The federal self-employment (SE) tax which includes mainly FICA (Social Security tax) and Medicare just keeps going higher and higher. If you’ve reached the breaking point, there may be a way to reduce those SE taxes by converting your existing unincorporated small business into an S corporation.
How to Evaluate the Option
If you’re a self-employed individual – meaning a sole proprietor, partner, or LLC member – you have to pay the SE tax on your net SE income. The SE tax has two parts:
1. The 12.4 percent Social Security tax. Social Security tax is due on net SE income up to a certain amount. Unfortunately, the ceiling goes up every year because of inflation adjustments. For 2016 (and 2015), the Social Security tax ceiling is $118,500..
2. The 2.9 percent or 3.8 percent Medicare tax. The Medicare part of the tax is due on an unlimited amount of net SE income. In other words, there’s no ceiling.
So until your net SE income exceeds the Social Security tax ceiling of $118,500 in 2016 (and 2015), you owe the SE tax at the painfully high rate of 15.3 percent consisting of 12.4 percent Social Security plus 2.9 percent Medicare.
After the annual ceiling is exceeded, the Social Security tax portion drops away, and the SE tax rate falls to 2.9 percent to cover the Medicare tax. Please note that the Medicare tax jumps to 3.8 percent once your self-employment income exceeds $200,000 for unmarried individuals or $250,000 for married couples filing jointly.
Note: The tax results are the same if you operate your business as a single-member LLC, which is treated as a sole proprietorship for federal tax purposes.
While the SE tax is painful now, it will get worse in the future.
So now could be the best time to consider an S corporation conversion. Based on current tax law the SE tax doesn’t apply to earnings from an S corporation business. Unless this law is changed the S corporation conversion could save some of these SE taxes.
However, the FICA tax applies to salary compensation paid to an S corp shareholder-employee. In 2016 (and 2015), the FICA tax rate is 15.3 percent on salary up to the $118,500 Social Security tax ceiling. Salary above the Social Security tax ceiling is subject to a 2.9 percent or 3.8 percent FICA tax rate to cover the Medicare tax.
The employee share of the FICA tax is withheld from an S corporation shareholder-employee’s salary; the other portion is paid by the corporation directly to the U.S. Treasury.
The Tax Savings
The FICA tax is only due on an S corporation shareholder-employee’s salary. So when the company pays only a portion of its profits to the owner, or owners, in the form of a reasonable salary the remaining portion can be paid out in the form of cash distributions and only the salary portion will be hit with Social Security and Medicare taxes (in the form of the FICA tax). The profits paid out as cash distributions are exempt from the FICA tax (and exempt from the SE tax too).
For example, assume a business makes $200,000 net profit before any shareholder salaries. If that income is earned in a sole proprietorship, partnership, or LLC the resulting SE taxes may exceed $21,000. However if this same income is earned by an S corporation which then pays its shareholder a reasonable salary of say $80,000 the resulting SE taxes will be roughly $12,000. That’s a $9,000 annual saving. Please note that the income tax implications under both scenarios are similar.
These tax-saving results are not a one-time phenomenon. You can collect similar Social Security and Medicare tax savings, or better, in future years if the business maintains or exceeds its current level of profitability.
Converting an unincorporated small business into an S corporation may not be a great idea in all situations but it works for some businesses. Consult with one of our firm’s tax specialists for further information on this and to evaluate if you might be the right candidate for this strategy.
Of Course, there Are Caveats
Potential Audit Target: The IRS is aware of the strategy of converting an unincorporated business into an S corp to save on taxes. The government is trying to audit more S corps to see if they are paying unreasonably low salaries to shareholder-employees. However, S corp audit rates are still low. The tax-saving advantage of converting is lost if the IRS successfully asserts that S corp distributions to shareholder-employees are actually disguised salary payments. If that happens, the IRS will assess unpaid FICA taxes, interest and penalties. Your tax adviser can help you build a case so that in the event of an IRS audit, you have well-documented support that salaries are not unreasonably low.
Impact on Retirement Contributions: When considering an S corp, keep in mind that paying a modest salary can reduce the amount you can contribute to a tax-favored retirement program (such as a profit sharing or SEP plan). However, you may be able to mitigate this concern by setting up a 401(k) or defined benefit pension plan.
Other Complexities: An S corporation conversion creates some paperwork and other issues.
That is because transactions between an S corp and its shareholders, including asset and liability transfers upon incorporation, must be carefully planned to avoid adverse federal (and possibly state) income tax consequences. You also have to meet state-law corporation requirements such as conducting annual meetings and keeping minutes.
Plus, a number of tax law hurdles must be cleared for S corp status to be available. For example, shareholders must be individuals or specified types of trusts. The Social Security and Medicare tax savings must be big enough justify the extra effort of operating as an S corp.
Partnerships and Multi-Member LLCs
A business operated as a partnership or a multi-member LLC also faces high SE tax bills. Partners and LLC members are considered self-employed individuals for federal tax purposes. Therefore, they generally must pay SE tax on their share of net SE income from the partnership or LLC.
In this scenario, the same tax strategy is available. The co-owners can consider converting an existing partnership or LLC into an S corporation. Then, they can pay themselves relatively modest, yet reasonable, salaries while paying out the remaining profits as cash distributions. The salaries will be subject to Social Security and Medicare taxes, but the cash distributions will be exempt from those taxes. The tax savings will recur year after year, as long as the business maintains or exceeds its current profits.