Federal employment taxes, including Social Security and Medicare taxes, can be a significant financial burden for employees, employers, and self-employed individuals. With tax ceilings increasing annually, it’s important to explore strategies to mitigate these costs. Here’s an updated look at Social Security and Medicare taxes and some smart solutions to reduce their impact.
Understanding Social Security and Medicare Taxes
Social Security Tax Overview
- Employees pay a 12.4% Social Security tax on wages up to an annual ceiling, with 6.2% withheld from paychecks and the other 6.2% covered by employers.
- The 2024 wage ceiling for Social Security tax is $168,600, resulting in a maximum tax hit of $20,906.
- Projections indicate continued increases, with the ceiling expected to rise to $174,900 in 2025 and $242,700 by 2033, which could lead to a maximum Social Security tax bill of $30,095.
Self-Employment Tax Burden
- Self-employed individuals pay both the employee and employer share, meaning 12.4% of net self-employment income (after multiplying by 0.9235 for taxable income).
- In 2024, a self-employed person earning $168,600 will pay the full $20,906 Social Security tax out of pocket.
- As the wage ceiling increases, self-employed tax burdens will rise significantly.
Medicare Tax Considerations
- Medicare tax is 2.9%, split 1.45% from employees and 1.45% from employers.
- Self-employed individuals pay the full 2.9% Medicare tax.
- For high earners, an additional 0.9% Medicare tax applies to income exceeding:
- $200,000 for singles
- $250,000 for married joint-filers
- $125,000 for married filing separately
- Unlike Social Security tax, Medicare tax has no income ceiling and continues indefinitely.
Strategies to Reduce Employment Tax Burden
1. Operate as an S Corporation
- In an S corporation, only wages paid to shareholder-employees are subject to Social Security and Medicare taxes.
- Profits distributed as dividends are not subject to employment taxes.
- By paying a reasonable salary and taking the rest as federal-employment-tax-free distributions, self-employed individuals can significantly lower tax liabilities.
Example:
- A business earning $250,000 as a sole proprietorship would be subject to $27,602 in self-employment taxes.
- If converted to an S corporation and pays a reasonable $80,000 salary, the employment tax drops to $12,240.
- This results in $15,362 in tax savings.
Considerations
- The IRS requires salaries to be “reasonable,” meaning they must align with industry norms.
- S corporations must file corporate tax returns, keep minutes, and follow state corporate rules.
2. Utilize the Community Property State Rule
- In community property states, married couples can elect to treat their business as a sole proprietorship instead of a partnership.
- According to IRS Revenue Procedure 2002-69, the IRS will not challenge this classification.
- This allows one spouse to report all business income, reducing the Social Security tax burden.
Example:
- A husband-wife business earning $250,000 as a partnership would split income and owe $38,250 in self-employment tax.
- Converting to a sole proprietorship lowers the tax bill by $10,094.
Considerations
- The business must be wholly owned by the couple in a community property state.
- Proper documentation is necessary to establish this classification.
3. Avoid Unnecessary Partnership Classification
- If a husband-wife business is not truly a partnership, it may not be required to file Form 1065.
- IRS Private Letter Ruling 8742007 outlines five factors to determine if a partnership exists:
- A formal agreement between the spouses.
- Contribution of capital from both spouses.
- Control over income and capital.
- Sharing of profits and losses.
- Representation of the business as a partnership.
How to Reduce Self-Employment Taxes
- If these factors do not apply, the business can be treated as a sole proprietorship.
- This avoids self-employment tax on one spouse’s share of earnings.
Additionally, it eliminates the need to file a partnership tax return and potential $5,880 non-filing penalties.
Final Thoughts
With rising Social Security and Medicare tax ceilings, self-employed individuals and business owners should take proactive steps to reduce their tax liabilities. By utilizing an S corporation, leveraging community property tax rules, and avoiding unnecessary partnership classifications, significant tax savings can be achieved. Planning ahead and consulting with a tax professional can help ensure compliance while maximizing benefits.
