S Corp election can often save Medicare (3.8%) and FICA (12.4%), or social security, taxes when profits are taken as distributions rather than wages. Distributions aren’t subject to the Medicare and FICA taxes but wages are. There are articles all over the internet about how S corp election “can save you money in taxes.” But it’s unusual to see an article about how S corp election can increase your taxes. So here we go.
Top line summary: in some instances, FICA and Medicare tax savings from S Corp election cold be offset or eclipsed by paying the employer half of the FICA tax (when running your S corp payroll), potential decrease in the pass through deduction (especially true if spouse works for your practice or stay at home), decreased retirement plan matching (which is based on S Corp wage but not distributions), cost of S Corp tax prep, local and state corp/ franchise taxes on S corp distributions (in certain jurisdictions), increased unemployment taxes and de minimus payroll expenses and perhaps workmans compensation costs in certain states.
As a recall, S corp election saves you payroll (fica and Medicare taxes) for the part you elect to take as distribution. Fica taxes of 12.4% end once your wage is $147,000 for 2022. So assuming you take a 50/50 between wage and distribution, and have no other W2 job, it is more beneficial if your total profits fall UNDER $294,000 because this would allow you to eat into the fica tax.
Assuming all your income is from self employment, you had a profit of $200,000, S corp election with $100,000 wages and $100,000 in distributions vs sole proprietor profits of $200,000 would save you about $8900 in FICA and Medicare taxes; if a profit of $340,000 S Corp with $170,000 wage and $170,000 distributions vs sole proprietor would save $6100 in Medicare taxes. The $200,000 wage is over the FICA limit so you’re only saving on Medicare taxes.
But sometimes this can be offset by the pass through deduction. This was part of the tax law when Trump passed in 2017. 20% of QBI (qualified business income) can be taken as a tax deduction. QBI is the entire sole proprietor profit, but ONLY the S corp DISTRIBUTION but not the wage. So looking at the example above of a profit of $200,000, the sole proprietor gets to not pay taxes on 20% of $200,000, or $40,000- approximately a $8800 tax break. But the S corp only gets the tax break on the 20% of the $100,000 S corp distribution, or $20,000- approximately a $4400 tax break. So the tax savings from S corp election would be $8900-4400 or $4500, rather than the full $8900.
In the second example, the sole proprietor gets to not pay taxes on 20% of $340,000, or $68,000. At the 24% marginal rate this is a $16,320 tax break. But the S corp election gets you half that or $8160. The difference between the sole proprietor and S corp is $8160 in favor of the S corp. The Medicare tax savings by electing S corp is $6100. Last time I checked, I’d rather get a $8160 tax break than a $6100 tax break! NOT electing S corp is $2000 more in your pocket.
For those of you whose main source of a income is a W2 jobs in addition to a 1099 side gig or solo practice, S corp election doesn’t make sense until your business profit is high. Besides the potential of health care and a 401K as an employee in the W2 job, they pay both the employee AND employer portion, each 6.2%, of the FICA/ social security tax.
If you made $147,000 from a day job, which many MDs do, you would likely LOSE money by electing S corp taxation, unless your profits were over $300,000. Why? Because if you elected sole prop, your self employment taxes are on form SE and your W2 job maxes out the FICA portion. You’d only pay the Medicare tax, but not the 6.2% FICA tax.
But if you elect S corp, you run payroll for your own wages. Both the employee and employer portion of FICA tax (6.2% each, 12.4% total) is automatically withheld from your own paycheck. See form 941, line 5a. But you get a refund ONLY on the EMPLOYEE but NOT the employer part of the FICA tax. Don’t believe me? It’s schedule 3, line 10- “excess social security tax”, you get 6.2% back.
So if you have a W2 job and elect S corp, you’re paying a EXTRA 6.2% of taxes on the exact amount that your W2 wage was. You’d have to take 1.63 times your W2 wage in distributions from your solo practice to break even (6.2 divided by 3.8). Example: you earn $50,000 from a day job. If you elect S corp, you pay a extra $3100 in employer FICA taxes. To break even, you’d need to take $81,600 as a distribution rather than wage. If you did 50/50 wage/ distribution then you’d need at least $162,000 of profits to even consider electing S corp. And this doesn’t even include state/ local tax on S corp, accounting fees, perhaps increased unemployment taxes workmans comp and payroll fees.
Hypothetically if you made the full FICA limit $147,000 in wages as a W2, you’d need to take $239,610 in distributions, which means your side gig would have to make $386,6100 just to break even!
But wait, there’s more! What about the cost of tax prep- what does your accountant charge for form 1120s vs schedule C? I’ve done both of these myself, and form 1120S is more complicated and time consuming, especially if your business has assets. Accountants will charge you more for a S corp return.
There’s also the cost of payroll- this is de minimums for Gusto extra $5/ month or $60/ year
If you’re running a business with employees, in most states you’d pay extra unemployment taxes with S corp election. Because I had more unemployment insurance base salary (this happens when you hire any new employee, not just yourself), my unemployment tax rate jumped from 0.05% to 7.25% even without any claims against me! Arizona has base of $7000/ employee, with three employees that’s a extra $1506 in tax per year (which will eventually go down as long as I don’t have any unemployment claims).
You also might be responsible for extra workmans comp insurance- check to see if your state exempts the S Corp owner some do, some don’t. Maybe another $500.
Also, retirement plan contributions based on S Corp wage and not distribution. For sole proprietors, they are based on the entire profit. This matters most if you have a SEP IRA or 401k and are matching 20- 25%. For example, if you had a profit of $100,000 as a sole proprietor after self employment taxes, you could defer $20,000. But on the same $100,000 profit, if you take a $45,000 salary you could defer 25% or $11,250, and take a $43,750 distribution. It would It doesn’t make much of a difference if you have a simple IRA because you’re matching 3%. An extra $9750 deferred (which means it would eventually be taxed later) would save $2340 in taxes this year.
Before anyone thinks I’m against electing S corp- I elected S corp myself and am glad I did. I’m saving mid four figures in Medicare taxes each year for 2019-22 (offset by at least $2500 increased unemployment taxes, cost of tax prep software, slightly more of a PITA to do accounting- more time spent by me). Retrospectively, I should’ve first elected S corp in 2018, would’ve saved another $3000, the years before that wouldn’t have made much of a difference.
To sum it up, ask your accountant “what instances does it make sense to NOT elect S corp but stick with sole prop to save taxes?” If your accountant can’t tell you: 1. When the pass through deduction savings exceeds S corp distribution Medicare tax savings, or 2. When you have a W2 job and your solo practice FICA employer withholdings exceed your S corp distribution Medicare tax savings, or 3. When a combo of the above with state S Corp tax/ unemployment taxes/ tax prep fees exceeds distribution Medicare tax savings, then your accountant knows less about tax planning than certain ophthalmologists. Just saying.
Anyway, I searched high and low on the internet. Most articles will tout how much you’ll save by electing S corp. I could only find one single other article (link below) about when NOT to elect S corp:, written by a tax attorney and CFP. Although he agrees with me regarding the pass through deduction, he also forgot to write about how if you have another W2 job, you could lose money electing S corp.
I digress, but he made an error on the paragraph “determining the perfect salary”- if you take $200K profits as $100K wage/ $100K distribution you save $8207 in taxes, not $15,300. He forgot the (2021) FICA limit ends at $142,800 and calculated it all the way up to $200,000. Tsk, tsk….
OK, I can’t resist one last hypothetical. I’d love to see any of you ask your accountant, “when do you save taxes by NOT electing S corp but staying as a sole prop?”
Let’s consider an anesthesiologist who’s married and spouse doesn’t work. They are employed part time with a W2 of $142,800 (the 2021 FICA tax limit, ironically), and 1099 income totaling $187,000 (again ironically the 2021 limit for the pass through deduction when added to the W2 wage).
This anesthesiologist read on a physician finance blog that money could be saved by electing S corp (rather than sole prop/ disregarded entity without a LLC) so asked their accountant who agreed to file the forms for election (charging the doc $1500 to create the LLC and electing S corp, and charging a extra $500 for tax prep).
The accountant aggressively divides the $187,000 S corp profit to a $74,800 wage and $112,200 distribution (40/60). The accountant tells the doc that they didn’t have to pay Medicare taxes of 3.8% on the distribution so the S corp election saved a whopping $4200 (3.8% of $112,200) in taxes. Sounds good yes- that’s enough cash to buy a NBA finals fifth row ticket AND a Peloton bike plus!
Wrong. Again, don’t focus on one tax break at the expense of others. Look at the big picture. My goal is to maximize by bank and brokerage account, not reduce my taxes (or one type of tax at the expense of others, in this instance).
The doc also pays Gusto $600/ year to run payroll on their own W2 wages (hey, the $600 is tax deductible, less taxes right?). When the accountant runs the payroll, both halves of the FICA and Medicare tax are withheld from the S corp $78,000 wage. The employee half of the FICA taxes are given back as a credit on form 1040. After this refund, $6800 in FICA/ Medicare taxes are paid on the $78,000 wage. Of course, zero fica/ Medicare taxes are paid on the $112,200 distribution- this is why the accountant and doc think they saved $4200.
As a sole proprietor, this doc would pay Medicare taxes on the sole prop profit of the entire $187,000, but not FICA taxes- the W2 job has covered this. Medicare taxes turns out to be about $6141. Last time I checked, paying $6141 in taxes is less than paying $6800 in taxes.
But this doesn’t even take into account the pass through deduction. The sole prop gets the pass through deduction on the entire $187,000 profit; the S corp only on the $112,000 distribution. The difference of $75,000 at the 24% marginal tax rate is $18,000; the pass through deduction is 20% so that’s a extra $3600 cash (post tax) as a sole prop.
So far the sole prop is ahead by the $659 in FICA/ Medicare taxes, $3600 pass through deduction, $450 post tax for gusto payroll, and $1500 post tax accountant fees for S corp vs sole prop. This is $6209 that the sole prop is ahead- certainly NOT the $4200 that the doc and their account think S Corp election saved them.
To add insult to injury, the doc has a SEP IRA and lives in California or Illinois where there’s a 1.5% tax on S corp profits (but no tax on sole prop disregarded entities if no LLC formation). This business tax of 1.5% on the S corp distribution of $112,200 is another $1680 down the tubes.
And because SEP IRA is calculated on sole prop profits or S corp wages but not distributions, the sole prop can defer $37,400 but the S corp can only defer $18,700 into the SEP. Recall that SEP/ 401k are just a way to defer taxes (you still pay them at the future on withdrawal), but for argument’s sake, if you’re at the 24% tax bracket, deferring $37,400 rather than $18,700 saves another $4675 in taxes on this years’ return.
Total of $4675 from SEP plus $1680 extra S corp state tax plus $6209 from the paragraph above: electing S corp puts you behind $12,500.
Despite being behind $12,500, this doc who thinks she “saved $4200 in taxes thanks to my genius accountant” recommends her accountant to everyone in the doctors lounge…
(OK my calcs above don’t take into account that half of fica/ Medicare taxes are tax deductible but you get the idea… and as I said before, I myself have saved a ton with S corp election. But my point is situations can be different)
Also wanted to point out in some states a MD solo practice must be a Corp rather than a LLC- meaning that you can’t be taxed as sole prop. It almost never makes sense for us to be taxed as C Corp so a S Corp election is wise- even though the taxes would be higher than a sole prop which isn’t allowed.
One such state is California. Not only do you pretty much have to elect S Corp, but there’s a 1.5% business tax on distributions which offsets the 2.9-3.8% Medicare tax saved. So for every $100,000 you take in distributions you only get a $2400 tax break rather than the $3800 I get here in Phoenix. And many counties have additional taxes… guess someone has to pay for all the free stuff for poor people!
After I wrote all this, someone in our google group pointed out, being an LLC and taxed as a sole proprietor also gives you some extra tax benefits if you decide to hire your own child. You don’t have to pay any payroll taxes or income taxes. This could save you a few thousand dollars a year, depending on your income.
And after I wrote this email, many states incorporated a pass through workaround of the SALT dedication. A S corp owner can pay business taxes on their S corp distribution, which reduces their business profits. If their business profits are lower, then they pay less federal taxes. The business tax is a dollar for dollar credit on their state personal taxes.
Example: in Arizona my state tax rate is 4.5%. If I have $100,000 S corp distribution I can elect to pay $4500 in business tax. This amount is credited towards my individual state return ($4500 discount) so the net amount to the state is unchanged. But with $4500 less in business profits at the 35% marginal bracket, I save $1575 in federal taxes.
The higher your marginal state tax rate is and the higher your S corp distributions are, the more you will benefit from this. It does offset some of the advantages I describe above, particularly if you live in a high tax state like California.