How to Lawfully Avoid Self-Employment Tax

Self-employment tax represents the Social Security and Medicare taxes paid by individuals who work for themselves. This federal tax helps fund social insurance programs. Unlike traditional employees, self-employed individuals are responsible for both the employee and employer portions of these taxes. The self-employment tax rate is 15.3%, comprising 12.4% for Social Security and 2.9% for Medicare. It applies to net earnings from self-employment exceeding $400. This article explores legitimate strategies to reduce this tax burden.

Reducing Net Earnings Through Business Deductions

Self-employment tax is directly calculated on your net earnings from self-employment. Reducing your business’s net earnings through legitimate expenses directly lowers the amount subject to this tax. Accurate record-keeping of all ordinary and necessary business expenses is important for minimizing tax liability.

Ordinary and necessary business expenses are those common and accepted in your industry and helpful for your business. Many types of expenses can qualify. For instance, costs associated with maintaining a home office can be deductible if the space is used exclusively and regularly as your principal place of business. This deduction can cover a portion of rent or mortgage interest, utilities, insurance, and repairs.

Business travel expenses are another area for deductions. If you travel away from your tax home overnight for business, you can deduct costs such as transportation, lodging, and 50% of meal expenses. For using a personal car for business, you can deduct actual expenses or use the standard mileage rate. Expenses related to professional development, such as attending industry conferences, workshops, or obtaining certifications that maintain or improve skills for your business, are also deductible.

Other common deductible expenses include supplies, advertising and marketing costs, professional fees paid to attorneys or accountants, and business insurance premiums. Health insurance premiums paid by self-employed individuals can also be deductible, provided you are not eligible to participate in an employer-sponsored health plan. While the Qualified Business Income (QBI) deduction reduces your overall taxable income, it does not directly reduce your net earnings from self-employment for self-employment tax purposes. However, it still contributes to a lower overall tax burden.

Accurate record-keeping is important to substantiate all claimed deductions. The Internal Revenue Service requires taxpayers to maintain records showing the amount, date, purpose, and payee for each expense. Keeping detailed ledgers, receipts, invoices, and bank statements helps ensure compliance during an audit. By diligently identifying and documenting all eligible business expenses, self-employed individuals can reduce their net earnings and self-employment tax liability.

Utilizing S Corporation Status

Electing S corporation status for a business can offer an advantage in reducing self-employment tax. Unlike sole proprietorships or partnerships, where all business profits are subject to self-employment tax, an S corporation allows the owner to be treated as both an employee and a shareholder. This dual role enables a tax structure where the owner can pay themselves a “reasonable salary” and take remaining profits as distributions.

The distinction lies in how these two forms of income are taxed. The salary paid to the owner-employee is subject to Social Security and Medicare taxes, similar to a traditional W-2 employee’s wages. Both the employee and employer portions of these payroll taxes are remitted. However, any additional profits taken as distributions from the S corporation are not subject to self-employment tax. This allows a portion of the business’s income to bypass the 15.3% self-employment tax.

Determining a “reasonable salary” is an aspect of this strategy subject to scrutiny by the Internal Revenue Service. The IRS requires the salary to be comparable to what other businesses would pay for similar services in a similar role. Factors considered by the IRS include the owner’s training and experience, duties, time and effort devoted to the business, and comparable salaries. No specific formula is provided by the IRS, so a fact-based approach, potentially consulting industry salary data, is important.

If the IRS determines that the salary paid was unreasonably low, it can reclassify distributions as wages. This would then subject them to payroll taxes, potentially leading to back taxes, penalties, and interest. While informal rules of thumb, like the 60/40 split between salary and distributions, exist, they are not officially recognized by the IRS and may not withstand an audit.

Forming an S corporation involves steps like forming a legal entity (LLC or corporation) and filing Form 2553 with the IRS to elect S corporation status. Ongoing compliance requirements include maintaining separate bank accounts, running payroll for the owner-employee, and filing separate corporate tax returns (Form 1120-S). These administrative responsibilities and potential professional fees should be weighed against the potential tax savings.

Maximizing Contributions to Tax-Advantaged Accounts

Contributions to certain tax-advantaged accounts can reduce self-employment tax liability or overall taxable income. Self-employed retirement plans offer a direct reduction to net earnings from self-employment before the self-employment tax is calculated. Health Savings Accounts (HSAs) provide another avenue for tax savings by reducing adjusted gross income.

Self-employed individuals have access to several retirement plan options that allow for tax-deductible contributions. A Simplified Employee Pension (SEP) IRA is a popular choice due to its simplicity and high contribution limits. For 2025, you can contribute up to 25% of your net self-employment earnings, up to a maximum of $70,000. These contributions are made by the business on your behalf and are deductible from your gross income.

A Solo 401(k), also known as an individual 401(k), offers flexibility and potentially higher contribution limits, as you can contribute both as an employee and as an employer. For 2025, the employee contribution limit is $23,500, with an additional catch-up contribution of $7,500 for those age 50 or older, or $11,250 for those aged 60-63. As the employer, you can contribute up to 25% of your compensation. The total combined contribution for a Solo 401(k) in 2025 can reach $70,000, or up to $77,500 if including the age 50+ catch-up contribution. These contributions directly reduce your net earnings from self-employment.

A Savings Incentive Match Plan for Employees (SIMPLE) IRA is another option, suitable for small businesses with fewer than 100 employees. For 2025, employee contributions to a SIMPLE IRA are limited to $16,500, with a catch-up contribution of $3,500 for those age 50 or older, or $5,250 for those aged 60-63. Employers are required to make either a matching contribution or a fixed non-elective contribution. Contributions to SIMPLE IRAs also reduce your taxable income.

Health Savings Accounts (HSAs) provide a triple tax advantage. Contributions are tax-deductible, earnings grow tax-free, and qualified withdrawals for medical expenses are tax-free. To be eligible for an HSA, you must be covered by a high-deductible health plan (HDHP). For 2025, the maximum contribution for self-only coverage is $4,300, and for family coverage, it is $8,550. An additional catch-up contribution of $1,000 is permitted for those age 55 or older. While HSA contributions do not directly reduce net earnings for self-employment tax calculation, they lower your overall taxable income.