The S-Corp Advantage: Case Study On Tax Planning for High-Earners
Mar 30, 2024
As physicians, we dedicate years to honing our skills, studying tirelessly, and sacrificing personal time to serve our patients. Yet, amidst our commitment to healing, we often overlook a critical aspect of our professional journey: managing our finances effectively. One key area where this oversight can have a significant impact is in understanding tax rates and how they affect our earnings.
Two terms that often cause confusion are Marginal Tax Rates and Effective Tax Rates. Understanding these concepts is crucial, especially when considering the structure of your work as a professional. A prime example of this is your decision to operate as a professional corporation taxed as an S-corp versus traditional W-2 employment.
In 2024, 74% of US physicians are employees of hospitals, health systems or corporate entities. Even more shocking … 90% of physicians who take a new position this year will hire on as an employee. This is a massive generational shift with powerful negative effects on physician financial health and well-being. The bottom line is there are consequences to choosing employment—and taxes should be a huge consideration for you.
Today, we will explore the concepts of marginal tax rates versus effective tax rates. We will discuss how working as a professional corporation taxed as an S-corp can significantly lower your effective tax rate compared to being a traditional W-2 employee. Finally, I will provide you with a case study to illustrate this point.
Marginal Tax Rates: The Starting Point
First, let's clarify what I mean by marginal tax rates. Your marginal tax rate is the percentage of tax applied to your income for each tax bracket in which you qualify. In simpler terms, it's the rate at which your next dollar of income will be taxed. As physicians, many of us fall into higher income brackets, which means we face higher marginal tax rates on additional earnings.
For instance, under the current tax system in the United States, there are several tax brackets with increasing rates as income rises. As of this writing, these rates can range from 10% to 37%. When you earn more income and move into a higher tax bracket, the additional income is taxed at the corresponding marginal rate for that bracket.
Effective Tax Rates: The Whole Picture
While marginal tax rates are crucial to understand, they only tell part of the story. Your effective tax rate, on the other hand, provides a more comprehensive view of your overall tax burden. It represents the percentage of your total income that you pay in taxes after accounting for all deductions, credits, and exemptions.
So, why does this matter? Because your effective tax rate reflects what you actually pay on your entire income, not just the last dollar earned. For example, if your marginal tax rate is 32%, your effective tax rate may be lower due to deductions and credits, resulting in a lower overall tax burden.
The S-Corp Advantage: Lowering Your Effective Tax Rate
Now, let's explore how working as a professional corporation taxed as an S-corp can significantly impact your effective tax rate. Unlike traditional W-2 employment, where income is subject to both income tax and self-employment tax (which covers Social Security and Medicare contributions), S-corporations offer a unique advantage.
The S-Corp Advantage
Choosing to work as a professional corporation taxed as an S-corp can significantly lowers your effective tax rate. Here’s why:
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Pass-Through Taxation: S-corps benefit from pass through taxation, meaning profits and losses are reported on the shareholders personal tax returns, avoiding double taxation C-corps face.
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Self-Employment Tax Savings: S-Corp shareholders can classify part of their earnings as salary and the reminder as distributions, which are not subject to self-employment taxes, potentially lowering the overall tax liability.
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Flexibility in Income Allocation:Shareholders can optimize their overall tax strategy by shifting income to lower-tax-bracket individuals in their household, such as a spouse employed by the S-corp.
Additionally, S-corporations allow for various deductions and strategies to further optimize your tax situation. From business expenses to retirement contributions, there are numerous avenues to maximize tax efficiency and lower your effective tax rate as a professional corporation.
Traditional W-2 Employment
As a W-2 employee, your taxes are straightforward but less flexible. Your employer withholds taxes from your paycheck, and you are taxed on your entire income as personal income, including paying full payroll taxes. The higher your income, the more tax-advantaged deductions are phased out for you to use. Furthermore, losses from the S-corp can offset other income on your tax return, which is not possible with W-2 income.
To better understand the differences let’s look at a case study between a W-2 and S-corp for the same physician who earns the same amount of money in each contractual structure.
Case Study: Maximizing Tax Efficiency for Physicians
In our scenario Dr. Smith is a married doctor residing in Indiana, who earns $400,000 annually. We'll compare the tax implications of earning this income as a W-2 employee versus as a self-employed individual through his professional micro-corporation taxed as an S-corp.
W-2 Income:
As a W-2 employee, Dr. Smith's entire $400,000 income is subject to both income tax and payroll taxes. For simplicity, let's assume he's in the 32% marginal tax bracket and the combined employer and employee portion of payroll taxes (Social Security and Medicare) is 15.3%.
Here's how the taxes break down:
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Income Tax:
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Dr. Smith's income tax liability at a 32% marginal rate would be: $400,000 * 0.32 = $128,000.
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Payroll Taxes:
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Social Security and Medicare taxes apply to the first $142,800 of income for 2021. For the remaining $257,200, only the Medicare portion applies.
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Social Security tax (6.2% on first $142,800): $142,800 * 0.062 = $8,855.20
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Medicare tax (1.45% on all $400,000): $400,000 * 0.0145 = $5,800
Total Payroll Taxes: $8,855.20 + $5,800 = $14,655.20
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Total Taxes as W-2 Employee:
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Income Tax: $128,000
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Payroll Taxes: $14,655.20
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Total Tax Burden: $142,655.20
1099 Income through Professional Micro-Corporation Taxed as S-Corp:
Now, let's explore the tax implications if Dr. Smith structures his income through his professional micro-corporation taxed as an S-corp.
Assuming Dr. Smith's corporation generates $400,000 in revenue and incurs $100,000 in deductible business expenses, his net income would be $300,000. Let's further assume he pays himself a reasonable salary of $200,000 and takes the remaining $100,000 as distributions.
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Salary Portion:
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Dr. Smith's salary of $200,000 is subject to income tax and payroll taxes. Using the same tax rates as before:
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Income Tax (at 32%): $200,000 * 0.32 = $64,000
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Payroll Taxes (Social Security and Medicare):
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Social Security tax (6.2% on first $142,800): $142,800 * 0.062 = $8,855.20
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Medicare tax (1.45% on all $200,000): $200,000 * 0.0145 = $2,900
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Total Payroll Taxes on Salary: $8,855.20 + $2,900 = $11,755.20
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Distributions Portion:
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Dr. Smith's $100,000 distributions are not subject to payroll taxes, but they are subject to income tax.
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Income Tax (at 32%): $100,000 * 0.32 = $32,000
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Total Taxes as S-Corp Shareholder-Employee:
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Income Tax on Salary: $64,000
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Payroll Taxes on Salary: $11,755.20
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Income Tax on Distributions: $32,000
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Total Tax Burden: $107,755.20
Comparison:
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W-2 Employee Total Tax Burden: $142,655.20
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S-Corp Shareholder-Employee Total Tax Burden: $107,755.20
By structuring his income through his professional micro-corporation taxed as an S-corp, Dr. Smith could potentially save $34,900 in taxes annually compared to being a traditional W-2 employee. This substantial difference underscores the importance of understanding and leveraging tax-efficient strategies to maximize earnings and build wealth.
In conclusion, through thoughtful tax planning and utilizing the benefits of S-corporation taxation, physicians like Dr. Smith can optimize their financial outcomes and achieve greater prosperity in their professional endeavors.
Disclaimer: This case study is for illustrative purposes only and does not constitute tax advice. Individual circumstances may vary, and it's essential to consult with a qualified tax professional to assess the specific tax implications for your situation.
Empowering Physicians for Financial Success
At SimpliMD, we're committed to empowering physicians to thrive not only as healers but also as savvy business owners. Understanding the nuances of tax rates and leveraging strategies like forming a professional corporation taxed as an S-corp can make a profound difference in your financial journey.
By maximizing your earnings and minimizing your tax burden, you can allocate more resources toward your priorities, whether it's investing in your professional life, pursuing further education, or achieving personal financial goals.
In conclusion, as you navigate your professional path, remember to consider not just your marginal tax rate but also your effective tax rate. And consider exploring the advantages of working as a professional corporation taxed as an S-corp to optimize your tax efficiency and secure a brighter financial future.
Here are some action points if you recognize it would be a good idea for you to start your own micro-corporation taxed as an S-corp.
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Educate Yourself: Learn about micro-businesses, tax strategies, and legal considerations through online communities that support doctors as micro-businesses, such as SimpliMD. Seek guidance from experts who specialize in physician micro-corporations. Your best step involves becoming a SimpliMD member today and unlocking $2500 in products for only $99. And if you use this link I’ll give you 50% off your membership today!
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Form Your Micro-Corporation: Consult with professionals to set up your micro-business. Choose the right structure and understand your responsibilities. I highly recommend you choose someone who will personalize your micro-corporation. Schedule a business consultation with me to discuss things and I’ll help you get connected to our legal network to start your micro-corporation, or you can just move forward to engage with SimpliMD to get it all going.
