MSO Tax Strategy: Lowering Your Income & Self-Employment Tax Burden

Continuing our series on Managed Service Organizations (MSOs), this article explores a potential tax strategy high-net-worth business owners can use to reduce income and self-employment tax.

As previously explained, an MSO is a separate legal entity created to provide a range of management and administrative services to one or more operating businesses. Business owners operating pass-through entities (“PTEs”)—such as partnerships or sole proprietorships—can lower their income and self-employment tax by forming an MSO as a C corporation and contracting with the MSO to provide administrative services, such as HR and billing.

Income from PTEs, in addition to income tax, is generally subject to self-employment tax, which is 15.3% on net earnings (12.4% Social Security up to the wage base, plus 2.9% Medicare, with an additional 0.9% Medicare tax for high earners). By creating an MSO as a C corporation, the owner’s PTE can contract with the MSO. The PTE pays the MSO an arm’s-length fee for its services, which reduces the PTE’s net income subject to self-employment tax. The MSO, as a C corporation, pays a flat 21% federal income tax on its profits. This rate is generally lower than the top individual income tax rates. The profits remaining after operating costs and salary are taxed at the corporate rate and are not subject to self-employment tax. If profits are retained in the corporation, they avoid a second layer of tax until distributed as dividends.

Here is an example to demonstrate how this strategy can be helpful:

Suppose Taylor owns a PTE that yields a profit of $500,000 annually. Taylor forms an MSO as a C corporation, and the entity pays $200,000 to the MSO for management services. The MSO incurs $100,000 in operating costs that were previously paid by the PTE, leaving $100,000 as profit to the MSO. The $100,000 is taxed at 21%, and if retained, is not subject to the second layer of tax. The retained profits can then be reinvested in the MSO.

In contrast, if an MSO was not formed, the $100,000 would be taxed at an individual income tax rate of 35%. Additionally, Taylor’s self-employment tax is now calculated only on the reduced income ($400,000), saving self-employment tax on the $100,000 of profit shifted to the MSO’s retained earnings. This strategy will yield an immediate total tax savings of 17.8%: The applicable income tax rate is reduced from 35% to 21%; plus, the shifted profits are shielded from both the Medicare Tax and Additional Medicare Tax portions of the self-employment tax, equal to 2.9% and 0.9%, respectively.

In conclusion, by transferring non-operational income to a C corporation MSO, the owner reduces self-employment tax exposure and benefits from the lower corporate tax rate, as long as all transactions are at arm’s length and comply with the Internal Revenue Code and IRS guidance. If interested in this approach, it is advisable to consult with an experienced tax professional to ensure compliance and to maximize savings. Click here to schedule a time to discuss your options with one of our tax professionals or call us at (202) 455-6010.