Social Security tax changes will affect choice of business entity Attorneys and accountants regularly face the question from their business owner clients about the form of business entity they should use to conduct their business operations.    The principal choices are usually divided among the regular corporation, subchapter S corporation or limited liability company (“LLC”). The subchapter S corporation still remains the most popular choice for taxable entity although the LLC has grown dramatically in popularity. Making the right choice of business entity will grow in importance based upon recent proposals about the way in which employment earnings are taxed for Social Security purposes. The ongoing concern over the Social Security trust fund and its solvency is a political issue in this presidential election year. Democratic candidate Barack Obama has suggested increasing the level of employment income subject to Social Security taxation, including removing some of the income caps on those taxes.   While not explicitly endorsing an increase in Social Security taxation, Republican candidate John McCain has acknowledged that “nothing is off the table.” The looming potential of significant increases in Social Security taxes will affect entity selection, particularly for those owners who face the choice between using a subchapter S corporation or an LLC. Congress imposes Social Security taxes on employees and their employers under the Federal Insurance Compensation Act (“FICA”) and self-employed individuals under the Self–employment Tax Act (“SETA”). The FICA tax is comprised of two components: the Old Age Survivor and Disability Insurance program ("OASDI") imposing tax at the rate of 12.4 percent of employment income and the Medicare portion imposing tax at a rate of 2.9 percent. The FICA tax is split equally between employer and employee. SETA imposes the entire combined OASDI and Medicare tax of 15.3 percent on the self-employment income of the individual, although individuals may deduct one-half of the SETA tax in calculating their adjusted gross income. The OASDI portion of the FICA and SETA tax is capped at $102,000 for 2008, while the Medicare portion is not limited by any cap. If the cap on the OASDI portion is eliminated or substantially raised, subchapter S corporation owners may enjoy a tax advantage over LLC owners in that such a corporation will typically pay its active owner a base salary and perhaps a bonus. It will distribute any cash in excess of salary and bonus to the owner as a dividend. The dividend distribution is not subject to Social Security taxes. LLC owners who are active in conducting business on behalf of the LLC do not have the ability to choose between receiving payments as salary or dividends. The IRS treats LLC owners as self-employed individuals and expects all of the income allocable to active LLC owners to be employment income subject to SETA. This distinction creates a potential advantage for using the subchapter S corporation. The following example illustrates potential for dramatic differences in the after tax income of business owners using different entity forms. Assume Jane Smith is the sole owner of a distributor that generates $200,000 of net income that can be distributed to her. Further assume that there is no longer a cap on the OASDI portion of the FICA or SETA tax. If Jane conducts her business as a subchapter S corporation, she can choose to pay herself a salary of $100,000 and pay herself a dividend of $100,000. Her total FICA tax liability (employer and employee) will be $15,300. Now, assume that Jane is the single member of an LLC. All of the income from the LLC is allocated to her. She would pay SETA tax of $30,600 or double the amount of the subchapter S owner. She would be entitled to deduct $15,300 of the SETA tax in calculating her adjusted gross income, so that the net effect of the LLC form is not double the tax, but it is nonetheless substantial.   The IRS is already aware of the existing payroll tax advantage that subchapter S corporations enjoy and has actively audited such owners if it believes the subchapter S corporation is not paying a reasonable salary to the active owner. Many subchapter S owners who are active in their business operations will pay themselves little or no salary to reduce or avoid exposure to FICA tax. The IRS will usually seek to resolve this during audit so that the business owner recharacterizes dividends as salary up to the level of the OASDI cap. Congress may also respond by attempting to change the treatment of subchapter S dividend distributions in tandem with any substantial increase in Social Security taxes. Business owners need to be cognizant of the dramatic effect that changes in Social Security taxation may have on them and make sure that they can adapt to new Social Security tax legislation from Congress. The information in this article is intended for general purposes only and does not constitute legal advice.  Readers should not act upon the information in this article without individual professional counseling Ken Clingen, J.D., C.P.A., specializes in business counseling and tax planning as a founding member partner of Clingen Callow & McLean LLC, a full-service law firm of business advisers and counselors based in Wheaton.   Contact him at 630-871-2608 or at clingen@ccmlawyer.com.

Posted on Monday, October 20, 2008 (Archive on Monday, October 27, 2008) Posted by jstoltz  Contributed by jstoltz

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