“Hey, I was wondering how I should set up my business? Should I be an S-Corp or a partnership? What would you recommend?”
I get this question often, sometimes from readers of this column.
My first response is, “Are you Social Security exempt?”
That is because Form 4029 flips tax strategy on its head. What is true for virtually every American entrepreneur is not true for an exempt taxpayer.
This can lead to massive tax train wrecks. When a tax CPA who does not understand the exemption, gives mainstream tax advice to an exempt entrepreneur, it will almost always be misguided.
Wait, I thought a tax CPA knows all the tax laws?
Not exactly, for three reasons:
- The tax code is extremely complex and very few tax CPAs have a complete grasp of it, myself included.
- Most tax CPAs have specialties. A tax CPA might specialize in:
- Personal tax returns, or
- Small business tax returns, or
- Large corporate returns, or
- Benefit plans, or
- Non-profits
A tax CPA who deals only with large corporations will likely never run across Form 4029 in their entire career.
- Form 4029 is so obscure and unusual, I’d say less than 1% of tax CPAs (even the very good ones) have ever heard of it. Perhaps they’ve loosely heard of it, but even then, they do not understand its broad ramifications.
Quick Refresher
All American taxpayers are required to pay FICA tax, when applicable. FICA stands for “Federal Insurance Contributions Act” taxes. The taxes required to be paid under this act include Social Security tax (generally 12.4% tax) and Medicare tax (generally 2.9% tax). 15.3% total FICA tax.
FICA tax is collected through payroll withholdings (if you are an employee). The employee pays half the tax (7.65%) and the employer pays the other half.
If you are a business owner, Social Security tax is collected on your federal income tax return. It is collected on your income tax return for simplicity. The IRS is simply a flow-through that sends the Social Security tax to the Social Security Administration.
Taxpayers who have filed Form 4029 with the IRS, claiming an exemption from FICA tax due to religious reasons, are exempt from FICA.
Once you file that exemption form, you enter a world of tax strategy that is completely different from the average American entrepreneur.
Once you file that exemption form, you enter a world of tax strategy that is completely different from the average American entrepreneur.
How the SS-Exempt Tax World is Different
1. There isn’t much tax strategy to consider! That’s right. I’d say about 70% of tax strategy for mainstream companies is focused on reduction of Social Security tax.
For example, a small sole proprietorship, run by a family with several children, likely owes almost nothing in federal income taxes. However, they likely owe quite a lot in Social Security taxes.
The strategies a good tax CPA recommends will naturally focus on reducing Social Security taxes.
When SS-exempt taxpayers wonder how to “lower their tax bill,” I have to chuckle a bit. The exempt taxpayer often already has a substantially lower overall tax bill than their non-exempt counterparts.
2. You never (well, almost never) want to structure your company as a corporation. Most mainstream tax CPAs recommend electing S-corporation status once a sole proprietorship becomes wildly profitable. This is terrible advice for a SS-exempt taxpayer.
Not only does the driving motivation (reduction of Social Security taxes) not apply, it’s even worse than that. A corporation cannot be exempt from Social Security. Therefore, owner wages (which you must pay yourself if you are an S-Corp!), and the wages of all employees, are subject to Social Security tax.
The mainstream American entrepreneur moves from a partnership to an S-Corporation to avoid Social Security tax. An exempt Anabaptist moves exactly in the opposite direction!
There can be extreme edge cases where a corporation could still make sense, but they are extremely rare, and likely do not apply to you.
3. There is substantial incentive to work for SS-exempt owners, or own your own company. Business owners who are not SS-exempt must withhold FICA taxes even if their employees are SS-exempt. Therefore if you are SS-exempt and work for a non-exempt company, you will pay Social Security tax on your wages (7.65% tax).
For example, if a non-exempt company offers $30/hour, and an exempt company offers $28/hour, an exempt employee is modestly ahead to work for the exempt company.
The difference for business owners is even more pronounced. In general, a non-exempt sole proprietorship owes 15.3% Social Security tax on business profits. For a sole proprietorship earning $100,000 a year, that is approx. $15,000 in Social Security tax, that the exempt owner does not owe.
The tax hurdle for owning a company is therefore quite a bit lower for the exempt entrepreneur.
4. There is less incentive to create a real estate entity to collect rent from an operating company. A standard play in mainstream American business is to hold company real estate in a separate LLC. The operating company then pays rent to the real estate company.
A key driver for this is that rental income is not subject to Social Security tax. The rent payments lower the profit of the operating company (and its Social Security tax). For the real estate company, the rent payments create profit (which is not subject to Social Security tax). Social Security tax is reduced simply by forming this structure.
Beyond Social Security tax, there can be good reasons to hold real estate in a separate company. For example, if the real estate is separately held, the operating company can more easily be sold or transferred.
However, initial discussions usually do center around the Social Security tax aspect, which does not apply to exempt taxpayers.
5. For farmers, the incentive to donate commodities rather than cash can be reduced. A proven strategy for reducing Social Security tax is to donate grain (or other crops) to charity rather than selling the crops and donating cash.
That is because the income from the grain is subject to Social Security tax, but the cash donation does not reduce Social Security tax.
Obviously if you are SS-exempt, this benefit is meaningless.
Note: This strategy can still be helpful for exempt taxpayers who do not “itemize” deductions. In recent years fewer taxpayers itemize, which makes this strategy more applicable even in a SS-exempt situation.
6. It is easier to switch 1099 contractors to payroll. One reason businesses hire 1099 contractors is to avoid payroll taxes, primarily Social Security taxes.
Side note: This is an area of extensive abuse, both within and without Anabaptist circles. There are very few situations where “employees” can legitimately be hired as 1099 contractors.
If your workers are SS-exempt, from a tax perspective it doesn’t make a lot of difference whether they are contractors or employees.
Sure, there are a few items (e.g. unemployment taxes and work comp insurance) that may come into play. But in general, the tax burden to move from 1099s to real payroll is less than for a non-exempt company.
7. There can be obscure items to consider when selling a company. This point is certainly obscure, but in the right situation, it does need to be considered.
What aspects of a sale could be impacted by Social Security considerations?
The valuation and overall attractiveness of the company. SS-exempt companies have a hidden profit boost due to lower payroll taxes. A non-exempt buyer is going to subtract out that profit boost, which will reduce the overall value of the company.
Plus, if non-exempt owners are coming in, it’s possible exempt employees will leave (See Point 3).
These two points can result in reduced appeal on the mainstream business buyer market.
- Often in a buyout, the former owners are required to stay on for a couple of years. If this is structured as employment, and the new owners are non-exempt, the seller will pay Social Security on the ongoing wages.
- Plus, a general point for buyouts: How the selling price is allocated to various asset classes (e.g. receivables, goodwill, fixed assets, etc.) generally matters less in a SS-exempt situation. This is a complex point, and not even that big of a point, but could be relevant in the right situation.
Conclusion
This article is not an exhaustive review of the SS-exempt tax world, but offers guiding points on this very unique area of tax law.
I have not discussed the ethical pros and cons of whether you should be SS-exempt. My points are focused entirely on how the exemption impacts taxation.
Best wishes as you wrap up your 2025 taxes. And yes, if you’re a true serial entrepreneur, you’re still wrapping them up!
Don’t ask me how I know.
If you feel overwhelmed managing the finances of your growing company, contact Hoover Financial to discuss options for fractional CFO oversight. This option works well for growth companies with $5M+ revenue. Call 715.615.1344 or email scott@hoover.financial.
Scott lives in Wisconsin with his wife Priscilla and their nine children. In addition to his CPA work, he and his family have a small farm where they raise produce and a few animals. In his spare time, he enjoys writing articles on finance and faith.