If you own a profitable unincorporated small business, you may be getting fed up with high and ever-increasing self-employment (SE) tax bills. The SE tax is the way the government collects Social Security and Medicare taxes from self-employed folks.
In this column, I’ll suggest a strategy to control those taxes, which we will call federal-employment taxes for purposes of our discussion. The strategy involves operating your business as an S corporation instead of continuing to run it as a sole proprietorship, LLC, or partnership. But before getting to the strategy, let’s first cover the necessary background information.
Federal employment taxes on self-employment income
If you’re self-employed, the maximum 15.3% SE tax rate hits the first $132,900 of your 2019 net self-employment (SE) income. That 15.3% rate consists of:
• 12.4% of net SE income for the Social Security tax component of the SE tax plus
• 2.9% for the Medicare tax component.
Above the $132,900 Social Security tax ceiling, the Social Security tax component goes away. But the Medicare tax component continues at a 2.9% clip before rising to 3.8% at higher levels of SE income. Once the 3.8% Medicare tax rate kicks in, it continues to hit SE income up to infinity.
Example 1: For this year, you expect your prosperous unincorporated small business to generate net SE income of $250,000. To calculate your 2019 SE tax bill at tax-return time, you’ll multiply the net SE income amount by .9235 (don’t ask why; it’s complicated). For simplicity, let’s say the $250,000 of net SE income is after applying the .9235 factor.
So when you file your 2019 Form 1040 sometime next year (this example assumes you’re a married joint-filer), your SE tax bill will be a whopping $23,730: ($132,900 x 12.4%) + ($250,000 x 2.9%). Ouch! And your SE tax bill is likely to get bigger every year due to inflation adjustments to the Social Security tax ceiling.
Federal-employment taxes on salaries paid to S corporation shareholder-employees
For 2019 salary paid to an S corporation employee (including an employee who also happens to be a shareholder of the corporation), half of the Social Security tax on salary income is withheld from paychecks. The other half is paid by the S corporation. For 2019, the Social Security tax hit stops after your salary exceeds $132,900. So the first $132,900 gets hit with Social Security tax at a combined 12.4% rate (6.2% withheld from paychecks and 6.2% paid by the S corporation).
Above the $132,900 Social Security tax ceiling, the Social Security tax hit on your salary goes away. But the Medicare tax continues at a 2.9% rate, before rising to 3.8% at higher salary levels.
The tax-saving S corporation strategy
That’s the bad news. The good news is that S corporation taxable income passed through to a shareholder-employee and S corporation cash distributions paid to a shareholder-employee are not subject to federal employment taxes. In other words, only salaries paid to an S corporation shareholder-employee are subject to federal employment taxes. This tax fact places S corporations in a potentially more favorable tax position than businesses that are conducted as sole proprietorships, LLCs, or partnerships.
Advice: Start running your business as an S corporation. Then implement the tax-saving strategy of paying modest (but still reasonable) salaries to yourself (and the other shareholder-employees, if any). Pay out most or all of the remaining corporate cash flow as federal-employment-tax-free cash distributions.
Example 2: Same as Example 1, except this time you operate your business as an S corporation that generates taxable income of $250,000 before paying your $80,000 reasonable salary. Only that $80,000 salary is subject to federal employment taxes, which amount to $12,240: [$80,000 x (12.4% + 2.9%) = $12,240].
Compare $12,240 to the $23,730 federal employment tax bill in Example 1 if you run the business as a sole proprietorship, LLC, or partnership. Which amount would you rather pay?
Operating as an S corporation and paying yourself a modest salary will work as long as your salary can be supported as a reasonable amount — albeit on the low side of reasonable. Otherwise you run the risk of the IRS auditing your business and imposing back employment taxes, interest, and penalties. But the risk is minimal if you collect and maintain evidence showing that you could hire an outsider to perform the same work for an equal salary. Your tax adviser can help with that.
A potentially unfavorable side effect of paying a modest salary to yourself is reduced capacity to make deductible contributions to your tax-favored retirement account. If the S corporation maintains a SEP or garden-variety profit-sharing plan, the maximum annual deductible contribution is limited to 25% of your salary. The lower your salary, the lower the maximum contribution. However, if the S corporation sets up a 401(k) plan, paying yourself a modest salary won’t preclude making relatively generous annual deductible contributions to your account.
Another potentially unfavorable side effect of paying a modest salary to yourself is reduced Social Security benefits at retirement.
Finally, operating as an S corporation will trigger some tax complexities. You must file annual federal income tax returns for the corporation, and maybe state returns too. Transactions between S corporations and shareholders (including transfers of business assets to the new corporation) must be carefully scrutinized for potential tax consequences. State-law corporation requirements such as conducting board of directors meetings and keeping minutes must be respected. So there is some additional compliance paperwork, but the federal employment tax savings may be well worth it.
How to convert your unincorporated business into an S corporation
To convert an existing sole proprietorship, LLC, or partnership into an S corporation, you must first form a corporation under applicable state law. Then you may need to transfer ownership of some business assets to the new corporation. Next, you make an S election for the new corporation. Do that by filing IRS Form 2553 (Election by a Small Business Corporation) by no later March 15 of the conversion year (assuming the corporation will use the calendar year for tax purposes). So the deadline to make an S election for calendar year 2019 is behind us, but you can still make the election for calendar year 2020 and beyond.
The bottom line
Converting an existing unincorporated small business into an S corporation to reduce federal employment taxes can be a really good idea in the right circumstances. But before implementing this strategy, consider the aforementioned caveats. Finally, please consult your advisers to make sure that all the other tax and legal implications are evaluated. This is not a good DIY project!
Recommended: More than 44% of Americans pay no federal income tax
Projected 2020-2028 Social Security tax ceilings
The federal-employment tax hit on 2019 SE income is expensive enough, but it’s only going to get worse in future years. That’s because the Social Security tax component of the SE tax will continue to increase due to annual inflation adjustments to the Social Security tax ceiling.
The just-announced Social Security Administration (SSA) projections for the 2020-2028 Social Security tax ceilings are as follows. 2020: $136,800 (up from $132,900 for 2019); 2021: $142,200; 2022: $149,100; 2023: $155,700; 2024: $162,300; 2025: $168,900; 2026: $175,800; 2027: $183,300; 2028: $191,100
These projections are bad news for folks with substantial SE income. More bad news: the SSA now projects that the Social Security trust fund will become insolvent in 2034. So, Social Security tax hikes — in the form of higher rates, or higher ceilings, or both — are probably more likely than not. That’s why you should consider the tax-saving S corporation strategy in appropriate circumstances.