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Avoiding or Reducing Self-Employment (SE) Taxes
A common complaint from those who own their own business is self-employment tax. Can you avoid, reduce, eliminate or lower your self-employment taxes or SE taxes? Yes, to a large extent actually but it takes some effort.
If you own a business as a sole proprietor or as a garden variety single-member LLC (one owner or shareholder) your business income will be reported on your personal tax return under Schedule C and is subject to self-employment tax (currently 15.3%) and ordinary income tax. So, you could easily pay an average of 40% (15.3% in SE taxes + 25% in income taxes) on all your net business income in Federal taxes. Wow, that sucks! Similar taxation for partnerships too.
Drive this concept into your head, pretty please. On business income as an LLC or partnership, you are being taxed twice. Once at the self-employment tax level and again at the ordinary income tax level. Income taxes are a concern, but they are not the crux of the S Corp election and subsequent tax savings.
We are all humans, and we generally spend what we make. And if you are not prepared for 30% to 40% in taxes for your business income, it could be a shocker on April 15.
How SE Tax Is Computed
So, if you make $50,000 net income after expenses you do not pay a straight 15.3% on that income. You first deduct 7.65% from $50,000 to arrive at $46,175. Then you multiply this number by the 15.3% resulting in $7,065 in self-employment taxes.
The effective rate, so-to-speak, is about 14.1%, not a straight 15.3%. Probably doesn’t make you feel any better but there you go.
Quick Analysis of S Corp Savings
PR Tax is the total amount of payroll taxes. Pretty graphical representation below-
PR is accountant slang for Payroll Taxes. The bulk of which are Social Security and Medicare taxes, which are combined to be called FICA taxes. You might have other PR taxes such as unemployment (Yes, some states require it even for one-person corporations) and state disability insurance (SDI).
As mentioned, salaries started at 40% thru $500,000 and then reduced to 30% at $2M and $2.5M. This is a jumping off point. The IRS standard is “reasonable” which includes all sorts of things such as Bureau of Labor Statistics, comparison of salary to distributions, zodiac sign, etc.
Medicare taxes of 2.9% continues into perpetuity for LLCs and partnerships who do not elect S corporation status. This is one of the major component of savings in the upper incomes since Medicare taxes are capped at the amount of salary with S Corps. In other words, if you earn $1M you will pay Medicare taxes on the net income, but if you elect S Corp status and pay yourself a $400,000 salary you only pay Medicare taxes on the $400,000.
The Medicare surtax starts for those earning $200,000 and filing single, and $250,000 for those filing jointly. And this too continues into perpetuity for LLCs and partnerships. In the data, we assumed a joint tax return. For example, at $500,000 net business income there is a $1,906 Medicare surtax. But if this business elects S corporation taxation and pays $200,000 salary, there is not a Medicare surtax. And there is not a net investment income (NII) tax on the distributions either (more on that loophole later).
Savings as a percentage of income starts to drop off at $127,200 which makes sense given the Social Security cap for 2017. And those savings bottom out around $300,000 net business income and then begin a decent climb rate. Without getting into excruciating details and mental gymnastics, there is an interesting dynamic at $300,000 between Medicare taxes including the surtax on the LLC / partnership income, the salary being paid within an S Corp election, and Medicare taxes associated with that salary.
The Source of the Savings
As stated earlier, a K-1 is a statement that each shareholder receives, and it is similar to a W-2 since it reports the income that each shareholder is responsible for from a taxation perspective. As we discussed earlier, there are three types of tax returns that generate a K-1. A partnership, an S corporation and an estate or trust.
There are two types of K-1s for the purposes of our self-employment tax conversation- one is generated from a partnership tax return (Form 1065) and the other is generated from an S corporation tax return (Form 1120S). These K-1s look nearly identical and both are reported on page 2 of Schedule E and your Form 1040. Schedule E is the form used for rental properties, royalties and other investment income including business income from a partnership or an S Corp.
However, a K-1 generated from a partnership tax return which has ordinary business income in box 1 and / or guaranteed payments in box 4 will typically be subjected to self-employment taxes. Conversely, ordinary business income in box 1 on a K-1 from an S corporation will not be taxed with self-employment taxes. The S corporation election changed the color of money (we love this saying).
Note: S Corps do not have guaranteed payments like partnerships might- S Corps would call these payments wages or salary. A partnership (and an LLC for that matter) cannot pay its partners or owners a wage or salary. IRS frowns on this. Any periodic payment that is recurring in a partnership to one of the partners is called a guaranteed payment and is reported separately from partnership income. Both might be subjected to self-employment taxes.
You might hear terms such as pass-through entity or disregarded entity- a disregarded entity is a single-member LLC. As the terms suggests, it is disregarded, and therefore does not have to file its own tax return since the taxable consequence is reported on the owner(s) personal tax returns as a sole proprietorship.
A pass-through entity passes its Federal tax obligation onto the partner of a partnership, the shareholder of an S corporation or the beneficiary of an estate or trust. States might impose a business tax or a franchise tax on the partnership or S Corp directly (they legally cannot impose an income tax.. more in Chapter 3 about interstate commerce rules).
Quick Recap, The S Corp Money Trail
However, as a shareholder or investor, you are simply getting a return on your investment, much like a dividend. That income, as the Romneys, Gates and Buffets of the world enjoy, is a form of investment income and therefore is not subjected to self-employment taxes (tiny exception for income over $200,000 (single) or $250,000 (married) where Medicare surtax is charged).
And when we say self-employment taxes, we are really talking about Social Security and Medicare taxes. From a sole proprietor perspective, they are self-employment taxes. From an employee perspective, they are Social Security and Medicare taxes. Same thing. Let’s look at another visual in terms of how the money travels (yes, picture page!)-
Taxpayer's Comprehensive Guide to LLCs and S Corps