Social Security for Business Owners
Posted June 26, 2020
Posted June 26, 2020
If you are a business owner who files as an S Corporation, understanding how Social Security and its bend points function is an important step in retirement planning and efficient tax management. This blog is geared towards small business owners who can control their W2 income and their distributions. However, much of it still applies to W2 employees on how your current salary affects your Social Security paycheck in retirement. We aren’t going to go into how Social Security works; for more about that, please read this blog post, but we will be discussing how business owners can maximize their Social Security in the most tax-efficient manner.
One of the strategies that small business owners use to reduce their tax burden is to pay themselves a small salary as a W2 employee of their business and then take a large percentage of their compensation through an owner distribution. The advantage of taking a distribution instead of W2 income is that the owner avoids paying FICA taxes (Social Security & Medicare). This can save the business owner 15.3% in taxes because they don’t have to pay the 7.65% FICA tax as both the employee and employer (for any W2 employees still reading this, your employer pays half your FICA taxes).
I run into issues regarding this strategy because the IRS expects business owners to pay themselves a “reasonable salary,” and unfortunately, there is no exact number that defines that. The guidance the IRS provides is that the salary should be what the business owner would pay a new employee with the following criteria:
“Some factors considered by the courts in determining reasonable compensation:
There is a lot of a grey area in determining the right salary to pay yourself as the business owner, and we won’t be able to cover that in this post (make sure to talk with your advisor and CPA for that advice). We will talk about planning considerations regarding optimizing your Social Security benefit while limiting your tax obligations.
Social Security is designed to replace a larger percentage of a low-income worker’s retirement income than a high-income earner’s wage. While I can’t find anything that supports this, I think it’s a pretty safe assumption that the designers of Social Security believed that the higher income workers had the ability to save for retirement through other means (401k, IRA, etc.) where a lower-income individual might not have the means to do so.
Because of this, Social Security has things called bend points in how your Social Security benefit is calculated. There are currently two bend points in your average indexed monthly earnings (AIME): $960 and $5,785 in 2020.2 While you have the ability to have unlimited earnings each year, the Social Security wage base is capped at $137,700 per year or $11,475 per month in 2020, meaning that any earnings above that amount are not subject to the Social Security portion of the FICA tax.
So, you can see there are diminishing returns in your Social Security check as your salary increases. You get the most bang for your buck if you only pay yourself $11,520, but unfortunately, that likely would not fall into the “reasonable salary” category. However, capping your salary at that second bend point of $69,420 could be considered a reasonable salary. Depending on what you do and where you live, this might be a much more appropriate cap on your own salary and allows you still replace 32% of your income for Social Security purposes. Then you can take the rest of your income via an owner distribution so that you avoid paying 15.3% in FICA taxes and only getting 15% of your earnings replaced by Social Security.
You can certainly pay yourself less than that second bend point, especially if your business is not super profitable, but paying yourself above that second bend point has diminishing returns. I would caveat that you should absolutely speak with your own CPA and advisor to determine what you think would be defensible as a “reasonable” salary if the IRS came knocking.
I’m absolutely not advocating anyone cheat the system to get out of paying taxes. Still, I want to use the rules of our tax system to our advantage and avoid overpaying the IRS and leaving Uncle Sam a hefty tip.
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