The federal self-employment (SE) tax just keeps going higher and higher. If you've reached the breaking point, there may be a way to tame the SE tax beast by converting your existing unincorporated small business into an S corporation.

How to Evaluate the Option

If you're a self-employed individual — meaning a sole proprietor, partner, or LLC member — you have to pay the SE tax on your net SE income. The SE tax has two parts:

1. The 12.4% Social Security tax. Social Security tax is due on net SE income up to a certain amount. Unfortunately, the ceiling goes up every year because of inflation adjustments. For 2017, the Social Security tax ceiling is $127,200 (up from $118,500 for 2016).

2. The 2.9% or 3.8% Medicare tax. The Medicare part of the tax is due on an unlimited amount of net SE income. In other words, there's no ceiling.

So until your net SE income exceeds the Social Security tax ceiling of $127,200 in 2017 (up from $118,500 for 2016), you owe the SE tax at the painfully high rate of 15.3% consisting of 12.4% Social Security plus 2.9% Medicare.

After the ceiling is exceeded, the Social Security tax portion drops away, and the SE tax rate falls to 2.9% to cover the Medicare tax. However, the Medicare tax jumps to 3.8% once your self-employment income exceeds the applicable threshold ($200,000 for unmarried individuals or $250,000 for married couples filing jointly).

Note: The tax results are the same if you operate your business as a single-member LLC, which is treated as a sole proprietorship for federal tax purposes.

While the SE tax is painful now, it's could get worse in the future.

So it may be time to consider an S corporation conversion. Reason: The SE tax doesn't apply to earnings from an S corporation business.

However, the FICA tax applies to salary compensation paid to an S corp shareholder-employee. In 2017, the FICA tax rate is 15.3% on salary up to the $127,200 Social Security tax ceiling. Salary above the Social Security tax ceiling is subject to a 2.9% or 3.8% FICA tax rate to cover the Medicare tax.

The employee share of the FICA tax is withheld from an S corporation shareholder-employee's salary; the other portion is paid by the corporation directly to the U.S. Treasury.

The Tax Savings

The FICA tax is only due on an S corporation shareholder-employee's salary. So when the company pays only a portion of its profits to the owner, or owners, in the form of a reasonable salary, with the remaining portion paid out in the form of cash distributions, only the salary portion is hit with Social Security and Medicare taxes (in the form of the FICA tax). The profits paid out as cash distributions are exempt from the FICA tax (and exempt from the SE tax too).

Key Point

These tax-saving results are not a one-time phenomenon. You can collect similar Social Security and Medicare tax savings, or better, in future years if the business maintains or exceeds its current level of profitability.

Converting an unincorporated small business into an S corporation is not a great idea in all situations but it works for some businesses. Consult with your tax advisor for more information.

Of Course, there Are Caveats

Potential audit target. The IRS is aware of the strategy of converting an unincorporated business into an S corp to save on taxes. The government is trying to audit more S corps to see if they are paying unreasonably low salaries to shareholder-employees. However, S corp audit rates are still low. The tax-saving advantage of converting is lost if the IRS successfully asserts that S corp distributions to shareholder-employees are actually disguised salary payments. If that happens, the IRS will assess unpaid FICA taxes, interest and penalties. Your tax advisor can help you build a case so that in the event of an IRS audit, you have well-documented support that salaries are not unreasonably low.

Impact on retirement contributions. When considering an S corp, keep in mind that paying a modest salary can reduce the amount you can contribute to a tax-favored retirement program (such as a profit sharing or SEP plan). However, you may be able to mitigate this concern by setting up a 401(k) or defined benefit pension plan.

Other complexities. An S corporation conversion creates some paperwork and other issues.

That is because transactions between an S corp and its shareholders, including asset and liability transfers upon incorporation, must be carefully planned to avoid adverse federal (and possibly state) income tax consequences. You also have to meet state-law corporation requirements such as conducting annual meetings and keeping minutes.

Plus, a number of tax law hurdles must be cleared for S corp status to be available. For example, shareholders must be individuals or specified types of trusts. The Social Security and Medicare tax savings must be big enough justify the extra effort of operating as an S corp.

Partnerships and Multi-Member LLCs

A business operated as a partnership or a multi-member LLC also faces high SE tax bills. Partners and LLC members are considered self-employed individuals for federal tax purposes. Therefore, they generally must pay SE tax on their shares of net SE income from the partnership or LLC.

In this scenario, the same tax strategy is available. The co-owners can consider converting an existing partnership or LLC into an S corporation. Then, they can pay themselves relatively modest, yet reasonable, salaries while paying out the remaining profits as cash distributions. The salaries will be subject to Social Security and Medicare taxes, but the cash distributions will be exempt from those taxes. The tax savings will recur year after year, as long as the business maintains or exceeds its current profits.