(And Maybe Even be Happy About It)
I was on a webinar this morning with a group of businesspeople, and as I was listening in, another CPA started explaining the focus of his practice.
It sounds like his main service involves restructuring the form of his clients’ businesses to reduce the amount they pay in self-employment taxes. What’s not to like, right?
But as he talked about what he did, and his target market, and I heard some of the marketing suggestions from the organizers, alarm bells and objections kept going off in my head.
“It’s not that simple!”
“There’s more to it than that!”
I frantically attempted to type a series of counterpoints into the little question box on GoToWebinar, but was unsuccessful in my efforts to present a more balanced picture of the strategy being discussed. And since the webinar has literally (figuratively) set my brain on fire, I had to write this blog post to get all my thoughts out there so that you can make an informed decision about the value of this strategy.
First, I want to make it clear that I’m not condemning the CPA for promoting this common strategy. In the right situations, for the right client, it could absolutely be the right option. But it won’t work for everyone, and I will politely and firmly object (or write a blog manifesto) if I think the strategy is being marketed as a “slam dunk” that should always be implemented.
Second, I feel like I should outline the strategy so you know what I’m talking about:
Basically, the “move” is to switch from being taxed as sole-proprietor or partnership (the default for LLCs is to be taxed as a partnership) to being taxed as an S-Corporation.
You would be both a shareholder and an employee of the S-Corp, and the general strategy is to employ yourself at a lower salary to reduce the payroll taxes that you’d pay. As the shareholder, the remaining profits of the business would be taxed to you at your individual income tax rate, avoiding paying self-employment taxes on that portion of your income.
If you’re an entrepreneur, or self-employed professional or freelancer, you probably hate that time of year when your CPA tells you how big your tax bill is. Self-employment taxes, on top of federal income taxes, and then state taxes (especially in Oregon and California, where I practice)… that all adds up in a hurry.
So if someone comes along promising that they can cut your self-employment taxes by more than $10k every year by changing the legal form of your business, why wouldn’t you jump at the chance?
Here are some reasons why it might not make sense for you:
1. Self-employment taxes primarily benefit you.
The 80/20 of self-employment taxes is that over 80% of the amount you pay goes toward Social Security (12.4% is Social Security, 2.9% is for Medicare, for a total of 15.3%) and the rest goes toward Medicare, both of which are designed to provide benefits to you when you reach a certain age.
2. You want to max out the amount you’ll get from Social Security when you retire.
If you reduce your self-employment income, and your annual compensation is less than the max subject to FICA (currently $118,500), you’re likely to be reducing the size of any future Social Security checks that you were hoping to collect.
3. You know that you don’t have the infrastructure in place to handle the required “corporate formalities” of an S-Corp.
If you’re still struggling to keep your business accounts separate from your personal accounts, or you’re habitually late renewing your business license, or you’re always late with some other regular reporting requirements, those are signs that you’re not ready for this step yet. Adding another tax return, annual meetings, and keeping corporate minutes are just more headaches and likely time-bombs until you get your act together.
4. All the value from your business comes directly from the work you perform.
The IRS will require that you pay yourself “reasonable compensation,” which will be subject to payroll taxes. If you’re the only one working in your business, and your business doesn’t require significant capital investment, the IRS might take the view that reasonable compensation might be a lot higher than you hoped, which would reduce the amount of self-employment tax you could avoid.
5. You have no attractive reinvestment opportunities for the money “saved” from self-employment taxes.
Since you’d likely be giving up future retirement income by reducing your self-employment taxes, I hope you’re thinking about how you can use the extra cash to at least replace what you’re giving up (and that your financial advisor would be asking you that same question). If investing the tax savings in your business won’t make your business more profitable, or if there aren’t any attractive investment opportunities available to you, you might decide that paying the tax might be your best long-term option.
So before jumping blindly on the S-Corp bandwagon so that you can start bragging about how much money you’re saving on self-employment taxes, talk to your CPA. Talk to your financial advisor. Give them permission to talk to each other about your situation.
Understand the pros and cons. Run tax projections. Consider the other tax-planning moves you could make to reduce your taxes (if you haven’t gotten the basics in place, you’re probably leaving money on the table).
Make an informed decision, because you’re the one who will have to live with the results.
There’s some situations where I really like S-Corps, and think they’re a great choice for my clients. In other situations, they aren’t the best option.
S-Corps definitely aren’t a one-size-fits-all solution for everyone who has self employment income, and you should be extremely wary about anyone who presents them that way.