The Tax Benefits of Fractional Work

All fractional workers are independent contractors. This is an important technicality and the basis for why doing fractional work brings with it a number of tax benefits compared to that of a full-time employee (which we’ll call a W2 employee).

This Playbook is a walkthrough of what these tax benefits are and how to make sense of them. It’s designed particularly for those coming from a full-time job and used to receiving a salary / paycheck.

Important: This Playbooks is NOT your accountant. It is not tax advice. It doesn’t know your specific circumstances.

Instead, it offers a simplified framework for how to think about taxes and tax benefits while doing fractional (i.e. independent contractor) work. We’ll touch on:

1. Should you set up an LLC?
2. What are the different types of tax savings?
3. What about retirement?

The purpose of understanding these principles, despite them being dense and boring, is that if done correctly you can take home much more money post-tax doing fractional work compared to full-time W2 work (assuming the same gross salary). And that’s worth taking advantage of!

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Setting Up an LLC (+ S-Corp)

Having your own business is a pre-cursor to unlocking all of the tax benefits we talk about in this Playbook. However, not everyone is a good fit for it, as it depends on your expected income.

Luckily, whether to set up a business, and even what type of business entity to set up, is a pretty easy decision for fractionals to make. Here’s the shortcut.

The $80,000 Threshold

The generally accepted rule-of-thumb is that if you expect to make $80,000 or more from fractional work in a calendar year, you will save money by setting up an LLC.

The more you make above $80,000, the higher your tax benefits will be.

If you expect to make less than $80,000 from your fractional work, the tax benefits of setting up an LLC will likely not outweigh the costs (formation, maintaining your books, filing your taxes, etc.). If this is you, your best bet is likely to skip the business entity altogether. It won’t be worth the extra cost and labor. Your clients can pay you directly to your personal bank account.

Note: This is $80,000 in independent contractor income. NOTHING to do with any W2 earnings you may also have in the same year through a full-time job.

The Right Setup for Fractional Employees

Assuming you expect to make more than $80,000 / year in fractional work, then yes you absolutely should set up your LLC. Specifically, you should set up what’s called a single-member LLC (legalese for a business-of-one).

Then, the next critical step is to elect to be taxed as an S-Corp. I cannot emphasize enough how critical the S-Corp is. Setting up an LLC is not enough, and if that’s all you’ve done you may actually be losing more money than if you never incorporated at all. The S-Corp tax election is what will drive most of your tax savings as a fractional worker.

If you’ve already set up your LLC but did not elect to be taxed as an S-Corp - fear not. You can take this extra step at any time, and even potentially backdate it to the beginning of the year (case dependent).

If this seems unapproachable or headache-inducing, I get it. But here’s the silver lining - the LLC + S-Corp recommendation is not really up for debate (ask any tax expert and they’ll give you the same answer). Assuming you meet the $80K threshold, the question is not whether to set this up, it’s how to do it (and we’ll cover that further down).

NOTE: There is one important exception here, and that’s if you’re a resident of NYC. NYC has a special tax on S-Corps called the GCT (General Corporation Tax). It’s a roughly 9% additional tax on your income, and makes the decision to elect S-Corp status a bit tougher. Personally, I am in NYC, and still decided to do it.

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The Different Tax Benefits

There are three basic tax benefits for the self-employed. Business expenses, reimbursements, and profit distributions. In reality, as you get more advanced and your financial situation changes, you unlock more benefits, but these three apply to everyone. Remember though, the pre-cursor is that you have your LLC + S-Corp set up correctly.

Business Expenses

You can reduce your taxable income by declaring business expenses. Everything from SaaS subscriptions to your co-working space to that work trip. As long as it’s within IRS guidelines, you’re free to expense it and reduce your tax bill.

To simplify, let’s imagine you spend $200/mo on a co-working space. If you use your business to pay for it, you’re paying $200 pre-tax. If you don’t have your business set up, you’d be paying this $200 post-tax, a.k.a. about $240 of your pre-tax money (assuming 20% effective tax rate to keep it easy). That’s a $40/mo savings just because you’re a business owner. Just don’t make the same mistake as David from Schitt’s Creek!

Some expenses have special rules, like client meals are only 50% reimbursable. But hey - better than 0%!

One more thing for the credit card points freaks - these expenses are a perfect reason to open up a new credit card solely for your business. Get those points bonuses, baby!

Reimbursements

Reimbursements are another kind of business expense. It’s an opportunity to take items that you typically pay for out of your personal bank account, and reimburse yourself for those items through your business.

Examples of reimbursements might be a home office, your phone bill, car miles, even your home cleaner(!!!).

Imagine your apartment costs $2,000 / month. You estimate that 15% of it is used exclusively for your home office. That means roughly $300 of your monthly rent becomes reimbursable by your business. So instead of paying this $300 with your post-tax money from your personal bank account, you pay for it (via a reimbursement) with your pre-tax business account, a savings of perhaps $60 / month (again assuming a 20% effective tax rate).

Profit Distributions

OK, here’s the big one. And this is the one where having an S-Corp becomes a game changer.

Imagine you make $200,000 per year doing fractional work, after subtracting typical expenses. Without an S-Corp election, you’d be responsible to pay regular income taxes AND self-employment taxes on the full $200,000.

There’s no avoiding the income tax. But we can avoid some of the self-employment taxes.

Self-employment taxes are Social Security, Medicare, etc. It’s about 15.3% on top of your regular income taxes. As a side note, when you’re a W2 employee, this 15.3% tax still gets paid, but it’s split evenly between the employer and the employee. The W2 employee pays 7.65%, and so does the employer.

But when you’re self-employed, you are both the employee AND the employer! So that’s why you must now pay both.

Enter the S-Corp election.

As a business owner, you can now pay yourself in two ways. A “salary” and a “profit distribution”. You’re paying yourself both times, but the taxes are different.

OK - are you ready now? You only need to pay self-employment taxes on your salary. Your profit distributions are not subject to self-employment tax.

The IRS mandates that you must pay yourself a “reasonable salary” based on the type of work you do. That’s literally the language in the tax code, and it does not get more specific than that.

Your accountant will guide you on what the right salary choice is, and there are many different ways to defend your choice based on what the average might be in your general professional area.

One common rule of thumb is a 50/50 split, meaning pay yourself half in salary and half in profit distributions. To keep it easy, let’s go with that. (But know that you can choose to lower your salary even more, it all depends how aggressive you want to be and how defensible it is).

Back to our $200,000 example. If you reserved 50%, $100,000, for profit distributions, that’s a savings of $15,300 per year (because you’re avoiding that 15.3% self-employment tax). The lower your salary, the more you save. The higher your business income is, the more you save.

The profit distributions, the reimbursements, the business expenses - they all add up. If we assume a few hundred bucks a month in pre-tax savings from reimbursements/expenses, we’re looking at about $16,000 in tax savings on a $200,000 gross income.

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How To Set Up Your LLC

If you think you’d benefit from setting up an LLC + S-Corp, you have a few options to do it.

Do It Yourself

I don’t recommend this, so skip this section if you trust me. Still reading? Fine. You can set up an LLC yourself using services like LegalZoom. You’ll have an LLC set up and then be left to fend for yourself on everything else related to LLC management. LegalZoom won’t help you file your S-Corp election, won’t help with quarterly tax estimates, bookkeeping, and the other random stuff that comes your way as an LLC owner.

Unless you’re literally a fractional accountant, please consider seeking an expert. Your time is better spent with your clients and making money.

Your Personal Accountant

If you have an accountant or firm that handles your personal taxes, talk to them about doing the same for your business taxes. Ask them about S-Corp tax election for single-member LLCs, and see how knowledgeable they are. If they nail the talking points, they may be a good fit.

Hire a Business Accountant / Firm

If you do your own personal taxes or your accountant isn’t knowledgeable enough about solopreneurs like yourself, you can hire one. There are many online marketplaces and directories for accounting firms. One I’ve recently come across is called Sam’s List that seems helpful.

Sign up for Collective

This is the route I chose for my own fractional practice and have been very happy with. Collective is a tech-enabled accounting firm that specializes only in solopreneurs. Their team and their content is how I’ve learned 90% of what I’ve written in this Playbook.

Collective takes care of your back-office, including monthly bookkeeping, quarterly tax estimates, and yearly taxes. It’s designed to help you maximize your savings as a solopreneur with the strategies I describe above.

It’s a great fit if you want to have this stuff “done for you”.

Collective is also a partner of Fractional Jobs, so if you sign up you can use the code “FRACTIONALJOBS” for 1 month free.

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And Then… Retirement

Retirement planning is another way that business owners can create tax benefits for themselves.

Compared to a W2 employee, the big opportunity here is a Solo 401K. It’s a 401K that you can fully manage for yourself. It’s only available to business owners.

With a Solo 401K, you choose however you want to invest the money, including in individual stocks, real estate, even crypto. You’re also totally free to make use of strategies like the Mega Backdoor Roth (different than the Backdoor Roth, and worth researching if you’re interested, it’s a massive tax saver).

While both of these benefits are technically available for employer-managed 401Ks too, the reality is that virtually all employer-managed 401Ks are too restrictive about what you can invest in or what strategies you can execute.

Investing in individual stocks, or strategies like the Mega Backdoor Roth, are really only feasible with a Solo 401K.

How to Set Up a Solo 401K

Again, several options. Some banks offer this, like Fidelity, Charles Schwab, Vanguard. More listed here.

I personally chose Carry, because:

1. They’re ONLY focused on Solo 401Ks and other retirement options for business owners
2. It's incredibly easy to use with a modern interface that us techies expect (are you reading this, Fidelity?)
3. They’re the only ones I could find that make it possible to do the lucrative Mega Backdoor Roth

You can sign up for Carry here (they’re also a partner of Fractional Jobs).

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The Key Takeaways

If you’re encountering all this information for the first time, it’s a lot to process. Thankfully, we have tax professionals to handle all the specific nuances of self-employment.

However, it’s still crucial to understand the basics of why being self-employed is beneficial from a tax perspective.

The truth is - the tax code is rigged in favor of business owners. Doing fractional work gives you the opportunity to become a business owner, and so you should take advantage of it.

1. You’ll spend pre-tax money on business expenses
2. Reimbursable yourself for expenses like a home office (another version of spending pre-tax money instead of post-tax)
3. Your profit distributions aren’t eligible for the 15.3% self-employment tax
4. More retirement planning options (e.g. the Solo 401K) become available to you

As your business grows and you get more advanced, even more options emerge.

When all is said and done, given the tax advantages, doing fractional work should allow you to take home an extra 10% or more compared to an equivalent W2 job (assuming gross pay is the same and in the general ballpark of $100K - $400K).

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Of course - you do need clients to work with to make this happen. And that’s where Fractional Jobs comes in. We help fractional leaders find incredible clients to work with. If you haven't yet, add your email address below to get job alerts in your function area.