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How Are S-Corps Taxed?

The following is an excerpt from my book LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less.

S-corporations, like partnerships, are pass-through entities. That is, there is no federal income tax levied at the corporate level. Instead, an S-corporation’s profit is allocated to its shareholder(s) and taxed at the shareholder level.

Tax Forms for S-Corporations

Form 1120S is the form used for an S-corporation’s annual tax return. (This makes sense, given that Form 1120 is used for a regular corporation’s annual return.) As with a partnership, Schedules K and K-1 are used to show how the business’s different types of income and deductions are allocated among the owners.

No Self-Employment Tax!

The big benefit of S-corp taxation is that S-corporation shareholders do not have to pay self-employment tax on their share of the business’s profits.

The big catch is that before there can be any profits, each owner who also works as an employee must be paid a “reasonable” amount of compensation (e.g., salary). This salary will of course be subject to Social Security and Medicare taxes to be paid half by the employee and half by the corporation. As a result, the savings from paying no self-employment tax on the profits only kick in once the S-corp is earning enough that there are still profits to be paid out after paying the mandatory “reasonable compensation.”

EXAMPLE: Larissa is the sole owner of her S-corporation, an advertising agency. Her revenues from the business are $60,000 per year, and her annual expenses (not counting salary) total $10,000. Therefore, her S-corp’s profit for the year (before subtracting her own salary) is $50,000.

Larissa’s plan is to pay herself $40,000 in salary, and count the remaining $10,000 as profit, thus saving money as a result of not having to pay self-employment tax on the $10,000 profit.

Unfortunately, Larissa learns that the average advertising professional in her area and with her level of experience earns roughly $70,000 annually. As such, she’s going to have a difficult time making the case that $40,000 is a reasonable level of compensation.

In the end, Larissa ends up setting her salary at $50,000 in order to avoid trouble with the IRS. Sadly, her S-corp’s profit (after paying her salary) ends up being $0, so she isn’t really saving any money on taxes as a result of S-corp taxation.

Determining a Reasonable Salary

So what’s a reasonable salary? This exact question is frequently the topic of debate in court cases between the IRS and business owners who are, allegedly, paying themselves an unreasonably small salary in order to save on self-employment taxes.

What makes the situation tricky is that the tax code itself does not provide any specific guidelines for what’s reasonable. That said, the following factors are frequently considered by courts when ruling on the issue:

  • The duties and responsibilities of the shareholder-employee,
  • The training and experience of the shareholder-employee,
  • The amount of time and effort devoted to the business,
  • The amount of dividends paid to shareholders (especially as compared to compensation paid to shareholder-employees),
  • The wages of the business’s other employees (i.e., those who are not shareholders), and
  • What comparable businesses pay for similar services.

Cost Basis in an S-Corporation

Much like owners of a partnership, shareholders of an S-corporation are taxed on their allocated share of the business’s profits — no matter whether or not those profits were actually distributed to them. But, also like an owner of a partnership, a shareholder of an S-corporation is not taxed on distributions from the business, so long as those distributions do not exceed his cost basis in the S-corp.

A shareholder’s cost basis in an S-corporation is increased by his allocated share of the business’s income and by contributions he makes to the business. His basis will be decreased by his share of the business’s losses and by distributions he receives from the business.

EXAMPLE: Austin forms an S-corporation and contributes $40,000 cash to the business. In the calendar year in which the business is formed, the business pays Austin a salary of $30,000, after which it has remaining ordinary business income of $20,000. During the year, the corporation also makes a distribution to Austin of $25,000.

When Austin forms the corporation, his cost basis in the business is $40,000 (the amount he contributed). The $20,000 ordinary business income increases his basis to $60,000, and the $25,000 distribution reduces his basis to $35,000. $35,000 is his cost basis at the end of the first year.

The $30,000 salary will be taxable to Austin as ordinary income, and it will be subject to normal payroll taxes as well. The $20,000 ordinary business income will be taxable to Austin as ordinary income, but it will not be subject to payroll taxes or self-employment tax. The $25,000 distribution will not be taxable to Austin at all, because his cost basis before the distribution was greater than $25,000.

Deduction for Pass-Through Income

Because S-corporations are pass-through entities, profit from an S-corporation qualifies for the deduction for pass-through business income. That is, you may qualify for a deduction of up to 20% of your share of the S-corporation’s profit. Of note, any compensation (e.g., wages/salary) that the S-corporation pays to you is not considered to be pass-through income. It is only allocations of profit from the S-corporation that are considered to be pass-through income.

State Taxation of S-Corporations

Of course, each state has its own rules regarding S-corp taxation. Some work like the federal income tax in which shareholders pay taxes on their share of the income. Other states tax the S-corp directly. For instance, in Illinois, S-corporations pay a 1.5% tax on the S-corp’s Illinois income. This tax is in addition to the income tax that shareholders pay on their share of the S-corp’s income.

In Summary

  • S-corporations are pass-through entities. That is, the corporation itself is not subject to federal income tax. Instead, the shareholders are taxed upon their allocated share of the income.
  • Form 1120S is the form used for an S-corp’s annual tax return.
  • Shareholders do not have to pay self-employment tax on their share of an S-corp’s profits. However, before there can be any profits, owners that work as employees for the S-corp will need to receive a “reasonable” amount of compensation.
  • S-corporation taxation is similar to partnership taxation in that owners are taxed upon their share of the business’s income, regardless of whether or not it is actually distributed to them. Also similarly, distributions from the business are not taxable so long as they are not in excess of the shareholder’s basis in the S-corporation.
  • For tax years 2018-2025, you can claim a deduction equal to 20% of your share of an S-corporation’s profit, subject to limitations.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less

Topics Covered in the Book:
  • The basics of sole proprietorship, partnership, LLC, S-Corp, and C-Corp taxation,
  • How to protect your personal assets from lawsuits against your business,
  • Which business structures could reduce your Federal income tax or Self-Employment tax,
  • Click here to see the full list.

How to Form an S-Corporation

The following is an excerpt from my book LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less.

S-corporations are simply C-corporations that have elected to receive a special kind of tax treatment. In other words, the only difference between an S-corporation and a C-corporation is taxation.

Electing S-Corp Taxation

Electing S-corp taxation couldn’t be any easier. All you have to do is fill out a single form (Form 2553), and your corporation will be taxed as an S-corp for as long as you continue to meet the various shareholder requirements for S-Corp taxation.

Also, LLCs are allowed to elect S-corp taxation by filling out a Form 2553.

Who Can Elect S-Corp Taxation?

In order for a corporation (or LLC) to be eligible for S-corp taxation, it must meet all of the following requirements:

  1. It must be a domestic corporation or LLC (as opposed to a foreign one).
  2. It must have no more than 100 shareholders/members.
  3. The shareholders can only be individuals, estates, and tax-exempt organizations. (In other words, no corporations or partnerships as shareholders.)
  4. It can have no nonresident alien shareholders.
  5. It can have only one class of stock.
  6. It cannot be a bank or insurance company.
  7. All shareholders must consent to the election.

Effective Date of S-Corp Election

When you elect S-corporation taxation (by filing Form 2553), the election takes effect on January 1 of the following year, with a few exceptions:

  • If you file Form 2553 by March 15 of a given year, you can choose to have the election be effective as of January 1 of that year.
  • In the year your business is formed, if you file Form 2553 within the first two months and fifteen days of the business’s existence, you can choose to have the election be effective for the business’s first year.

In some circumstances, the IRS may grant “relief for a late election.” That is, they may allow your S-corp election to be effective for a given year, even if you did not file Form 2553 within the first two months and fifteen days of that year. In order to qualify for such relief:

  • The business must have been otherwise-eligible for S-corp taxation,
  • The business must file Form 2553 along with Form 1120S (the form for an S-corporation’s annual tax return),
  • The corporation (as well as its shareholders) must not have already reported income for the year inconsistently with the S-corp election, and
  • The business must have “reasonable cause” for its failure to file the election on time.

Obviously the term “reasonable cause” leaves a lot of room for interpretation. The IRS tends to grant a good deal of leeway here, but your best bet is certainly to file within the first two months and fifteen days of the year if you want to be sure your election will be effective that year.

Losing S-Corp Status

If at any time your corporation or LLC no longer meets all of the requirements for S-corp taxation, your S-corp election will be terminated automatically. Alternatively, your S-corp election can be terminated by choice at any time, as long as shareholders/members owning more than 50% of the shares of the business consent to the revocation.

If your S-corporation status is terminated, you will have to wait five years before making another S-corporation election, unless you get specific consent from the IRS to do so earlier.

When an S-corp election is terminated, the business will go back to being taxed how it was taxed before the election. That is, a corporation will go back to being taxed as a C-corp, a single-member LLC will go back to being taxed as a sole proprietorship (unless the LLC had elected C-corp taxation before it elected S-corp taxation), and a multiple-member LLC will go back to being taxed as a partnership (unless the LLC had elected C-corp taxation before it elected S-corp taxation).

Simple Summary

  • The only difference between an S-corp and a C-corp is the way in which they are taxed.
  • To elect S-corp taxation for a corporation or an LLC, simply fill out IRS Form 2553.
  • In order to be eligible for S-corp taxation, a corporation must meet several requirements regarding the nature of the business and the number and type of shareholders.
  • In order for your S-corp election to be effective for a given year, you must usually file Form 2553 by March 15 of that year.
  • Your business’s S-corporation status will be automatically terminated if, at any point, it ceases to meet any of the requirements to be an S-corporation.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less

Topics Covered in the Book:
  • The basics of sole proprietorship, partnership, LLC, S-Corp, and C-Corp taxation,
  • How to protect your personal assets from lawsuits against your business,
  • Which business structures could reduce your Federal income tax or Self-Employment tax,
  • Click here to see the full list.

Partnership: Unlimited Liability Concerns

The following is an excerpt from my book LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less.

It’s obvious that before you form a partnership with somebody, you should make sure that he or she is a person you trust and in whom you have confidence. What’s not necessarily as obvious is exactly how much you must trust this person before forming a partnership actually becomes a good idea.

Unlimited Liability — Even for Each Other!

Generally speaking, every partner in a partnership has unlimited liability for all of the partnership’s debts. (Note: limited partnerships, which we’ll discuss momentarily, work somewhat differently.) It’s very much like a sole proprietor’s unlimited liability but with one crucial difference: You’re now personally responsible for debts of the business, even if you had nothing to do with creating them.

EXAMPLE: Tom and Jennifer run a local newspaper, and their business is organized as a partnership. One week while Jennifer is on vacation, Tom reprints — without permission — an article from another newspaper. The other paper decides to sue for copyright infringement. Even though Jennifer had nothing to do with the legal infraction, she could potentially be held liable for the entire amount of the judgment. Such is the risk of being a partner in a partnership.

Of course, Jennifer might be successful if she took Tom to court to sue for the amount that she ended up paying. But she’d still be out the cost of the legal fees, not to mention the hassle involved.

Partners as Agents of the Partnership

Each partner can be held responsible not only for liabilities resulting from a lawsuit, but also for liabilities stemming from a contract signed by only one of the partners. This is due to the fact that each partner is an “agent” of the partnership. As an agent, each partner has the legal power to bind the partnership — and thus each of the partners — to a contract.

Fortunately, there are some limitations to a partner’s power as an agent of the partnership. Most importantly, each partner can only act as an agent in affairs that are within the scope of the partnership’s business. For example, if you run a retail store that sells locally grown produce, you don’t have to worry about your partner buying a sailboat under the name of the partnership. Given that the purchase of a sailboat is clearly outside the scope of the business, your partner would have no power as an agent to bind the partnership to the contract.

Limited Partnerships

So far, our discussion of partnerships has been about what are known more precisely as “general partnerships.” In addition to general partnerships, there is another form of partnership known as the “limited partnership.” Generally speaking though, whenever somebody simply uses the term “partnership,” he’s referring to a general partnership.

The difference between the two structures is that, in a limited partnership, there are two types of partners: general partners and limited partners. General partners have unlimited liability for the debts of the partnership, while limited partners do not. Limited partners (much like shareholders of a corporation) cannot lose an amount greater than their investment in the partnership. A limited partnership can have as many or as few of each type of partner as it wants, with the one notable exception that there must be at least one general partner.

One important rule about limited partnerships is that the limited partners cannot participate in managerial decisions or in the day-to-day operation of the partnership. If they do, they’ll lose their limited liability. Therefore, in many limited partnerships, the general partners are the original founders, and the limited partners are outside investors.

In Summary

  • In a general partnership (commonly referred to as simply a “partnership”), each partner has unlimited liability for all of the partnership’s debts.
  • Each partner, as an agent of the partnership, has the power to bind the partnership to a contract.
  • Partners do not, however, have the power to bind the partnership to contracts that are clearly outside the scope of the business.
  • In a limited partnership, limited partners have limited liability. They can only lose the amount that they initially invested. General partners in a limited partnership have unlimited liability.
  • Limited partnerships can have as many or as few limited partners as they choose, but they must have at least one general partner.
  • Limited partners cannot engage in the management or day-to-day operations of the partnership.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less

Topics Covered in the Book:
  • The basics of sole proprietorship, partnership, LLC, S-Corp, and C-Corp taxation,
  • How to protect your personal assets from lawsuits against your business,
  • Which business structures could reduce your Federal income tax or Self-Employment tax,
  • Click here to see the full list.

Legal Advantages to Forming a Corporation

The following is an excerpt from my book LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less.

For most legal purposes, corporations are distinct entities. In other words, corporations are treated (more or less) as if they were people. They’re allowed to own things, rent things, sue or be sued, and so on.

Limited Liability

The reasoning behind the concept of the corporation — a business legally distinct from its owners — was to allow the owners to not have to worry about being held personally liable for the debts of the business. Generally speaking, because the corporation is a separate entity, anybody wishing to bring a lawsuit against the business has to bring it against the corporation rather than against the owners personally.

This protection is in fact one of the fundamental elements of our entire economy. For example, what are the odds that anybody would have invested in Chipotle or McDonald’s if they knew that they could be held personally liable if anybody were to bring a lawsuit against the company as a result of getting sick from one of their products? And who would have bought shares of General Motors if there was a chance they’d be held personally liable for accidents caused by faulty manufacturing?

If corporations didn’t offer the protection they do, hardly anybody would invest in new companies.

Planning on Outside Investment? Plan on Incorporating.

For the above-mentioned reason, if you’re planning on securing cash from outside investors, it’s quite likely that your only option is going to be to form a corporation. (To be more specific, it’ll likely have to be a C-corporation due to S-Corporation ownership restrictions.)

Another reason that investors are more likely to invest in a corporation is that shares in a corporation can usually be sold more easily than ownership interests in any other type of business. Investors like knowing that if they want to get out, they can.

Ongoing Legal Requirements

One slight drawback to forming a corporation is that there are a few ongoing legal requirements that will take up your time. For example, whenever the directors of a corporation make a major decision, it must be recorded in a document known as a “resolution.” A resolution doesn’t have to be anything fancy or complicated. Just be aware that forming a corporation means you’re going to be in for a little more paperwork.

Also, most states require an annual meeting of the directors and shareholders of the corporation, as well as a record of what was discussed at the meeting. Of course, if you’re the only owner, this just means preparing one more document every year, as the “meeting” with yourself probably doesn’t have to be very long.

Tort of Corporate Shareholders

As with an LLC, it’s possible for the owners of a corporation to be liable as a result of torts they personally commit (e.g, negligence, fraud, etc.), even if the tort was performed in the service of the corporation.

“Piercing the Corporate Veil”

Whenever you read anything about the limited liability provided by the corporate form, you’re likely to encounter the term “piercing the corporate veil.” This term refers to the fact that, under certain circumstances, a court may decide that a corporation is not materially separate from its owners and that the plaintiff should be allowed to come after the owners for their personal assets.

Some of the things that may lead a court to pierce the corporate veil include:

  1. Fraudulent activity by the corporation or its owners,
  2. Intermingling of funds between corporate accounts and personal accounts of the owners,
  3. Disregard for corporate formalities (such as the preparation of resolutions and holding of annual shareholder meetings),
  4. Undercapitalization of the corporation (i.e., the corporation was formed without enough funding to be able to satisfy its existing and likely obligations),
  5. Absence of corporate financial records, and
  6. Anything else that would lead a court to believe that the corporation is merely a formality, and is not materially distinct from its owners.

Simple Summary

  • Generally speaking, the owners of a corporation will not be held personally liable in the case of a lawsuit against the corporation.
  • If you plan on attracting outside investors, you may have to form a C-corporation.
  • It’s possible for shareholders of a corporation to be held personally liable for torts they commit in the service of the corporation.
  • If a court decides that a corporation is not in fact distinct from its owners, the court may decide to “pierce the corporate veil,” thereby allowing a plaintiff to come after the involved shareholders’ personal assets.
  • Important steps toward preventing a court from piercing the corporate veil include: keeping your personal and corporate finances separate, keeping excellent records, following corporate formalities, and providing the corporation with sufficient funding.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less

Topics Covered in the Book:
  • The basics of sole proprietorship, partnership, LLC, S-Corp, and C-Corp taxation,
  • How to protect your personal assets from lawsuits against your business,
  • Which business structures could reduce your Federal income tax or Self-Employment tax,
  • Click here to see the full list.

Single Premium Immediate Annuity: Why They’re Useful and When to Buy Them

The following is an excerpt from my book Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less.

Most annuities are a raw deal for investors. They carry needlessly high expenses and surrender charges, and their contracts are so complex that very few investors can properly assess whether the annuity is a good investment.

That said, one specific type of annuity can be a particularly useful tool for retirement planning: the single premium immediate annuity (SPIA).

What’s a SPIA?

A single premium immediate annuity is a contract with an insurance company whereby:

  1. You pay them a sum of money up front (known as a premium), and
  2. They promise to pay you a certain amount of money periodically (monthly, for instance) for the rest of your life.

A single premium immediate annuity can be a fixed annuity or a variable annuity. With a single premium immediate fixed annuity, the payout is a fixed amount each period. With a single premium immediate variable annuity, the payout is linked to the performance of a mutual fund. For the most part, I’d suggest steering clear of variable annuities. They tend to be complex and expensive. And because they each offer different bells and whistles, it’s difficult to make comparisons between annuity providers to see which one offers the best deal.

In contrast, fixed SPIAs are helpful tools for two reasons:

  1. They make retirement planning easier, and
  2. They allow for a higher withdrawal rate than you can safely take from a portfolio of stocks, bonds, and mutual funds over the course of a potentially-lengthy retirement.

Retirement Planning with SPIAs

Fixed SPIAs make retirement planning easier in exactly the same way that traditional pensions do: they’re predictable. With such an annuity, you know that you will receive a given amount of income every year, for the rest of your life — no matter how long you might live. With a traditional stock and bond portfolio, retirement planning is more of a guessing game.

SPIAs and Withdrawal Rates

Fixed SPIAs are also helpful because they allow you to retire with less money than you would need with a typical stock/bond portfolio. For example, even with the low interest rates that prevail as of this writing, according to immediateannuities.com (a website that provides annuity quotes from various insurance companies), a 65-year-old male could purchase an annuity paying 5.88% annually.

If that investor were to take a withdrawal rate of 5.88% from a typical stock/bond portfolio (and continue spending the same dollar amount each year going forward), there’s a meaningful chance that he’d run out of money during his lifetime—especially given the current environment of low interest rates and high stock valuations. That risk disappears with an annuity.

How is that possible? In short, it’s possible because the annuitant gives up the right to keep the money once he dies. If you buy a SPIA and die the next day, the money is gone.* Your heirs don’t get to keep it — the insurance company does. And the insurance company uses (most of) that money to fund the payouts on SPIAs purchased by people who are still living.

In essence, SPIA purchasers who die before reaching their life expectancy end up funding the retirement of SPIA purchasers who live past their life expectancy.

But I Want to Leave Something to My Heirs!

For many people, it’s a deal-breaker to learn that none of the money used to purchase an annuity will go to their heirs.

The relevant counterpoint here is that, depending on how your desired level of spending compares to the size of your portfolio, choosing not to devote any portion of your portfolio to an annuity could backfire. That is, there’s a possibility that, rather than resulting in a larger inheritance for your kids, the decision results in you running out of money while you’re still alive, thereby causing you to become a financial burden on your kids.

Inflation Risk

Another important downside of single premium immediate annuities is that they are exposed to inflation risk. That is, the amount of income that the annuity pays each year is fixed, thereby leaving you with a purchasing power that will be eroded over time via inflation.

It is possible to purchase an annuity with a cost-of-living adjustment (COLA) each year. But that naturally requires paying a higher initial premium. Also, the COLA is a fixed percentage (e.g., the income increases by 2% annually), so you are still exposed to the risk of high inflation eating away at your purchasing power.

Not too long ago, it was possible to purchase a SPIA that had a COLA that was linked to the consumer price index (i.e., the actual rate of inflation), thereby eliminating inflation risk. But in 2019, the last insurance company offering such products decided to stop selling them. Will they be available again in the future? It’s possible, but I wouldn’t count on it.

It’s worth noting that for some people the lack of inflation protection may not be a problem at all. Some people explicitly desire to spend more per year in early retirement than in late retirement. A fixed nominal dollar amount may actually be a good fit for people with such a preference (because it has the effect of front-loading spending, when we measure spending in terms of actual purchasing power).

Annuity Income: Is It Safe?

Because the income from an annuity is backed by an insurance company, financial advisors and financial literature usually refer to it as “guaranteed.” But that doesn’t mean it’s a 100% sure-thing. Just like any company, insurance companies can go belly-up. It’s not common, but it’s certainly not impossible. However, if you’re careful, the possibility of your annuity provider going out of business doesn’t have to keep you up at night.

Check Your Insurance Company’s Financial Strength

Before placing a meaningful portion of your retirement savings in the hands of an insurance company, it’s important to check that company’s financial strength. I’d suggest checking with multiple ratings agencies, such as Standard and Poor’s, Moody’s, or A.M. Best. (Note that each of these companies uses a different ratings scale, so it’s important to look at what each of the ratings actually means.)

State Guaranty Associations

Even if the issuer of your annuity does go bankrupt, you aren’t necessarily in trouble. Each state has a guaranty association (funded by the insurance companies themselves) that will step in if your insurance company goes insolvent.

It’s important to note, however, that the state guaranty associations only provide coverage up to a certain limit. And that limit varies from state to state. Equally important: the rules regarding the coverage vary from state to state.

For example, the guaranty association in Connecticut provides coverage of up to $500,000 per contract owner, per insurance company insolvency. But they only provide coverage to investors who are residents of Connecticut at the time the insurance company becomes insolvent. So if you have an annuity currently worth $500,000, and you move to Arkansas (where the coverage is capped at $300,000), you’re putting your money at risk.

In contrast, the guaranty association in New York offers $500,000 of coverage, and they cover you if you are a NY state resident either when the insurance company goes insolvent or when the annuity was issued. So moving to another state with a lower coverage limit isn’t a problem if you bought your annuity in New York.

Minimizing Your Risk

In short, annuities can be a useful tool for maximizing the amount you can safely spend per year. But to maximize the likelihood that you’ll receive the promised payout, it’s important to take the following steps:

  1. Check the financial strength of the insurance company before purchasing an annuity.
  2. Know the limit for guaranty association coverage in your state as well as the rules accompanying such coverage.
  3. Consider diversifying between insurance companies. For instance, if your state’s guaranty association only provides coverage up to $250,000 and you want to annuitize $400,000 of your portfolio, consider buying a $200,000 annuity from each of two different insurance companies.
  4. Before moving from one state to another, be sure to check the guaranty association coverage in your new state to make sure you’re not putting your standard of living at risk.

*There are some exceptions. For example, you can buy a SPIA that promises to pay income for the longer of your lifetime or a given number of years. But purchasing such an add-on reduces the payout, thereby reducing the ability of the SPIA to do what it does so well—provide a relatively high payout with very little risk.

Simple Summary

  • If you desire a larger “floor” of safe income than you will receive from Social Security (and pension, if applicable), a single premium immediate fixed annuity may be a good idea.
  • Such annuities allow for a higher level of spending than would be safely sustainable from a typical portfolio of other investments.
  • In exchange for this safety, you give up control of the money as well as the possibility of leaving the money to your heirs.
  • Another drawback of single premium immediate annuities is that they leave you exposed to the risk that inflation will significantly erode your purchasing power over time.
  • Before buying an annuity, check the financial strength of the insurance company and make sure you’re familiar with the rules and coverage limits for your state’s guaranty association.

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

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How to Calculate Self-Employment Tax

(The following is an excerpt from my book Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less.)

The self-employment tax is a tax that gets added to your normal income tax. The tax is calculated by multiplying your earnings from self-employment by approximately 15%.

Why the Self-Employment Tax Exists

At first glance, it seems unfair that entrepreneurs — the most important driving force behind our economy — would be forced to pay an additional tax. In reality, however, sole proprietors are simply paying this particular tax instead of another one.

If you’ve had a job where you were paid a salary or an hourly wage, you’re probably familiar with the fact that part of your income was withheld for taxes. A portion of the amount withheld from an employee’s wages goes to pay the Social Security and Medicare taxes.

The way these taxes are structured, the burden is shared equally between the employee and the employer. The employee’s share is calculated as 6.2% of the employee’s wages for Social Security tax and 1.45% for the Medicare tax. At the same time, the employer also pays both taxes, calculated at the same rate. As a result, an amount equal to 12.4% (or 6.2% + 6.2%) is paid in total for Social Security tax, and an amount equal to 2.9% (or 1.45% + 1.45%) is paid in total for the Medicare tax.

Given that you are self-employed, there is no employer with whom you can split the burden. You are therefore responsible for paying both halves of the Social Security and Medicare taxes, or 15.3% in total. We simply call the tax something different; we call it the self-employment tax.

How to Calculate Your Self-Employment Tax

As long as your “net earnings from self-employment” are $400 or more, you will be responsible for paying the self-employment tax — calculated as 15.3% of your net earnings from self-employment.

To calculate your net earnings from self-employment, subtract your business expenses from your business revenues, then multiply the difference by 92.35%. (This odd multiplication figure is the result of the fact that you’re allowed to deduct 50% of your self-employment tax when calculating the income upon which the tax will be charged.)

It’s important to note that the 12.4% Social Security tax only applies to the first $137,700 of earned income per year. (This limit is updated annually. The figure here is for 2020.) The 2.9% Medicare tax, however, does not have a limit.

(For more information, see the book on Amazon: Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less.)

The Importance of Business Expenses (Schedule C Deductions)

Now that you’re self-employed, you have an additional, extra-valuable level of deductions: business deductions. The reason business deductions are so valuable is that they reduce not only your taxable income (and thus your regular income tax), but also your earnings from self-employment, thus reducing your self-employment tax as well.

From now on, whenever you learn that a particular expenditure can be deducted, it will be important for you to determine whether that expenditure counts as a personal expense, or if it can be classified as a business expense, thereby saving you even more money.

In order for an expense to be deductible for your business, it must be both “ordinary” and “necessary.” The IRS considers an ordinary expense to be one that is both common and accepted in your field. A necessary expense is one that is helpful and appropriate for your business. (Note that this means that an expense does not have to be absolutely indispensable for it to be considered necessary.)

Deduction for One-Half of SE Tax

Each year, when calculating your income tax, you are allowed a deduction (specifically an “adjustment to income”) equal to 50% of the amount you pay as self-employment tax.

Simple Summary

  • The self-employment tax exists simply to take the place of the Social Security and Medicare taxes that you and your employer would be paying if you had a job as an employee.
  • The tax is calculated as 15.3% of your net earnings from self-employment (or 2.9% for amounts beyond the annual maximum amount subject to Social Security tax).
  • Business deductions (sometimes called Schedule C deductions) are more valuable than either adjustments to income or itemized deductions. This is because business deductions reduce your earnings from self-employment, thereby reducing your regular income tax and your self-employment tax.
  • Each year, you are allowed an adjustment to income (i.e., a deduction) equal to 50% of the amount you pay for self-employment tax.

For More Information, See My Related Book:

Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • Estimated tax payments: When and how to pay them, as well as an easy way to calculate each payment,
  • Self-employment tax: What it is, why it exists, and how to calculate it,
  • Business retirement plans: What the different types are, and which one is best for you,
  • Click here to see the full list.
A testimonial from a reader on Amazon:
"Quick and easy read. No fluff, just straight to the point and gives you more helpful information that you might imagine. If you are looking to get the bottom line information you need to start your business right then this book is a must have."
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