Are you a full-time freelancer planning to make $80,000 or more this year? Then it’s time to hunker down and get real about your tax-saving strategies because there’s some serious money to be saved.
Are you *gasp* kinda excited to learn about taxes? Well get ready because we’re showing you how you can save $5,000 or more in freelance taxes this year, and every year after.
What’s the secret sauce? Form an S Corp.
Read our helpful guide on how you could save on your freelance taxes with an S corp.
Sole proprietors take a hit on taxes: Here’s how
The vast majority of freelancers—we’re talking over 80%—are classified as sole proprietors.
You automatically become a sole proprietor if you start a one-owner business and don’t form a business entity, such as a limited liability company (LLC) or corporation. And because sole proprietorships are easy and cheap to run, they’re popular with the freelance folk.
Here’s how taxes work when you’re a sole proprietor:
- You and your business are considered one and the same for tax purposes
- You don’t pay taxes or file tax returns separately for your sole proprietorship
- You report any income you earn, and losses you incur, on your personal tax return (IRS Form 1040)
- If you earn a profit from your business, you add that money to any other income that you’ve earned, such as interest income or your spouse’s income if you’re married and filing jointly
- If you incur a loss, you can use it to offset income from other sources
- Once you add up all of your earnings from all sources, that becomes the total that’s taxed at your personal tax rate
Straightforward enough, right? It’s clear that, when it comes to income taxes, being a sole proprietor isn’t bad. The problem, though, is that income taxes are only part of the story.
You also have to pay self-employment taxes on your net self-employment earnings, which consist of two separate taxes: Social Security tax and Medicare tax (the same Social Security and Medicare taxes that employees and employers pay).
Let’s break it all down:
1. Social Security tax is 12.4% (up to an annual income ceiling). Net self-employment earnings (or employee wage income) over the ceiling aren’t subject to the tax.
What’s the ceiling for 2024? It’s $168,600. So, if you earn exactly $168,600, you’ll pay $20,906 in Social Security tax. If you earn more than $168,600 you’ll still pay $20,906. If you earn less than $168,600, you’ll pay less than $20,906. But $20,906 is the maximum you must pay, no matter how big your income.
2. Medicare tax is 2.9% up to an annual ceiling, which is $200,000 for single taxpayers and $250,000 for married couples filing jointly.
Anyone who earns more must pay 3.8% tax on income that exceeds the ceiling—in other words, that income will be subject to an additional 0.9% Medicare tax.
3. The combined Social Security and Medicare tax is 15.3%. Thanks to certain deductions, though, the “effective” tax rate is a bit lower.
So, what do we mean when we say that sole proprietors take a hit with their taxes?
Many freelancers pay more Social Security and Medicare taxes than they do income tax. Plus, they must pay all of those taxes themselves, unlike employees who only have to pay half of those taxes because their employers cover the other half.
To put things in perspective, employees only pay a maximum of 7.65% in Social Security and Medicare tax, while freelancers pay 15.3%.
Basically, the privilege of working as a sole proprietor comes with some tax burdens.
If you’d like to see how much you could save on freelance taxes, we’ve developed an S Corp tax savings estimator to determine your potential tax savings.
How S Corps could save you money on freelance taxes
Even if you’re running a one-person business, you don’t have to be a sole proprietor. Instead, you can form a corporation or limited liability company and have it taxed as an S Corp.
It’s true, an S Corp is (or used to be before Collective) more expensive to form and run than a sole proprietorship. But it provides you with substantial savings when it comes to your Social Security and Medicare taxes.
Here’s what happens after you form an S Corp:
You won’t personally own your business anymore
Instead, it will be owned by your corporation or LLC, providing you with limited liability. With liability protection, you generally won’t be personally liable for your business’s debts or lawsuits.
You don’t get limited liability when you’re working as a sole proprietor and sole proprietors are personally liable for everything.
As a pass-through tax structure, your S Corp doesn’t pay freelance taxes
Any business profits or losses are passed through to you, the owner, in proportion to your share ownership. You file everything on your personal tax return and are taxed at your personal income tax rate.
For example, if you’re the only shareholder, all of the profits or losses of your business will go to you and you pay income taxes on them, just like when you were working as a sole proprietor.
But there’s one major difference: You’ll become an employee of your S Corp, which means you’ll be the sole shareholder (owner) and an employee. And your S Corp is expected to pay you a “reasonable wage” for your work via payroll.
As an employee, your S Corp must withhold federal income and employment (Social Security and Medicare) taxes from your employee wages, and pay state and federal payroll taxes on your behalf.
Remember: you’re the employee and your S Corp is your employer. You’ll each pay half of the Social Security and Medicare taxes due on your wages, and then your business gets to deduct your salary and it’s portion of payroll taxes.
There’s no employment tax on S Corp distributions
A key thing to understand about S Corps is that you don’t pay employment tax on distributions from the business. A distribution is earnings and profits that pass through the business to you the owner. Basically it’s what you earn outside of your employee wages.
So, the larger your distribution, the less employment tax you’ll pay.
Note: The S Corp is the only business tax structure that makes it possible for its owners to save on employment taxes. This is the main reason why S Corps are extremely popular with smart business owners.
If you weren’t being paid any employee wages at all, you wouldn’t have to pay any employment taxes. But, as you probably already expected, this isn’t allowed.
The IRS requires that an S Corp shareholder-employee pay themselves a reasonable salary— this is a facts and circumstances test that is completely dependent on your situation.
What counts as a reasonable salary varies because there aren’t any precise rules. But, if you pay yourself too little in wages, the IRS can allocate part of your shareholder distribution as wages and require that you pay employment taxes on that.
Here’s an example of how it works:
Mel, a consultant, forms an S Corp that earns $100,000 in profit. Her business pays her $60,000 in employee wages and bonuses. The remaining profits pass through the S Corp and are reported as a distribution on Mel’s personal income tax return (not as employee wages).
But because it isn’t viewed as employee wages, neither Mel nor her business pay employment tax on this amount. Mel and her business only pay a total of $9,100 in employment taxes instead of $15,300. That’s a lot of savings!
Click here for tips on how to pay yourself a salary from your S Corp.
Examples of S Corp tax savings
The more money you pay yourself as a distribution, the more Social Security and Medicare tax you’ll save when you run an S Corp. Likewise, the more profit your business earns, the more you’ll save.
You need to earn at least $40,000 in profit for an S Corp to make sense, though. Otherwise, the costs of forming and running it exceeds the benefits of an S Corp.
Here are some charts that show the tax savings for businesses with $40,000, $80,000, and $100,000 in profit. As you can see, the smaller your employee wages, the larger your savings will be.
The charts also show the savings when 60% and 40% of your business profit is paid to you in wages, with the remainder paid as a shareholder distribution.
Sole Proprietor vs. S Corp: $40,000 Profit
Sole Proprietor vs. S Corp: $80,000 Profit
Sole Proprietor vs. S Corp: $100,000 Profit
S Corp drawbacks
Although S Corps can help you save a lot of money when it comes to your freelance taxes, there are a few drawbacks. And, for some freelancers, these drawbacks outweigh the benefits of running an S Corp, particularly if they aren’t earning as much income from their business.
Extra payroll costs
As an S Corp, you’ll have accounting and payroll costs that are much higher than what they’d be if you were a sole proprietor. That’s because you have to prepare two tax returns instead of one, factor in employee payroll, and keep accurate accounting records for your corporation.
This means you’ll need to hire an accountant and/or payroll service and use bookkeeping software. All three can cost at least a couple thousand dollars annually.
Your S Corp pays federal unemployment insurance (FUTA)
This is a maximum $420 tax, but some states also require that you pay state unemployment insurance.
State insurance expenses will cost you a few hundred dollars per year, but if you pay, you’ll get a credit against your FUTA tax and your payments will be reduced.
You might need to get additional insurance
For example, you might have to pay state disability insurance and/or obtain state workers’ compensation coverage (most states don’t require this for corporations with one employee/shareholder).
Plus, some states even impose special taxes on S Corps. As an example, California levies a 1.5% tax on S Corp income, with a minimum $800 tax due every year.
You pay less into Social Security
When you retire, it’s likely that your Social Security benefits will be smaller. You could easily make up for this, though, by putting some of your tax savings into a retirement account like an IRA or Solo 401(k).
The pass-through deduction
S Corps can reduce your pass-through deduction, also known as the Qualified Business Income Deduction or QBI Deduction.
This is a new deduction as of 2018 which lets sole proprietors and owners of pass-through businesses (Sole Proprietorships, LLCs, partnerships, and S Corps) deduct up to 20% of net business income or 20% of individual taxable income minus net capital gains from their income.
So, for example, if you have $100,000 in net business income, and $150,000 in individual taxable income, you could deduct up to $20,000. Unfortunately, the employee wages that S Corps pay their shareholder/employees don’t count towards this deduction, which reduces the deduction.
Let’s break this down even further., If an S Corp with $100,000 in profit paid its sole shareholder/employee $60,000 in wages, it would only have $40,000 in net business income left for the pass-through deduction, so the deduction would only be $8,000.
When you factor in the reduction of the pass-through deduction, the savings from an S Corp may not be quite as good for some.
Note: The pass-through deduction is temporary and scheduled to end after 2025. There’s no guarantee that it’ll last that long either.
How to get S Corp tax status
Here’s how you obtain S Corp tax status:
- Form a corporation or LLC in order to own and operate your business.
- Once you do, you’ll own the corporation as the sole shareholder or LLC member.
- File an S Corp election by filing IRS Form 2553 with the IRS.
Just keep in mind that there are certain limitations on who can form a corporation, and you must file Form 2553 within the filing deadline for your S Corp tax status to take effect in the current tax year.
Ultimately, if you’re earning at least $80,000-100,000 in profit from your business, definitely consider forming an S Corp for the advantages and tax savings that it can provide.
Sure, being an S Corp shareholder/employee can be a bit more complicated than being a sole proprietor, but the savings can make it all worthwhile and the platforms like Collective can make it simple and affordable.
Organizing an S Corp with Collective
Collective is founded by longtime freelancers and not only makes it simple and affordable to organize as an S Corp, but also matches you with a bookkeeper and tax preparer who are specialized in freelancers and S Corps.
With support from the experts at Collective, you can save loads of time and money when you’re ready to form and launch your S Corp, so you won’t have to do it all on your own.
Check out Collective and use the S Corp tax savings estimator to see your potential savings with Collective.
Thanks to Collective, I don’t have to worry about bookkeeping, taxes and other government related tasks and can focus 100% on my work. If you’re self-employed and need help with tax, bookkeeping and ongoing support, all-in-one place, you’ll love Collective!
Arjun Dev Arora
Strategy, Venture, Technology
Ugur Kaner is the co-founder and CEO of Hyke, the online platform that helps freelancers save $15,000 or more in taxes every year