SE Tax: There's No PLace To Hide

June,

I have a question that I think is probably quite common. Is it wise to incorporate for the purpose of saving the 15% self-employment tax?

I have been operating as a self-employed person for a couple of years now and have read your book which says that most people don't need to incorporate, but I am confused now because many folks in my professional circle are saying they save money by incorporating because of this. I live in California.

What do you think?
Alexis


Hello Alexis,

There is a misconception about self-employment [SE] tax and incorporation. Actually there's a lot of cheating regarding SE tax and incorporation and the IRS is making headway to deal with it.

I know from previous correspondence with you that you are a web designer. So I will use you as an example with some oversimplified numbers and situaions.

If you work at your computer designing away for 40 hours a week at $50 per hour. You have gross income of $2000 a week. If you have $1000 a week expense you have a net income of $1000 a week. Let's say $50,000 per year. On that $50,000 you must pay SE tax whether you are an indie or an employee of your own corporation.

If you owned a domain name -- let's say gogreen.com -- that you bought for $100. That is an asset of your business. If a conservation organization bought it from you for $1000 you would have a $900 gain. You would not have to pay SE tax on that gain.

So you see the difference.

When people incorporate often they pretend that the income is not earned as it is with you sitting in front of your computer but that it is similar to the gain on the sale of the domain name. And that is how they avoid paying SE tax. In IRS circles it's called fraud.

Of course there is income that an indie may earn because of her reputation or her "name" that would not be subject to self-employment tax. In that case incorporation might be worthwhile.

Let's say web designers typically charge $50 per hour. But, you, Alexis Web Design, are known throughout the region and everyone wants Alexis as designer. So you raise your fee to $500 per hour. Then some of your income, were you incorporated, would not be subject to SE tax.

As I said, that is an oversimplified explanation but I hope it will give you a basic understanding.

-- June