Table of Contents
Your consulting business generated $180,000 net profit in 2024. You file Schedule C and calculate your self-employment tax: $180,000 × 15.3% = $27,540 in Social Security and Medicare taxes—separate from and in addition to your income tax. A colleague running an identical business structured as an S-corporation paid himself $120,000 in salary (paying $18,360 in payroll taxes on the salary) and took $60,000 as S-Corp distributions (paying zero self-employment tax on distributions). His self-employment tax savings: $9,180 annually. Over five years, that's $45,900 in unnecessary taxes you paid simply due to business structure choice.
Understanding important tax reduction strategies determines how company structure election can cut your tax by 30-50% through reasonable salary strategies, which business deductions reduce both income tax and self-employment tax, how qualified business income deductions provide additional 20% deductions on pass-through income, and legal methods to minimize tax without triggering IRS scrutiny. Getting it wrong means paying $10,000 to $30,000 annually in excess tax when legal alternatives exist, or triggering IRS audits by using aggressive strategies that cross legal boundaries.
In this article you'll learn exactly how self-employment tax is calculated and why it's so expensive for profitable businesses, when the S corp election reduces your tax and how to determine a reasonable salary.
What is self-employment tax and why is it so expensive?
Self-employment tax is the Social Security and Medicare tax paid by self-employed individuals—the equivalent of FICA taxes that employees and employers pay.
How self-employment tax is calculated
Self-employment tax is 15.3% of net self-employment income, consisting of:
- Social Security tax: 12.4% on net self-employment income up to $176,100 for 2025 (wage base limit)
- Medicare tax: 2.9% on all net self-employment income with no limit
- Additional Medicare tax: 0.9% on net self-employment income exceeding $200,000 (single) or $250,000 (married filing jointly)
Calculation: Net self-employment income × 92.35% × 15.3% = self-employment tax
The 92.35% adjustment accounts for the employer portion of self-employment tax being deductible.
Why self-employment tax is so expensive
- You pay both portions: Employees pay 7.65% (their half) and employers pay 7.65% (employer half), totaling 15.3%. Self-employed individuals pay both portions—the full 15.3%.
- No deductions reduce it: Most business deductions reduce your income tax but your self-employment tax is calculated on net profit. There are limited ways to reduce the net profit subject to self-employment tax.
- It applies before income tax deductions: You calculate self-employment tax on Schedule C net profit before taking the standard deduction, QBI deduction, or other adjustments that reduce income tax.
- It's in addition to income tax: Self-employment tax is separate from and in addition to income tax. A $150,000 profit triggers $21,194 self-employment tax PLUS approximately $25,000-$35,000 in federal income tax depending on filing status and other deductions.
Self-employment tax vs FICA tax
Employees: Pay 7.65% FICA tax (withheld from paychecks). Employer pays additional 7.65%. Total 15.3% but employee only feels 7.65%.
Self-employed: Pay full 15.3% self-employment tax directly.
W-2 employees never pay more than 7.65%. Self-employed individuals always pay 15.3% (or 15.3% + 0.9% on income over $200,000/$250,000).
One-half self-employment tax deduction
You can deduct one-half of your self-employment tax as an adjustment to income on Schedule 1. This reduces your income tax but doesn't reduce your self-employment tax itself.
Example: You paid $21,194 in self-employment tax. You can deduct $10,597 as an adjustment to income, reducing your taxable income for income tax purposes. But you still paid the full $21,194 in self-employment tax.
Strategy 1: S-corporation election to reduce self-employment tax
The most powerful strategy to reduce self-employment tax is electing S corp status and paying yourself a reasonable salary while taking remaining profits as distributions.
How S-corporations avoid self-employment tax on distributions
Sole proprietorships and partnerships: All net profit is subject to 15.3% self-employment tax.
S-corporations: Only wages/salary paid to shareholder-employees are subject to payroll taxes (the equivalent of self-employment tax). S-Corp distributions to shareholders are NOT subject to self-employment tax.
This creates significant S-Corp taxes savings: pay yourself a reasonable salary (subject to payroll taxes), then take remaining profits as S-Corp distributions (avoiding self-employment tax on distributions).
Example: S-corp vs sole proprietorship
Scenario: Your business generates $180,000 net profit.
As a sole proprietorship:
- Schedule C net profit: $180,000
- Self-employment tax: $180,000 × 92.35% × 15.3% = $25,479
- Income tax: Approximately $30,000-$40,000 depending on deductions
- Total taxes: $55,000-$65,000
As an S-corporation:
- Pay yourself reasonable salary: $120,000
- S-Corp distributions: $60,000
- Payroll taxes on salary: $120,000 × 7.65% (employer portion) + $120,000 × 7.65% (employee portion) = $18,360
- Self-employment tax on distributions: $0 (distributions not subject to SE tax)
- Income tax: Approximately $30,000-$40,000 (same as sole prop)
- Total taxes: $48,000-$58,000
Tax savings from S corp election: $7,000-$9,000 annually ($25,479 SE tax as sole prop vs $18,360 payroll tax as S-corp = $7,119 savings)
What is "reasonable salary"?
The IRS requires S-corporation shareholder-employees to pay themselves "reasonable compensation" for services performed. You cannot pay yourself $0 salary and take all profits as S-Corp distributions to avoid payroll taxes entirely.
Reasonable salary factors:
- Industry compensation standards for similar work
- Your qualifications and experience
- Time and effort devoted to the business
- Dividend history (cannot take all profits as S-Corp distributions year after year)
- Comparable salaries in your geographic area
- Business profitability
General guidelines:
- 40-60% of net profit as salary is typically reasonable for service businesses
- Businesses with significant capital or inventory may justify lower salary percentages
- Higher profit businesses can justify lower percentages (paying yourself 40% of $500,000 = $200,000 is reasonable even though 60% would be $300,000)
Example reasonable salary determinations:
- Business generates $100,000 profit: Reasonable salary $50,000-$60,000 (50-60%)
- Business generates $200,000 profit: Reasonable salary $80,000-$120,000 (40-60%)
- Business generates $500,000 profit: Reasonable salary $150,000-$250,000 (30-50%)
IRS scrutiny of low salaries
The IRS audits S-corporations that pay unreasonably low salaries. Red flags include:
Zero salary: Taking no salary and only S-Corp distributions is illegal and triggers automatic IRS adjustment.
Token salary: Paying yourself $20,000 salary and taking $180,000 in S-Corp distributions when you work full-time in a $200,000 profit business will be challenged.
All distributions, no salary history: Taking S-Corp distributions for years without ever paying salary draws IRS attention.
Salary below industry standards: Paying yourself $40,000 when industry standards for your role are $100,000+ will be questioned.
Case law: What happens when salary is too low
In numerous court cases, the IRS has successfully recharacterized S-Corp distributions as wages when salaries were unreasonably low, assessing back payroll taxes, penalties, and interest.
Watson v. Commissioner (2010): David Watson, a CPA, paid himself $24,000 annual salary while taking $200,000+ in S-Corp distributions from his accounting firm. The Tax Court ruled $91,044 was reasonable compensation, recharacterizing $67,044 of distributions as wages. Watson owed back payroll taxes plus penalties.
Herbert v. Commissioner (2012): Real estate agent paid himself $0 salary and took all profits as S-Corp distributions. Court ruled this violated S-corp requirements and recharacterized distributions as wages.
The lesson: Pay yourself a defensible reasonable salary based on industry standards and your role in the business.
When S-corp election makes sense
S corp election provides self-employment tax savings but has additional costs and complexity:
Additional costs:
- Payroll processing fees ($500-$2,000+ annually)
- Separate tax return preparation (Form 1120-S) ($800-$3,000+ annually)
- Registered agent fees in some states
- State franchise taxes in some states
Breakeven analysis: Generally, S corp election provides net savings when net profit exceeds $60,000-$80,000. Below this threshold, the additional S-Corp taxes and costs may exceed self-employment tax savings.
Example: $50,000 profit business:
- SE tax as sole prop: $7,200
- Payroll tax as S-corp (paying $35,000 salary, $15,000 distributions): $5,355
- Savings: $1,845
- Additional S-corp costs: $1,500-$3,000
- Net result: May lose money or break even
Example: $150,000 profit business:
- SE tax as sole prop: $21,194
- Payroll tax as S-corp (paying $100,000 salary, $50,000 distributions): $15,300
- Savings: $5,894
- Additional S-corp costs: $1,500-$3,000
- Net result: Save $2,900-$4,400 annually
How to elect S-corporation status
Step 1: Form a legal entity - You must first form an LLC or corporation with your state. Sole proprietorships cannot make S corp election.
Step 2: File Form 2553 - File Form 2553 (Election by a Small Business Corporation) with the IRS to elect S-corporation tax treatment.
Timing: File by March 15 to have S corp status effective for the current tax year, or file during the year for next year's effective date.
Step 3: Set up payroll - Establish payroll processing to pay yourself W-2 wages. You cannot just take draws—you must run formal payroll with withholding.
Step 4: File Form 1120-S annually - S-corporations file Form 1120-S (not Schedule C) and issue K-1s to shareholders reporting their share of income.
Strategy 2: Maximize business deductions to reduce net profit
Business deductions reduce net profit subject to self-employment tax. The more legitimate deductions you claim, the lower your self-employment tax.
Understanding which deductions reduce self-employment tax
Schedule C deductions: All ordinary and necessary business expenses deducted on Schedule C reduce net profit and therefore reduce self-employment tax.
Above-the-line deductions: Deductions taken on Schedule 1 (like self-employment tax deduction, retirement contributions) reduce income tax but NOT self-employment tax because they're taken after calculating SE tax.
Standard/itemized deductions: These reduce income tax but NOT self-employment tax.
Focus: Maximize Schedule C deductions to reduce the net profit subject to 15.3% self-employment tax.
Home office deduction
If you use part of your home exclusively and regularly for business, you can deduct home office expenses.
Simplified method: $5 per square foot up to 300 square feet (maximum $1,500 deduction).
Regular method: Deduct percentage of actual home expenses (mortgage interest/rent, utilities, insurance, repairs, depreciation) based on business-use percentage.
Example: 200 square foot home office in 2,000 square foot home = 10% business use. Annual home expenses: $30,000. Home office deduction: $3,000.
Self-employment tax savings: $3,000 × 15.3% = $459 SE tax savings plus income tax savings.
Vehicle expenses
Track business use of your vehicle and deduct either actual expenses (gas, maintenance, insurance, depreciation) or standard mileage rate ($0.70 per mile for 2025).
Example: 15,000 business miles at $0.70 = $10,500 vehicle expense deduction.
SE tax savings: $10,500 × 15.3% = $1,607.
Retirement plan contributions
SEP-IRA, Solo 401(k), or SIMPLE IRA contributions reduce net self-employment income subject to self-employment tax if structured correctly.
Key: Employer contributions to retirement plans are deducted on Schedule C (reducing SE tax). Employee deferrals to 401(k) do NOT reduce SE tax.
SEP-IRA: Contribute up to 25% of net self-employment income (after adjusting for SE tax), maximum $70,000 for 2025. Fully deductible on Schedule C.
Solo 401(k) employer contribution: Up to 25% of net self-employment income, deductible on Schedule C.
Example: $150,000 net profit. SEP-IRA contribution of $30,000 (approximately 20% after SE tax adjustment). This reduces net profit to $120,000, saving $30,000 × 15.3% = $4,590 in self-employment tax plus income tax savings.
Health insurance deduction
Self-employed individuals can deduct health insurance premiums. The deduction is taken on Schedule 1 (not Schedule C), so it reduces income tax but NOT self-employment tax.
Strategy: If you're an S-corporation, include health insurance premiums in your W-2 wages (shown in Box 1 as wages). This allows you to deduct them without counting them as taxable wages, effectively reducing S-Corp taxes.
Section 179 and bonus depreciation
Deduct the full cost of equipment, vehicles, and other business property in the year purchased using Section 179 or bonus depreciation (instead of depreciating over multiple years).
Section 179: Deduct up to $2.5 million (Under OBBBA) in qualifying property purchases.
Bonus depreciation: Deduct 100% (under OBBBA), phasing from 60% in 2024, of qualifying property purchases in the first year.
Example: Purchase $50,000 in equipment. Deduct full $50,000 in year of purchase using Section 179.
SE tax savings: $50,000 × 15.3% = $7,650 (plus income tax savings).
Maximize all legitimate deductions
Other deductions that reduce self-employment tax:
- Professional development and education
- Business travel and meals (50% of meals deductible)
- Professional licenses and memberships
- Business insurance
- Legal and professional fees
- Office supplies and equipment
- Software and subscriptions
- Marketing and advertising
- Contract labor and subcontractors
Aggressive but legal: Take every deduction you're entitled to. Maintain documentation. The IRS allows all "ordinary and necessary" business expenses.
Strategy 3: Qualified Business Income (QBI) deduction
The qualified business income deduction (Section 199A) provides an additional deduction of up to 20% of qualified business income, reducing income tax (though not self-employment tax directly).
How the QBI deduction works
Eligible taxpayers can deduct up to 20% of qualified business income from sole proprietorships, S-corporations, partnerships, and LLCs.
Example: Your Schedule C shows $150,000 net profit. You may qualify for a $30,000 QBI deduction (20% of $150,000), reducing your taxable income to $120,000.
Important: The QBI deduction reduces income tax, not self-employment tax. Your SE tax is still calculated on the full $150,000 net profit.
QBI deduction limits and phase-outs
Below threshold: If your taxable income is below $247300 (single) or $494600 (married filing jointly) for 2025, you generally qualify for the full 20% deduction with no limitations.
Above threshold: If taxable income exceeds these amounts, limitations apply based on:
- W-2 wages paid by the business
- Depreciable property owned by the business
- Type of business (specified service trades or businesses face additional restrictions)
Specified service trades or businesses (SSTBs): Include health, law, accounting, consulting, financial services, brokerage, and businesses where principal asset is reputation or skill of employees. SSTBs face complete phase-out of QBI deduction when income exceeds $241,950 (single) or $483,900 (married filing jointly).
Maximizing QBI deduction
Pay W-2 wages in S-corporations: For businesses above the income threshold, paying higher W-2 wages increases the QBI deduction (because the deduction is limited to the greater of 50% of W-2 wages or 25% of W-2 wages plus 2.5% of depreciable property).
Invest in depreciable property: Purchasing equipment, vehicles, and other depreciable property increases the QBI deduction calculation above the income threshold.
Structure to avoid SSTB classification: Some businesses can structure to avoid being classified as specified service trades or businesses, maintaining QBI deduction eligibility.
Strategy 4: Spousal employment to shift income
Hiring your spouse as a legitimate employee can provide tax benefits in certain situations.
How spousal employment works
Pay your spouse a reasonable salary for legitimate work performed in your business. The salary is deductible to your business (reducing net profit and self-employment tax) and is income to your spouse.
Net effect: If you're in a higher tax bracket than your spouse would be on the spousal income alone, or if spousal employment creates access to certain tax benefits, this strategy provides savings.
Benefits of hiring your spouse
Access to employer retirement plans: Your spouse qualifies for employer retirement plans. You can make larger total family retirement contributions.
Health insurance: Provide health insurance to your spouse as an employee benefit, potentially making it deductible.
Income shifting: Shift income from your high bracket to your spouse's lower bracket (though this only works if filing separately, which usually isn't advantageous).
Important: The salary must be for legitimate work actually performed. Paying your spouse $80,000 for non-existent work triggers IRS scrutiny.
Strategy 5: Income timing strategies
Control the timing of income and expenses to optimize self-employment tax across years.
Deferring income
If you had a high-income year and expect lower income next year, defer income to next year by:
Delaying year-end billings: Bill clients in January instead of December, pushing income to next year.
Using cash-basis accounting: Most small businesses use cash basis, recognizing income when received. Delay receiving payment to defer income.
Accelerating expenses
Purchase equipment, supplies, and services before year-end to deduct them in the current year, reducing current-year net profit and self-employment tax.
Example: December 20 equipment purchase vs January 5 purchase:
- December purchase: Deduct in current year using Section 179, reducing current year SE tax
- January purchase: Deduct in next year
If the current year is high-income and next year is expected to be lower, accelerate deductions to the current year.
Multi-year averaging consideration
Self-employment tax doesn't allow income averaging (like farmers can use), but you can strategically time income and expenses to smooth income across years, preventing spikes that hit the Social Security wage base maximum.
How NSKT Global can help reduce self-employment tax
NSKT Global specializes in self-employment tax reduction strategies for businesses and self-employed individuals, helping clients legally minimize self-employment tax through optimal business structures and tax planning.
We offer comprehensive self-employment tax planning including S corp election analysis determining if S-corp election would reduce your taxes and calculating optimal salary/distribution splits, reasonable salary determination using industry data and IRS guidelines to set defensible salary levels, entity structure consultation advising on optimal business structures (sole prop, LLC, S-corp, C-corp) for your situation, and retirement plan design maximizing SEP-IRA or Solo 401(k) contributions to reduce self-employment tax.
Whether you're a sole proprietor paying over $15,000 annually in self-employment tax seeking reduction strategies, considering S corp election and need reasonable salary analysis. Our expert team ensures you implement legal strategies reducing self-employment tax by $5,000-$20,000+ annually for typical clients, structure S-corporations with defensible reasonable salaries preventing IRS recharacterization, maximize all legitimate business deductions through comprehensive tax planning, and maintain full documentation supporting tax positions if audited by IRS.
