I was talking to another physician entrepreneur recently about his tax situation when we realized I had a significant tax advantage over this other doc. The reason why is that, as a partner, my clinical income is paid on a K-1 whereas this other doc, as an employee, sees his clinical income come in on a W-2. We both have S Corps for our entrepreneurial ventures. So what's the big deal? Well, as the CPAs in the audience know, the difference is over $8K in Social Security taxes. Let me explain.
Double Social Security Taxation
The idea behind Social Security taxes for a high earner is that you only have to pay them on the first dollars you make each year, $137,700 in 2020. After that, Social Security taxes go away. Medicare taxes are assessed on all of your earned income, so we're really only talking about Social Security taxes here. Social Security taxes have two halves, the employee half (6.2%) and the employer half (6.2%) that add up to 12.4%. 12.4% * $137,700 = $17,074.80, of which $8,537.40 is paid by the employee and $8,537.40 is paid by the employer.
This is no big deal if you don't make more than $137,700. You just pay Social Security tax on everything. It's also not a big deal if you make more than $137,700 at a single job. After $8,537.40 has been paid for the year, no more is taken out of your paychecks and the employer doesn't have to make any more payments either.
But what happens if you have TWO W-2 jobs and you make $150K at both of them? Well, it turns out that EACH employer will withhold $8,537.40 from your paychecks. EACH employer will also pay $8,537.40 from their own pocket. Well, that's not fair at all is it? No, it isn't. And luckily, despite the fact that life isn't fair, Congress and the IRS have made a provision where you can get back the extra money you had withheld from your paychecks for Social Security. It's called Line 11 of Schedule 3 of Form 1040 and it looks like this:
No big deal, right? That seems fair. However, guess what isn't fair? The employer is hosed. Congress and the IRS don't seem to care about employers as much as employees. Maybe they don't have as many votes or maybe it's just a bit of “socking it to the rich” since business owners are likely to be richer. So while the employee can get their $8,537.40 back, the employer cannot. It's gone. No way to reclaim it. Sucks to be the hospital right? But what if YOU WERE the hospital? How would that feel?
Well, that's the situation you are in if you are paid on a W-2 for your clinical work and you are an S Corp for your entrepreneurial (or even side-gig clinical) work. S Corps pay their owners both wages and distributions, but payroll taxes (Social Security and Medicare taxes) are due on just the wages.
Normally this is a good thing and the reason people form S Corps, because if you are a sole proprietorship or a partnership you have to pay payroll taxes on ALL of your income. But the way sole proprietorships and partnerships pay this (essentially as a “self-employment” tax at year-end on Schedule SE that flows into line 14 of Form 1040) ensures you don't overpay the employer half of Social Security tax.
With an S Corp, you pay this differently, on Form 941 that you file each quarter. Now YOUR S Corp is the “hospital that is getting hosed” having to pay extra Social Security tax.
So in my case, with my clinical K-1, my S Corp W-2, and my S Corp K-1, the employer half of SS tax is only withheld once. But in this other physician entrepreneur's case, that tax is withheld twice. He's basically out $8,537.40. I guess it's not quite that bad, since that tax is a deductible business expense, but it still stinks to pay.
Mixing In Retirement Accounts and the 199A Deduction
Things get even more complicated when you descend into the pit of despair that is figuring out the best way to maximize the 199A deduction. This massive deduction for a pass-thru business (qualifying sole proprietorship, partnership, or S Corp) owner is well worth making changes in your financial life for. But there were already many factors at play in this calculation BEFORE the extra Social Security taxes folks like my physician entrepreneur friend have to pay came into the equation. These include:
- Making sure your salary is high enough to be reasonable per IRS guidelines
- Making sure your salary is high enough to max out retirement accounts
- Ensuring salary is high enough to maximize the 199A deduction
- Making salary as low as possible to minimize Medicare taxes
If you don't have a good grip on how the 199A deduction works (which frankly is most of the people reading this post), you should probably brush up on that first. In fact, I wrote a great post a year ago that discusses the four factors above that is probably worth reading first.
Don't forget that with the 199A deduction it matters whether you are below the first 199a phase-out limit ($163,600 single, $326,600 married for 2020), above the second limit ($213,300 single, $426,600 married) or between the two limits. And if you're above the first limit, it matters whether your business is a specified service business like medicine or law.
I'm not going to reproduce that post today, but if you have no idea why our salaries as WCI owners are set at approximately 28.6% of the sum of our salaries and the ordinary business income, you should probably go back and review the post. Basically, that % is where we minimize Medicare tax while maximizing the 199A deduction.
The method doesn't necessarily change if you have another W-2 job as we are discussing in today's post, but it does make the benefit much less significant. Now, every additional dollar you pay in salary/wages as an S corp owner without non-owner employees to try to increase the 199A deduction, at least up to $137,700 in 2020, means you're not only paying additional Medicare tax, but also the much larger Social Security tax.
Life Above the Upper Phaseout Limit
So let's say you make $500K at your W-2 job and your S Corp salary is $50K and you decide to pay yourself an extra $10K in salary in order to increase your 199A deduction. This increases your 199A deduction by $5K and if you have a marginal tax rate of 37% like I do, that would save you $1,850 in federal income taxes. But that $10K increase in salary would cost you more in payroll taxes, 2.9% for Medicare and 12.4% for Social Security for 15.3% total. Of course, half of that is deductible at 37%, so really it's 12.47%. 12.47% of $10K is $1,247. This move, while good, is not nearly as good as it would be for me who only has to pay the additional Medicare taxes. Instead of only coming out $603 ahead, I'd come out $1,614 ahead with the same change.
Once you get above the $137,700 wage limit, it would be exactly the same, of course.
Life Below the Lower Phaseout Limit
Now, if your taxable income is lower, below the lower phaseout limit, you're not playing this game anyway because the 199A deduction is not subject to the 50% of wages paid test. In that case, increasing your salary not only increases your payroll taxes, but also decreases your 199A deduction because it decreases your ordinary business income. These folks now have even more incentive to keep their salary as low as possible.
Now your biggest concern is likely your retirement accounts. Minimizing your salary is great, but the lower the salary, the less you can put in retirement accounts. Plus, any “employer contributions” into those retirement accounts reduces your ordinary business income and thus your 199A deduction just like paying additional salary.
The best workaround is likely doing employee contributions plus Mega Backdoor Roth IRA contributions, although this might involve getting a new retirement plan and even a professional to help you make sure you're doing it right.
Life Between/Around the Phaseout Limits
To make matters worse, lots of docs are actually right around or between these two phaseout limits. If you thought life was complicated above or below the limits, you had no idea. Now you actually want to use lots of tax-deferred accounts to try to get your taxable income into the range where you can actually take the 199A deduction and have as little of it phased-out as possible. That might mean paying yourself a larger salary in order to contribute more to get your taxable income down!
Holy Cow Batman! Good luck planning that all out in advance. Better to grow that side business above the phaseout limits as soon as you can just to make tax planning easier!
What To Do If This Is You
So what should you do? Well, the first thing to do is get yourself out of this situation if you can. Consider changing jobs to a partnership job if possible.
You could even try to talk your employer into hiring you as an independent contractor, but make sure you get paid enough more to make up for the loss of benefits. Be sure to sell them on the fact that they won't have to pay those extra SS taxes so that amount can be paid to you as salary instead. This will eliminate the “double Social Security taxation” issue. Of course, it also takes you from having two unrelated employers to just one, which means you only get one $57K 401(k) limit.
Probably more realistically, figure out where you stand in relation to the phaseout limits. If you are well above both limits and not in a specified service business, go ahead and just pay yourself the higher salary even though the benefit isn't as much as it is for someone else. If you are below both limits, try to keep that salary low, even if it means less retirement account contributions. The savings you get with the 199A deduction and the lower Social Security taxes probably makes up for the retirement account benefits. Whether well above or well below the limits, Mega Backdoor Roth IRA retirement account contributions are likely a good move.
If you're in the middle, and especially if you are in a specified service business, try to forecast things as accurately as you can to make the best decision and give serious consideration to tax-deferred contributions.
What do you think? Are you paying double Social Security tax? Are you struggling with how to set your S Corp salary or whether to form it at all? How did you determine how to set your salary? Comment below!