1. What Is the Self-Employment Tax?
2. What Are Nontaxable Dividends?
3. Other Ways to Save on Taxes
4. You Can't Save on State Taxes

You can save taxes by incorporating your business, as your income won't be subject to a self-employment tax because you can pay yourself in nontaxable dividends.

When you're running your own business, you're self-employed. Most businesses start out unincorporated as either a sole proprietorship or partnership, as these business structures involve less paperwork and regulations to worry about. Additionally, there are fewer management and administrative costs.

However, what many of these fledgling business owners don't realize is that they will be subject to the self-employment tax at the end of the year.

What Is the Self-Employment Tax?

The self-employment tax is a version of the Medicare and Social Security taxes you'd pay in a normal job. Usually, the rate for individuals 7.65 percent, and the company you're working for covers the other half.

However, when you're managing your own company, you're responsible for both the employer and the employee shares of this tax. This means you'll need to pay double, equating to a rate of 15.3 percent.

There are some stipulations to how this tax works:

  • The Social Security portion of the tax, which equates to 12.4 percent, is only applied on your first $84,900 of income (as of 2002).
  • The Medicare portion, which equates to 2.9 percent, has no limits.
  • If you're self-employed, you'll have the ability to deduct half your self-employment taxes from your taxable income, slightly reducing your burden.

With this information in mind, consider a person who makes $100,000 in net profits during the course of a year. They will be required to pay $12,400 in self-employment taxes. This does not take into account local, state, and federal taxes, which must be calculated separately.

What Are Nontaxable Dividends?

When you incorporate into an S corporation, you'll still pay yourself wages like you did before. However, you'll have the an additional means of compensating yourself for work — nontaxable dividends.

Nontaxable dividends are unique because they don't go through the double taxation like dividends paid to shareholders in a C corporation. While you'll still pay federal taxes on nontaxable dividends from your S corporation when you file your individual tax return, you won't have to pay self-employment tax on the money.

To understand better, imagine an S corporation that has $100,000 in net profits. The owner pays himself a fair salary of $50,000, and then awards himself with $25,000 in nontaxable dividends. In this example, his tax burden will only be $7,650. Compared to the $12,400 he would have had to pay in self-employment taxes otherwise, that is a huge savings. The savings is still palpable even when you consider professional fees, incorporation costs, workman's compensation insurance, and other costs related to operating a corporation.

However, don't just think you can give yourself an unlimited amount of taxable dividends. You still need to pay yourself a fair salary based on market conditions. It's easier to justify your salary if your corporation is more than just you providing individual services, but in many cases, this is not possible.

Other Ways to Save on Taxes

Incorporating has a few other benefits when it comes to taxes. For example, if you already have a C corporation but decide to switch to an S corporation, you could save big if your state has a high corporate income tax.

Having children is another way to circumvent high taxes. As long as your kids are over the age of 14, you can assign them shares in your S corporation. They will pay taxes on the shares at lower rates than you would. Additionally, handing over shares reduces your estate tax obligation, further saving you big.

You Can't Save on State Taxes

While the above tips can definitely help you with the self-employment tax, they'll do nothing to help you on your state taxes. Many entrepreneurs think they can circumvent the system by incorporating in a state with a low- or no-tax rate. However, this tactic is useless, as it doesn't matter where you incorporate, but where you operate.

For example, if you live in California (a state known for having high taxes) and try to incorporate in Nevada (a state with no taxes), you'll still have to pay taxes on the money you earned in California.

If you need help with how to save taxes by incorporating, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.