Should you convert your Single Member LLC to an S-Corporation?
Submitted by Bryan Eto, CPA BeachFleischman
The federal self-employment (SE) tax just keeps going higher and higher. If you’ve reached the breaking point, there may be a way to tame the SE tax beast by converting your existing unincorporated small business into an S corporation.
How to evaluate the option
If you’re a self-employed individual — meaning a sole proprietor, partner, or in some instances an LLC member — you have to pay the SE tax on your net SE income. The SE tax has two parts:
The 12.4% Social Security tax
Social Security tax is due on net SE income up to a certain amount. Unfortunately, the ceiling goes up every year because of inflation adjustments. For 2017, the Social Security tax ceiling is $127,200 (up from $118,500 for 2016).
The 2.9% or 3.8% Medicare tax
The Medicare part of the tax is due on an unlimited amount of net SE income. In other words, there’s no ceiling.
So until your net SE income exceeds the Social Security tax ceiling of $127,200 in 2017 (up from $118,500 for 2016), you owe the SE tax at the painfully high rate of 15.3% consisting of 12.4% Social Security plus 2.9% Medicare.
After the ceiling is exceeded, the Social Security tax portion drops away, and the SE tax rate falls to 2.9% to cover the Medicare tax. However, the Medicare tax jumps to 3.8% once your self-employment income exceeds the applicable threshold ($200,000 for unmarried individuals or $250,000 for married couples filing jointly).
Note: The tax results are the same if you operate your business as a single-member LLC, which is treated as a sole proprietorship for federal tax purposes.
While the SE tax is painful now, it’s could get worse in the future.
So it may be time to consider an S corporation conversion. Reason: The SE tax doesn’t apply to earnings from an S corporation business.
However, the FICA tax applies to salary compensation paid to an S corp shareholder-employee. In 2017, the FICA tax rate is 15.3% on salary up to the $127,200 Social Security tax ceiling. Salary above the Social Security tax ceiling is subject to a 2.9% or 3.8% FICA tax rate to cover the Medicare tax.
The employee share of the FICA tax is withheld from an S corporation shareholder-employee’s salary; the other portion is paid by the corporation directly to the U.S. Treasury.
The Tax Savings
The FICA tax is only due on an S corporation shareholder-employee’s salary. So when the company pays only a portion of its profits to the owner, or owners, in the form of a reasonable salary, with the remaining portion paid out in the form of cash distributions, only the salary portion is hit with Social Security and Medicare taxes (in the form of the FICA tax). The profits paid out as cash distributions are exempt from the FICA tax (and exempt from the SE tax too).
These tax-saving results are not a one-time phenomenon. You can collect similar Social Security and Medicare tax savings, or better, in future years if the business maintains or exceeds its current level of profitability.
Converting an unincorporated small business into an S corporation is not a great idea in all situations but it works for some businesses. Consult with your tax advisor for more information.
Beach Fleischman 2201 E. Camelback Rd. Phoenix, AZ 85016 602.265.7011 | http://beachfleischman.com | twitter: @BeachFleischman