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Self-Employment Tax Minimization: Effect on Social Security Benefits

Posted on August 1, 2016 by Scott Fouch and Stacey Kaden

 

Owners of small businesses must consider many factors when choosing the legal structure of their business. One of the most important considerations is the effect of the business structure on the amount of income subject to the self-employment tax. For many taxpayers, self-employment taxes can exceed the federal and state income tax liabilities combined. Not surprisingly, practitioners have devised strategies to reduce the amount of income that is subject to the self-employment tax. Taxpayers are generally receptive to any strategy that reduces the amount of taxes they have to pay. However, minimizing self-employment taxes comes with a cost because the major component of the self-employment tax is Social Security. Any reduction in Social Security taxes paid will also reduce the amount of Social Security benefits received by the taxpayer at retirement. This article examines the effect of self-employment tax minimization strategies on Social Security benefits at different income levels and the potential retirement income that could be generated if the self-employment tax savings are reinvested.

Self-Employment Tax

 


The self-employment tax consists of two main taxes: Social Security and Medicare. The Social Security tax is 12.4 percent of self-employment income, with self-employment income limited to the maximum Social Security tax base.1 The tax base is indexed for inflation and is $118,500 for 2016.2 The Medicare tax is 2.9 percent of self-employment income with a 0.9 percent surtax on self-employment income exceeding a specific threshold based on the taxpayer's filing status.3 There is no maximum base for Medicare. For income tax purposes, the taxpayer is allowed a deduction for one-half of the self-employment tax paid (not including the surtax) in calculating adjusted gross income.4

 

Sources of Self-Employment Income

 


Net earnings from self-employment are used to determine both the amount of self-employment tax paid and the future Social Security retirement benefits.5 Net earnings from self-employment include net income earned by an individual from the conduct of any trade or business.6 To the extent that an owner operates a small business as a sole proprietorship, the net income from the business will be subject to self-employment taxes. A general partner in a partnership includes the distributive share of income from a trade or business as self-employment income.7 A limited partner includes only a guaranteed payment received for services provided to the partnership as self-employment income and not the distributive share of income from the partnership.8 The treatment of limited liability company members is less clear because a lack of authoritative guidance and because an LLC member may have characteristics of both a general and limited partner.9

 

Strategies for Reducing Self-Employment

 


Two recent Tax Notes articles analyzed strategies that practitioners have recommended to taxpayers to reduce their self-employment tax liability.10 The most common strategy is implemented through the formation of an S corporation. An S corporation differs from a sole proprietorship or partnership in that the distributive share of trade or business income from an S corporation is not subject to the self-employment tax. The only caveat is that the S corporation must pay a reasonable salary to any shareholder providing services to or on behalf of the corporation. The owner-shareholder pays employment taxes (Social Security and Medicare) on the salary received, but the remaining income from the business is not subject to the self-employment tax.

 

The second strategy, which has been used in multi-member LLCs, makes use of the special treatment of limited partners for self-employment tax purposes. LLC members are given guaranteed payments equivalent to the fair market value of services provided to the LLC. The LLC members are then treated as limited partners, and only the guaranteed payment is considered self-employment income. Alternatively, the LLC can issue two types of membership units. Membership units representing a passive investment in the LLC are treated as limited partnership interests and are not subject to the self-employment tax. Membership units representing operational control are considered general partnership interests and are subject to the self-employment tax. A single individual could own both types of membership interests. This strategy carries a greater risk because the tax treatment lacks clarity.11

Calculating Social Security Retirement Benefits

 


Knowing how Social Security benefits are determined helps in understanding the effect of any self-employment tax minimization strategy on those benefits. Social Security retirement benefits are based on the average indexed earnings (self-employment or salary) during the 35 years in which the retiree earned the most. Therefore, any tax planning strategy that reduces the amount of reported earnings that would have been included in the 35-year base period will directly affect the amount of the retirement benefit.

 

Retirement benefit calculations start with average indexed monthly earnings (AIME).12 AIME is calculated by summing annual earnings for the highest 35 years (not to exceed the maximum Social Security earnings base for any year), adjusting to current-year dollars, and then dividing by 420 months. Given AIME, the table below can be used to determine a retiree's monthly Social Security benefit:

                      Table 1. Monthly Retirement


                       Benefits Schedule (2016)a
 ______________________________________________________________________

 If AIME Is     But Not
 More Than:     Over:    The Monthly Social Security Benefit Is:
 ______________________________________________________________________

      $0           $856  90% of AIME
    $856         $5,157  $770 plus 32% of the excess AIME over $856
  $5,157         $9,875  $2,146 plus 15% of the excess AIME over $5,157
  $9,875b            --  $2,854
 ______________________________________________________________________

                          FOOTNOTES TO TABLE 1

      a 2016 Social Security Administration SSA Publication
 No. 05-10070.

      b Max base for 2016 of $118,500/12 = $9,875.

                      END OF FOOTNOTES TO TABLE 1

Because the statutory percent gets smaller as average monthly benefits rise, the return generated on Social Security tax payments decreases. Table 2 shows the after-tax annual Social Security tax paid, the after-tax future annual Social Security benefits, and the internal rate of return (IRR) at various income levels generated from Social Security. The calculations are based on a single self-employed individual who turns 30 in 2016 and begins receiving retirement benefits at age 67 (full retirement age). The IRR is calculated assuming the taxpayer takes the standard deduction, has no income other than the self-employment income before retirement, and Social Security is the only income at retirement.13 For simplicity, 2016 income, self-employment tax, and Social Security rules and rates are used for all calculations. The calculation uses a 19-year term for retirement benefits, which is based on the average of the male and female life expectancy for age 67.14

                 Table 2. Returns on Social Security Taxes Paid


 ______________________________________________________________________________

 Self-Employment Income Level           $20,000    $40,000   $80,000   $120,000
 ______________________________________________________________________________

 Annual Social Security tax paid        -$2,176    -$4,237   -$8,016   -$11,818

 Annual Social Security benefit         $11,868    $17,779   $27,560    $33,101

 Total return on Social Security
 taxes                                 $144,980   $181,032  $227,048   $191,653

 Internal rate of return                  3.56%      2.67%     1.99%      1.28%
 ______________________________________________________________________________

                               [table continued]
 ______________________________________________________________________________

 Self-Employment Income Level                $170,000   $220,000   $280,000
 ______________________________________________________________________________

 Annual Social Security tax paid             -$12,637   -$12,269   -$12,269

 Annual Social Security benefit               $34,253    $34,253    $34,253

 Total return on Social Security
 taxes                                       $183,238   $196,854   $196,854

 Internal rate of return                        1.17%      1.27%      1.27%

When evaluating the rate of return generated from Social Security tax payments, comparison with the risk-free rate is appropriate. Although the Social Security trust fund may become insolvent, the government's ability to print money essentially eliminates the risk that Social Security benefits would not be paid. The three-month U.S. Treasury bill rate is the most common return that is used to approximate the risk-free rate. The average rate of return on a three-month U.S. Treasury Bill since 1954 and the most recent 10-year period are provided below:

                                Table 3


 ______________________________________________________________________

 Time Period                                  Average Rate of Returna
 ______________________________________________________________________

 1954 - 2015                                            4.53%
 2006 - 2015                                             1.1%
 ______________________________________________________________________

                           FOOTNOTE TO TABLE

      a Annual 3-month U.S. Treasury bill rates retrieved from
 http://www.federalreserve.gov/releases/h15/data.htm.

                        END OF FOOTNOTE TO TABLE

The past 10 years have been a period of historically low interest rates. However, when comparing the return on Social Security with the longer period returns, the return on Social Security does not exceed the risk-free rate of return for any income level. Given the low rates of return generated from Social Security taxes paid, most alternative investments would increase the overall taxpayer's wealth. Nevertheless, when a tax planning strategy has both costs and benefits, it is incumbent on the practitioner to make sure the client fully understands both. Presenting a self-employment minimization strategy only from the tax savings side without fully explaining the corresponding reduction in retirement benefits carries potential malpractice risks. The remaining sections of this article will analyze the effects of the self-employment minimization strategies on retirement benefits and provides quantifiable results that can be shared with clients.

Effect on Retirement Benefits

 


The effect of the self-employment tax minimization strategies on pre-tax Social Security retirement benefits is relatively straightforward. A reduction in annual self-employment income in each of the following ranges would result in a corresponding reduction of annual Social Security retirement benefits by the percentage listed times the reduction in the earnings base.

 

                                Table 4


 ______________________________________________________________________

 Earnings Base Range                               Benefit Percentage
 ______________________________________________________________________

 $118,500 to $61,885                                       15%
  $61,884 to $10,273                                       32%
       $10,272 to $0                                       90%

 

  • Example 1: Assume that taxpayer, age 30, has a business that is anticipated to generate annual income of $110,000 that would normally be subject to self-employment taxes. However, using one of the self-employment tax minimization strategies, only $75,000 is included in the Social Security income base. The tax minimization strategy would result in an annual reduction of Social Security retirement benefits of $5,250 calculated as follows:

    • ($110,000 - $75,000) x 15% = $5,250

    Example 2: Assume the same facts as in Example 1, except that only $50,000 is included in the Social Security base. The tax minimization strategy would result in an annual reduction of Social Security retirement benefits of $11,020 calculated as follows:


                                Table 5
 ______________________________________________________________________

 ($110,000 - $61,885) x 15% =                             $7,217
 ($61,885 - $50,000) x 32% =                            + $3,803
                                                        ________

                                                         $11,020

Effect on Taxes Paid and Social Security Benefits

The tax savings from the self-employment tax minimization strategy will differ slightly depending on whether an S corporation or an LLC is used as the implementation vehicle.15 Because the S corporation method has the least implementation risk and can be used with single-owner businesses, the following examples are based on replacing a sole proprietorship with an S corporation that pays the owner a reasonable salary for services provided.

 

Any strategy that reduces the amount of income subject to the self-employment tax will also reduce the amount of Medicare taxes paid. Receipt of Medicare benefits is independent of the amount of Medicare taxes paid during the lifetime of the taxpayer. Therefore, the only cash-flow effect of the self-employment income tax minimization strategy related to Medicare is the tax savings generated.

Table 6 shows the annual after-tax self-employment tax savings and the corresponding after-tax annual reduction in Social Security benefits for 10 business income and reasonable salary scenarios. Table 6 presents the results for a single individual under the same assumptions that were used in Table 2.

              Table 6. Annual Tax Savings and Reduction in


                        Social Security Benefits
 ______________________________________________________________________

 Total Annual                       Annual Social     Annual
 Business          Reasonable       Security Tax      Medicare Tax
 Income            Salary           Savings           Savings
 ______________________________________________________________________

  $50,000           $30,000            $1,855              $434
  $80,000           $32,000            $4,544            $1,063
  $80,000           $50,000            $2,591              $606
 $110,000           $44,000            $6,141            $1,436
 $110,000           $70,000            $3,368              $788
 $160,000           $64,000            $5,812            $2,089
 $160,000          $100,000            $1,973            $1,191
 $250,000           $80,000            $3,986            $3,931
 $400,000          $100,000            $1,915            $8,048
 $400,000          $200,000                $0            $5,627
 ______________________________________________________________________

                           [table continued]
 ______________________________________________________________________

                                    Annual            Percentage
                                    Reduction in      Reduction in
 Total Annual      Annual Self-     Social            Social
 Business          Employment       Security          Security
 Income            Tax Savings      Benefits          Benefits
 ______________________________________________________________________

  $50,000            $2,289           -$5,176               25%
  $80,000            $5,607          -$11,362             41.2%
  $80,000            $3,197           -$5,602             20.3%
 $110,000            $7,577          -$11,678             36.8%
 $110,000            $4,156           -$4,738             14.9%
 $160,000            $7,901           -$8,175             23.9%
 $160,000            $3,164           -$2,775              8.1%
 $250,000            $7,917           -$5,775             16.8%
 $400,000            $9,963           -$2,775              8.1%
 $400,000            $5,627                $0                0%

The self-employment tax minimization strategy generates a significant tax savings under each scenario examined. Even under the most modest assumption of business income of $50,000 and a reasonable salary of $30,000, the taxpayer will see an annual reduction in after-tax self-employment taxes of $2,289. At the higher income levels, the Medicare tax savings equal or exceed the Social Security tax savings. There is a clear tax benefit from implementing the strategy, and the benefit is significant across income levels. However, it is important the taxpayer understand that any time the strategy reduces the income subject to Social Security below the maximum Social Security base ($118,500 for 2016), there will also be a reduction in Social Security retirement benefits. Under the scenarios examined, the taxpayers could lose as much as 41.2 percent of his Social Security retirement income. Only in the case of a reasonable salary in excess of the maximum wage base of $118,500, is there no reduction in Social Security retirement benefits.

Net Effect of Minimizing Self-Employment

 


Under the scenarios examined, the self-employment tax minimization strategy was implemented when the taxpayer was age 30. Therefore, the taxpayer receives the benefit of lower self-employment taxes for 37 years while the reduction in Social Security benefits will only occur for 19 years. To account for the difference in periods, Table 7 shows a comparison of the lifetime after-tax savings generated from the self-employment income minimization strategy to the corresponding lifetime after-tax reduction in Social Security retirement benefits.

 

             Table 7. Lifetime Tax Savings and Reduction in


                        Social Security Benefits
 ______________________________________________________________________

                                    Total Lifetime
 Total Annual                       Social            Total Lifetime
 Business          Reasonable       Security Tax      Medicare Tax
 Income            Salary           Savings           Savings
 ______________________________________________________________________

  $50,000           $30,000           $68,645           $16,054
  $80,000           $32,000          $168,127           $39,320
  $80,000           $50,000           $95,866           $22,420
 $110,000           $44,000          $227,212           $53,138
 $110,000           $70,000          $124,624           $29,146
 $160,000           $64,000          $215,040           $77,292
 $160,000          $100,000           $72,995           $44,072
 $250,000           $80,000          $147,493          $145,459
 $400,000          $100,000           $70,873          $297,780
 $400,000          $200,000                $0          $208,185
 ______________________________________________________________________

                           [table continued]
 ______________________________________________________________________

                                    Total Lifetime
                   Total Lifetime   Reduction in
 Total Annual      Self-            Social
 Business          Employment       Security          Net Lifetime
 Income            Tax Savings      Benefits          Cash Flows
 ______________________________________________________________________

  $50,000           $84,699          -$98,344          -$13,645
  $80,000          $207,447         -$215,883           -$8,436
  $80,000          $118,286         -$106,443           $11,843
 $110,000          $280,350         -$221,883           $58,467
 $110,000          $153,770          -$90,017           $63,753
 $160,000          $292,332         -$155,325          $137,007
 $160,000          $117,067          -$52,725           $64,342
 $250,000          $292,952         -$109,725          $183,227
 $400,000          $368,653          -$52,725          $315,928
 $400,000          $208,185                $0          $208,185

A review of the results shows that there are only two scenarios in which the taxpayer loses more in lifetime Social Security benefits than is saved through lower self-employment taxes paid. These occur at the two lowest business incomes and reasonable salary levels of (1) $50,000 and $30,000 and (2) $80,000 and $32,000. Even under those two scenarios, the incremental return on the Social Security taxes paid would be only 0.53 percent and 0.21 percent, respectively. Given those numbers, there is little doubt that a self-employment tax minimization strategy provides a significant net benefit to the small business taxpayer.

Although a comparison of lifetime cash flows can provide useful information that can be shared with the taxpayer, when reinvestment of the tax savings is considered, the potential impact of the strategy can be fully understood. To illustrate the effect of reinvesting the tax savings on retirement benefits, the five income levels at which the tax savings could be reinvested in a Roth IRA were analyzed.16 Table 8 shows the annual after-tax retirement income that could be generated if the self-employment tax savings are completely reinvested. The retirement income benefits are based on the assumption that the taxpayer reinvested the self-employment tax savings into a Roth IRA account (up to the maximum amount allowed) with any excess tax savings being reinvested into a taxable account. Results are shown assuming three investment rates of return assumptions.

                      Table 8. Reinvestment of Tax Savings


 ______________________________________________________________________________

                                                           Annual
 Total                                                     Reduction
 Annual                                                    In Social
 Business                      Reasonable                  Security
 Income                        Salary                      Benefits
 ______________________________________________________________________________

  $50,000                        $30,000                    -$5,176
  $80,000                        $32,000                   -$11,362
  $80,000                        $50,000                    -$5,602
 $110,000                        $44,000                   -$11,678
 $110,000                        $70,000                    -$4,738
 ______________________________________________________________________________

                               [table continued]
 ______________________________________________________________________________

            Average Annual Retirement
            Benefits From Reinvested                 Lifetime Increase in
 Total             Tax Savings                       Retirement Benefits
 Annual    ____________________________       _________________________________
 Business
 Income       3%         7%       10%            3%         7%          10%
 ______________________________________________________________________________

  $50,000  $10,576    $35,512   $90,320       $102,600    $576,384   $1,617,736
  $80,000  $25,842    $86,477  $219,409       $275,120  $1,427,185   $3,952,893
  $80,000  $14,769    $49,594  $126,136       $174,173    $835,848   $2,290,146
 $110,000  $33,738   $107,261  $259,394       $419,140  $1,816,075   $4,706,613
 $110,000  $19,200    $64,472  $163,974       $274,778  $1,134,946   $3,025,484

Even at the most conservative reinvestment rate of 3 percent, which is less than the historical risk-free rate, the taxpayer can more than double the retirement income lost by reinvesting the self-employment tax savings. At higher but realistic investment returns,17 the numbers are even more compelling. At a 10 percent return on reinvestment, the taxpayer would generate after-tax retirement benefits that would replace the Social Security benefits lost by anywhere from 17 to 34 times. The self-employment minimization strategy could potentially increase the taxpayer's wealth from $1,617,736 to $4,706,613, depending on the income level.

Later Implementation of the Strategy

 


The numbers above assume that the self-employment minimization strategy was implemented relatively early in the taxpayer's career (age 30). The earlier the implementation, the greater the benefit will be to the taxpayer. To look at the effects of a later implementation, retirement benefit replacement results for a taxpayer with business income of $110,000 and a reasonable salary of $70,000 were examined over time (see Table 9).

 

      Table 9. Retirement Benefits Based on Age at Implementation


 ______________________________________________________________________

                   Annual            Annual Retirement Benefits From
                   Reduction              Reinvested Tax Savings
                   In Social       ____________________________________
 Age at            Security
 Implementation    Benefits          3%           7%           10%
 ______________________________________________________________________

 30                -$4,738         $19,200      $64,472     $163,974
 35                -$4,061         $15,233      $44,319      $99,932
 40                -$3,384         $11,812      $29,950      $60,166
 45                -$2,707          $8,860      $19,705      $35,475
 50                -$2,030          $6,314      $12,401      $20,144
 55                -$1,354          $4,118       $7,193      $10,624
 60                  -$677          $2,223       $3,480       $4,714
 65                     $0            $589        $832        $1,043
 ______________________________________________________________________

                           [table continued]
 ______________________________________________________________________

                                      Lifetime Increase in
                                      Retirement Benefits
                      _________________________________________________
 Age at
 Implementation          3%                7%               10%
 ______________________________________________________________________

 30                   $274,778        $1,134,946        $3,025,484
 35                   $212,268          $764,902        $1,821,549
 40                   $160,132          $504,754        $1,078,858
 45                   $116,907          $322,962          $622,592
 50                    $81,396          $197,049          $344,166
 55                    $52,516          $110,941          $176,130
 60                    $29,374           $53,257           $76,703
 65                    $11,191           $15,808           $19,817

As expected, the later the self-employment minimization strategy is implemented, the lower the net benefit to the taxpayer. However, even an implementation date as late as age 60 provides a significant increase in annual retirement benefits across investment return assumptions. Although there is likely a time at which the costs associated with changing the business structure will outweigh the benefits, the data suggest that date would be very close to the taxpayer's time of retirement.

Other Factors Related to Social Security Benefits

 


Social Security provides benefits other than just retirement income. A strategy that reduces Social Security taxes will also reduce potential disability benefits and survivor benefits for a taxpayer's child.18 Once a reasonable salary is determined, the practitioner should discuss the potential reduction in disability and survivorship benefits to determine if additional private insurance is needed.19

 

For married taxpayers, minimum Social Security retirement benefits are one-half of their spouse's Social Security. If a spouse has no earned income, he will still receive one-half of the taxpayer's Social Security at retirement even though no additional Social Security taxes were paid. The previous scenarios were run for married taxpayers using similar assumptions. Although there were more scenarios in which the reduction in lifetime Social Security benefits exceeded the lifetime self-employment tax savings, the highest incremental return on Social Security taxes paid was 1.37 percent. Therefore, the planning strategy is relatively unaffected by marital status.

Conclusion

 


Taxpayers must consider many factors when choosing the business structure for a small business. This article makes it clear that the effect of the business structure on the taxpayer's income subject to self-employment taxes should be considered for every profitable small business. A self-employment minimization strategy provides significant net savings for taxpayers. The results hold true at all business income and reasonable salary levels and virtually all implementation dates. Taxpayers who choose to reinvest their Social Security tax savings could increase their retirement income well in excess of a million dollars. However, as most practitioners are aware, many taxpayers will simply reinvest the Social Security tax savings in the business or find other uses for the savings. Therefore, if the self-employment minimization strategy is to be implemented, it is critical that the practitioner make the taxpayer aware of any potential reduction in Social Security benefits so that alternative retirement funding can be considered at the time of implementation.

 


FOOTNOTES


1 Section 1401(a).

2 IRS, News Release IR-2015-119 (Oct. 21, 2015).

3 Section 1401(b).

4 Section 164(f).

5 Net earnings from self-employment are reduced by one-half the self-employment tax rate multiplied by the net earnings from self-employment without regard to the base limit. Alternatively, net earnings from self-employment are simply multiplied by 0.9235. Section 1402(a)(12).

6 Section 1402(a).

7Id.

8 Section 1402(a) and 1402(a)(13).

9 For more discussion of classification issues for LLCs, see Claire Y. Nash, "Ending De Facto Self-Employment Tax Holiday for LLC Members," Tax Notes, Sept. 13, 2010, p. 1164.

10 Donald B. Susswein, "Limited Partners and the Self-Employment Tax," Tax Notes, Jan. 12, 2015, p. 259; Willard B. Taylor, "Payroll Taxes -- Why Should We Care? What Should Be Done?" Tax Notes, Nov. 26, 2012, p. 983.

11See Susswein, supra note 10.

12 Social Security Administration "Social Security Benefit Amounts," available at https://www.ssa.gov/oact/cola/Benefits.html.

13 It is also assumed that the income at age 30 exceeds any income that would have been earned before that time. Therefore, only income earned at age 30 and after would be included in the Social Security base.

14 Social Security Administration, "Retirement & Survivors Benefits: Life Expectancy Calculator," available at https://www.ssa.gov/oact/population/longevity.html.

15 Only 92.35 percent of self-employment income is subject to Social Security and Medicare taxes whereas the full salary paid to an employee would be subject to the taxes.

16 Roth IRA contributions are completely phased out at a modified adjusted gross income of $132,000 for a single taxpayer in 2016 (Notice 2015-75, 2015-46 IRB 668). Taxpayers in the last five scenarios would not be eligible to participate in a Roth IRA.

17 The average annual return on a diversified all-stock portfolio since 1928 is 10.1 percent, and the average annual return on a diversified 40 percent stock and 60 percent bond portfolio is 7.8 percent; see Vanguard Group, "Vanguard Portfolio Allocation Models," available at https://personal.vanguard.com/us/insights/saving-investing/model-portfolio-allocations.

18 SSA, "Social Security Understanding the Benefits," Publication No. 05-10024 (Mar. 2016).

19 The potential reduction in benefits can be calculated using the SSA's "Social Security Online Benefits Calculator," available at https://www.ssa.gov/oact/quickcalc/.


END OF FOOTNOTES