Email
As Americans, we pay, among many other taxes that are often of less consequence, an income tax and a payroll tax. Income taxes are assessed against taxable income, which is after a variety of exemptions and deductions.
Payroll taxes are what many people call “social security taxes.” We pay a 6.2 percent Old Age Survivor Disability Insurance tax (OASDI) and a 1.45 percent Medicare tax. Employers must match the 7.65 percent payroll tax paid by the employee. Self-employed (SE) people pay both halves, for a total of 15.3 percent.
Up until 1993, both the OASDI and the Medicare tax payments stopped at a designated income level. After 1993, it is only the OASDI tax that stops, with the 2013 stopping point set at $113,700.
Because of the income limitation, the payroll tax hits lower-income taxpayers relatively harder than upper-income taxpayers. While it is true that approximately 46 percent of us do not pay income tax, about 5 out of 6 people do pay income or payroll tax.
Those who do not pay either tax tend to be retired people with no earned income and not enough investment income to be subject to the income tax.
We have a revenue problem. We also have a spending problem, but we have a revenue problem. Taxes as a percent of GDP are too low to reach a balanced budget in any feasible political scenario.
So we need what was once called “revenue enhancement.” Some people argue that the regressive nature of the payroll tax (lower-income people pay proportionately more) screams for some action. Action is more likely in a world that needs revenue enhancement.
One suggestion is to eliminate the cap on the OASDI tax, subjecting all earned income to the 6.2 percent tax. I don’t want to debate the policy of this, but do want to focus on the incentives it would create.
Let’s say that someone earns $150,000 in salary from a large company. This person now pays $9,224 in payroll taxes. If the OASDI cap were eliminated, the payroll tax for this person would rise by $2,251. This is a tax increase of 1.5 percent of earnings.
If someone else made a salary of $250,000, the tax increase created by complete elimination of the cap would be $8,451, or 3.4 percent of earnings. If possible, that person would certainly try to avoid the added tax.
How, you ask? Well it’s easier if the person is self-employed, including working for their own corporation. So let’s go back to the person with $250,000 of income, and now say that person is self-employed.
Because they must pay both halves of the payroll tax, the SE tax will increase by $15,608 if the OASDI cap is removed (this is less than double the employee’s increase due to the way the tax is computed).
Clearly, no matter how patriotic they may be, anyone would try to avoid such a stiff tax burden. The “traditional” approach has been to establish an S corporation and to pay payroll taxes only on salary paid to the owner, which is typically set at a fairly low amount. Non-salary income is subjected to income tax only, and may be distributed without any further tax.
The IRS has challenged this approach on the grounds that the salary is too low, and they have enjoyed some success in this regard. An alternate approach, which has gained some ground lately, is to run the business through an LLC taxed as a partnership.
This LLC approach requires two owners, which rules out some entrepreneurs, but the two owners can be husband and wife. Recent court decisions have supported treating LLC members the same as limited partners for SE tax, which is a good thing.
If subject to the limited partner SE test, the LLC member pays the 15.3 percetn SE tax only for fixed (“guaranteed”) payments for services. This is similar to the salary approach used by S corporations, except it has attracted less attention.
The “answer” to minimizing payroll taxes is complicated and cannot be fully addressed in this column. But any efforts to raise, or even eliminate, the cap on OASDI tax will surely be met with a counteroffensive by business owners and an expanded practice for tax consultants.
James R. Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at jimhamill@rhcocpa.com.<br>
