Which entity is best to help clients reduce self-employment tax?
Want to help your business clients lower their self-employment taxes? If your clients started their businesses not knowing how much more payroll taxes take from their income than when they were employees, they’re probably still getting over the shock. Here’s how you can provide some guidance on how structuring their companies as S Corps or LLCs can help clients keep more of their earnings for themselves.
As employees, payroll taxes are split between the business and the employee. Once your clients venture forth on their own, there is no longer an employer to split the taxes with and the responsibility for paying them falls solely on the self-employed.
Currently, the self-employment (SE) tax rate is 15.3%, which includes a 12.4% Social Security tax and a 2.9% Medicare tax. Furthermore, your clients may be taxed another .09% of additional Medicare tax if their earnings reach the following thresholds:
|Filing Status||Threshold Amount|
|Married filing jointly||$250,000|
|Married filing separately||$125,000|
|Head of household (with qualifying person)||$200,000|
|Qualifying widow(er) with dependent child||$200,000|
If your client pays for health insurance, he or she is allowed a deduction for the cost of the premiums under the Small Business Jobs Act, and if the client is a caregiver, there are special rules regarding SE taxes, but otherwise the amount for SE taxes is pretty straightforward.
How Can an S Corp Help?
One option for your clients to lower their SE taxes is to elect S Corp status. Although the IRS does tend to scrutinize S Corps carefully to make sure no one is trying to hide earnings, the S Corp structure absolves your clients of some tax liability. Here’s how.
As an S Corp, your client is considered an employee of the S Corp. Although earnings are passed through to the employee (and therefore must be claimed on the employee’s personal tax return), the client can classify some of the earnings as salary and some as distribution. Employees are liable for the 15.3% SE taxes on the salary portion of their income but are only responsible for regular taxes on the distributions. Your clients could save a substantial amount of taxes by dividing earnings into salary and distributions.
The risk factor is significant if the IRS decides your client is trying to hide earnings by taking a small salary and larger distributions. Make sure you have the client designate a “reasonable” amount as salary, per the IRS, which means what the person would be making if they were an employee in the same industry. Since your client may look to you for guidance on this, it’s important to familiarize yourself with industry salaries so the client is not at risk for an audit and possible penalties.
You’ll also want to advise your client of the S Corp filing deadline (March 15) and any additional fees and taxes for which S Corps are liable. (These may vary depending on your home state.)
How Can an LLC Help?
Like the S Corp, a Limited Liability Company (LLC) is a “pass-through entity,” and all profits and losses are passed through to the members (or owners). What’s different depends on the number of members/owners in the LLC. If your client is the sole member of an LLC, the IRS treats the business as a sole proprietorship in that the LLC does not pay taxes nor file a tax return. However, all profits (even if not distributed) must be claimed on your client’s personal tax return.
If your client’s LLC has multiple members, each member pays income taxes on their designated share of the LLC’s profits. For example, if your client owns 60% of the LLC, they pay taxes on 60% of the profits (and also can claim 60% pf the losses). As stated above, the IRS does not distinguish between whether profits were distributed or kept in the business. The member still must claim their share of the profits on their returns and SE taxes must be paid on that amount. The advantage is LLC members can deduct half of the total SE amount from their taxable income, and therefore save on income taxes.
The exception is for those members who are not active in the operation of the business. Limited members who are solely investors (that is, they make no management decisions and do no actual work in the business) may not need to pay SE taxes at all. To avoid the SE tax, limited members cannot be 1) personally liable for the LLC’s debts, 2) have any authority to contract for the LLC, or 3) participate in the LLC’s business for more than 500 hours per year.
Again, you’ll want to make sure your client understands the compliance requirements involved before deciding to structure the business as an LLC. Most states require LLCs to pay a franchise tax and an annual registration fee. An LLC will also need to file Articles of Organization with the state and create an operating agreement which spells out the shares and responsibilities of the members.
Do your homework on the ins and outs of S Corps vs. LLCs for tax purposes, and you’ll be ready to advise your clients on the best business structure to help them keep more of what they’ve earned.