Vermont Bar Journal, Vol. 40, No. 2 Spring 2014, Vol. 40, No. 1 | Page 28

by John H.W. Cole, Esq., and Mark E. Melendy, Esq.

Practice Structure Can Save Taxes
Payroll Taxes Have Skyrocketed

Forty years ago the payroll tax rate was
11.7%. Today it is 15.3%. Forty years ago
the Taxable Wage Base was $13,200. Today
it is $117,000. The Medicare payroll tax of
2.9% does not even have a limit. The OldAge, Survivors, and Disability Insurance
(OASDI) payroll tax on the taxable wage
base has gone from $1,544 to $17,901.
While payroll taxes have increased 1,159%
during this time period, income tax rates
have been reduced and tax brackets have
increased, causing more of your income to
be taxed at lower rates. For many practitioners payroll taxes on their earnings now
take as big a bite, if not bigger, than federal income taxes.
Forty years ago, the self-employment
tax rate on the earnings of an unincorporated practice was lower than the OASDI
tax rate on amounts paid as salary by a corporation. That is no longer the case. Under today’s rules, if you are self-employed
(which term describes a solo practitioner
or partner) your payroll taxes are imposed
on the net income from your practice, adjusted by a factor to make your practice
income the equivalent of W-2 wages of
someone practicing through a corporation.
Then the same rate, 15.3%, is used to determine your payroll taxes. Thus, except for
the tax advantages allowed corporations,1
discussed below, the payroll taxes imposed
on incorporated and unincorporated practices are essentially the same.
Payroll Taxes and
Retirement Plan Funding

One major difference between practicing as a corporation and self-employed is
that compensation paid for your services
to your corporation is taxed as wages instead of as self-employment income. More
importantly payroll taxes do not apply to
amounts funded by a corporation to retirement plans. Instead the plan funding for all
corporate employees is treated as a business expense.
The plan funding on behalf of a selfemployed practitioner is not deducted
on Schedule C (or partnership return) as a
business expense. Instead it is deducted as
an adjustment to income on his Form 1040.
As a result the plan funding of a self-employed practitioner is subject to self-employment taxes. For example, if you are
self-employed, making less than the taxable wage base, and fund $20,000 into a
retirement plan, your plan funding is sub28

ject to a payroll tax of $3,060.
S Corporation Profits Not
Subject to Payroll Taxes

If you practice law as a corporation you
have two choices: an S Corporation or a C
Corporation, so named after the subchapters of the Internal Revenue Code that apply to them. If you practice as an S corporation, the net corporate income, after payment of wages and plan funding,
is passed through to you as a shareholder.
This passed through income is not subject
to payroll taxes. If you are self-employed
all income is subject to payroll taxes. For
example, if you are the sole shareholder of
an S corporation with profits before salary
of $110,000 and your salary is $90,000, the
pass through income would be $20,000.
The pass through of this $20,000 would
save payroll taxes of $3,060 (.153 x 20,000).
You can’t simply avoid the payment of
payroll taxes by not paying salary, however.
Under the tax laws, you must be paid a reasonable salary. That still permits a reasonable amount of pass through income. For
example, profit that arises from the efforts
of employees can be passed through and
a reasonable return on your investment in
your practice can be passed through. Passing through 20% of income before payment of compensation is a safe, conservative, rule of thumb.
S Corporation Profits Can
Avoid Medicare Surtax

Practicing as an S corporation can also
help avoid the .9% Medicare Surtax, which
applies to wages or self-employment income in excess of $200,000 for single taxpayers ($250,000 if married). For example,
if you are unmarried and practice as an S
corporation, you could take home a salary
of $200,000 and let $40,000 in profits pass
through. The $40,000 would not subject to
the .9% Medicare Surtax. The higher your
net income, the more significant the S corporation advantage becomes.
C Corporation Taxation

If you practice law as a C corporation,
there are two additional differences in income taxation. First, the C corporation is
subject to corporate level taxes on its net
income, if it has any. Most C corporations
of professionals pay out all income as either compensation, retirement plan funding, or fringe benefits, so corporate level
THE VERMONT BAR JOURNAL • SPRING 2014

taxation is not a significant consideration,
other than making certain that no income
is retained. Secondly, and more importantly, a C corporation can provide tax free
fringe benefits not available to S corporation shareholders or to the self-employed.
C Corporation Avoids Payroll
Taxes on Health Insurance

Practicing as a C Corporation avoids
paying payroll taxes on the cost of health
insurance. The cost of health insurance of
a self-employed practitioner or the shareholder of an S corporation is not deductible as a business expense.2 Instead the insurance cost is passed through as Schedule C or K-1 income to the self-employed
and as compensation to the shareholder
employee of an S corporation. The cost of
health insurance can be deducted as an adjustment to gross income on their 1040 in
both cases, but only after it has been subject to payroll taxes. Thus, if you are selfemployed or an S corporation shareholder, and your health insurance costs $12,000
per year, then $1,836 in payroll taxes have
to be paid on this expense.
Other C Corporation Fringe Benefits

Additionally, a C corporation can have a
number of tax-free fringe benefits, such as
a Medical Reimbursement Plan that pays
plan participants tax free for their out-ofpocket expenses not covered by health insurance. Thanks to the Affordable Care Act
the health insurance deductibles for a family of four can now easily reach $12,000. A
tax-free reimbursement of this medical expense can save payroll taxes of $1,836 and
income taxes of $2,400 to $5,400, depending upon your tax bra