One of the crucial decisions commercial fishermen must make is what business entity to use for their business. Why does this matter? Your choice on incorporation has a big influence on taxation.
There are different tax consequences depending on the corporate structures you have in place. Sole Proprietorships, LLCs and S-corps are the most common for commercial fishermen. C-corps are sometimes used for large operations but are generally rare, so they will be left out for now.
Sole Proprietorships – this is the simplest structure, but has some differences to other entities from a tax perspective. Simplicity is related to the lack of filing & compliance tasks to establish the entity. Tax-wise, however, all profit is treated as wages, which is subject to ~15% FICA/payroll taxes on wages below approximately $137,000 (for 2020), but decreases beyond that. FICA taxes include Social Security and Medicare taxes.
LLCs – they can be taxed like a Sole Prop (above), or like an S-corp (below).
S-Corps – The S-Corp is an election on how your corporation is taxed. The S-Corp tax election can be advantageous for commercial fishermen due to the fact that you can pay yourself in two tiers: wages and distributions. Wages are subject to FICA taxes, which are ~15%. Distributions, on the other hand, are not subject to FICA taxes. It is important to note that both tiers are included in ordinary income.
The profitability of your business will influence how much of a benefit this means for you as there are some higher compliance and filing costs for S-corps vs. LLCs. The bottom line is that the dividend distribution tier avoids applicable FICA taxes, which can be as high as ~15%. As a slight offset to this benefit, half of FICA taxes are deductible (whether you itemize or not) from ordinary income. Still, if your wages were $100,000 and you shifted half to dividend distributions, this could save you about $6,000 in taxes. Importantly, the IRS has safeguarded against all income being distributed as dividends - the owner(s) of the business must also take reasonable compensation in the form of wages (IRS guidance on this topic here).
Case Study:
Tom started a fishing operation 5 years ago as a sole proprietorship due to simplicity. At the time, ex-vessel prices in his fishery were low. His total net income then (after crew & expenses) was about $35,000. In the following years, demand for his product rapidly grew, and even with similar poundage per season, his income is now $135,000. However, his business is still setup as a sole proprietorship and his $135,000 income is all subject to FICA Taxes. When his income was lower, FICA taxes on his $35,000 income would have been approximately $5,000. With his current income, FICA taxes on his $135,000 income is now approximately $19,000.
Tom reincorporates as an S-Corp. He must pay himself a reasonable salary (IRS guidance here), which he has determined is half of the total $135,000 net income, or $67,500.
The other $67,500 he takes as dividend distributions, which is not subject to FICA taxes and is passed through to Tom’s personal tax return as ordinary income.
Once you take into account that half of FICA taxes are deductible (the dollar benefit to you equals the deducted amount multiplied by your ordinary income rate), Tom could save approximately $8,400 in overall taxes using this strategy.
*These numbers are purely for illustrative purposes and should not be used as any guidance for determining reasonable compensation or your specific tax liability. This should not be interpreted as tax advice.
To be clear, any amount in wages or distributions still flows through to your personal income tax return and will be subject to federal and state income tax rates.
A choice you make on your business structure early on could have increasing implications as your situation evolves. Understand the consequences of choosing one corporate structure over another means you can make the best choice for your operation.
About Robert
Robert Seid is a financial advisor and Partner at Blue Summit Wealth Management, an independent wealth advisory firm in San Diego, CA. He also captains an Alaska commercial fishing vessel in Bristol Bay. His experience in both industries provides him the perspective to share financial guidance specifically geared for commercial fishermen. To learn more about how Robert and Blue Summit can help you and your operation succeed, please visit www.bluesummitwealth.com.
Robert started in the Bristol Bay fishery in 2011 as a green crew member, walking the yards to find his first opportunity. His love for nature and adventure found a home in Bristol Bay and, after his first year on the water, he was hooked. He has returned every year since and purchased his own vessel in 2019. As a skipper, his dedication to commercial fishing has only continued to grow.
**All opinions expressed by Robert Seid in this article and website are solely Robert's opinions and do not reflect the opinions or guidance of Blue Summit Wealth Management.
