Saturday, June 6, 2009

Are You Voting Yourself Unnecessary FICA Taxes?

If you're an S-Corporation or C-Corporation, you may be voting yourself an additional tax burden by the way you choose to pay yourself -- through salary and bonuses (W-2) or through shareholder distributions.

If you're an LLC, you have the choice of paying taxes as an S-Corp, thus making the ideas in this article applicable to yourself, as well.

We're talking about FICA and Medicare taxes, which apply only to your W-2 income, not your shareholder distributions of retained earnings, one alternate way to withdraw money from your company.

At a recent Chief Executive Boards International meeting, a member said he was putting cash back into his company to keep it afloat during a period of negative net profit and cash flow. Not pleasant, but it happens sometimes. When asked whether he was still taking a salary, he replied "Yes, and I've reduced it to $90,000." The discussion that followed centered on the tax he was voluntarily paying (FICA and Medicare) by continuing to pay himself well, despite a lousy year and the need to return the same money to fund the company's temporary losses. The problem is that he's taking a voluntary 15% haircut on those W-2 dollars -- both the employer and employee sides of the FICA/MC tax. In fact, if he immediately reduced his salary to a still-reasonable $40,000 (for running a small company at a net loss), he'd save both the employer and employee sides of the FICA/MC tax, or 15% -- $7,500 per year.

Disclaimer: This article is not tax, legal or financial advice. It is an invitation to examine the way the Social Security System actually works, so you can use your best judgment in setting your own compensation as a business owner.

There are widespread misconceptions and misunderstandings about FICA and medicare taxes and how they benefit business owners long term. Those misunderstandings tend to cause people to pay more than they need to and get less benefit than they expect.

First, let's qualify this discussion to the case where there's a single owner or a small number of owners who can manage both salary and distribution decisions between themselves.

Then, let's examine how the Social Security system actually works and what benefit you're getting for any "discretionary" difference in salary you award yourself (what you actually pay yourself, vs. what IRS determines to be "reasonable"). For every $10,000, of that discretionary difference, you're voluntarily kicking in $1,500 to the Social Security system. Now, this discussion is just about what you're paying yourself in salary from an S-Corp or C-Corp, BEYOND what's considered "reasonable" by the IRS. ZERO is not "reasonable". What's "reasonable?" Some use an old CPA "rule of thumb" that salary should be at least 60% of total owner/operator's cash compensation, the 40% remainder being shareholder distributions. Some say 50/50. Others use an "hourly wage" theory. Here's a long thread of discussion, although dated, that's most interesting (and colorful):

Most people willingly pay FICA/MC taxes, thinking they're "building" their eventual Social Security benefit. When you examine the mechanics of how your contributions actually affect your benefit calculation (available at, you might be inclined to change that viewpoint. The problem is in the underlying math. The core calculation for Social Security benefits is a thirty five year average of earnings -- the 35 highest years' earnings during your working career, using the thirty-five highest years of W-2 income, as adjusted for inflation. Here's the detail on how that works:

The devil's in both the average and the "highest years" part. If, for example, you pay yourself $100,000 when $50,000 may be "reasonable", you'd think you're adding $100,000 to the average calculation. If you have 35 years of salary history, however, you're only replacing a lesser year that's adjusted for inflation -- perhaps to, say, $30,000. Thus, you've contributed $7,500 in additional FICA/MC for only a $70,000 boost to your total 35-year income (affecting its average by only $2,000 when divided by 35).

Now, here's the other part -- how your payout is actually calculated from that 35-year average. Having lived with a progressive income tax system (the more you make, the higher marginal tax rate you pay), you might not be surprised that Social Security benefits are progressive -- in reverse -- the more you made (and paid in FICA), the lower marginal payout rate you get. Here's the actual math, based on this year's adjustments (monthly benefit):

  • 90 percent of the first $744 of average indexed monthly earnings, plus
  • 32 percent of average indexed monthly earnings over $744 and through $4,483, plus
  • 15 percent of average indexed monthly earnings over $4,483.

So, if your indexed average lifetime earnings top about $54,000, your incremental benefit rate is only 15%. An Engineer's starting salary beats that.

With that in mind, let's examine the choice you're really making -- whether to give yourself a marginal raise of, say, $10,000/year (just considering the raise itself). And, for simplicity, let's assume that's not just washing out a prior inflation-adjusted year. That raise would boost your lifetime earnings by $10,000, but after you divide by 35, it actually changes the 35-year average by only $286. And, if your career inflation-adjusted average beats $54,000, your incremental Social Security benefit increases by $43. per year. Even in the next-lower bracket, it increases by only $92/year. Combined employer/employee FICA + Medicare on the $10,000 raise is a haircut of $1,500. Does that sound like a good deal to you? Of course, a $10,000 pay cut saves you $1,500 you can invest right now. At only a 6% long-term return, that's $90/year income, starting right now, and you still have the $1,500!

It's even worse if your spouse is on your payroll. Since your spouse automatically gets 50% of your own Social Security benefit, it's highly likely that her (or his) Social Security contribution is totally lost (unless his or her 35-year average income is more than 50% of yours -- rare, but possible.

Social Security is not a system that's built to favor or benefit high-income individuals. It wasn't designed for that. What you have to decide is how high you want your income subject to FICA & Medicare taxes (W-2) to be, and develop a rationale for why that's "reasonable", if ever questioned. In a lousy year, "reasonable" could arguably be a pretty small number.

Note that $106,800 (for 2009) is the maximum salary to which FICA applies, and is also the maximum amount applied to your 35-year average income calculation. The Medicare cost component of roughly 3% (employeer + employee sides) applies for all W-2 compensation in excess of $106,800.

Disclaimer: Information contained in this article is neither legal, financial, nor tax advice, and may contain inadvertent factual errors. If, however, these ideas cause you to re-examine your own salary, please check with your own legal, financial and tax advisors to be sure it's right for your specific situation.

Footnote: If you're serious about analysis, get your recent "Social Security Statement" (they send those out annually) and then go get the Indexing Factors for Earnings: Enter your estimated retirement year, and you get the factors by which your earnings history is indexed to today's dollars. Multiply those factors by the respective years' earnings history. Then sort (descending) the resulting annually-adjusted amounts and total the best 35 years.

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Terry Weaver

Chief Executive Boards International

Chief Executive Boards International: Freedom for business owners & CEOs -- Less Work, More Money, More Freedom to enjoy it

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