A Common Tax Mistake Could Be Costing You Thousands Annually Posted on October 1, 2015 by Larry Bodine By David B. Mandell and Carole F. Foos Are you an owner of a law practice taxed as a flow-through entity…such as an S corporation? As such, you may be paid both as an employee of the practice – receiving a W-2 – and as an owner of the practice – through a K-1 distribution. The key difference between income earned as employee compensation (W-2) and income earned as a K-1 profit distribution is: You pay FICA (Medicare and Social Security) tax on the income earned as an employee but not necessarily on K-1 profit distributions. While the large Social Security portion of FICA phases out after income of $118,500 in 2015 the Medicare tax has no phase-out. The Medicare tax increased a few years ago to 3.8 percent for higher income taxpayers, under the Affordable Care Act. While this is only a 3.8 percent tax, we have seen poor advice here cost attorneys $10,000 or more each year, every year of their career. Over one’s career, this can amount to nearly half a million dollars of lost capital…for no good reason! You don’t want to be Smith Do you see yourself in either of these? Smith is part of a three-attorney law practice. She earns about $400,000 annually. She calls the two other lawyers “partners” but technically they are co-owners of the practice, an S corporation. Each month, Smith gets paid $20,000. Then at the end of each six month period, she gets another $80,000 based on the practice’s performance. Her accountant deems both the monthly and semi-annual payments to be salary payments. Thus, she pays Medicare tax on all $400,000 for a tax of $12,950 at the 3.8 percent rate on wages exceeding $250,000 and at 2.9 percent on the first $250,000 of wages. This, of course, is in addition to state and federal income taxes, property taxes, etc. If she works for 25 years earning the same income, she will have lost over $615,000 in Medicare taxes, assuming a five percent growth rate. Down the road, Jones is in the exact same economic situation. However, his CPA treats the monthly payments as W-2 wages and the semi-annual payments as K-1 distributions of the profit earned by the practice. Thus, he pays Medicare on $240,000 for a cost of $6,960. If Jones works for 25 years earning the same income, he will have lost about $330,000 in FICA taxes, assuming a 5 percent growth rate – an improvement of $285,000 over Smith. These cases are hypotheticals and any change or deviation from the circumstances discussed above could affect the outcome. Obviously, you would not want to be Smith. Yet, we are continually astounded when we see so many lawyers are in the same position – having all, or most, of their income treated as W-2 compensation when in fact much of it is earned because of the profitability of the practice rather than the attorney’s personal services. Wouldn’t all of us prefer to be in Jones’ situation? If we are allowed to be – yes. So, the question really comes down to – what are the tax rules that govern this situation? Salary vs. Distributions In discussions with a number of CPAs with over 15 years of experience, the consensus is that a lawyer should follow a simple rule: basically that one can reasonably be paid as a W-2 salary what one would need to pay an associate with the same training to come join your practice. The rest of your compensation can be characterized as distributions. One CPA, practicing for more than 20 years, commented “this is what I do for my clients, and when the issue has been discussed in audits over the years, the IRS finds it very difficult to argue that our client should be paid more on their W-2 than a staff member doing the same job.” Looking again at the examples above, Smith could attract another attorney to her practice paying $250,000 salary. This would allow her to avoid Medicare tax on $150,000 – saving over $5,500 annually. Not coincidentally, Jones is in the right situation. As hard as you work, throwing away hundreds of thousands of dollars over a career – for no good reason – is a shame. Yet it happens every day. For a free hardcopy of Fortune Building for Business Owners and Entrepreneurs, please call 877-656-4362. Visit www.ojmbookstore.com and enter promotional code NTL25 for a free ebook download for your Kindle or iPad. David B. Mandell, JD, MBA, is a former attorney and author of several books, including Fortune Building for Business Owners and Entrepreneurs. He is a principal of the financial consulting firm OJM Group www.ojmgroup.com, where Carole C. Foos, CPA is a principal and lead tax consultant. They can be reached at 877-656-4362 or [email protected]
