With a new 3.8% tax on “unearned” income kicking in in 2013, it’s very difficult to limit your tax to just “ordinary” income tax. If your income is earned, you pay 15.3% Self-Employment (Social Security) tax. If your income is un-earned, you now have the new 3.8% Net Investment Income (NII) tax to pay.
Profits from an S corporation are just about the only income that escapes Self-Employment tax as well as the 3.8% NII tax. The S corporation is now an even more attractive form of entity to minimize taxes for owners of certain businesses, depending upon the facts and circumstances. After paying reasonable compensation to the owners, the remainder of the profits flow through to owner’s personal tax returns subject only to income tax, not Self-Employment or NII tax.
There are several areas you can address to possibly reduce your overall tax. Is your “Reasonable Compensation” unreasonably high? If it is, you may be paying Social Security tax on that compensation unnecessarily. Even if you are over the Social Security wage limit ($113,700 in 2013) you still continue to pay the Medicare tax of 2.9% coupled with the new 0.9% Medicare surcharge for high-wage earnings totaling 3.8%. Find out what is the standard of executive compensation for companies of your size, industry niche and profitability.
Another area where you might be able to shift income is if you have self-rented property. If your rent is higher than market, you could pay the additional 3.8% NII tax on that excess rent. By reducing your rent to a more reasonable level, you will increase your S Corporation income which is not subject to the additional tax. When was the last time you reviewed the reasonability of your rent? Now is a good time.
In an atmosphere of high income tax rates, deductions are more valuable. If you are paying higher income tax rates and are also subject to exemption phase-outs, itemized deduction phase-outs, self-employment tax and 3.8% NII tax you could be giving half of your money away to Uncle Sam. This means that contributions to a pension plan will be half paid for by tax savings. If you have a plan, consider increasing the contributions. If you don’t, maybe it’s time to set one up.
In today’s high tax environment, business owners should be proactive to keep income taxes down. In addition to the traditional advice to maximize pension and other expenses, shifting income to your S Corp via salary or rent adjustments can help keep the tax man at bay.