All of us who earn money as self-employed persons have to pay the federal Self-Employment Tax (the "SET") on our income from our work. Self-employed persons include sole proprietors, members of single-member LLCs taxable as sole proprietorships and members of multi-member LLCs taxable as partnerships. The SET is, in effect, an annual premium for federal old age, disability and survivor insurance. These are, obviously, major federal benefits.
However, the SET is also a very big tax. In 2020, self-employed persons must pay SET in the amount of 15.3% of the first $137,700 of their earned income – their "contribution and benefit base" (to use the IRS's terminology) – and 2.9% of any excess. Thus, if, in 2020, your self-employment income is $137,700, your SET will be $21,068.10 – a lot of money. And the contribution and benefit base increases significantly every year; in 2021, it will be $142,800, and the SET will increase correspondingly. However, as most self-employed persons will know, they are entitled to an annual federal income tax deduction of 50% of their SET. This is to equalize their Social Security Tax situation with that of employees.
There are two main ways that self-employed persons can lawfully reduce their SET:
- If they do business through a single-member or multi-member LLC, they can make an S election for their business. However, if, before they make this election, they are doing business as state-law sole proprietorships – i.e., without using an LLC or other entity to conduct their business – they must first form an entity, since only entities can make this election. (It will be useful to point out here that "LLC" is a purely legal term, while "S corporation" is a purely tax term. But IRC rules permit LLCs to make S elections. Thus, a business entity can be both an LLC and a corporation – that is, an S corporation – at the same time.)
- If they are sole proprietors or members of LLCs, self-employed persons may be able to make substantial SET savings through a little-known but powerful IRS proposed regulation called Prop. Reg. § 1.1402(a)-2 (the "Prop. Reg."). However, to use the Prop. Reg., sole proprietors must find a suitable partner – perhaps a spouse – and thus qualify for partnership taxation.
In this column, I'll discuss Subchapter S. In my next column, I'll discuss the Prop. Reg.
Here are the key points you should know about Subchapter S for Social Security Tax purposes:
1. Subchapter S is a "pass-through" tax regimen. That is, the income of an S corporation belongs to the corporation itself from a financial viewpoint, but from a federal tax viewpoint, the IRS views this income as passing through directly to the S corporation's owners and as taxable to them even if their corporation doesn't distribute it to them.
2. Shareholders of S corporations who work for their corporations must pay themselves "reasonable compensation" for their work. This means, in general, paying themselves the same compensation they'd pay an unrelated third party for that work. However, in practice, even if they pay themselves a somewhat lower amount, there's a decent chance that the IRS won't audit them on the above "third party" ground. S corporation reasonable compensation rules are fairly flexible.
3. S corporation shareholders who work for their corporations must pay FICA taxes on their S corporation compensation – the employee equivalent of the SET. However, the net income of their corporation after this compensation and after all other S corporation expenses will not be subject to FICA taxes. Thus, the lower their S corporation compensation, the greater will be their FICA savings.
4. However, if you do business through an LLC taxable as an S corporation and you have no employees or substantial business assets, the IRS, if it audits you, may well claim that all of your income is derived from your work and thus that all of it must be treated as compensation subject to FICA taxes. This could mean a very nasty audit.
5. However, a preliminary Social Security Tax issue you must address if you are a self-employed person is whether you really want to reduce your SET, either through Subchapter S or through the Prop. Reg. This is because, in so doing, you will also be reducing the above federal benefits. But many start-up businesses decide to pay only a minimal SET in their first few years of business and to use their tax savings to grow their business.
6. A second key Subchapter S issue arises under Internal Revenue Code Section 199A. As many readers of this column will know, Section 199A provides annual federal income tax deductions to owners of pass-through businesses of up to 20% of their net business income. Under section 199A, for most self-employed persons, the best federal tax regimen is not Subchapter S, but rather, sole proprietorship or partnership taxation.
This is because under Subchapter S, their net income will be reduced by their S corporation compensation; this will reduce their section 199A deduction. Thus, self-employed persons must work with their accountants to determine their net tax savings under, on the one hand, Subchapter S, and, on the other, sole proprietorship or partnership taxation. And in doing so, they must also take into account any relevant New Hampshire state taxes.
But, as I'll discuss next week, for many self-employed persons, the magic bullet for Self-Employment Tax purposes is the Prop. Reg.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.