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