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You are here: Home > Taxpayers Guide to LLCs and S Corps > Chap 3 - S Corporation Benefits > Avoiding or Reducing Self-Employment SE Taxes

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  • Taxpayers Guide to LLCs and S Corps

    • Introduction

      • About the Author
      • Progressive Updates
      • Introduction Disclaimer
      • Shameless Self-Promotion
      • Book Introduction
      • Quick Reference 2021
      • Quick Reference 2022
    • Chap 1 - Business Entities, LLCs

      • Basic Business Entities
      • Sole Proprietorship
      • Single Member Limited Liability Company
      • Multi-Member Limited Liability Company
      • Partnerships
      • C Corporations
      • Professional Corporations and LLCs
      • S Corporations
      • Section 199A Qualified Business Income Tax Deduction
      • S Corp Versus LLC
      • LLC Popularity (Hype)
      • Formation of an LLC or S Corp
      • Nevada Fallacy of an LLC
    • Chap 2 - Customized Entity Structures

      • Your Spouse as a Partner (Happy Happy Joy Joy)
      • Family Partners
      • Holding Company and Operating Company
      • Parent-Child Arrangement (Income Flows "Up")
      • Parent-Child Arrangement (Income Flows "Down")
      • Multi-Member LLC That Issues Invoices
      • Things to Work Through with Multiple Entities
      • Recap of Benefits with Multiple Entities
      • State Apportionment with Multiple Entities
      • California Multi-Member LLC S Corp Twist
      • Economic versus Equity Interests
      • Structuring Deals with Angel Investors
      • ESOPs and S Corporations
      • Another Employee Ownership Situation
      • Medical C Corp
      • Fleischer Tax Court Case
      • Joint Ventures
      • Loans or Capital Injections
      • Using a Trust in Your Formation Considerations
      • Operating Agreements
      • Exit Plans, Business Succession
      • Liability Protection Fallacy of an LLC
      • Charging Orders
      • Using a Self-Directed IRA to Buy a Rental, Start A Business
    • Chap 3 - S Corporation Benefits

      • Avoiding or Reducing Self-Employment SE Taxes
      • Tax Savings with Health Insurance
      • S Corp Hard Money Facts, Net Savings
      • Officer Compensation with Solo 401k Plan Deferral
      • W-2 Converted to 1099
      • Net Investment Income, Medicare Surtax and S Corps
      • Three Types of Income
    • Chap 4 - The 185 Reasons to Not Have an S Corp or LLC

      • Chapter 4 Introduction
      • Additional Accounting Costs
      • Additional Payroll Taxes
      • SEP IRA Limitations
      • Trapped Assets
      • Distributing Profits, Multiple Owners
      • Other W-2 Income
      • State Business Taxes (Not Just Income Taxes)
      • Deducting Losses
      • Distributions in Excess of Shareholder Basis
      • Stock Classes
      • Vesting and Expanding Ownership
      • Bad Loans to the S Corp
      • Social Security Basis
      • Payroll Taxes on Children
      • C Corp to S Corp Problems
      • Going Concern
      • Recap of S Corp Downsides
      • Growing Business, Debt Service
    • Chap 5 - State Nexus Problems

      • Chapter 5 Introduction
      • Chapter 5 Disclaimer
      • Wayfair Case Part 1
      • Nexus Theory
      • Constitutional and Legislative Standards
      • Sales and Use Tax, Income Tax
      • Physical and Economic Presence, Nexus Attached
      • Wayfair Case Part 2
      • Services and Tangible Personal Property (TPP)
      • Costs of Performance, Market-Based Approach
      • Allocation and Throwback
      • FBA, Drop Shipments, Trailing Nexus Revisited
      • Recap of State Tax Issues
      • State Tax Issues and Nexus
    • Chap 6 - S Corporation Election

      • Formation (Election) of an S-Corp
      • Electing S-Corp Filing Status, Retroactive for 2022
      • Another Option, Dormant S Corp
      • Missing Payroll, Now What
      • Mid-Year Payroll
      • Nuts and Bolts of the S Corp Election
      • Ineffective S Corp Elections
      • S Corp Equity Section
      • Terminating S Corp Election
      • Distributed Assets
      • 5 Year Rule
      • Life Cycle of an S Corporation
    • Chap 7 - Section 199A Deduction Analysis

      • Section 199A S Corp Considerations
      • Calculating the Qualified Business Income Deduction
      • Section 199A Defining Terms
      • Specified Service Trade or Business (SSTB) Definitions
      • Trade or Business of Performing Services as an Employee
      • Services or Property Provided to an SSTB
      • Section 199A Deduction Decision Tree
      • Section 199A Reasonable Compensation
      • Section 199A Pass-Thru Salary Optimization
      • Cost of Increasing Shareholder Salary
      • Section 199A Rental Property Deduction
      • Negative Qualified Business Income
      • Qualified Property Anti-Abuse
      • Aggregation of Multiple Businesses
      • Section 199A W-2 Safe Harbors
      • Additional Section 199A Reporting on K-1
      • Section 199A Frequently Asked Questions
    • Chap 8 - Section 199A Examples and Comparisons

      • S Corp Section 199A Deduction Examples
      • Section 199A Side by Side Comparisons
      • Section 199A Basic Comparisons
      • Section 199A Health Insurance Comparison
      • Section 199A 200k Comparison
      • Section 199A 250k Comparison
      • Section 199A Specified Service Business Comparison Part 1
      • Section 199A Specified Service Business Comparison Part 2
      • Section 199A Phaseout
      • Section 199A Recap
      • Section 199A Actual Tax Returns Comparison
    • Chap 9 - Reasonable Shareholder Salary

      • IRS S Corp Stats
      • Reasonable S Corp Salary Theory
      • IRS Revenue Rulings and Fact Sheet 2008-25
      • Tax Court Cases for Reasonable Salary
      • Risk Analysis to Reasonable Shareholder Salary
      • Reasonable Salary Labor Data
      • Assembled Workforce or Developed Process Effect
      • RCReports
      • W-2 Converted to 1099 Reasonable Salary
      • S Corp Salary Starting Point
      • Multiple Shareholders Payroll Split
      • Additional S Corp Salary Considerations
      • Reasonable Salary Recap
    • Chap 10 - Operating Your S Corp

      • Chapter 10 Introduction
      • Costs of Operating an S Corp
      • New S Corp Puppy, What Do I Do Now
      • Accounting Method
      • 1099-NEC Issued to Your SSN
      • Take Money Out of the S Corp
      • Processing S Corp Payroll
      • Taking Shareholder Distributions
      • Reclassify Shareholder Distributions
      • Accountable Plan Expense Reimbursements
      • Accountable Plan Requirements
      • Shareholder Distributions as Reimbursements
      • S Corp Tax Return Preparation
      • Distributions in Excess of Basis
      • Minimize Tax or Maximize Value (Economic Benefit)
      • Tracking Fringe Benefits
      • Other Tricks of the Trade with S Corps
      • Adding Your Spouse to Payroll
      • Chap 10 - Comingling of Money
    • Chap 11 - Tax Deductions, Fringe Benefits

      • Chapter 11 Introduction
      • Four Basics to Warm Up To
      • Section 199A Deductions – Pass Through Tax Breaks
      • 185 Business Deductions You Cannot Take
      • Depreciation
      • Small Business Tax Deductions Themes
      • Value of a Business Tax Deduction
      • Deductions the IRS Cannot Stand
      • Automobiles and LLCs, S Corps
      • Business Owned Automobile
      • Section 179 and Bonus Depreciation
      • You Own the Automobile, Get Reimbursed By The Mile
      • You Own the Automobile, Take Mileage Deduction
      • You Own the Automobile, Lease Back to Your Company
      • Automobile Decision Tree
      • Home Office Deduction
      • Tax-Free Rental of Your Home
      • Tax Home
      • Business Travel Deduction
      • Deducting Business Meals
      • Sutter Rule
      • Cohan Rule
      • Capital Leases versus Operating Leases
      • Putting Your Kids on the Payroll
      • Educational Assistance with an S-Corp - Section 127
      • Summary of Small Business Tax Deductions
      • Comingling of Money
      • Reducing Taxes
    • Chap 12 - Retirement Planning

      • Retirement Planning Within Your Small Business
      • Self Employed Retirement Plan Basics
      • Retirement Questions to Ask
      • Tax Savings and Tax Deferrals
      • Using a 401k in Your Small Business Retirement Options
      • The Owners-Only 401k Plan
      • Having Staff with a Solo 401k Plan
      • Self-Directed 401k Plans
      • Traditional 401k (A Company Sponsored Plan)
      • 401k Plan Safe Harbor Provision
      • 401k Plans with Roth Option (Roth 401k)
      • Two 401k Plans
      • Rolling Old 401k Plans or IRAs into Your Small Business 401k Plan
      • 401k Loans and Life Insurance
      • 401k Plans and Roth IRA Conversions
      • Turbo Charged 401k Plans
      • SIMPLE 401k
      • SEP IRA
      • SEP IRA, Roth IRAs and the Roth Conversion
      • Controlled Groups
      • Owner Only 401k Plans in MMLLC Environment
      • Non-Qualified Deferred Compensation Plan
      • Exotic Stuff
      • Expatriates or Expat Tax Deferral Planning
      • Small Business Retirement Planning Recap
      • Personal Defined Benefit Plan
    • Epilogue

      • WCG Fee Structure
      • More About WCG
      • Consultative Approach
      • Core Competencies
      • No BS
      • Expectations of Our Clients
      • Final Words
      • Tax Consultation Business Advising, S Corp Consult
    • Chap xx - Health Care

      • Disclosure and Updates
      • Gaming the HSA System
      • Health Care Summary
      • Health Savings Accounts (HSAs)
      • Long-Term Care
      • Multiple Employees
      • One Person Show or Husband-Wife Team, S Corporation
      • Section 105 Health Reimbursement Arrangement (HRA)
      • Section 125 Cafeteria Plans and Flex Spending (FSA)
      • Sole Proprietors and Single Member LLCs
    • Chap yy - Business Valuations, Sale, Exit Planning

      • Business Valuation Techniques
      • Buy-Sell Agreements
      • Deal Structure
      • Debt Service
      • Exit Plans, Succession
      • Purchase Price Allocation
    • Chap zz - Other S Corp Thoughts

      • 1099 Income as Other Income, No Self-Employment (SE) Taxes
      • Audit Rates and Risks with an S-Corp
      • Recap of S-Corps
      • Rental Losses with an S-Corp
      • Rentals Owned by an LLC Fallacy
      • W-2 or 1099-MISC That Is The Question
  • Expat and Expatriate KB

    • Expat FAQs

      • Are there any downsides to claiming the foreign earned income exclusion?
      • Are there exceptions to the bona fide residence or physical presence tests?
      • As an ExPat, do I need to file a State tax return?
      • Can I deduct mortgage interest paid on my foreign home?
      • Do I have to pass the same test each year?
      • Does voting through an absentee ballot mess up my bona fide foreign residency?
      • How do fluctuating currency values affect my taxes?
      • How do I handle my foreign rental property?
      • How do I qualify for the foreign earned income exclusion?
      • How do moving expenses affect my exclusion?
      • How do partial years work with the foreign earned income exclusion?
      • How do tax treaties affect my ExPat situation?
      • How does the foreign housing exclusion or deduction work?
      • If I am a self-employed ExPat, what taxes am I responsible for?
      • If I don't qualify for the housing deduction, can I still deduct expenses?
      • May I still make contributions to my IRA as an ExPat?
      • What amount can I deduct for foreign earned income exclusion?
      • What happens if my host country has a form of social security?
      • What is a tax home or abode, and how do they relate to each other?
      • What is considered foreign earned income?
      • What is foreign earned income exclusion?
      • What is the bona fide residence test?
      • What is the difference between foreign tax credit and deduction?
      • What is the physical presence test?
  • Rental Property KB

    • Rentals FAQs

      • Can I claim my residence as a rental, sell it for a loss and deduct the loss?
      • Can I deduct internet expenses?
      • Can I deduct my cell phone charges?
      • Can I deduct the taxes associated with public improvements?
      • Can I rent out half a duplex or a room in my house?
      • Do I need receipts for my rental expenses?
      • Do rental properties offer good tax sheltering?
      • How are repairs and improvements different?
      • How do I handle my foreign rental property?
      • How do passive loss limitations affect me?
      • I purchased a rental property last year. What closing costs can I deduct?
      • If I don't have any rental income can I still claim a loss?
      • If I move back into my rental, how does that work?
      • If my employer provides a cell phone, is that income?
      • Is depreciating my rental a good thing?
      • My rental sale was a huge loss. What can I do?
      • Rentals Owned by an LLC Fallacy
      • What are tax issues with an LLC owning a rental property?
      • What are the exceptions to rental activities?
      • What are the rules on a home office deduction?
      • What is active participation versus material participation?
      • What is considered rental income?
      • What rental property expenses can I deduct?
    • Real Estate Pros

      • Are rental activities always passive activities?
      • Are there downsides to the real estate professional designation?
      • Are there specific material participation tests for real estate professionals?
      • Do I need to group my rental activities together?
      • How do I record the hours spent as a real estate professional?
      • If I meet the 750-hour test, do I also meet the 500-hour material participation test?
      • What activities count and don't count?
      • What are some of the IRS tricks to deny my real estate professional designation?
      • What are some of the tax court cases for real estate professionals?
      • What are the general tests for material participation?
      • What is active participation versus material participation?
      • What is the definition of real estate professional?
      • Why designate myself as a real estate professional?
  • Other Tax Information KB

    • Audits

      • Can I ignore an IRS notice or claim I never received it?
      • How can I pay my taxes or my notice of deficiency?
      • How can I prepare for my face to face or interview field audit?
      • How do I appeal the collections of unpaid taxes?
      • How does a joint return get handled during an audit?
      • How does bankruptcy affect my unpaid taxes?
      • How much is interest and penalty on taxes owed?
      • How should I respond to an IRS notice or letter?
      • What are my chances of being audited?
      • What are some of the types of IRS notices and letters?
      • What can the IRS do if I don't pay my taxes- what is the collections process?
      • What causes or triggers an IRS audit?
      • What if I cannot pay my taxes?
      • What IRS publications deal with audits?
      • What is the appeals process?
      • What is the period of limitations for an audit?
      • What types of audits could I face?
      • Who can be with me at my IRS audit or conference?
    • Charitable Contributions

      • Are there ways to earmark money for an individual?
      • Do I need receipts for my donations?
      • Does deducting charitable contributions cause an audit?
      • How do I determine the value of my donation?
      • What are some of the donations I can deduct?
      • What are some other charitable deductions?
      • What are the limits of my donations?
      • Who qualifies as a charity?
      • Why give to charities?
    • Education, Tuition Deductions

      • Are Educational Savings Accounts Worth It
      • Are There Tax Breaks for Going to College
      • Are There Tax Savings When My Employer Pays for My Education
      • Can I deduct the cost of sports, games or hobbies while in college?
      • IRAs and Savings Bonds To Help With Higher Education Costs
      • What College Expenses Can I Deduct From My Income
      • What constitutes a full-time student for tax purposes?
    • Homes and Real Estate FAQs

      • Can I deduct the loss on my primary residence?
      • Can I deduct the taxes associated with public improvements?
      • Can I exclude the gain on my home sale?
      • How does a Federal Disaster affect my casualty loss?
      • My home was destroyed- what deduction can I take? How do casualty losses work?
      • The Mortgage Forgiveness Debt Relief Act and Debt Cancellation
      • What are the rules on a home office deduction?
      • What is Cancellation of Debt? Is it taxable income?
    • Medical, Health Insurance

      • What are qualified medical expenses?
      • Why can't I deduct health insurance premiums?
    • Mortgages, Bad Debts

      • Can I deduct a bad debt on my tax return?
      • Can I deduct the loss on my primary residence?
      • Is cancellation of debt always taxable?
      • The Mortgage Forgiveness Debt Relief Act and Debt Cancellation
      • What is Cancellation of Debt? Is it taxable income?
    • Recordkeeping

      • Are there specific records I need to keep?
      • Do I need receipts for my expenses?
      • How does proper recordkeeping affect my audit results?
      • How long do I have to keep records?
      • How should I maintain my tax records?
      • What are the requirements for mileage records?
      • Why should I keep tax records?
    • General Tax Questions

      • Can I deduct internet expenses?
      • Can I deduct my cell phone charges?
      • If my employer provides a cell phone, is that income?
      • Tax Brackets Misconceptions- Should I earn more money?
      • What is the marriage penalty and how does it affect our tax returns?
  • Small Business KB

    • Small Biz FAQs

      • Hobby Versus Business

        • 3 out of 5 Test
        • Hobby Versus Business Testing
        • Philosophy of Business Losses
        • Private Track Coach Deducts Business Losses for Eight Years, Court Says OK
        • WCG (formerly Watson CPA Group) Philosophy on Hobby Losses
      • Independent Contractors

        • Behavioral Control
        • Colorado's Criteria for Contractor Status
        • Employee or Independent Contractor
        • Employee or Independent Contractor Status
        • Financial Control
        • IRS Determination, Form SS-8
        • Misclassified Workers Can File Social Security Tax Form
        • Salespeople As Contractors
        • Sample Response to CO Unemployment Claim
        • Statutory Employee and NonEmployees
        • Tax Court's Checklist
        • Type of Relationship
      • LLC and S-Corps (superseded)

        • As a one-person show, should I still form an LLC? An S-Corp?
        • Automobiles and LLCs, S Corps (superseded)
        • Can I call my 1099 other income which avoids employment taxes?
        • Determining the S-Corp Payroll Amount
        • Estimated Tax Payments, Withholdings Issues for an S-Corp
        • How do I convert my LLC to an S-Corp?
        • How does an LLC or S-Corp's income affect my taxes?
        • If the S-Corp taxation is what I ultimately want, should I form an LLC or C-Corp?
        • Is there a way to avoid Self-Employment tax?
        • Should I convert my LLC to an S-Corp (Sub-S Election)?
        • Should I form an LLC with my spouse?
        • The S-Corp Grind, Operational Hassles
        • The Zero Dollar Paycheck
        • What are the operational hassles of an S-Corp LLC?
        • What is an Accountable Plan?
        • The Money Trail for S-Corp Elections
        • 185 Reasons NOT to S-Corp, Downsides to S-Corp Election
      • Can I call my 1099 other income which avoids employment taxes?
      • Can I deduct country club dues as a business expense?
      • Can I deduct internet expenses?
      • Can I deduct my cell phone charges?
      • Health Care Expenses, Premiums, HRAs, HSAs - Section 105
      • Hobby Versus Business Article
      • How can I avoid or reduce Self-Employment (SE) taxes?
      • If I am a self-employed ExPat, what taxes am I responsible for?
      • If my employer provides a cell phone, is that income?
      • LLCs and S-Corps
      • Retirement Planning within an S-Corp
      • S-Corp Hard Money Facts, Net Savings
      • Turn Your Vacation Into a Tax Write Off
      • What are tax issues with an LLC owning a rental property?
      • What are the rules on a home office deduction?
      • What business or corporate expenses can I deduct?
      • What do I do with a 1099-K?
      • What is the difference between a hobby and a business?
      • What is the difference between an LLC, S-Corp and a C-Corp?
      • Why can't I deduct health insurance premiums?
  • Archive

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Avoiding or Reducing Self-Employment SE Taxes

Created OnJuly 11, 2021
UpdatedOctober 16, 2021
byJason Watson, CPA
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By Jason Watson, CPA
Posted Sunday, July 11, 2021

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? Ok, we just said two things that mean the same thing twice. Yes, you may reduce self-employment taxes to a large extent, but it takes some effort starting with an S Corp election (let’s not get ahead of ourselves yet).

If you own a business as a sole proprietor or as a garden variety single-member LLC (one owner or member) 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 + 24% in income taxes) on all your net business income in Federal taxes. Wow, that sucks!

A similar taxation exists for partnerships / multi-member LLCs too since the issuing K-1 will identify the income subjected to self-employment taxes (and of course income taxes, just like the example above).

The “double” taxation should not be a stranger to you. When you were paid a W-2 salary of wage, you had Social Security and Medicare taxes taken out of your paycheck, and you also had income taxes withheld based on some payroll table. Only income taxes were “negotiated” by deductions and credits; Social Security and Medicare taxes were not.

Back to the sole proprietors and LLCs. We are all humans, and we generally spend what we make. If you are not prepared for 30% to 40% in taxes for your business income, it could be a shocker on April 15.

The recent tax reform and specifically the pass-through taxation changes in Section 199A do not alter the theory of self-employment tax savings. The additional pass-through deduction afforded to small business owners complements the benefits of an S corporation. Please bear with us as we go through the mechanics of saving self-employment taxes with an S Corp.

How Self Employment Tax Is Computed

A bit of disclosure is in order. Self-employment taxes are 15.3% which is derived from the “employer” portion at 7.65% and the “employee” portion of 7.65%. However, a small business gets to deduct its portion of payroll taxes from income before determining the taxable income. Huh?

Think of your last job where you received a W-2. The employer might have paid you $100,000 and withheld your portion of Social Security and Medicare taxes on your behalf. The business also had to pay its portion of Social Security and Medicare taxes, so its total expense was the $100,000 salary plus $7,650. Similar concept with sole proprietorships and LLCs.

Here is an illustrative table-

Net Business Income 100,000
less SE Tax Adjustment at 7.65% 7,650
Taxable Business Income 92,350
SE Tax at 15.3% 14,130
Tax Deductible Portion 7,065

Do you see the $14,130 or 14.13% of $100,000? That is essentially your effective rate of tax on self-employed business income because of the deductible portion of 7.65%. Probably doesn’t make you feel any better but there you go.

Quick Analysis of S Corp Savings

If you own a business and have elected to be treated as an S Corp (Subchapter S) for taxation, the business now files a corporate tax return on Form 1120S. We will detail this out with a fancy graphic, but basically an S corporation chops up the net economic benefit to the owner between salary and net ordinary business income after expenses and deductions. This split is important. Why?

The salary is subjected to Social Security and Medicare taxes; the net ordinary business income is not. The salary is paid to the employee (you). The net ordinary business income may be paid to the investor (also you). You’ll see several references to this concept that as an S corporation owner you are both employee and investor.

Let’s look at some quick numbers. These are based on using a salary of 40% of net ordinary business income after expenses and deductions for amounts up to $500,000 and then decreased incrementally to 30% for the millionaire at $2,500,000 below (real case actually). The 40% / 30% is for illustration (we will discuss reasonable shareholder salary in silly detail in a later chapter dedicated to only reasonable salary determinations).

Here is our summary table-

Income Total SE Tax Salary Total Payroll Tax Savings $$ Delta %
30,000 4,239 12,000 1,836 2,403 8.0%
50,000 7,065 20,000 3,060 4,005 8.0%
75,000 10,597 30,000 4,590 6,007 8.0%
100,000 14,130 40,000 6,120 8,010 8.0%
150,000 18,711 60,000 9,180 9,531 6.4%
200,000 20,050 80,000 12,240 7,810 3.9%
300,000 22,972 120,000 18,174 4,798 1.6%
500,000 29,991 200,000 20,494 9,497 1.9%
750,000 38,764 262,500 22,307 16,457 2.2%
1,000,000 47,537 350,000 24,844 22,693 2.3%
2,000,000 82,630 600,000 32,094 50,536 2.5%
2,500,000 100,177 750,000 36,444 63,733 2.5%

Chart Notes

Let’s review some interesting things about the data on the previous page.

The bulk of payroll taxes are Social Security and Medicare taxes, which are combined to be called FICA taxes when payroll specialists are kicking it around the water cooler. You might have other payroll 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% through $500,000 and then reduced to 30% at $2M and $2.5M. This is a jumping-off point. The IRS standard is “reasonable shareholder salary” which includes all sorts of non-qualitative things such as your expertise, Bureau of Labor Statistics, comparison of salary to distributions, zodiac sign, favorite color, etc.

Social Security taxes of 12.4% stop at $142,800 (for the 2021 tax year) of net ordinary business income for LLCs and partnerships who do not elect S corporation status. It also stops at $142,800 for salaries.

Medicare taxes of 2.9% continues into perpetuity. Not only does this go on into perpetuity, it also goes on forever (yes, that is supposed to be a joke). This is one of the major components 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 entire net ordinary business 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. This too continues into perpetuity for LLCs and partnerships. In the data, we assumed a joint tax return. For example, at $500,000 net ordinary 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. There is not a net investment income (NII) tax on the S corporation ordinary income either (more on that loophole later) since you materially participate; in other words, your investment into your S Corp is not passive.

Savings as a percentage of income starts to drop off at $142,800 which makes sense given the Social Security cap for the 2021 tax year. 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

The S Corp election of your Partnership, LLC or C corporation changes how the business reports income to the IRS. An S Corp prepares and files a Form 1120S which is a corporate tax return. That in turn generates a K-1 for each shareholder. Remember, shareholder, investor and owner are synonymous terms for our discussions.

This might be your first brush with the term K-1. A K-1 is similar to a W-2 since it reports income and other items for each member, partner, shareholder, owner or beneficiary, and is coded to tell the IRS how the business activities should be treated.

A K-1 is generated by an entity since the entity is passing along the income tax obligation to the K-1 recipient (hence the concept pass-through entity, or PTE for TLA lovers). There are three basic sources for a K-1, and the source dictates how the income and other items on the K-1 are handled on your individual tax return (Form 1040). Here they are-

  • Partnership / MMLLC (Form 1065)
  • S Corporation (Form 1120S), and
  • Estate or Trust (Form 1041)

There are two types of K-1s for the purposes of our self-employment tax conversation- one is generated from a partnership tax return and the other is generated from an S corporation tax return. These K-1s look nearly identical and both are reported on page 2 of Schedule E in conjunction with your Form 1040. Schedule E is the tax 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 for an active partner or member. 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 changes 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. The 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 just heard the term “pass-through entity” and you might also hear the term “disregarded entity”- a disregarded entity is a single-member LLC. As the terms suggests, it is disregarded for tax purposes, and therefore does not have to file its own tax return since the taxable consequence is reported on the owner(s) individual tax returns (Form 1040) as a sole proprietorship (Schedule C).

A pass-through entity passes its Federal tax obligation onto the partner of a partnership, the member of an LLC, 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, LLC or S Corp directly (they legally cannot impose an income tax… more about interstate commerce rules later).

Quick Recap, The S Corp Money Trail

So, when your partnership, LLC or corporation is taxed as an S Corp you are considered both an employee and a shareholder (think investor). As an employee being paid a salary, your income is subjected to all the usual taxes that you would see on a paystub- Federal taxes, state taxes, Social Security taxes, Medicare taxes, unemployment and disability.

However, as a shareholder or investor, you are simply getting a return on your investment. 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).

As you recall, 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-

avoid self employment taxesThe four boxes on the left is the money trail of your sole proprietorship, LLC or partnership. The series of boxes on the right is the money trail of your entity being taxed as an S corporation. Note the $60,000 chunk of income on the far right hand side that is not being taxed at the self-employment tax level. This is the source of your savings.

Also note that all your $100,000 is being subjected to income taxes. This is a common misconception- a lot of business owners believe there is a magical income tax reduction with an S Corp election. Not true. The only reduction is in self-employment taxes. All other tax deductions such as operating expenses, home office expense, mileage, meals, 401k plans, etc. are equally deductible with or without an S corporation.

Still not sure or not convinced? No problem… please check out Line 4 on Schedule 2 on your 2020 Form 1040 tax return. This number reflects the self-employment taxes paid on your business income.

We want to reduce this by 60 to 65%. If you see $15,000 then we can save $9,000 ($15,000 x 60%). This makes sense right? $100,000 in biz income would be $15,000. 8 to 10% of $100,000 is $9,000.

The previous table showed significant savings using a 40% salary without self-employed health insurance (SEHI). Again, we are only focused on the self-employment tax and payroll tax savings at this point. Section 199A from the Tax Cuts & Jobs Act of 2017 will be wormed into overall tax savings in a later chapter dedicated to qualified business income deduction. While reducing overall taxes and leveraging the pass-through tax deduction cannot be ignored, we are isolating payroll taxes to drive home a critical point.

Multiple Owners Savings

We have been discussing a one-person band in terms of savings and the flow of money. However, let’s briefly chat about the killer savings for a more than one owner situation. If the business had net ordinary business income after expenses and deductions of $150,000, and was split down the middle, each owner (two in this example) would pay nearly $7,000 in unnecessary self-employment taxes or $14,000 combined. A big number for sure, but consider the following.

WCG recently had a 9-person consulting firm being taxed as a partnership where each member earned about $125,000. The before and after analysis yielded a savings of just over $100,000 combined. Our fee for the S Corp administration (Vail Business Advisory Service) plus all the tax returns and tax planning was about $12,000 or approximately $1,350 per owner. And each owner saved about $12,000 in taxes and therefore pocketed $10,000 each.

The super sad part of this is that this entity was in place for over a decade with similar income and owners. Over a million dollars was wasted in unnecessary taxes. When you look at it that way, it makes you gulp a bit.

What happens when the business pays for your health insurance?

Jason Watson, CPA, is a Senior Partner of WCG, Inc., a boutique yet progressive tax and
consultation firm located in Colorado and South Dakota serving clients worldwide.


Jason Watson CPA LinkedIn     Jason Watson CPA Email

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