ALL ABOUT SMALL CORPORATION AND ITS ADVANTAGES

 

Owning a small business without incorporation can lead to hefty self-employment (SE) tax bills, and that's never pleasant.

In 2023, the SE tax hits you hard at 15.3% on the initial $160,200 of net SE income. This includes 12.4% for Social Security tax and 2.9% for Medicare tax. The Social Security tax ceiling has risen to $160,200 from $147,000 in 2022, and this upward trend is expected to continue due to inflation. Beyond this ceiling, the Medicare tax persists at 2.9% before climbing to 3.8% for higher net SE incomes, thanks to the additional 0.9% Medicare tax on all income.

Enter the S corporation advantage.

In 2023, S corporation employees, including shareholder-employees, face a FICA tax wage withholding rate of 7.65% on the first $160,200 of wages—6.2% for Social Security tax and 1.45% for Medicare tax. Once past $160,200, the rate drops to 1.45% because the Social Security tax no longer applies. However, the 1.45% Medicare tax persists and increases to 2.35% for higher compensation due to the 0.9% additional Medicare tax.

While an S corporation employer matches payments, the 0.9% Additional Medicare tax falls solely on the employee. Consequently, the combined employee and employer FICA tax rate for Social Security tax is 12.4%, and for Medicare tax, it's 2.9%, rising to 3.8% at higher compensation levels—mirroring SE tax rates.

Strategic move: Transition to an S corporation.

Wages paid to an S corporation shareholder-employee are subject to federal employment taxes, but any remaining S corp taxable income passed through to the employee-shareholder is exempt. This also applies to cash distributions. By paying justifiable salaries and distributing the rest as federal-employment-tax-free shareholder distributions, an S corporation can be tax-efficient. In contrast, taxable income from a sole proprietorship, partnership, or LLC is generally fully subject to the SE tax.

Caution: There might be a downside.

Opting for an S corporation and paying modest shareholder-employee salaries may limit deductible contributions to retirement accounts. For instance, with a SEP, the maximum deductible contribution for a shareholder-employee is capped at 25% of salary. So, lower salaries mean lower contributions. However, setting up a 401(k) plan in an S corp allows for modest salaries without hindering generous contributions.

Considerations beyond taxes.

Switching from an unincorporated business to an S corporation involves legal and tax implications, making it a substantial decision. We can guide you through all the nuances and help you make an informed choice.