09 May 4 Things Doctors Should Consider Before Using An S-Corporation
You’ve all probably heard at one time or another how incorporating or forming an LLC can save you money on your taxes. The reality is much more complicated and the real answer is that it depends on your situation.
Let’s get the basics out of the way to be sure we’re all on the same page. An S-corporation is NOT a legal entity like an LLC or corporation is. Rather, it is a set of tax rules found in Sub-chapter S of the Internal Revenue Code. This set of tax rules can apply to either an LLC OR a corporation so long as the right form is filed with the IRS and the other rules are met.
The S-corporation rules follow what is called “pass-through” taxation which means that the owners are taxed directly on the profits of the company. If the company has $50,000 of profit then the owners are going to be taxed on $50,000 of income regardless of how much money, if any, they received from the business.
Partnerships also offer pass-through taxation but the partners must also pay “self-employment tax” on their share of the profits while S-corporation owners do not. The self-employment tax is the equivalent of payroll taxes for employees but the self-employed person/partner is responsible for the full 15.3% tax. Normally the 15.3% is split between the employer and employee.
For S-corporation owners, their share of the profits are NOT subject to self-employment tax but there’s a catch. They must pay themselves a “reasonable salary” which is subject to payroll taxes. This means an S-corporation owner is taxed in two ways – through wages received and through their share of profits. To be clear, this isn’t double taxation but just a mechanical reporting difference. And this leads us to the first consideration –
1. Reasonable Salary
As you likely surmised, we have incentive to make an S-corporation owner’s salary as low as possible to avoid paying payroll taxes. The IRS is very aware of this and will often audit S-corporations who they think are paying too little salary.
The determination of what is a reasonable salary is very subjective but we do have several court cases on the topic. The gist of the case law is that the salary has to reflect the value of the services rendered by the owner to the company. The cases often look to comparable salary data to determine what is reasonable.
This is where it gets difficult for doctors. For an S-corporation to be worth it, there needs to be a big enough spread between the salary and total profit before salary. Here’s an example –
In the high salary example there’s only $87,685.20 of income NOT subject to any type of payroll taxes. For those math whizzes out there, this is only a 2.9% savings when compared to a partnership. What gives? I thought employment taxes were 15.3%?
It’s 15.3% on the first $132,900 in 2019. After that it’s only 2.9%. Most of the savings comes when you get your salary below the $132,900.
Once your income subject to payroll taxes gets above the $132,900 the savings from an S-corporation are a lot less. This poses a challenge for doctors because in nearly every setting a reasonable salary for a doctor will be above the $132,900.
And for reference, the $132,900 is adjusted each year. That’s just the amount for 2019.
One strategy is to set your salary at or just below the $132,900. You can still get savings to make it worthwhile but not have the savings be so big that you’re an easy target for the IRS. As the saying goes, pigs get fat but hogs get slaughtered.
2. Qualified Business Income Deduction (QBI)
Starting in 2018, business owners and the self-employed could claim a deduction equal to 20% of their “qualified business income”. The calculation of the deduction is actually quite complex so I’m going to oversimplify to demonstrate one aspect of it. Any salary you pay yourself does not count towards the 20% deduction. This means the very act of switching to an S-corporation and paying yourself a salary reduces your QBI deduction. Here’s an example –
As you can see there’s a substantial difference in the QBI deduction by switching to an S-corporation.
There are other factors around the QBI deduction such as the taxable income limit. This prevents doctors (and other specified fields like accounting) from claiming the QBI deduction once their income gets to a certain point.
The creation of the QBI deduction made S-corporations less beneficial than before for many taxpayers. And because it’s so complex, the only real way to plan for this is to run different scenarios and see how each one comes out.
3. Retirement Plan Options
In a partnership and sole-proprietor setting, the amount you can contribute to a SEP-IRA and 401(k) is based off of your total income. In an S-corporation it’s based off of your salary.
Setting a lower salary can in many cases reduce the amount you’re able to contribute to your retirement plan.
4. Salary From Other Sources
If you are a full-time employee somewhere and moonlight, using an S-corporation for your moonlighting will almost certainly cost you more in taxes.
Remember the $132,900 cap we talked about in the Reasonable Salary section? That comes into play here. If your normal job is paying you $275,000 and you earn another $50,000 moonlighting, you’re only going to pay 2.9% in self-employment tax on the $50,000.
If you decide to use an S-corporation for the moonlighting, the S-corporation will have to pay the full 15.3% on your salary. When you file your tax return you can get half of the excess payroll taxes refunded but the employer portion your S-corporation paid isn’t coming back.
This is because each individual only climbs the $132,900 ladder once. But each employer has to climb the $132,900 ladder for each employee even if that employee is already earning more than that amount from another employer.
An S-corporation can produce tax savings in certain circumstances. But as the points above show, saving in one area like payroll taxes can hurt you in another area like how much you can contribute to retirement.
I’ve found that running the numbers with and without an S-corporation is the only way to really know if it’s worth it because of these competing factors.