One of the most frequently-asked questions from physicians with IC income is, “Do I need to set up an s-corporation?” Answer: It depends. In this post, let’s examine how an S-corp. works and exactly what this choice “depends” on.
You might want to begin with a refresher on the differences between the three most popular entities that physicians choose among. You can read the short version on our blog at What Business Entity Should I Choose? or the long version on WCI at Should Doctors Use Personal Service Corporations? (NOTE: I wrote this article before TCJA 2017 became law.)
An S-corp and an LLC both provide you with the same layer of protection, so why not go with the simpler version, the LLC? After all, you’ll save yourself a few thousand dollars on the costs of administration (your cost for income tax and payroll preparation). However, you may be able to save even more money by incorporating. That is because of the Medicare tax differential. Here’s how it works:
The profits from an LLC are taxed fully for Social Security and Medicare taxes (or “FICA”, taken together)*. That means you’ll pay 15.3% FICA taxes on the first $132,900 (the Social Security wage base in 2019) of profits and an additional 2.9% Medicare taxes on all profits above the wage base.
The profits from an S-corporation are not taxed for FICA purposes. This is the Medicare differential. Because, under normal circumstances, full-time physicians will always earn more than the SS wage base, tax savings are generated by the Medicare differential between LLC profits (fully taxed) and S-corp profits (not taxed).
This now sounds like a big “duh” in favor of S-corps. Doesn’t everybody want to save money by paying lower Medicare taxes? Yes – unless other costs outweigh the Medicare tax savings. Those costs are the administrative fees for professionals to prepare corporate income tax returns and handle your payroll.
When you incorporate, you play both Dr. Jekyll and Mr. Hyde. You are both owner and employee of the corporation. As the corporate owner, you hire yourself, the employee. In addition, if this is your “side hustle” and you already work as a W2 employee in your “day job”, you’re paying extra FICA taxes that you will never get back. That’s because you, the s-corp employer, must pay the 6.2% SS taxes on you, the employee, on the first $132,900 of income (2019 limit).
On the other hand, an LLC is kind of a melding of you as business owner and worker bee. LLC business results are reported on a Schedule C included with your 1040, so no separate income tax return is required. This saves money.
You receive remuneration from your S-corp in two different ways:
- As the employee, you are paid a “fair salary” by the corporation for your productivity.
- As the corporate owner, you pay yourself a “distribution” of the profits that are left after paying other expenses (including your salary). These profits are taxable for income, but not Medicare, taxes no matter whether you leave them in the business or write yourself a check.
Obviously, for an S-corp to make financial sense, you must have significant profits remaining after paying yourself this “fair” salary. How do you calculate a fair salary? There are two criteria:
- The IRS typically will not challenge the “fairness” of your salary if it is at least equal to the remaining profits after you’ve paid yourself, and
- You should pay yourself a reasonable amount considering your profession, production, and location.
The reasonableness of your salary is one of the areas most heavily scrutinized by the IRS. This is due to the temptation for S-corp owners to take a minuscule paycheck, thus escaping Medicare taxes on the remaining profits of the business.
In general, your net profit should be no lower than $350k – $400k for an S-corp to be economically feasible (depending on the cost of CPA/payroll services).
*FICA taxes are not due if you are using the s-corp to own rental property. FWIW, however, corporations are a poor vehicle for holding appreciating property such as real estate.