Avoiding Self-Employment Tax on Passive Business Income

Avoiding Self-Employment Tax on Passive Business Income

Self-employment tax is one of the biggest hidden costs of being your own boss. At 15.3%, it covers both the employer and employee sides of Social Security and Medicare taxes—and it applies to net earnings from self-employment, not just W-2 income. But here’s the good news: not all business income is subject to self-employment tax. If structured correctly, you may be able to treat some of your income as passive—and avoid that extra tax burden altogether.

Let’s break this down. If you're a sole proprietor, partner in a general partnership, or a single-member LLC taxed as a disregarded entity, virtually all your business profits are subject to self-employment tax. But not all business activities are created equal in the eyes of the IRS. Some income can qualify as passive, which is not subject to self-employment tax—though it’s still subject to regular income tax.

For example, income from rental real estate is generally considered passive—unless you’re a real estate professional or provide substantial services. Likewise, if you're a limited partner in a partnership or own a passive interest in a business where you're not materially involved, your share of the profits may be exempt from self-employment tax.

Another powerful strategy is to use an S-Corporation. As an S-Corp owner, you’re required to pay yourself a “reasonable salary” for work performed, which is subject to payroll taxes. But any remaining profit distributed to you as a shareholder is not subject to self-employment tax. That’s why many business owners elect S-Corp status—to legally split income and reduce their tax liability.

Let’s say your business earns $150,000 in profit. You pay yourself a $70,000 salary and take the remaining $80,000 as a shareholder distribution. That $80,000 avoids the 15.3% self-employment tax—saving you over $12,000 in payroll taxes alone.

Of course, the IRS keeps a close eye on business owners who try to underpay themselves to dodge taxes. You need to document your role, responsibilities, and industry salary norms to justify your compensation level.

Bottom line: Not all income is created equal in the tax world. Understanding the difference between active and passive income—and structuring your business accordingly—can help you reduce your self-employment tax burden and keep more of your hard-earned profits. Talk to your CPA about which strategies are available based on how you earn. The right structure could mean thousands in annual savings.

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