Wednesday, September 4, 2019
WHEN CHOOSING A BUSINESS ENTITY DON’T FORGET FICA TAXES
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!