Sole Proprietorship VS. S-Corp VS. Solo 401K VS. Taxes

[Djeayzonne]

I had just about decided to change from sole proprietorship to S-corp,
but then reading some more stuff, including some recent posts here has got me thinking about this.

Basically, I want to try and find the best balance of reducing taxes while being able to throw as much money into the solo 401K as possible.

Going S-corp reduces my self-employment tax at the expense of a reduction in the employer-side contribution of the solo 401K, which will also increase my federal income taxes.
There are also other expenses such as unemployment tax that would be incurred.

I have been using the Cash Flow Excel file found on this site to try and do some estimations, but it doesn't seem to be set up such I can try and compare the two scenarios.

Any body have some first-hand experience with going from sole proprietorship to s-corp?
How can I estimate these two scenarios with better accuracy?
How do I calculate exactly how much the employer-side contribution can be in both scenarios?

[l2jperry]

I have an S-Corp... but I have employees so the solo 401k is out the door for me anyway... the only thing I would consider is what you think you can get away with as far paying yourself a salary. If you can get away with paying your self a low enough salary then it makes more sense to be an S-Corp in my opinion.

[Heroes821]

I am in the process of doing almost the exact same thing except for 2017 taxes. Can you link me where you read the S-corp can put less into the solo 401k then the LLC because I have not heard that before.

[bacchi]

I am in the process of doing almost the exact same thing except for 2017 taxes. Can you link me where you read the S-corp can put less into the solo 401k then the LLC because I have not heard that before.

The profit sharing for the solo 401k is based on W2 wages. If you hold your salary low to generate more K1 distributions, the 25% of your salary will naturally be smaller.

Smaller salary, smaller FICA taxes, smaller profit sharing, more distributions
vs.
Larger salary, more FICA taxes, more profit sharing, smaller distributions

[Heroes821]

That makes sense. I'm still a little lost on the distributions part some things I've seen have shown them as "dividends" from the company profits. I'm CPA wanted me to look at SEP, SIMPLE, and I 401k and I think the solo 401k wins out especially since I should break the $50k vanguard number to avoid fees once my previous employer rollover happens.

[MDM]

I have been using the Cash Flow Excel file found on this site to try and do some estimations, but it doesn't seem to be set up such I can try and compare the two scenarios.

That seems correct. :)

But if there is a simple way to add such a feature it could happen.  Hasn't been much call for it up to now.

[Djeayzonne]

Yeah, I just handed in my paperwork to Fidelity yesterday to open a solo 401K with them.
It has no fees and no conditions on that.

I still haven't received any feedback to my actual questions, but perhaps an S-corp but making the salary artificially a little high might be the best way to go?

[MidWestLove]

use this tool from Vanguard and put in your numbers for net business profit as it would break it down by retirement account type -  https://personal.vanguard.com/us/SbsCalculatorController

another piece to consider how stable is your income, i.e. do you want to be locked into the plan where funding is required.

[DavidAnnArbor]

Oh wow that's a great calculator for the individual 401k sole proprietor.

[Frugalman19]

Yeah, I just handed in my paperwork to Fidelity yesterday to open a solo 401K with them.
It has no fees and no conditions on that.

I still haven't received any feedback to my actual questions, but perhaps an S-corp but making the salary artificially a little high might be the best way to go?

What is your profession? I work at a tax office and we have seen a substantial amount of audits on s-corps for the wages vs distribution scam. If you dont have employees, the IRS will argue it is all wages and subject to FICA taxes.

[bacchi]

Yeah, I just handed in my paperwork to Fidelity yesterday to open a solo 401K with them.
It has no fees and no conditions on that.

I still haven't received any feedback to my actual questions, but perhaps an S-corp but making the salary artificially a little high might be the best way to go?

What is your profession? I work at a tax office and we have seen a substantial amount of audits on s-corps for the wages vs distribution scam. If you dont have employees, the IRS will argue it is all wages and subject to FICA taxes.

Yeah, it's pretty hard to justify paying yourself only $50k when your sole client is paying you $120k.

[BlueHouse]

Yeah, I just handed in my paperwork to Fidelity yesterday to open a solo 401K with them.
It has no fees and no conditions on that.

I still haven't received any feedback to my actual questions, but perhaps an S-corp but making the salary artificially a little high might be the best way to go?

What is your profession? I work at a tax office and we have seen a substantial amount of audits on s-corps for the wages vs distribution scam. If you dont have employees, the IRS will argue it is all wages and subject to FICA taxes.

Can you elaborate?  Are there circumstances where they don't question it at all?  Or are they trying to make a grab for more tax money after years of accepting this practice, so long as the salary was realistic (say $150k)?

[Djeayzonne]

Yeah, I just handed in my paperwork to Fidelity yesterday to open a solo 401K with them.
It has no fees and no conditions on that.

I still haven't received any feedback to my actual questions, but perhaps an S-corp but making the salary artificially a little high might be the best way to go?

What is your profession? I work at a tax office and we have seen a substantial amount of audits on s-corps for the wages vs distribution scam. If you dont have employees, the IRS will argue it is all wages and subject to FICA taxes.

I am a freelance translator/localizer. My wife helps out kind of like a secretary. I'm starting to lean toward just staying sole proprietor.  If what you say is true and common, then all the more reason.

[CareCPA]

Yeah, I just handed in my paperwork to Fidelity yesterday to open a solo 401K with them.
It has no fees and no conditions on that.

I still haven't received any feedback to my actual questions, but perhaps an S-corp but making the salary artificially a little high might be the best way to go?

What is your profession? I work at a tax office and we have seen a substantial amount of audits on s-corps for the wages vs distribution scam. If you dont have employees, the IRS will argue it is all wages and subject to FICA taxes.

Can you elaborate?  Are there circumstances where they don't question it at all?  Or are they trying to make a grab for more tax money after years of accepting this practice, so long as the salary was realistic (say $150k)?

From my knowledge, the distributions from an S Corp are supposed to represent a return on your invested capital, which is why S-Corp income is not taxed as self-employment income. If you are the only employee of an S-Corp, and your business is a service business, it is difficult to argue that any of the income is from anything other than your direct labor (as opposed to capital investment) which is why they re-classify it as wages.

[Frugalman19]

Yeah, I just handed in my paperwork to Fidelity yesterday to open a solo 401K with them.
It has no fees and no conditions on that.

I still haven't received any feedback to my actual questions, but perhaps an S-corp but making the salary artificially a little high might be the best way to go?

What is your profession? I work at a tax office and we have seen a substantial amount of audits on s-corps for the wages vs distribution scam. If you dont have employees, the IRS will argue it is all wages and subject to FICA taxes.

Can you elaborate?  Are there circumstances where they don't question it at all?  Or are they trying to make a grab for more tax money after years of accepting this practice, so long as the salary was realistic (say $150k)?

From my knowledge, the distributions from an S Corp are supposed to represent a return on your invested capital, which is why S-Corp income is not taxed as self-employment income. If you are the only employee of an S-Corp, and your business is a service business, it is difficult to argue that any of the income is from anything other than your direct labor (as opposed to capital investment) which is why they re-classify it as wages.

This exactly.

If all you do is translate for people, then all of your income is based on your personal service work, there is no capital at work here.

If you had a manufacturing business and you had employees creating things for you to sell, then it would not be your work it would be your business investment making money for you, that is why they allow the S-corp distribution.

If youre taking a high enough salary then most of the time they will never look at you.

[Vilgan]

If its just you and you aren't paying subs to do work for you - I'm not sure that S corp really makes sense. You are going to have trouble justifying the distributions as something other than wages and if you are treating everything as wages then S corps are way more expensive w/ extra taxes and paperwork for no real benefit.

[BlueHouse]

Yeah, I just handed in my paperwork to Fidelity yesterday to open a solo 401K with them.
It has no fees and no conditions on that.

I still haven't received any feedback to my actual questions, but perhaps an S-corp but making the salary artificially a little high might be the best way to go?

What is your profession? I work at a tax office and we have seen a substantial amount of audits on s-corps for the wages vs distribution scam. If you dont have employees, the IRS will argue it is all wages and subject to FICA taxes.

Can you elaborate?  Are there circumstances where they don't question it at all?  Or are they trying to make a grab for more tax money after years of accepting this practice, so long as the salary was realistic (say $150k)?

From my knowledge, the distributions from an S Corp are supposed to represent a return on your invested capital, which is why S-Corp income is not taxed as self-employment income. If you are the only employee of an S-Corp, and your business is a service business, it is difficult to argue that any of the income is from anything other than your direct labor (as opposed to capital investment) which is why they re-classify it as wages.

So with that explanation, it doesn't seem to make sense for services businesses at all (whelp).  Thanks for the info. 

[CareCPA]

Yeah, I just handed in my paperwork to Fidelity yesterday to open a solo 401K with them.
It has no fees and no conditions on that.

I still haven't received any feedback to my actual questions, but perhaps an S-corp but making the salary artificially a little high might be the best way to go?

What is your profession? I work at a tax office and we have seen a substantial amount of audits on s-corps for the wages vs distribution scam. If you dont have employees, the IRS will argue it is all wages and subject to FICA taxes.

Can you elaborate?  Are there circumstances where they don't question it at all?  Or are they trying to make a grab for more tax money after years of accepting this practice, so long as the salary was realistic (say $150k)?

From my knowledge, the distributions from an S Corp are supposed to represent a return on your invested capital, which is why S-Corp income is not taxed as self-employment income. If you are the only employee of an S-Corp, and your business is a service business, it is difficult to argue that any of the income is from anything other than your direct labor (as opposed to capital investment) which is why they re-classify it as wages.

So with that explanation, it doesn't seem to make sense for services businesses at all (whelp).  Thanks for the info.

It just depends on how aggressive you/your accountant want to be, and what you can believe you can justify.
It's also easier to defend distributions if you have employees, so it could make sense in the future if you are currently the only employee and anticipate growing.

[supomglol]

We have a sole-member service-based S-Corp.  Our accountant instructed us to pay the sole member a salary at market-rate (in our case, ~$60k/year).  We "run payroll" through a traditional payroll service which further solidifies that money as a "salary".  All other funds left over in the business after expenses/salary, is considered "Profit" and is distributed (in our case, to the sole member). 

Thus, we avoid self-employment tax on any profits > $60K. 

[Heroes821]

We have a sole-member service-based S-Corp.  Our accountant instructed us to pay the sole member a salary at market-rate (in our case, ~$60k/year).  We "run payroll" through a traditional payroll service which further solidifies that money as a "salary".  All other funds left over in the business after expenses/salary, is considered "Profit" and is distributed (in our case, to the sole member). 

Thus, we avoid self-employment tax on any profits > $60K. 

Good to know that explains why my CPA was strongly suggesting a payroll company.

[supomglol]

We have a sole-member service-based S-Corp.  Our accountant instructed us to pay the sole member a salary at market-rate (in our case, ~$60k/year).  We "run payroll" through a traditional payroll service which further solidifies that money as a "salary".  All other funds left over in the business after expenses/salary, is considered "Profit" and is distributed (in our case, to the sole member). 

Thus, we avoid self-employment tax on any profits > $60K. 

Good to know that explains why my CPA was strongly suggesting a payroll company.

Yes, in addition to adding legitimacy to your salary: you also gain a vale of protection from the agencies whom payroll companies re-transmit monies to.  If there is some issue with your tax payments or withholding  - you have someone to redirect them to rather than attempting to handle the mess yourself. 
Setting everything up with a payroll company can be a pain initially, but it does have other advantages such as being able to easily set up company-contributed 401K funds, tuition reimbursement, or even add additional employees at a later date if your business grows. 

[Djeayzonne]

We have a sole-member service-based S-Corp.  Our accountant instructed us to pay the sole member a salary at market-rate (in our case, ~$60k/year).  We "run payroll" through a traditional payroll service which further solidifies that money as a "salary".  All other funds left over in the business after expenses/salary, is considered "Profit" and is distributed (in our case, to the sole member). 

Thus, we avoid self-employment tax on any profits > $60K.

Yes, but is it worth it considering the added cost of payrol, loss of maximum solo401k contribution, CPA requirement to do s corp taxes, added expense of unemployment taxes, etc.?
Do you lose the ability to deduct half of your self-employment tax from your income for federal income tax calculation purposes?


Would love some feedback on this, as that is exactly the information I was looking for?

[DavidAnnArbor]

Mr. Money Mustache himself delves into this very issue of his S Corporation in his blog.  http://www.mrmoneymustache.com/2016/02/10/should-you-do-your-own-taxes/

[misshathaway]

The current episode 391 of Radical Personal Finance also has a rundown on this about 3/4 of the way in. I was just listening to it this morning. The rest is on sole proprietor business tax hacks.

[Frugalman19]

We have a sole-member service-based S-Corp.  Our accountant instructed us to pay the sole member a salary at market-rate (in our case, ~$60k/year).  We "run payroll" through a traditional payroll service which further solidifies that money as a "salary".  All other funds left over in the business after expenses/salary, is considered "Profit" and is distributed (in our case, to the sole member). 

Thus, we avoid self-employment tax on any profits > $60K.

I have personally been in audits, where the IRS says, yes its a fair salary, but all of your income is based on work you do. So it should all be wages. This person was a speech therapist. So literally all of the income from the business was an hourly rate for her time.

Then they proceeded to go back a number of years and adjust. SO your CPA is doing what might keep you under the radar, so to speak, but if you got audited there is a chance it could all come crumbling down.

This particular client had to pay back taxes and penalties for the past 3 years, 10s of thousands of dollars.

I do business taxes for a living, so im not just making this stuff up.

[Laserjet3051]

We have a sole-member service-based S-Corp.  Our accountant instructed us to pay the sole member a salary at market-rate (in our case, ~$60k/year).  We "run payroll" through a traditional payroll service which further solidifies that money as a "salary".  All other funds left over in the business after expenses/salary, is considered "Profit" and is distributed (in our case, to the sole member). 

Thus, we avoid self-employment tax on any profits > $60K.

I have personally been in audits, where the IRS says, yes its a fair salary, but all of your income is based on work you do. So it should all be wages. This person was a speech therapist. So literally all of the income from the business was an hourly rate for her time.

Then they proceeded to go back a number of years and adjust. SO your CPA is doing what might keep you under the radar, so to speak, but if you got audited there is a chance it could all come crumbling down.

This particular client had to pay back taxes and penalties for the past 3 years, 10s of thousands of dollars.

I do business taxes for a living, so im not just making this stuff up.

i agree,i think you astutely summarize the issue of splitting income between wages and distributions. audits for many s-corps could certainly result in the type of outcome you describe above.

[SeattleCPA]

I was on vacation and so didn't see this thread until now. But here are some hopefully helpful comments about the S corporation choice you confront:
1. You basically never come out ahead by paying more payroll taxes so you can do a larger pension fund contribution. The math doesn't work that way. (Think about that 15.3% payroll tax as a "load" you pay to get your money into the pension fund... you just can't make it up.) You can construct a spreadsheet to prove this, but I've made the calculations hundreds of times for different clients and you never come out ahead by paying payroll taxes just to get money into your pension.
2. You are very unlikely to get audited for what that's worth. There are 4.2 million S corporations in the country and IRS audits about 10,000 a year, so less than 1 in 400 S corporations get audited. That shouldn't be considered a license to go crazy, but I would be cautious about being too cautious because of an audit risk. (BTW, we do a lot of 1120S returns andn so regularly represent taxpayers in an audit and the shareholder-employee compensation issue pops up on about a quarter of the audits, but it's never been a big problem in my experience.)
3. The last time the Congress looked seriously at the issue of S corporations in 2010, they explicitly addressed the issue of "one person" S corporations and the House of Representatives decided one person S corporations are okay for (essentially) blue collar small businesses but not for white collar businesses. The Senate looked at that decision and abandoned the legislation--presumably because it just didn't show fairness. (The law was HR 4213 and here's the most recent update on the legislation: https://democrats.senate.gov/2010/07/19/h-r-4213-the-american-jobs-and-closing-tax-loopholes-act-of-2010/#.WCoGpvkrJPY)
4. Per the Forum rules, this is supposed to be okay to do... so here's an S corporation tax savings calculator you can use to check your savings:
http://evergreensmallbusiness.com/s-corporation-tax-savings-calculator/
5. A final point: Keep in mind that when you do an S corporation you move some deductions from your 1040 (where they save only income taxes) to your 1120S S corporation tax return (where they save both income taxes and payroll taxes.) Examples of this include the employer match part of any pension deductions, your health insurance, your HSA contribution. This "double deduction" often means people get better deal from an S corporation than a first analysis suggests.

Bottomline: I would not abandon the S corporation idea. But do your math... and make sure you have ample savings to pay for the costs and headaches. (I would not ever recommend an S corporation option for someone who's going to save $2K or even $3K... you want to save $4K or $8K or $12K...)

[Malum Prohibitum]

What is your profession? I work at a tax office and we have seen a substantial amount of audits on s-corps for the wages vs distribution scam. If you dont have employees, the IRS will argue it is all wages and subject to FICA taxes.

  Audits?  Scam?  My accountant has me pay a fair wage and the rest are distributions (law office).  I know lots of people doing it this way, all the information Google returns (even from the IRS) indicate to do it that way, and this is the first I am ever hearing of this.  What is a "substantial amount of audits," and did the subjects of the audits pay themselves a market wage?  Did they have aggressive representation throughout the audit?

What is "work at a tax office?"  What do you do?  Are you an accountant?

[Malum Prohibitum]

What's a Reasonable Salary?
The instructions to the Form 1120S, U.S. Income Tax Return for an S Corporation, state "Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation."
The amount of the compensation will never exceed the amount received by the shareholder either directly or indirectly.  However, if cash or property or the right to receive cash and property did go the shareholder, a salary amount must be determined and the level of salary must be reasonable and appropriate.
There are no specific guidelines for reasonable compensation in the Code or the Regulations. The various courts that have ruled on this issue have based their determinations on the facts and circumstances of each case.
Some factors considered by the courts in determining reasonable compensation:

• Training and experience
  Duties and responsibilities
  Time and effort devoted to the business
  Dividend history
  Payments to non-shareholder employees
  Timing and manner of paying bonuses to key people
  What comparable businesses pay for similar services
  Compensation agreements
  The use of a formula to determine compensation

  Straight from the IRS web site.  https://www.irs.gov/uac/wage-compensation-for-s-corporation-officers

[Malum Prohibitum]

Another link to the IRS, worth a read, including cases won by the IRS, in which the standard seems to be uniformly whether the shareholder is paid a reasonable salary for the services performed.

https://www.irs.gov/businesses/small-businesses-self-employed/s-corporation-employees-shareholders-and-corporate-officers

[Malum Prohibitum]

On the other hand, if most of the gross receipts and profits are associated with the shareholder's personal services, then most of the profit distribution should be allocated as compensation.

https://www.irs.gov/businesses/small-businesses-self-employed/s-corporation-compensation-and-medical-insurance-issues

[Malum Prohibitum]

From my knowledge, the distributions from an S Corp are supposed to represent a return on your invested capital, which is why S-Corp income is not taxed as self-employment income. If you are the only employee of an S-Corp, and your business is a service business, it is difficult to argue that any of the income is from anything other than your direct labor (as opposed to capital investment) which is why they re-classify it as wages.

  This appears to be what the last link I posted is saying.

[SeattleCPA]

Malum, I agree that the real issue is whether shareholder-employee compensation is reasonable.

But I would suggest that rather than looking at the IRS for guidance, it makes more sense to look both at what Congress has discussed and decided (see that link to the HR 4213 legislation in my first post in this thread) and also at court cases like David Watson, which was a one-shareholder-employee-S-corporation situation where shareholder tried to take basically $2K a month in salary and $15K a month in distribution and is available here:

http://media.ca8.uscourts.gov/opndir/12/02/111589P.pdf

Note: In end, court said in this case that roughly $7500 a month was fine...

P.S. For what it's worth, I prepare about 200 1120S returns a year (which is a lot)

[Malum Prohibitum]

2015, I took about 52% in wages and the rest 48%, in distributions.

I had anticipated doing the same for the foreseeable future. 

I am an attorney.  S corp.  I have employees off and on.  I had another attorney and a secretary working for me part of the year 2015.  In 2016, a secretary part of the year.  At the moment I am just one employee again.

My wages were about $50k for 2015.   Am I skating on thin ice?

[SeattleCPA]

I don't know if you're on thin ice or not, but here are some things that might be helpful to know:

First, average S corp salary is around $40K so given that there are 4 million S corps and given that they audit roughly 10K a year, at $50K there are roughly 2 million small S corps more interesting than you and so more more likely to join the "honored" 10,000 who annually get audited.

Second, while $50K might be a little low in some areas, if you can, you might look at trying to use self-employed health insurance and an employer pension match to create "compensation" that isn't subject to payroll taxes. E.g., if you pay Malum the shareholder-employer a base wage of $50K but then in addition provide $10K of health insurance, that counts as wages but isn't subject to payroll taxes. Not to go all accountant on you, but if you also did a 25% SEP match (so $15K on the $60K of base wages and health insurance) you're now up to $75K in compensation in a sense. But you've still "only" paid payroll taxes on $50K.

Third, you want to see if there's anything you can do to dial down your distributions since that's what IRS can come in and recategorize. Example: If you give $5K a year to charity, your S corp ought to do that (which means your distributions are $5K less).

Hope that helps.

P.S. I think Warren Buffet has in recent years paid himself $100K... (That's a way to explain the $15,300 of FICA taxes he  says he paid since the rate is 15.3%)... and that's another good data point to keep in mind.

[jwright]

Malum, what kind of law to you practice?  If you do estate planning and simply charge by the hour, there is a better argument that all of you personal service time is wages and subject to payroll tax.  I work with several plaintiffs firms that are incorporated as S-Corps.  They can put in a fewer hours on a case for a higher yield.  The nature of that business does not lend itself to considering the income self-employment income.  That would fall under the "time and effort" bullet point you posted above.