The USA "self-employment tax dodge" mystery

Question

For non-US readers:

In the US, for those who are self-employed, there are many specific taxes. One particular tax is the confusingly named "The Self-Employment Tax".

Thus, if you are self-employed, you pay a number of specific taxes, all of which have various confusing names. (Here's a random example! The "Individual Shared Responsibility Payment" - !)

One particular tax, of the many that self-employed people pay, is the (confusingly named!) "The Self-Employment Tax".

So, this QA is in fact about that particular tax, "The Self-Employment Tax".

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First I will explain how I believe self-employment tax works in the US:

• Sally makes $200,000 in the year. She is paid as a ordinary 1099 worker.
• She pays S.E. tax of about $20,000 on that.

(Note for overseas readers who are following along. So, among the various/many taxes she pays, >>one<< of them is the "S.E. tax" - $20,000 in the example. This QA is only about the "S.E. tax" specifically.)

~ Alternately ~

• Sally sets up an LLC which will be treated as an SCorp (or, she just sets up an Scorp)
• The SCorp gets $200,000
• The SCorp pays her $100,000 income
• The SCorp gives her $100,000 profit distribution
• Sally pays only $10,000 S.E. tax (ie, on the 100k income portion)
• Sally undeniably seems to save $10,000

What is my question:

it seems "too good to be true." (Especially in the USA!)

In fact, is the above actually correct?

So my exact question: for Sally who makes $200,000 in 1099 income as her total income, is it a flat fact that she can save (about) $10,000 simply by using the "SCorp dodge" described?

Are there any gotchyas, or other aspects that in fact eliminate the huge gain?

(I have already heard that the "salary" (so, 100k above) has to be "reasonable", let's assume that in the example given it is "reasonable". I also appreciate there are other unrelated benefits in the US to the corp approach - say, simply being able to deduct expenses better, etc etc. Here I'm just asking about the "Self-employment tax dodge!")

cheers!

Answer 1

You pretty much have it straight. In the first case, for 2017, She would have to pay 12.4% (social security) on 127,200 of salary and 2.9% (medicare) on the full amount. That would be $15,772, and $5,800 for a total of $21,572.

In the second case, she would pay at total of $15,300.

In the case you cite there is pretty much no downside to achieve the ~$6,000 savings except perhaps for the increase in tax preparation. Filing as an S-Corp LLC can cost at least double that it takes to do a standard business return. Even if the person does the taxes themselves, this indicates the complexity.

Now let's say instead that instead Sally decides to take a salary of 30k per year, increasing her SS tax savings dramatically (21572-4590=16982). That has some consequences:

• Doing this long term will lower her social security payout.
• She could trigger an audit by the IRS and they could find that she is being too underpaid.
• If she becomes disabled, and is relying on social security disability her benefit may be drastically reduced.
• If she is in a partnership, all partners would also be required to participate in the dividend disbursement.

So there are drawbacks. For the numbers you are suggesting, saving 6k when making 200k does not seem like the increase in complexity is worth it.

The far better benefit takes place in being able to do a solo-401K. There Sally could do her 18K max, but also the company can contribute 25% of profits as a match. In this case, that would be over 50K. Sally could easily meet the 54k max (2017), greatly outpacing her peers for retirement savings and saving money on her top marginal rate.

Answer 2

On the surface I agree with the previous responses, however, since you are for tax purposes an employee, some states will require to you to carry workman's compensation insurance, and unemployment insurance (state & federal). In addition, there could be a higher income tax rate of the IRS believes you are a personal service corporation. Something not generally thought of as a positive is you social security income on retirement which can be higher based on your annual salary. However, there is an allure to the S Corporation.

Answer 3

You are fundamentally wrong. The self-employment tax is actually not really a tax per se. It is the part of your FICA taxes that ordinarily would be paid by the employer.

The ordinary FICA tax rate for employees is 6.2% for Social Security, plus 1.45% for Medicare (7.65% total), up to the cap. In addition, the employer pays the same amount, called payroll taxes.

If you work on a 1099, your self employment tax is simply the sum of these two, or 15.3%. Half of that is tax deductible (because the employer part for an employee is also tax deductible).

The following is slightly simplified and not 100% accurate, but will give you the idea.

Let's say Sally works on a 1099 and makes $100k. Assuming no other deduction, her self employment tax would be $15,300.

If she funnels the money through a corporation, she would be an employee of that corporation. The corporation would pay $7650 in payroll taxes, and she would pay $7650 in FICA taxes.

Now if the corporation only paid her $50k as salary, and another $50k as profit distribution, you would be theoretically correct - but the IRS would go after her for tax evasion. Converting earned income (a salary or the like) into unearned income (profits, dividends) is illegal for exactly that reason.

In the end, of course sometimes profit distributions are legitimate. The IRS would look at the totality of the circumstances. But what you described sounds like a fairly obvious case.

Answer 4

First of all SE tax tops out at income around 100K. That is, if one earns 200K, SE tax is only calculated on the first 100K. So the example doesn't quite illustrate the question.

Second, SCorp earnings are recognized by shareholders as they occur. So the 200K the SCorp earns has to be considered as income by the shareholders regardless of whether the income was paid out or not.

So, Earning through an SCorp will have almost no effect on actual total taxes owed.