VP, Corporate Strategy and International Expansion, FreshBooks
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Here’s the thing: Making sure employees are paid the right amount on time is crucial to keeping them motivated. And for small business owners, determining exactly how much money should be withheld for state and federal income taxes, benefits and payroll taxes on their own can be complicated.
If your client is entering the world of self-employment for the first time, they may not be aware of how much their payroll taxes cost – and the impact it has on their bottom line. A recent FreshBooks study found 24 million Americans want to quit their jobs and be self-employed, so there could be a significant uptick in your newly self-employed clientele looking for your expertise in this area.
There are a number of strategies you can share with your clients to help them lower their self-employment taxes. Here are some important considerations for your clients as they assess their unique situations to develop a plan.
Start with the Basics: Business Structure
How is your client’s business set up? Business structure can affect self-employment taxes. If your client designates their company as an S Corporation, they can reduce self-employment taxes, so it’s an important conversation to have.
Plus, the new Tax Cuts and Jobs Act (TCJA) of 2017 has changed many of the rules. Choosing the right business entity is more important than ever because that decision may lower or increase your client’s net taxation. They may want to look at the potential 20 percent pass-through deduction for the self-employed, sole proprietors, S Corporations and partnerships to see if they should be claiming it.
Let’s take a closer look at payroll considerations. With an S Corporation, or an LLC that’s taxed as one, your client can divide their profits into two payment types: the salary as an employee and the distributions as a shareholder or owner. Let them know the key benefit here is that Social Security and Medicare taxes are paid on the salary portion but not on the distributions.
For most businesses, it only makes sense to register for S Corp status if your client will save on taxes. But how would the client know? To figure that out, first help them identify a reasonable salary for someone with their job description. If any profit remains after paying themselves, then it is likely worth looking into S Corp designation. They can’t pay themselves $10,000 in salary and $80,000 in distributions, however. The salary has to fall in line with the fair market rate. This is closely monitored by the IRS, so it’s not worth risking a red flag.
This is a great time to stress to your clients that any money they withhold from their employees’ paychecks for payroll taxes technically belongs to the government. If they don’t make their payments on time, they can face significant fines or have their business shut down.
Another important consideration for your clients is that changing their business structure to an S Corporation or an LLC will add more administrative obligations to their workload. An S Corporation typically has more formalities, including adopting bylaws, issuing stock, holding initial and annual director and shareholder meetings and keeping meeting minutes with corporate records. Many small businesses prefer the LLC because it has fewer reporting requirements and easier to manage.
Review your client’s goals and objectives with them (will there be an acquisition or merger in the future? What are their expected income totals?) to determine which type of business entity to form to their best advantage.
Can They Lower Their Reported Net Profit?
Your client may not fully realize that their net profit – their gross revenue minus deductible business expenses – is used to calculate their self-employment tax. Lowering their reported net profit really is a key strategy to lowering their self-employment taxes.
Make sure your client is including all allowable business expenses on their Schedule C – business travel, entertaining, cell phone bill and web hosting, computer equipment, home office deduction and more. The cost of banking fees, office and cleaning supplies and meals can add up fast.
If your client takes classes to get certifications in their field or to enhance their business knowledge, they can typically write off those costs. The same is true for any licensing or registration costs. Your client may be leaving money on the table if they forget about tracking these expenses. However, many clients don’t realize that all of these are deductible expenses that can lower their overall tax burden.
Basically, you want to make sure your client is aware of any unique deductions that can be used to defray their total tax bill and keeps records of those expenses, no matter how small.
Why Client Pricing Impacts Taxes
Is your client charging enough? One of the most important ways to manage self-employment taxes is to make sure that your client’s pricing and rates reflect all their costs, including the taxes they have to pay.
They’re responsible for paying the Medicare and Social Security tax themselves and covering vacation time and other time off for appointments or family issues. Are they able to compensate themselves appropriately to cover these higher costs?
Taxes can be confusing for your clients who are new to self-employment, so as their accountant, you play a key role in developing a plan to minimize tax impacts and charge enough to cover their taxes. This will help them have a clear picture of where they’re at.