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| Use an S Corporation to Cut Social Security and Medicare Taxes Self-employed people quickly find out that the federal self-employment tax can be just as burdensome as the income tax. The self-employment person’s version of the FICA tax withheld from the wages of employees. Both are used to fund Social Security and Medicare, so we’ll refer to both as Social Security taxes for ease. You may want to consider operating your business as an S corporation to save Social Security taxes. Here’ how. The taxable income of an S corporation owned by you is passed through to you and is included in your Form 1040. As the shareholder-employee of your S corporation, you will pay yourself a salary, which is subject to a 15.3 percent FICA rate on the first $90,000 for 2006 (above that level, the rate is 2.9 percent). Your salary is a deduction to the corporation and reduces the corporate taxable income that is passed through to you. Under current law, that pass-through income is not subject to either FICA or self-employment tax. The tax planning idea is to pay yourself a relatively low but yet reasonable salary (which minimizes FICA tax) and pay out the rest of your corporation’s income in the form of S corporation distributions. You still get all the cash without the big Social Security tax bite. Example: Say the taxable income of your business (before your salary) is $100,000. You draw a salary of $30,000; only that amount is subject to the 15.3 percent PICA remaining $70,000 could be distributed to you without any FICA or self-employment tax. So the PICA tax would be only $4,590 (15.3 percent x 30,000). In contrast, if you ran the same business as a sole proprietorship or single-member LLC, you would pay over twice as much self-employment tax! The key point is that the $30,000 salary must be reasonable circumstances surrounding the S corporation distributions as additional salary. If that happens, you will be assessed back PICA taxes and possibly interest and penalties as well. This idea works best if your business is not limited to the delivery of personal services by you. In that case, you would have a hard time arguing that all the corporation’s income should not be treated as your salary. The S Corporation is such a tax loophole that Congress is studying the situation where profitable one owner S corporations do not pay any payroll taxes because no salary is taken. Odds are Congress will try to close this loophole somehow by 2007. In the meantime, you should take a reasonable salary from your S corporation BUT many do not. | |