Many sole proprietors and partners pay too much self-employment tax, especially those who earn $125,000 or less and have kids. Those farmers may wind up paying more in self-employment tax than they would in income tax, says Paul Neiffer, The Farm CPA.
Consider that self-employment taxes on $125,000 income—a pretty good salary up until five years ago—is about $18,000. Income taxes, on the other hand, after taking deductions for three kids and "everything else," would be closer to $7,000 to $10,000, says Neiffer.
How do you reduce self-employment taxes? Neiffer advises farmers first to hold their farming operations and land in separate tax entities. In that way, the rent they charge themselves for land typically is not subject to self-employment taxes. He also suggests that farmers pay their children for farm labor.
Neiffer recommends that beginning farmers with children consider setting up a Subchapter C Corporation, even though that could give rise to double taxation later. In the meantime, if the C Corp. is established properly, the farmer’s homestead, including the utilities and furnishings, can be fully deductible.
"And then, if we structure it properly, all the groceries and meals that are provided to the employees of the corporation, including the owner—as long as they are provided to everyone involved in the farm operation—are at least 50% deductible, or 100% deductible in some cases," says Neiffer. "And it’s tax-free to the owner."
Health insurance can also be tax-free and deductible, if structured properly and there’s only one employee. If there are multiple employees, and you haven’t bought the right health insurance policy, you might be subject to a penalty of as much as $100 per day per employee, Neiffer warns. Extreme care must be taken in structuring tax-free health insurance benefits.
But it’s mostly small or beginning farmers who stand to benefit from this approach. "If you’ve got 5,000 acres free and clear, this may not be that big of a deal," Neiffer says.
Farmers sometimes pay too much in self-employment taxes, but there’s also a danger in paying too little. They need to find the sweet spot.
"We want to make sure that farmers pay in a certain amount of self-employment tax to build up their social security benefits," Neiffer says. "A good goal would be to pay self-employment taxes on about $10,000 of earnings per year during their career. Otherwise, they may not have built up enough to maximize their tier one social security benefits at retirement."