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How can I avoid or reduce Self-Employment (SE) taxes?
By Jason Watson (Google+)
*** This is legacy information. Please see our completely revamped and really cool book on this ***
Avoiding or Reducing Self-Employment (SE) Tax
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.
We encourage you to keep reading this KB Article for the quick facts and considerations. Additional in-depth articles are linked below, but you can also read our insomnia-relief version as a PDF with the following link-
If you own a business 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. The same is true for a business that has not formed a corporation such as a sole proprietor and partnerships. So, you could easily pay an average of 30% (15.3% in SE taxes + 15% in income taxes) on all your net business income in Federal taxes. Wow!
However, if you own an LLC 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. What’s the big deal? you say. Before we get into that, let’s look at some quick numbers (based on a required yet reasonable salary of 50% of total income)-
|Income||LLC SE Tax||S Corp
We’ll chat about why the savings drops off after $100,000. For now, let’s look at why there are savings at all. The S-Corp election of your LLC changes how the LLC 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 and owner are synonymous terms.
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. There are two types of K-1s for the purposes of our discussions- one is generated from a Form 1065 and the other is generated from a Form 1120S. A Form 1065 is also called a partnership tax return, and typically your K-1 will be subjected to self-employment taxes.
However, a K-1 generated from a Form 1120S (LLC or C-Corp, either with the S-Corp election) is reported on the shareholder’s personal tax return on Schedule E. Schedule E is the form used for rental properties, royalties and other investment income including business income from an S-Corp.
You’ll hear terms such as pass-through entity or disregarded entity- these mean essentially the same thing from a taxation point of view since the S-Corp is not paying taxes. Rather it is passing the liability through to the shareholders.
The Money Trail for S-Corp Elections
So, when your partnership, LLC or corporation is an S-Corp you are both an employee and a shareholder (think investor). As an employee, 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 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 where Medicare tax 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 (FICA) and Medicare taxes. Same thing.
Let’s look at another visual in terms of how the money travels-
S-Corp Hard Money Facts, Net Savings
In creating the table above we prepared fictitious tax returns to get exact numbers. At $75,000 in net income an S-Corp will generally save about $3,475 in self-employment taxes. If you use WCG (formerly Watson CPA Group) for your payroll and corporate tax preparation needs, our fee will generally be about $1,200 (give or take $200 depending on your unique situation). So some of the $3,475 is lost in additional accounting expenses but you could easily save $2,200 after it is all said and done, and the extra effort is minimal.
At $100,000 you could still net out a $3,400 savings. Not bad.
The savings between an LLC and an S-Corp LLC drops off at some point because what is paid as a reasonable salary is equal to or greater than the Social Security cap. For example, if your LLC earns $250,000 your Social Security contribution limit will have been reached at $113,700 for 2013. And if your LLC becomes an S-Corp, your reasonable salary at 50% (or $125,000) will also meet the limit. There are some Medicare issues to consider as well.
The Organization of an S-Corp
There is a misconception floating around out there that an S-Corp is a standalone entity. Not true. There are basically three broad types of entity formation- Partnerships, Limited Liability Companies (LLCs) and Corporations (C-Corps). Each can elect to be treated as an S-Corp for taxation purposes only under subchapter S of the revenue code, but the underlying entity and subsequent corporate governance is either a Partnership, LLC or C-Corp.
So while we might talk about your “S-Corp”, we are truly talking about your partnership, LLC or C-Corp being treated as an S-Corp for taxation. And while there are partnerships and C-Corps out there who elect to be treated as an S-Corp, this article will focus on the S-Corp LLC. However, the information is valid for each entity type.
Downsides to S-Corp Election
Not everything that glitters is gold so there are a handful of downsides, some manageable, to the S-Corp election. A lot of these examples stand alone, and some of these depend on the net income of the business. We can help guide you through the decision-making process.
Please read the expanded KB Article on the disadvantages or downsides to the S-Corp election. Here is a summary-
- Additional Accounting Costs
- Possible State Income Taxes
- Deducting Losses Could Be Limited
- Distributing Profits
- Other W-2 Income
- Social Security Basis
- Payroll Taxes on Children
Operational Hassles of an S-Corp
You’re probably thinking that running an S-Corp adds all kinds of burdens. There are very few operational hassles with an S-Corp. All the things you do now to maintain your financial records remain the same. And the things you do in terms of corporate governance such as meetings, minutes and voting, also remain the same.
The two other requirements are paying a reasonable salary through payroll and preparing a corporate tax return. And if you use WCG (formerly Watson CPA Group) (and you should), then this hassle is ours not yours. Well, not entirely true- we are attached at the hip if we prepare your tax returns, but the hassle is mostly ours.
Reasonable Salary Determination
There are several factors to consider when coming up with a reasonable salary. The IRS through Fact Sheet 2008-25 released a less than helpful laundry list (last update was in 2008). Guidance is poor, and typically we start off at 50% of net income. There are some other tricks of the trade that will be explained later (accountable plans, salary shifting, etc.).
As far as actually writing paychecks, WCG (formerly Watson CPA Group) offers bookkeeping and payroll services. Here is the typical individual pricing, and the discounts for combining some services-
|Corporate Tax Return Only||$375 to $775||depending on the quality of your books|
|Quarterly Bookkeeping||$200 to $400||per quarter|
|Quarterly Payroll||$150||per quarter, 1-5 employees|
|Monthly Bookkeeping||$150 to $300||per month|
|Monthly Payroll||$125||per month, 1-5 employees|
|W-2 Preparation||$75||per year, 1-5 employees|
There are two types of discounts. First, if we perform the bookkeeping then the corporate tax return is fixed at $375. Second, if we perform all three services (tax return, bookkeeping and payroll) an additional 10% discount is provided.
For example, you need quarterly bookkeeping, quarterly payroll and a corporate tax return. The range would be $1,850 to $2,650 before the 10% discount. Or $1,665 to $2,385 after the discount. This is per year. Most one or two-person companies with a single checking account and a single credit card can expect to spend right around $1,800 per year or $150 per month.
Just an S-Corp tax return and payroll (no bookkeeping) will be about $1,200 per year.
These general fees will cover most situations. However, depending on the number of transactions, accounts and employees, these fees might have to be adjusted to reflect additional complexities.
Unless you have other employees, we suggest shareholders to pay a reasonable salary to themselves quarterly, for a total of four pay checks per year. This will coincide with your estimated tax payments on your K-1 income. Remember, you can write checks directly to yourself as often as necessary throughout the quarter. These are considered shareholder distributions.
Estimated Tax Payments
Estimated tax payments change as well when you have an S-Corp. When computing your estimated tax liability for the quarter you must include the taxes (income and employment taxes) that will be withheld from your paycheck.
Corporate Tax Return
An S-Corp must file a corporate tax return by March 15 and there are additional financial reporting requirements. However, if you use WCG (formerly Watson CPA Group) to prepare your tax returns and we’ll make it seamless and pain free. Ok, taxes and pain free don’t really go together, but you get the idea.
Determining the Payroll Amount
As an S-Corp, you are taking money out of the business in four ways-
- Rent paid to you by the S-Corp for the use of your assets (this is getting more rare),
- Reimbursements through an Accountable Plan, Health Expenses, Education Assistance, and
- Shareholder distributions.
The big question becomes what to pay yourself as a wage. The amount of wages can change quarterly depending on your quarterly profit levels. While your particular situation might warrant further discussion, a good place to start is half of your net profits being paid as wages. If your income is routine or consistent, then you can also elect to pay a strict annual wage on a quarterly basis.
There are two methods of paying wages- one is forward looking and one is backward looking. The forward looking method is to establish the quarterly wage, and write that check separately to the shareholder(s) with the associated taxes withheld. The backward looking method is to continue to pull money out of the business as needed (daily, weekly, monthly, etc.) for your living expenses. Then, those monies are reclassified as either wages or shareholder distributions, and the taxes associated with the reclassified wages are processed, filed and paid.
If you have other W-2 income from another job or employer, more discussion is required to minimize tax consequences. Since each job doesn’t know about the other, taxes withheld will be based on just one income and not two. We strongly suggest keeping W-4 exemptions very low or zero on the lower income until some history is built and you can manage expectations.
The $0 Paycheck
Every situation is different, however the backward looking method of determining your paycheck offers the best flexibility for S-Corps, especially with fluctuating cash flows and profit levels. For example, you earned $20,000 for Q1 and you withdrew $20,000 in cash over the quarter. For Q1’s payroll, we would re-classify $10,000 as wages and run that through payroll, but we would create an employee deduction back to the company so the paycheck would be $0. Therefore only taxes are being withdrawn from your account, and not an entire wage plus taxes.
In other words, it is unnecessary to stockpile $10,000 in your business account just to run payroll for half of Q1’s net profits. You would only need to keep enough cash available to cover the taxes, and we can plan for that payment about 30 days out from the due date. Make sense?
Pull Money Out, Accountable Plan
One of the goals of any business owner is to be able to pull money out of the company without creating a taxable event. There are four big ways to accomplish this-
- Reimbursements for Out of Pockets Business Expenses (Accountable Plan)
- Fund Your Retirement Account
- Reimbursements for Health Insurance Premiums, Expenses
- Paying for an Employee’s Education
We encourage S-Corps to create an Accountable Plan which allows shareholders (or owners of garden variety LLCs) to turn in expense reports for home office use, mileage, cell phone, internet, meals and travel. It is easy to do, and is a great way to pull money out of the business, and actually reduces the amount of taxes paid. A win-win scenario.
If you reimburse yourself without an Accountable Plan, that money is considered taxable income. You in turn have to deduct those expenses as unreimbursed employee business expenses subject to itemized deductions and income thresholds.
For more information on Accountable Plans please read our tax article on LLCs at-
For a sample Accountable Plan form that you can use-
Retirement Planning within an S-Corp
There are lots of options with retirement planning within your S-Corp. 401ks, SEPs, SEP conversions to Roth IRAs, etc. There are also several options and combination of options, and we can work with your financial advisor to settle into the best plans.
Health Care Expenses, Premiums, HRAs, HSAs
An S-Corp allows you set up a plan to reimburse shareholders (and employees) for medical premiums and expenses plus make contributions to a Health Savings Account (HSA).
Health Insurance Premiums
In IRS Notice 2008-1 premiums paid under individual medical and health insurance plans may be deductible on your personal tax return (the usual Form 1040). By including the cost of health insurance as wages in Box 1 on your W-2, the S-Corp gets a “wage expense” deduction, which in turn reduces the K-1 income for all shareholders (but each shareholder gets comparable a bump in W-2 income as a part of his or her reasonable salary).
On your personal tax return, you will get a deduction for health insurance premiums paid. This directly reduces your adjusted gross income, and is not a Schedule A itemized deduction (which is good). If this procedure is not followed, the premiums can only be deducted on Schedule A subject to the 7.5% or 10.0% income thresholds for medical expenses (which is not good).
Health Reimbursement Arrangement (HRA), Health Savings Account (HSA)
Also, an S-Corp can also adopt a Section 105 Health Reimbursement Arrangement (HRA). By adopting an HRA you can maintain your current reasonable salary yet reclassify a portion of it (and perhaps a large portion of it) as reimbursement for health care expenses.
Even if you have an HSA at your other job, you can use the HRA to reimburse your medical expenses and let the HSA grow. When you need a new hip at age 70, you’ll be drawing money from somewhere- either your 401k or your HSA. So in some regards, your HSA becomes a retirement vehicle.
Child’s College Education with an S-Corp
Your S-Corp can pay up to $5,250 of an employee’s tuition and education expenses including your children who work for the S-Corp. But there are some rules for your child. He or she must-
- Be age 21 or older,
- Be a legitimate employee of the S-Corp,
- Not own more than 5% of the S-Corp, and
- Not be your dependent.
The Age 21 rule stems from attribution rules whereby a child under the age of 21 is deemed to own the same percentage as their parents. So, if you own 100% and your child is 20, your child is considered to be a 100% owner for this benefit (and many others), which obviously exceeds the 5% rule.
Electing S-Corp Filing Status, Retroactive for 2013
First you must be eligible to become an S-Corp for taxation purposes. Second, Form 2553 (the S-Corp election form) must be filed with the IRS. It is typically due within 75 days of forming your business entity, however, there is relief for the late filing of Form 2553 and we can guide you through that (IRS Revenue Procedures 2003-43 and 2004-48).
There is also a strong possibility that we can make the S-Corp election retroactive for 2013. As mentioned earlier, one of the pillars of S-Corps is to pay a salary to the shareholders. So, what happens if it’s 2014 and you didn’t run any payroll? There are three options (in descending order of elegance)- reclassify distributions as wages, issue a 1099 to yourself and roll the dice. Read our expanded KB Article on this particular topic for more information.
Other Tricks of the Trade with S-Corps
The big theme with S-Corps is payroll for shareholders, and what constitute reasonable payroll as an overall percentage of net income. There are some tricks that you can consider to help reduce, lower or avoid self-employment tax, or Social Security and Medicare tax burdens. Lop siding salaries between owners, putting kids on payroll, income splitting, health insurance, etc. Please read the full KB Article on this topic or our S-Corp Tax Article at-
Car Ownership, Paying Rent, Home Office Deduction
When you own 2% or more of an S-Corp, the rules dramatically change when it comes to car ownership, paying rent for shareholder assets and home office deductions. In response, most tax professionals have favored an Accountable Plan that simply reimburses the shareholder for out-of-pocket expenses. There is more detailed information about Accountable Plans, and how they can help pull money out of the S-Corp to pay for mileage, home office, cell phone, internet, etc. Please read our tax article on LLCs-
For a sample Accountable Plan form that you can use-
Audit Rates and Risks with an S-Corp
There are audits risks with any business form, and for any taxpayer. Typically taxpayers under $200,000 in income face a 1% audit risk. And S-Corps face a 0.42% audit risk.
Therefore, S-Corps have become super popular because of the low audit risk and more importantly the savings of self-employment taxes. The IRS is catching on however, and is targeting S-Corps where little to no salary is being paid to the shareholders. And this is easy to do. The IRS connects the dots by back-tracking K-1s to your company’s EIN to your company’s list of W-2s to the W-2’s Social Security numbers back to your K-1. The IRS probably has an app for that.
If your K-1 does not have a corresponding W-2, or if your W-2 income is low compared to your K-1 income you are creeping up on the “let’s call this guy” list. In other words, your audit risk is increasing.
Recap of S-Corps
Here is a quick recap or summary of S-Corps, and why you might consider making the election-
- Must have an LLC or C-Corp in place
- Can save 4.6% of net income on taxes
- Must run payroll and prepare a corporate tax return
- Payroll can be ran quarterly, previous distributions can be reclassified as wages
- Pull money out with reimbursements for business expenses (home office, mileage, etc.)
- Hefty retirement contributions allowed, reduces income
- Health Reimbursement Arrangements (HRA) give dollar for dollar deduction
- Pay for your children’s college expenses through the S-Corp
- Can retroactively make the S-Corp election for 2013
- Low operational hassles
- Approximately $1,200 in extra accounting costs for tax preparation and payroll (your mileage may vary)
Attention! Sales pitch coming- S-Corps are easy, they typically make sense, and they will improve your financial position in life. Contact us to get started. Did that sound too cheesy?
WCG (formerly Watson CPA Group) provides initial S-Corp consultation for $150, for up to one hour. We can provide the consultation in person at our offices, teleconference or Skype, whatever is easier for you. If you become one of our clients, we will discount any additional services by $75 to help offset the initial consultation fee.
Please call or email us anytime with your questions and concerns, or to schedule a consultation. Thank you in advance, and we look forward to working with you!