When you have a small business on the side, three federal taxes apply.
????????????? Personal income tax (10 to 37 percent)
????????????? Social Security tax (12.4 percent on your first $128,400 in wages and self-employment income)
????????????? Medicare tax (2.9 percent on all wages and self-employment income plus an additional 0.9 percent on amounts over $200,000)
When you file a Schedule C because you’re a sole proprietor or haven’t formally organized your business, all three taxes apply on every dollar of (1) wages from your day job and (2) profits from your side small.
If you form an S-corporation to hold your side business, you can divide your profits into wages and dividends. Wages are subject to all three taxes, while dividends are subject to income tax but not Social Security or Medicare taxes.
Why Not Call All Your Income S-Corporation Dividends?
At this point, many people start to wonder why they can’t just call all of their S-corporation income dividends to avoid the extra taxes on wages. The answer is that you must pay yourself reasonable compensation for work you do for the S-corporation.
Reasonable compensation depends on the amount of effort you put in, market wage rates and other factors. In short, the IRS is trying to close the “everything is a dividend” loophole and collect Social Security and Medicare taxes at the same level as if you were working for someone else.
Example Tax Situations
Let’s take a look at a few tax situations. Remember that income taxes would remain the same, but there may be Social Security or Medicare savings.
New Computer Programmer
In our first example, a new computer programmer makes $75,000 at their day job and has $25,000 in programming side work.
????????????? As a Schedule C filer, the programmer would pay $3,825 in Social Security and Medicare taxes on the side work [$25,000 x (12.4 percent + 2.9 percent)].
????????????? As an S-corporation, the programmer would need to figure out reasonable compensation. Most of their income is from wages, but they’ve bought some computer equipment and probably have some goodwill as well. Let’s assume that reasonable compensation would be 70 percent in wages, leaving 30 percent in dividends. Therefore, they’d only pay $2,677.50 in Social Security and Medicare taxes on the side work [70 percent x $25,000 x (12.4 percent + 2.9 percent)].
That’s a $1,147.50 savings even though they had to call most of their profits wages.
Now let’s say our same computer programmer earns $25,000 on the side from affiliate marketing on their blog.
????????????? As a Schedule C filer, they’re still paying that same $3,825 in Social Security and Medicare taxes — all side income is treated the same.
????????????? As an S-corporation, their reasonable compensation amount will probably be much lower than the previous scenario. Let’s say the time they spent running their blogs is worth $5,000. That leaves $20,000 in profits that can be taken out as dividends. The Social Security and Medicare taxes on the $5,000 are only $765.
In this scenario, our computer programmer saves $3,060 in taxes by forming an S-corporation.
To learn more about whether you can save money by forming an S-corporation and other things you need to consider, contact our Seattle tax consulting firm.