By John H.W. Cole, Esq.
In my previous tax planning article I discussed how graduated tax rates worked and how to save on income taxes by deferring taxable income to later years. The saving results from the fact that (1) a portion of income isn’t taxed at all, due to exemptions and deductions, and (2) income is taxed in segments, at graduated rates. Even the wealthiest individual only pays 10% on his first $16,750 of taxable income. This article discusses payroll taxes and the new income surtaxes that will apply in 2013.
Once upon a time only a small portion of wages and self employment earning were subject to payroll taxes. In the last forty years payroll taxes have increased more than income taxes, by increasing the portion of earnings to which they apply. OASDI (Social Security) payroll taxes are 12.4% (employer and employee share combined) of compensation up to $106,800 (the 2011 taxable wage base), and an HI (health insurance) tax of 2.9% (combined) applies to all compensation. The taxable wage base is indexed for inflation, and increases almost every year. For 2011 only, a 2% tax holiday for employees was enacted as an economic stimulus.
Payroll taxes are imposed on gross wages or self employment income, unreduced by adjustments to gross income, exemptions or deductions. Income taxes, on the other hand, are imposed upon taxable income, after adjustments to gross income, exemptions, and deductions (standard or itemized). For example, if a married taxpayer has a salary of $26,000, $14,600 of personal exemptions, and the standard deduction of $11,400, he will pay no income taxes. However, he and his business will pay a combined $3,978 in payroll taxes.
If in the same example his income is increased to $94,400, his income taxes will be $9,363. His payroll taxes will be an astonishing $14,443. His greatest tax liability does not come from income taxes; it’s from payroll taxes. Payroll taxes can’t be totally avoided, but they certainly can be reduced.
The most obvious way to avoid unnecessary payroll taxes is to avoid having to pay payroll taxes on employee benefits. Take health insurance, for example. My annual premium is $12,000. If the $12,000 is paid by my corporation it’s a tax free benefit to me, deducted by my corporation on its tax return. The same payment if I was a self employed individual would be subject to payroll taxes, and would be deducted on my Form 1040 as an adjustment to gross income. If my self employment income were below the taxable wage base, my health insurance would cost me $1,836 in unnecessary payroll taxes.
The same result occurs with retirement plan funding. If $20,000 is funded into a profit sharing plan for me by my corporation, there are no payroll taxes on this plan funding and the corporation deducts the $20,000. If I were self employed the $20,000 of plan funding would be considered self employment income subject to payroll taxes. It could not be deducted as a business expense but would be deducted, instead, on my Form 1040. If my self employment income were below the wage base, the payroll tax on my $20,000 of plan funding would be $3,060. Between health insurance and plan funding that’s $4,896 down the drain.
I have $100,000 invested in my business between furniture, fixtures, and equipment. I am certainly entitled to at least a 10% ($10,000) return on my investment. If my business is incorporated as an S corporation I am entitled to receive that return as pass through income – not subject to payroll taxes. If I were self employed and my income was under the taxable wage base, that’s another $1,530 down the drain, for a total of $6,526 of unnecessary taxes.
The pain is not limited to those with self employment income under the taxable wage base. Assume that I am self employed, that my earnings are well in excess of the taxable wage base and that I am funding my plan to the maximum ($49,000). The sum of my plan funding, health insurance and return on investment is $71,000. The HI tax on this amount is $2,059 (2.9% x $71,000).
Taxpayers have a civic duty to pay their taxes, but certainly not to overpay them because Congress taxes different business structures differently. The additional accounting costs of doing business as an S corporation, instead of as a sole proprietor, LLC, or partnership are very small. Just ask your accountant. Instead of a complex, personal return you report the same information on a corporate return and have a simple personal return (and a lower tax profile). Your accounting fees will increase by less than $1,000 while your tax savings will be much greater. If you are doing business with others as a partnership or an LLC there is no increased reporting expense for changing to an S corporation because you are already filing a separate return. The bottom line is that most small businesses could avoid paying unnecessary payroll taxes by doing business as an S corporation.
But Wait, There’s More
Additional ways of avoiding payroll taxes involve how you structure the ownership of your office building, who owns office equipment, and who pays for leasehold improvements. The most advantageous structure will vary from state to state, but the goal is to make certain that the return on your investment in your business is not subject to payroll taxes.
The .9% Medicare Surtax
The Patient Protection and Affordable Care Act of 2010 (PPACA) added a .9% Medicare tax on wages and self-employment income in excess of $200,000 ($250,000 if married). This new tax is effective in 2013 and is imposed on the employee only (no employer share). Assume that my self employment earnings are well in excess of the $250,000 and that I am funding my profit sharing plan to the maximum ($49,000). The sum of my plan funding, health insurance and my $10,000 return on investment is $71,000. The HI and Medicare Surtax on this amount will be $2,698 (.038% x $71,000) down the drain.
The 3.8% Medicare Tax on Unearned Income
PPACA also added a Medicare tax on the lesser of net investment income or the excess of adjusted gross income over the threshold amount, effective for 2013. The threshold amount is $250,000 for a married taxpayer and $200,000 for a single taxpayer. Basically, it means that if your adjusted gross income is over $250,000, you are going to pay an additional tax on your investment income.
There are two exceptions to what is considered unearned income. (1) income from a qualified retirement plan is not unearned income; and (2) pass through earnings from S corporations in an active trade or business are not unearned income. There are three ways to avoid this tax. (1) Fund your retirement plan to the maximum so that your earnings on investments will not be subject to the surtax (when withdrawn); (2) shift income to family members; and (3) when investing in an active business make certain that it is operated through an S corporation.
Did Anyone Say C Corp?
Although I have focused above on the difference between conducting business in an unincorporated structure versus conducting business as an S Corporation, I personally do business as a C corporation. The reason for this is that I have $10,000 of medical expenses (including dental, eye care, and items not covered by insurance) which are paid for by my corporation’s medical reimbursement plan. This saves me $1,530 in payroll taxes, $2,500 in federal income taxes, and $900 in Vermont State Income Tax, for a total tax savings of $4,930. It also allows me to lower the premium on my high deductible health insurance policy by more than my out-of-pocket cost for items otherwise covered. In my situation it’s a no brainer.
Conclusion
Businessmen can avoid paying unnecessary payroll taxes, and in 2013 avoid paying unnecessary Medicare surtaxes, by tailoring the structure of their business and investments to their specific situation, and by maximizing their retirement plan funding. The time to look at their structure is as soon in a calendar year as possible, and whenever contemplating a significant capital expenditure related to their business or investments.
For further information, comments, or questions, contact me at jcole@erisajd.com
In My Next Article: The Magic of Tax Free Compounding
Tax Planning for Graduated Rates
By John H.W. Cole, Esq.
This article and several that will follow explore the elements of tax planning. Because a tax plan can be overwhelming when it is all put together my memos will develop the components one at a time. The first component is taking advantage of graduated tax rates.
Federal Income Taxes are imposed upon Taxable Income – Taxable Income is Gross Income less allowable deductions and exemptions. Gross Income is your income from all sources, most commonly wages and investment income.
Example: Ken and Barbie had a combined Gross Income of $212,700 in 2010. They had two dependent children which translates into $14,600 of personal exemptions. They file a joint return, and claim the standard deduction of $11,400.
Their Taxable Income for 2010 was $186,700 ($212,700 of Gross Income reduced by the standard deduction of $11,400 and personal exemptions of $14,600).
For 2010, the tax rates were as follows for married taxpayers filing jointly.
Taxable Income
- of the
-
But Not Base % on amount
-
Over Over Tax Excess over—
-
$ 0 $ 16,750 $0 10% $0
-
16,750 68,000 1,675.00 15% 16,750
-
68,000 137,300 9,362.50 25% 68,000
-
137,300 209,250 26,687.50 28% 137,300
-
209,250 373,650 46,833.50 33% 209,250
Ken and Barbie’s 2010 taxes were determined as follows:
- Income Tax Rate
- On their first $ 26,400 0 0% (offset by exemptions & deductions)
- On their next 16,750 1,675 10%
- On their next 51,250 7,688 15%
- On their next 69,300 17,325 25%
- On their next 49,000 13,720 28%
- Totals: $ 212,700 $ 40,408
Suppose that Ken had set up a qualified plan and deferred $49,000 into it. Ken and Barbie’s federal taxes would now be determined as follows:
- Income Tax Rate
- On their first $ 26,400 0 0% (offset by exemptions & deductions)
- On their next 16,750 1,675 10%
- On their next 51,250 7,688 15%
- On their next 69,300 17,325 25%
- Totals: $ 163,700 $ 26,688
By deferring $49,000 into a qualified plan, Ken and Barbie would avoid paying $13,720 in federal income taxes. If they lived in a state with a state income tax, like Vermont (9%), they could save another $4,410 in state income taxes. By avoiding paying payroll taxes on the $49,000 they would save another $1,421. Their total tax savings would be a combined $19,551.
Flash forward to 2011 when Ken and Barbie retire. Assume the same exemptions and the use of the standard deduction. They withdraw the $49,000 from the plan. Their taxes are determined as follows:
-
Income Tax Rate
-
On their first $ 26,400 0 0% (offset by exemptions & deductions)
-
On their next 16,750 1,675 10%
-
On the remaining 5,850 878 15%
-
Total $ 49,000 $ 2,553
The $49,000 of retirement plan income would not be subject to payroll taxes. In Vermont it would not be subject to state income taxes because it is below the state income tax threshold. Accordingly the tax savings from delaying a year would be $16,998. In Virginia, which imposes a state income tax on this amount of income, the tax savings would be slightly less, at $15,698.
Of course, Ken and Barbie may have other sources of income when they retire. However, the above example assumed retirement the following year, so a similar amount of outside income would have been present in both 2010 and 2011. An additional $40,000 of investment income would change their top bracket to 33% in 2010, while in 2011 an additional $40,000 would still be taxed at only 15%.
Furthermore, the example does not take into account the fact that tax brackets are indexed and that any increase in tax rates would only take place at very high income levels. In 1993 the 28% bracket for joint filers was $36,900 of taxable income. Today the 28% bracket starts at $137,650 of taxable income.
Let’s go back to the beginning and assume that Ken and Barbie did not defer the $49,000. Instead they paid their payroll taxes, and state and federal income taxes, and invested the money for 20 years, and enjoyed a 6% return. At the end of 10 years they would have accumulated $66,496, after taxes.
Sheltered in a qualified plan, the same $49,000 would have become $112,596, almost double.
Assume they took the entire $112,596 out at once, as their only income for the year, and that brackets never went up (although in fact they do). Their taxes would be determined as follows:
- Income Tax Rate
- On their first $ 26,400 0 0% (offset by exemptions & deductions)
- On their next 16,750 1,675 10%
- On their next 51,250 7,688 15%
- On their next 18,196 4,549 25%
- Totals: $ 112,596 $ 13,912
They would have $98,685 in after tax dollars to live on for the year, compared with $66,496 from investing on the outside.
The first lesson of this example is that some of your income isn’t taxed at all. Secondly, that which is subject to tax is taxed progressively starting with low tax rates. Third, significant taxes can be saved by shifting income from high tax rate years to lower tax rate years. The tax planning objective is to move income out of the 25%-33% federal bracket and 9% state bracket into the 15% federal bracket and 0-4% state income tax bracket.
The final lesson is that because of reduced income, rising brackets, or both, the low tax bracket years for most of us lie further down the road, when we retire, or at least slow down. The way to retire with the greatest amount of income is to take advantage of tax deferral vehicles, such as IRAs, SEPS, and qualified retirement plans.
For further information, comments, or questions, contact me at jcole@erisajd.com
In my next Article: Payroll taxes and the new Medicare Surtaxes
