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Tax Strategy for Self-Employment Income, Part 1: The Tax Exposure

Contributed by mm | August 25, 2005 4:40 PM PST

I thought I pretty much mastered income tax after I built out my 2005 tax projection back in February. I am wrong. My life is taking an interesting turn, which requires me to upgrade my tax knowledge to the next level. Specifically, my wife is expecting an individual contractor career soon now that she had said goodbye to the office life, and just as I disclosed recently, I'm earning some steady and not-so-insignificant sideline income apart from my job too.

So, I am starting an excursion (out of my presumably decade-long personal finance journey) to find out the right handling of meaningful sideline, or self-employment income, with the goal of legitimately reducing our tax bills.

Actually, I already tested the water in filing 2004's federal tax return. For the first time, my return included Schedule SE, the form that is used to calculate self-employment tax. My net earnings from self-employment was not much in 2004, but we expect it to turn to low five-figure in 2005 and similar, if not higher, amount for 2006.

Before I start to explore the myriad of options presented to people in the self employment status, let me document the tax landscape we are facing, and relevant information that might influence our decisions. All bullets are forward looking statements for rest of 2005 and forward.

(Please don't think I'm showing off here or wanting to bring another heated discussion of class warfare; I just plan to lay down the facts before exploring different options in an objective manner.)

• I intend to keep working for my current employer with an entry-level six-figure annual income (for both 2005 and 2006). Although much of the income will be foreign-earned, all income will still be subject to FICA tax (6.2% up to about $90,000 for social security tax and 1.45% flat for medicare tax).

• We are looking at low five-figure income outside from office jobs for both 2005 and 2006. Such income is typically subject to FICA tax (i.e. self-employment tax), and counted as ordinary income (which is therefore subject to federal income tax). With regard to self-employment tax, since people with self-employment income have to pay for the employer's share of FICA tax too, we are talking about 12.4% for social security tax and 2.9% for medicare levy. Basically, I will assume all my sideline income will only face medicare consequences because I will exceed the social security tax cap from my job income anyway. My wife's independent contract income is likely to face the 15.3% cut from the big brother -- although we can claim half of the self-employment tax as deduction.

• For 2005, we will likely sit in the 33% tax bracket thanks to the relocation expenses my employer will pay for us (good part: they will gross up the tax too). For 2006, thanks to the foreign earned income exclusion of up to $80,000/person/year, our marginal tax rate will probably fall back to 25%, if not even lower. (We still have to pay tax in our hosting country, and alternatively, we can claim foreign tax credit instead of foreign income exclusion.) For analysis purposes in this series, I will use 28% as the hypothetical marginal tax rate.

So much for the background. Further in this series, I will list out the options I know of, and investigate them one by one. This ought to be an interesting series.

Please read the next part in this series: The Framework.

This Post Has Received 29 Comments. Share Your Opinions Too.

Shital Shah Commented on August 25, 2005

This is excellent post. I'm perticularly interested in knowing how one can calculate his/her tax bracket for a typical case (i.e. full time emplyed with fixed yearly salary).

MM Commented on August 25, 2005

Thank you Shital. Tax bracket is not that difficult to figure out. You can estimate your taxable income first, and then look at the tax table.

1stMill Commented on August 25, 2005

Hi MM.

You should consider establishing a separate company for your self-employment income. Two benefits: (i) You will limit your personal liability, and (ii) you will be able to deduct a whole host of business expenses from your self-employment income.

Your choices may come down to an S corp or an LLC (it would be worth seeing a tax-savvy lawyer prior to making your decision). Unfortunately, all options will mean more paperwork and likely some fees.

One other thing to consider: Establishing a separate company may open new doors for deferring income. Again, an hour with a tax-savvy lawyer could help sort this out.

1stMill Commented on August 26, 2005

BTW, there are Web-based services that can help you establish a company for several hundred dollars.

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