On the Money Trail
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Opting Out of Social Security: The Well-Kept Secret
by Al Jacobs, author of Nobody's Fool
 

Before I offer suggestions on involvement in the Social Security system, let me relate an historical tale. The story involves an Italian citizen, born in 1882, who immigrated as a young man to Boston, Massachusetts, by way of Canada. His occupations during his life included grocery salesman, sewing machine repairman, cafe waiter, and hot dog stand operator. After several prison terms and eventual deportation, he ended his days in Brazil, dying near-penniless in a Rio de Janeiro charity ward in 1949. He receives but minor mention in encyclopedias, and relatively few accounts exist which document his life on earth. However, for one short period from December 1919 to August 1920, he personified success. His name: Charles Ponzi. His claim to immortality: the Ponzi Scheme.

By purporting to earn huge returns from postal reply coupons, he sold short-term notes to the public, paying off earlier note purchasers with receipts from later customers. Not unexpectedly, when the investors ultimately began to doubt his ability to honor the note commitments, his financial collapse promptly followed, with imprisonment not long afterward.

If you detect any connection between the Social Security system and this tale, perhaps it is that money is collected today to pay sums to those who decades ago paid significantly lesser amounts. For those of you that have become disillusioned with the program, I understand your pain. To watch your FICA tax money pour out in an unending stream is disheartening, particularly as the politicians continue to haggle among themselves over minutia. We are witnessing business as usual while a bevy of modern day Neros fiddle. But, perhaps the saddest part of all is that for the mass of you paying the bill to maintain this sinkhole, there is nothing you can do about it. You will continue to sustain the labyrinth until its eventual transition into the welfare system it will become.

If there is any good news, it is for that small but select group of persons with the ability to opt out of the system, either partially or wholly. These are generally the self-employed, with a certain amount of investment or other non-earnings income. The following scenario describes how this escape is possible.

Carrie D. Offeré, self-employed real estate broker and investor, age forty-five, unmarried, $70,000 net annual investment income from rents, mortgage interest, and dividends plus $40,000 net business income from real estate brokerage.

Only the $40,000 of business income, reported on Form 1040 Schedule C, is subject to social security tax. At 15.3 percent this amounts to $6,120 per year. However, she can avoid this cost by simply forming a corporation from which to operate the brokerage. As corporate income, it is FICA exempt.

Concurrently, another benefit is a more favorable income tax rate. Corporate income is taxed federally at 15 percent on the first $50,000, this far preferable to the 28 percent rate superimposed on $70,000 of other income. The tax reduction on her $40,000 of income is 13 percent [28 percent – 15 percent] for an additional savings of $5,200. Taking into account both FICA and federal income taxes, an annual $11,320 in reduction is possible.

As simple as this sounds, there are other matters to consider. Foremost among them is the question: what becomes of the corporate income? If passed on as salary it becomes taxable at 28 percent plus an FICA obligation of 7.65 percent each to corporation and Ms. Offeré; there is no advantage in that. A second possibility is a periodic dividend distribution. Although this avoids the social security consideration, it raises the specter of double taxation: 15 percent to the corporation plus her 28 percent bracket rate. Once again there is no benefit.

How then can the problem be resolved? For this technique to work, the income must remain in the corporation as undistributed earnings, meaning that it not be required for personal living expenses. With Ms. Offeré's investment income, and reasonable frugality, she can pull it off. Thus the corporation will, over a period of years, accumulate net worth. That, however, raises an additional hurdle called the accumulated earnings surtax of 15 percent. The Internal Revenue Service does not like to see corporations hoard earnings as it interferes with the double taxation they understandably find to their liking. Fortunately there is some leeway. An accumulated earnings credit of $250,000 prevents assessment of the tax until the aggregation reaches that amount. Also, any portion of the cache used for reasonable needs of the business may be further excluded. With prudent management, "reasonable needs" can be found for these funds. What sort of purposes, you might ask? Here is where it gets stickier. To avoid personal holding company status, and another 15 percent surtax, the corporation must restrict its investments so not to exceed specific percentages of certain types of income, most importantly interest, dividends, rents, and royalties.

As you see, though legitimate tax avoidance requires mastery of the details and a degree of discipline, it can be worth the effort. In this example over a ten-year period, by this single stratagem, $113,200 can be kept from the tax collector.

I’ll conclude with a final thought. There are those who accuse the government of running Social Security as a Ponzi scheme. This is an insult to the memory of Charles Ponzi. He never forced anyone to subscribe to his scam.