Social Security for Small Business Owners is an important part of any financial plan. Understanding how it works and how to plan for it is key to any tax or financial plan’s success. Our aim in this blog is to provide a simple, understandable guide to how your Social Security Benefits work as a Small Business Owner.

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How does Social Security for Small Business Owners Work?

On its face, Social Security is a simple program. You pay into the program during your working years to provide a retirement benefit that is guaranteed by the federal government. However, as with most things, it gets more complicated after that.

To qualify for Social Security benefits, taxpayers must earn 40 “credits.” Credits are earned for every $1,730 in covered earnings, up to the annual maximum of $6,920 in 2024. This means that you are eligible to earn 4 credits per year.

For those continuously employed, that means that you should be eligible for Social Security in 10 years.

Once you have qualified for benefits, your actual Social Security benefit is calculated through a formula that incorporates your highest 35 years of earnings. Your earnings for each year are capped at the taxable wage base which is $168,600 in 2024. This means that if you earn more than $168,600, the excess earnings will not count towards your Social Security benefit.

So, while you qualify after 10 years, your benefit is based off of your highest 35 years of income. These 35 years of income build your “earnings record” with Social Security.

This is the same whether you are a business owner or not.

What are covered earnings?

You may have noticed in the earlier paragraph that you earn your Social Security credits for “covered earnings.” This is where Social Security for Small Business Owners differs from the average W-2 employee.

The easiest way to define covered earnings is this: Covered earnings are earnings that are subject to FICA Tax or Self-Employment Tax.

For W2 employees, all wages are subject to FICA taxes. For Small Business Owners, it depends on your business structure.

What are the taxes associated with Social Security for Small Business Owners?

As a W2 employee, you pay 6.2% on the first $168,600 in wages you receive towards Social Security. Your employer then must match that same 6.2% and pay the IRS directly. This is not withheld from a paycheck and is an additional payment made directly from the business. These are called payroll taxes or FICA taxes.

As a Small Business Owner, you are required to pay both sides of the Social Security taxes for a total of 12.4% on the first $168,600 that you earn. However, some types of business income are not subject to these taxes.

As a note, Medicare taxes are 1.45% for an employee, 1.45% for the employer, and 2.9% for a Small Business Owner. One big change is that Medicare taxes are uncapped, unlike Social Security taxes. However, this blog will focus on Social Security taxes.

How are Small Businesses Structured?

Whether your business income is subject to Self-Employment Tax or FICA Tax is dictated by how your business is structured and the tax elections that you make. This means that you have some measure of control over how and when you pay your taxes.

There are four basic tax structures for small businesses in the United States:

• Sole Proprietorship
• Partnership
• S-Corporation
• C-Corporation

Every US based business is taxed in 1 of those 4 ways. You may have noticed that a Limited Liability Company (LLC) is missing from the above list. That is because forming an LLC is only a LEGAL decision and has no impact on your taxes. An LLC can be taxed as any of the 4 structures depending on ownership and the elections made.

How does a Sole Proprietorship qualify for Social Security Benefits?

A Sole Proprietorship is the simplest way for a business owner to file their taxes. A Sole Proprietorship can be either a true sole proprietorship (which has no legal protections) or a Single Member LLC that has made no tax elections.

As a Sole Proprietorship, all of your income after a small adjustment will be considered covered earnings. To arrive at your coverage earnings amount, you need to do the following:

Once you arrive at this figure, the entire amount is includible in your covered earnings and will be taxed at the full 12.4% for Social Security taxes (15.3% if you include Medicare).

This means that almost every dollar you earn as a Sole Proprietor earns credits towards your Social Security Benefits.

How does a Partnership qualify for Social Security Benefits?

A partnership is a tax structure with more than one owner in the business. However, a partnership may have general partners and limited partners involved at various levels. All earnings from a partnership, including guaranteed payments, are considered business income. This business income may or may not be subject to Self-Employment Tax. To determine if the income is subject to Self-Employment Tax, I have the following flow chart to help.

Once you determine if the income is subject to Self-Employment Tax, you then use the same formula as Sole Proprietorships:

This amount is then taxed and added to your social security earnings record. For limited partners, a recent tax court case reaffirmed the treatment of limited partners who work in the business. If you work actively in the business, you cannot be exempt from Self-Employment Taxes. Guaranteed payments will typically be made to those partners who are active in the business and will thus be included in Self Employment Taxes and considered covered earnings.

How will my small business that is taxed as an S-Corporation qualify for Social Security benefits?

An S-Corporation is a tax election that can be made by qualifying businesses. Most S-Corporations are LLCs that are taxed as S-Corporations. One of the main benefits to an S-Corporation is that the business income is not subject to Self-Employment Taxes. If you’ve been reading this far, you know that means the business income is not covered income and will not increase your social security benefits.

However, one consequence of filing an S-Election is that you must pay yourself a fair and reasonable W-2 Salary. This means that your income from the business is effectively split in two – W2 income and business profits.

By making this election, your business profits are excluded from Self-Employment Tax and your W-2 wages are subject to FICA tax. In most cases this results in most of the income being excluded from Self-Employment Taxes and the associated increases in Social Security Benefits.

While this election can save money on your taxes, I think it’s important to note that the tax savings in many cases come at the cost of lower Social Security benefits. An analysis that does not take these reductions into account, in addition to other considerations, is incomplete.

How will my small C-Corporation qualify for Social Security benefits?

A C-Corporation is similar to an S-Corporation in that your income is split into two streams – W2 income and business income. At that point, the similarities end. However, for the purposes of this blog we need not go further.

Your W-2 wages will be subject to FICA taxes and your business income will not be subject to Self-Employment Tax.

As with the other business structures, the earnings subject to tax, your W-2, will be included in your earnings record.

Summary

Each decision you make regarding your small business structure will have an impact on your social security benefits. Covered earnings result in Social Security taxes, which result in Social Security Benefits. While many rush to reduce their Social Security taxes, a more nuanced understanding of how your business structure is impacted by and impacts Social Security is a necessary component of your tax and financial plans.

At Ironclad Wealth Management, we specialize in planning for business owners with 1-25 employees. Our process covers taxes, protection, and investment planning. As part of this process, we incorporate Social Security benefits planning as part of our tax analysis. If you would like to schedule a complimentary intro call, reach out here to set up a time for us to learn more about how we can help.

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