By: Maria Pigna and Rachel Trickett
Certain provisions of the Biden Tax Plan could impact business planning. A lack of control of the US Senate will impact Biden’s ability to execute his tax agenda; this blog will consider what could happen and why “high-earning” self-employed individuals and business owners might want to consider operating as an S corporation.
The Biden Tax Plan
The President-elect has proposed:
Increasing the maximum individual income tax rate for “high-earning” individuals (i.e., those earning $400,000 and more in compensation annually) from 37% to 39.6%.
Increasing the corporate income tax rate from 21% to 28%.
If these proposals are adopted, “high-earning” self-employed individuals and business owners could be facing the steepest tax rates in over three decades plus applicable state and local income taxes.
The Tax Foundation[3] has calculated that marginal tax rates under Biden’s Tax Plan for self-employed individuals in the following high-tax jurisdictions would be:
CA CT NJ NY NYC
Federal Tax [4] 49.338% 49.338% 49.338% 49.338% 49.338%
State Marginal rate 13.39% 6.99% 10.75% 8.82% 12.696%
SALT Deduction (28%)[5] -3.724% -1.962% -3.010% -2.470% -3.555%
Total (w/o 28% limit) 58.91% 54.37% 57.08% 55.69% 58.48%
Total (28% limit) 62.64% 56.33% 60.09% 58.16% 62.03%
Self Employed 65.29% 59.43% 62.92% 61.10% 64.73%
Business Planning Opportunities
The Biden Tax Plan may encourage high-earning individuals to find ways of converting earned income into a form other than compensation in order to mitigate steep tax rates. One option is to operate as an S corporation as opposed to a sole proprietorship or partnership.
An S corporation is recognized as a corporation for legal purposes but for federal tax purposes is a pass-through entity. However, an S corporation is subject to the 12.4% Social Security tax as well as the 2.9% Medicare tax and 0.9% Medicare surcharge tax (together, “FICA”) only on “reasonable salary”[6] compensation paid to shareholders while remaining profits are taxed to the S corporations’ shareholder(s) as distributions that are not subject to FICA.
Operating as an S corporation could therefore result in considerable tax savings. To demonstrate the potential value, let’s compare a self-employed individual who earns $1 million in business profits operating as a sole proprietor as compared to operating as an S corporation:
Sole Proprietor/Partnership. The individual is subject to FICA on the entire $1 million, which is a tax expense of $153,000 ((12.4% + 2.9%) * $1,000,000) not including normal federal income taxes or state and local taxes.
S Corporation. If the individual pays himself a “reasonable salary” of $500,000, then only the $500,000 is subject to FICA, which is a tax expense of $76,500 ((12.4% + 2.9%) * $500,000) not including normal federal income taxes or state and local taxes.
Note that for federal income tax purposes, a corporation must file IRS Form 2553, Election by a Small Business Corporation, in order to gain S corporation status. Most states recognize the federal S-election, but New Jersey and New York require a separate S-election for state tax purposes. It is also important to keep in mind that some jurisdictions do not recognize S corporation status including, Louisiana, New York City, Tennessee, and the District of Columbia. These jurisdictions generally treat S corporations like other corporations.
_________________________ [1] For 2021, assuming no legislative change, the Social Security Administration website indicates that, based upon the statutory formula, Social Security taxes would apply to compensation up to $142,800. [2] 52.8% = 39.6% income tax + 12.4% Social Security + 2.9% Medicare Tax + 0.9% Medicare Surtax - 3.02% deduction (50% of 15.3% x 39.6% rate). [3] The Tax Foundation Report is dated October 20, 2020. [4] The Federal tax is: 39.6% marginal income tax rate; 6.2% employee Social Security; 1.45% Medicare tax (employee amount); 0.9% additional Medicare tax (0.9%) and an effective 1.188% Pease Limitation on deductions. [5] There are many open issues with the Biden Tax Plan including whether SALT (State and Local Tax) deductions will be subject to the 28% limitation on itemized deductions. [6] The IRS requires that an S corporation’s owner-employees be paid “reasonable salary” for the services they render to the business. There are no specific guidelines for such compensation in the Internal Revenue Code or the Treasury Regulations but rather factors considered by the courts in determining reasonable compensation, which is beyond the scope of this blog.