S Corps Control Social Security and Medicare Taxes
When a law firm is taxed as an S Corp, the primary tax savings are achieved by controlling social security and medicare taxes.
Law firm owners must pay the social security and medicare taxes withheld from employee paychecks and they must pay the social security and medicare taxes matched by the employer.
For 2014, Social Security and Medicare taxes consist of:
6.20% Employee Portion for Social Security (6.2% of first $117,000)
6.20% Employer Portion for Social Security (6.2% of first $117,000)
1.45% Employee Portion for Medicare (1.45% of all net income)
1.45% Employer Portion for Medicare (1.45% of all net income)
—
15.3% Total
Schedule C and Partnership Self-Employment Tax
When a law firm is taxed as a sole proprietorship (Form 1040, Schedule C) or a partnership (Form 1065) all net income is subject to self-employment tax.
Example
Law firm taxed as sole proprietorship on Form 1040, Schedule C.
Law firm net income is $150,000.
Self-employment tax is charged on 92.35% of the firm’s net income. In this example, self-employment taxes are charged on $150,000 X 92.35% = $138,525. The business would be allowed a deduction for the employer portion of social security (6.2%) and medicare taxes (1.45%) if the owners were on payroll, hence the 92.35% adjustment (100% – 6.2% – 1.45%).
Self-Employment Tax will be:
$7,254 Employee Portion for Social Security (6.2% X 92.35% adjustment X net income, limited to maximum amount of $7,254)
$7,254 Employer Portion for Social Security (6.2% X 92.35% adjustment X net income, limited to maximum amount of $7,254)
$2,009 Employee Portion for Medicare (1.45% X 92.35% adjustment X net income)
$2,009 Employer Portion for Medicare (1.45% X 92.35% adjustment X net income)
—
$18,526 Total Self-Employment Tax
S Corp Self-Employment Tax
When a law firm is taxed as an S Corp, social security and medicare taxes apply only to the wages paid to the owner. To continue the example, the law firm elected S Corp taxation. The firm owner received gross wages of $90,000. The remaining $60,000 was paid to the owner as distributions.
$5,580 Employer Portion of Social Security (6.2% of $90,000 wages)
$5,580 Employer Portion of Social Security (6.2% of $90,000 wages)
$1,305 Employer Portion of Social Security (1.45% of $90,000 wages)
$1,305 Employee Portion of Social Security (1.45% of $90,000 wages)
—
$13,770 Total Social Security and Medicare taxes.
Tax Savings
Self-employment tax savings from the S Corp election is $18,526 less $13,770 equals a $4,756 reduction.
There is one complicated component to this puzzle. The employer portion of self-employment tax is deducible in both scenarios. By decreasing the self-employment tax deduction, taxable income increases, and income taxes increase. The employer portion of self-employment tax for the Schedule C option is $7,254 + $2,009 = $9,263. The employer portion of self-employment tax for the S Corp option is $5,580 + $1,305 = $6,885. The employer portion of self-employment tax decreases $9,263 – $6,885 = $2,378 with the S election. Assuming a 29% combined federal and state income tax rate, the decreased self-employment tax increase income taxes by $2,378 X 29% = $690.
Net S Corp election savings is $18,526 less $13,770 less $690 = $4,066 net cash into the owner’s pocket each year! As the firm’s net income increases, so does the tax savings.
Tax Code Disclaimer
Technically, self-employment tax and FICA taxes (social security & medicare) are two different taxes from different parts of the tax code. The proceeds from both taxes are used to fund the same government programs & they happen to have the same percentages right now, but they are not the same tax. The above examples explain self-employment tax from a perspective of the FICA taxes everyone is used to seeing on their paychecks. The analysis and calculations are all correct. If you research self-employment taxes, you will not see the employer and employee split out of social security and medicare taxes.
