Unincorporated, businesses are susceptible to high self-employment (SE) tax bills because of how they are taxed. One way around this is to convert your business to an S corporation. For many business owners, this is an appealing option. Before you make the switch, here is what you need to know.

The Basics: Certain income, such as sole proprietorship and partnership income, is subject to SE tax. Also subject to the SE tax are single-member limited liability companies (LLCs) and multimember LLCs. Effective 2017, the maximum federal SE tax rate of 15.3 percent applies to the first $127,200 of net SE income. That rate is inclusive of both the Social Security tax (12.4 percent) and the Medicare tax (2.9 percent).

The rate declines once SE income reaches $127,200 because the Social Security tax component is eliminated. The Medicare tax will continue to accrue at the same rate of 2.9 percent. It will increase to 3.8 percent at higher income levels because of the additional Medicare tax (0.9 percent). As part of the Affordable Care Act, we anticipate the Medicare tax to disappear once the ACA is replaced.

For the purpose of this article, we make reference to the Social Security and Medicare taxes together as federal employment taxes.

How an S Corp can Lower SE Taxes: Converting your unincorporated business into an S corporation, can help lower your SE taxes. This is done by paying yourself a modest salary and then, distributing any remaining cash flow to shareholder-employees as federal-employment-tax-free distributions. This works in your favor because,

- For compensation paid to an S corporation employee, the FICA tax rate is 7.65 percent on the first $127,200. That rate is inclusive of both the Social Security tax (6.2 percent) and the Medicare tax (1.45 percent).

- Above $127,200, the rate drops to 1.45 percent because the Social Security tax component is eliminated. The Medicare tax component of 1.45 percent is indefinite.

- S corporation employees are required to pay an additional Medicare Tax of 0.9 percent at higher wage levels. The funds to pay FICA tax are withheld from employee paychecks.

The employer is responsible for matching the amounts of Social Security tax and Medicare tax, paid directly to the U.S. Treasury. The combined FICA and employer rate for the Social Security tax is still the same as the SE tax rates you face as an individual, but the employer is now responsible for them.

Where the tax savings arise is on the cash distributions made to shareholder-employees because only wages are subject to federal employment taxes.

In terms of federal employment tax treatment, S corporations are in a better position compared to businesses that are conducted as sole proprietorships, partnerships or LLCs.

Your Considerations – Before you change your business structure, consider the following caveats.

1. If you cannot prove your salary is reasonable, you are at a high risk of an IRS audit, back employment taxes, interest and penalties. To minimize the risk, collect evidence that proves someone hired externally to perform the same work would be paid the same salary.

2. Modest salaries will reduce the maximum eligible contribution to your retirement accounts. One workaround would be to set up 401(k) plans, where modest salaries won’t prevent substantial contributions.

3. Consider the added administrative tasks that are associated with operating as an S corporation. For example, S corporations are required to file a separate federal return. Also, there are state-law corporation requirements to abide by such as holding board of director’s meetings and keeping minutes.

Depending on the situation, converting your business to an S corporation can be a strategic move that reduces federal employment taxes. However, there are many legal implications to consider. The professionals in our office can answer the questions you may have. Call us today.

Tax Savings on an S Corporation