One of the main reasons I decided to incorporate my business was to decrease my taxable income. No, not illegally!

The most surprising change I didn’t see coming was that I’d be responsible for paying unemployment taxes.

“My state doesn’t require unemployment taxes for my company,” so you say. But you’re not out of the woods yet. If the state coffers don’t get you, the feds will.

Here’s the deal:

Generally, when operating as a sole proprietor, you’re not responsible for unemployment taxes. After all, if you become unemployed, it’s your own fault.

But a company that employs others (even if it’s only yourself) is generally required to pay some form of unemployment tax, in one way or another.

Depending on your situation, federal form 940 or 940-EZ will address the Federal Unemployment Tax I’ll be taking about.

The maximum unemployment tax you could be hit with is 6.2% (as of 2005) of your taxable paid wages, but that’s only if you don’t pay any unemployment tax at the state level.

But there is a catch that could save you a couple percent of tax, and I was even told by an IRS representative on the phone that it is one of the few ways for companies to legally pay less tax.

Unless you operate in NY, the rules are basically the same. If you pay unemployment taxes at the state level, your federal unemployment tax generally drops to only 0.8% (yes, only eight-tenths of a percent). This is regardless of your state tax percentage. For example, if you’re paying 2.7% unemployment tax to your state, then you’re entire tax bill would be 3.5%.

Now, if you are required to pay unemployment taxes, then you really don’t have a choice in this matter: you pay the state tax and the 0.8% federal tax.

But, you have more choices if your state has an optional unemployment tax. It boils down to this: if you can optionally pay less than 5.4% to the state, then file your state return as your total taxes will be less than the federal maximum 6.2%. However, if your state has an optional rate of above 5.4%, it makes more sense to file only the federal unemployment tax as you’ll save money.

For exact specifics with your situation, I recommend that you contact an accountant to discuss this issue.

Hope that makes sense and helps you keep a couple extra dollars in your pocket (er.. bank account I should say.)