Entity Owner Strategies that help minimize Social Security Taxes

Most business clients rightfully complain about the level of payroll (FICA or SE) taxes on their income.

In todays blog I will discuss few strategies and planning  which can reduce the burden off social security  taxes on small business owners .

Maximizing S Shareholder Distributions to Minimize Payroll Taxes

The taxable income passed through by an S corporation to shareholder-employees is not self-employment income for SE tax purposes This has lead to the tax planning strategy of minimizing the salary of S corporation shareholder-employees (and thus minimizing the payroll tax liability) and maximizing the amounts treated as S corporation dividend distributions. This still gets the cash in the hands of the shareholder-employee while minimizing the payroll tax burden. However, the taxpayer's age and qualification for maximum social security benefits should be considered before minimizing the current year payroll taxes. Also, the effect on the capacity to make deductible contributions to tax-favored retirement plan accounts should be considered (i.e., reduced salaries equates to reduced retirement plan contributions).

Example :     Minimizing salary income of S corporation shareholder-employees.

Amit is the sole shareholder of Shanti Inc., an S corporation. He works full-time in the business. During the current year, the corporation passes through ordinary income from operations of $85,000. The corporation pays an annual salary to Amit of $40,000. In addition, the corporation distributes $85,000 to Amit during the year as a distribution rather than paying this amount out as additional salary. Thus, wages and distribution payments to Amit for the year total $125,000.

If the $40,000 is a reasonable salary for the services performed by Amit, the transaction will probably withstand IRS scrutiny. In that case, the company and its shareholder have collectively saved the following amount of FICA tax by not paying the entire $125,000 as salary income to Amit :

OASDI Savings-[($117,000 wage base − $40,000 salary) × 12.4%]	$ 9,548
HI Savings-[($125,000 − $40,000) × 2.9%]	2,465
Total FICA tax savings	$ 12,013

 

  Caution: The IRS is well aware of this technique and, not surprisingly, frequently challenges such compensation arrangements as unreasonable. In several court cases, the IRS has successfully reclassified amounts originally treated as S corporation distributions to wage income-with the resulting additional FICA tax liability.

Example 4-8:     S shareholder distributions recharacterized as salary.

 Assume the same facts as in Example 4-7 except the IRS determines the $40,000 salary paid to Amit is unreasonably low. The IRS could recharacterize some or all of the $85,000 cash distributions as salary income subject to payroll taxes. Payroll tax penalties could also apply. The pass-through income from the S corporation would be amended to reflect the deemed wages and additional payroll taxes.

Thus, the planning technique works, but it must be used with judgment. In situations where any question exists, it is probably wise to document why amounts characterized as wages were not so low as to be unreasonable in relation to the services performed by the shareholder-employee. In addition, clients should be made aware that unreasonably low compensation of S corporation shareholder/employees is sometimes an audit issue with the IRS. Audit exposure is high especially when the shareholder/employee is a corporate officer,.

Following factors are considered in determining reasonable compensation (a) training and experience; (b) duties and responsibilities; (c) time and effort devoted to the business; (d) dividend history; (e) payments to nonshareholder employees, peers, and subordinates; (f) timing and manner of bonus payments to key employees; (g) the amount of compensation by comparable businesses for similar services performed; (h) compensation agreements; and (i) the use of compensation formulas by the corporation.

Employing Family Members

 Employing family members can be a useful strategy to reduce overall tax liability. If the family member is a bona fide employee, then the taxpayer can deduct the wages and benefits, including medical benefits, paid to the employee on Schedule C or F as a business expense, thus reducing the proprietor's SE tax liability (

 Employing the taxpayer's children can reduce overall tax liability. Children under age 18 who work for their parents are not subject to FICA or FUTA taxes. In addition, wage income would be taxed at the child's lower tax rate and may be wholly or partially offset by the child's standard deduction of up to $6,200 (for 2014). The wages must be reasonable for the work done. Additionally, a sole proprietor can provide up to $5,250 in annual tax-free educational assistance (for both undergraduate and graduate courses) to each eligible employee and deduct the costs (thus saving both income and SE taxes). Properly arranged, this benefit is available to the sole proprietor's child that is (a) age 21 or older, (b) a legitimate employee of the business, (c) not more than a direct 5% owner of the business, and (d) not a dependent of the parent business owner.

 Caution: Should the IRS choose to examine wages paid to family members, the taxpayer should be able prove the deduction. For payments to family members, it is especially important to ensure that basic business practices (e.g., keeping time reports, filing payroll returns, and basing pay on work performed, not on a relationship to the employer) are followed

 

 

Incorporating a Sole Proprietorship Can Save Payroll Taxes

 If a self-employed client is willing to live with the advantages and disadvantages of corporate taxation, using a C or S corporation can save payroll taxes. This is because essentially all of a sole proprietor's business income is subject to SE tax, while only the wage or salary income of a shareholder-employee is subject to FICA tax.

Incorporating a sole proprietorship can be especially beneficial when the business needs to retain income for expansion or debt retirement. Corporate income, unlike proprietor income, can be retained in the company free of either FICA or SE tax.

 

Leasing Property to a Closely Held Business

 A common tax planning strategy is for individuals to lease property to their closely held corporations or partnerships, especially in those states that do not impose sales or use tax on rental transactions. This can be an effective technique for withdrawing cash from a business entity without FICA or SE taxes, as would otherwise occur with salaries or guaranteed payments

 

These are some of the strategies that can be used to save social security taxes by effective tax planning .