An often-overlooked
issue when deciding on the type of entity to choose to operate your one-person
or closely-held business is the FICA or FICA-equivalent tax (self-employment
tax).
If
you operate as a sole-proprietor, filing a Schedule C, (or as a partnership)
your FICA-equivalent self-employment tax is calculated on net earnings from
self-employment BEFORE deducting health insurance premiums and retirement plan
contributions.
The
net amount on your Schedule C is $100,000.
You also deduct $24,000 in self-employed health insurance and a $15,000
contribution to your SEP retirement plan as adjustments to income. So, your net “out of pocket” is $61,000. Your self-employment tax is $14,130 -
$100,000 x .9235 = $92,350 x 15.3% = $14,130.
The Schedule C filer is entitled to a tax deduction, as an “adjustment
to income”, of $7,065 for half of the self-employment tax.
If
you operate as a corporation and take $55,000 as a salary your FICA tax is $4,207.50
- $55,000 x 7.65% = $4,207.50. The
corporation matches this and also pays $4,207.50, so the total cost is $8,415. As a corporation you are $3,000 -$5,000
less (the $5,715 in reduced FICA tax less the tax savings you would have
received from the self-employment tax adjustment to income) out of pocket.
If
the business has a $100,000 net gain, as per the Schedule C, and pays out $55,000
in wages, $39,000 in employee benefits (the owner’s health insurance premiums
and pension contribution) and $4,208 in FICA tax the net taxable income of the
corporation is $1,792. The federal
corporate income tax if a “C” corporation is $376. If it is an “S” corporation the taxpayer may
be allowed an additional $358 “Section 199a” deduction and pay federal income
tax as an individual on $1,434 - $315 for a taxpayer in the 22% bracket.
Clearly
the Schedule C filer pays substantially less in FICA-equivalent taxes than the
corporation pays in FICA taxes.
However,
regarding the 20% Section 199a deduction – for a “C” corporation there is no deduction
allowed, for the “S” corporation the deduction is on the net business income
reported on K-1 and does NOT include the sole-shareholder’s wages, but for a
sole-proprietorship filing a Schedule C the deduction is allowed on the net
amount reported on Schedule C less the adjustments to income for self-employment
tax, self-employed health insurance and retirement income contributions. In the above example the taxpayer’s “Qualified
Business Income” (QBI) eligible for the 20% deduction is $53,935 - $100,000
less $24,000 less $15,000 less $7,065 = 53,935 – which could result in a
deduction that reduces net taxable income by $10,787.
So,
a Schedule C filer could pay less federal income tax on his or her net “in
pocket”.
Obviously,
the payroll tax cost, or the QBI deduction, is not the only consideration to be
reviewed when choosing a business entity.
There are additional filing and administrative costs associated with
operating as a corporation – when creating the corporation, during its
operation, and when terminating/dissolving it.
There will probably be additional state payroll tax costs –
unemployment, disability and/or family leave insurance contributions – and may
be required worker’s compensation insurance premiums for the owner being paid
as an employee that would not exist for a sole-proprietor. And the management and administration of a
corporation is more time consuming and requires more detailed recordkeeping and
federal, state and local government filings.
As a
point of information – operating as a corporation provides the owner with “limited
liability”, but so does registering your Schedule C sole-proprietorship as a “Limited
Liability Company” (LLC). And if you are
an LLC you can file your taxes as either a sole proprietor on Schedule C (or as
a partnership if more than own owner) or a corporation, either “C” or “S”.
In
terms of the Social Security component of the FICA payroll tax, paying the tax
on a lower earnings base may affect the benefits you receive when you begin to
collect. In the above example the Social
Security earnings for the Schedule C filer is $92,350, but is only $55,000 for
the corporate employee. Social security
benefits are based on your 40 highest-earning years. FYI - there is a maximum wage/earnings cap on
the Social Security component of FICA tax, which applies to both wages and net
earnings from self-employment.
What
I am saying is that choosing a business entity is a serious and complicated
matter involving many important issues – both tax and non-tax. There is no “one size fits all” answer –
regardless of what a lawyer may tell you.
When deciding on the entity you should consider the difference in
payroll tax costs, and now under the GOP Tax Act the potential savings
from the Section 199a QBI deduction. Do
multiple calculations based on various amounts of anticipated income.
And
consult a tax professional BEFORE you consult an attorney!
TTFN
