President Obama recently presented his federal budget proposal for fiscal year 2015. The president envisions the government spending $3.901 trillion and collecting $3.337 trillion, leaving a deficit of $564 billion that will be financed by adding to the national debt.
Many elements of the new budget have been proposed in previous years by President Obama but weren't approved by Congress and thus were never enacted. The same fate will likely befall most, if not all, of the controversial elements included in the current budget.
But this year, there's one proposal that has a direct impact on small businesses and that also happens to have some Republican support in Congress: an increase in self-employment (SE) taxes.
The president has proposed changing the federal tax laws so more of the profits earned by small businesses become subject to SE taxes. According to a study conducted by the Government Accountability Office, this change could mean small-business owners might collectively pay as much as $1 billion or more per month in additional SE taxes. In a surprising twist of events, Rep. David Camp (R-MI), chairman of the House Ways and Means Committee, also presented a comprehensive proposal to reform the tax code, which includes very similar changes to the SE tax.
The ABCs of SE Taxes
Self-employment taxes for business owners or those who are self-employed are the equivalent of payroll taxes for employees. They consist of Social Security and Medicare taxes on the money you earn working for yourself.
For tax year 2013, they stand at 12.4 percent on the first $113,700 in earnings and 2.9 percent on all earnings respectively. While in theory this tax allows us to benefit from these entitlement programs when we become eligible, economic realities mean that younger self-employed persons won’t be able to count on the benefits that today’s retirees receive. In effect, SE taxes just become another tax with no long-term personal benefit. When combined with income taxes, that means that even a modestly profitable business could pay one-third or more of its profits in combined taxes.
Let's look a little deeper at this issue. If you have a well-organized small business, you likely pay yourself a fixed salary each month and also have profits in addition to that salary. Currently, SE taxes are due on the salary, but if you also withdraw profits from the business, then the IRS requires you to pay SE taxes on that amount as well. This can get very expensive.
To help alleviate this burden, the government created “Subchapter S” of the tax code, which allows corporations, limited liability companies and partnerships to request to be treated as “pass through entities” for federal tax purposes. This means that instead of the company paying income taxes on the profits, the actual recipients of the money (shareholders, members or partners) pay income taxes on those profits.
A key advantage of selecting Subchapter S status is that it allows filers to make a distinction between which withdrawals are salary and which are profit distributions. Income taxes are due on the total amount, but SE taxes are only required on the portion that's considered salary. For example, if your business earns $200,000 in profits and doesn't have Subchapter S status, then you would owe SE taxes on the full $200,000. But if you elect Subchapter S status, you can designate $50,000 as salary and $150,000 as a distribution, meaning SE taxes would only be due on the $50,000. The difference in SE taxes due would be $12,250 or more than $1,000 per month.
Since this provision became law decades ago, the IRS requires that compensation be “fair and reasonable” for the type of work that you perform. A nationally recognized consultant whose small business earned $1.5 million and declared only $20,000 of that as “salary” would almost certainly receive a letter from the IRS. But more reasonable allocations, such as the example described above, translate into real savings for most small businesses.
What the Change Means
Both President Obama and Rep. Camp propose eliminating the SE tax benefits of electing Subchapter S status. Obama’s proposal doesn't provide specifics, which might mean a total elimination of the benefit, in effect, making 100 percent of any distributions subject to SE taxes. Rep. Camp’s proposal would require that at least 70 percent of distributions be subject to SE taxes. While his proposal isn't quite as harsh, it would significantly reduce the benefit to small-business owners.
Unless you want to be required to pay more in SE taxes, you need to act. Consider the following:
1. Call your Congressional representatives. These are just proposed changes and haven't been enacted yet. There's still plenty of time to contact your representatives in the Senate and the House to implore them to reject any measures that will increase tax liabilities for small-business owners.
2. Optimize your current legal entity. If you haven't yet taken advantage of Subchapter S status, consider doing so. If your business is organized as a regular corporation, then you have to file Form 2553 to change your status. If your business is a limited liability company or a partnership, you can still elect Subchapter S status. Many people erroneously believe that only corporations can choose it, but that isn’t the case. The bifurcation of LLC income between compensation and distribution can be a little murky in some cases, but the same benefits are available and you don't need to form a corporation to earn them.
3. Take the self-employment tax deduction. Regardless of how much you pay in SE taxes, the IRS allows you to deduct 50 percent of those taxes on your income tax form. So if you paid $12,000 in SE taxes, you can deduct $6,000 from the amount of income subject to income taxes. This isn’t a game changer, but it helps.
4. Consult your tax and legal representative. Before taking any action, it’s important to consult your legal, accounting and tax advisors. This area of tax law can be complicated, and it’s best to invest in sound advice before proceeding with a particular strategy.
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