Author Topic: Solo 401K for sole proprietorship vs S-Corp  (Read 2293 times)

Djeayzonne

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Solo 401K for sole proprietorship vs S-Corp
« on: August 26, 2016, 09:21:40 PM »
I have just recently become aware of the solo 401K thanks to the responses I got in my first thread.

I am trying to decide if going S-Corp would be beneficial.

Can someone break down what the advantages/disadvantages/differences are between sole proprietorship and S-Corp specifically in regards to what you can do with and how you manage the solo 401K?

webguy

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Re: Solo 401K for sole proprietorship vs S-Corp
« Reply #1 on: August 26, 2016, 10:49:13 PM »
How much income are you making? An s-corp only starts to make sense financially with the tax savings if you're earning above 250k/year.

Djeayzonne

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Re: Solo 401K for sole proprietorship vs S-Corp
« Reply #2 on: August 26, 2016, 11:50:24 PM »
Oh, really, that high?

No, my gross is around 120K right now, which is a pretty significant jump up from last year.

Although I don't have so much fixed costs and such as my business is a service business that I can do from home.

protostache

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Re: Solo 401K for sole proprietorship vs S-Corp
« Reply #3 on: August 27, 2016, 04:51:10 AM »
I made a little calculator that shows you the tax savings you can expect:

https://www.petekeen.net/how-much-can-you-save-with-an-s-corp

S-Corp makes sense if you can justify paying yourself $118,500 or less in "reasonable salary" or if you are making more than $250k. It does two things. First, it means you only pay Social Security and Medicare on your salary. Social Security currently only applies to the first $118,500 of income, however, so between that and $250k only Medicare (2.9%) applies.

At $250k (for MFJ filers) the additional Obamacare Medicare surtax kicks in, which is another 0.9% on top of the 2.9%. The second interesting thing about an S-Corp is that distributions aren't subject to this additional Medicare tax.

Really this is a question for a CPA, who will be able to look at your numbers and tell you if it makes sense in terms of the tax savings offsetting the additional tax prep work. My CPA charges a minimum $750 to prep an S-corp return, so the tax savings have to justify that. As well, a CPA will help you determine what your reasonable salary could defensively be. The IRS has a bunch of guidelines and you want to be able to point to them and say you meet one or more if you ever get audited. You'll have to work with them to balance tax savings against 401k contributions because you can only contribute 25% of your salary +$18k as an S-Corp owner up to the $53k cap, whereas if you're filing as a disregarded entity (sole prop or default LLC) you can contribute 20% of net income + $18k up to the cap.
« Last Edit: August 27, 2016, 05:05:51 AM by protostache »

webguy

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Re: Solo 401K for sole proprietorship vs S-Corp
« Reply #4 on: August 27, 2016, 07:43:25 AM »
Yeah the nice thing about sticking as a sole proprietor is that you can just file your taxes yourself. It's a lot trickier when filing as an s-corp so I'd definitely recommend a CPA. Ours also charges around $750. The big advantage is that you only pay taxes on the salary that you pay yourself rather than the entire income, but if you're only earning $120k and a realistic salary for someone doing your job is $100k then you're only saving on $20k, but paying a lot more in tax preparation. There are other nuances to it than that (see prostache's post above) but that's the gist of it.  If you're anticipating earning a lot more next year then it could be worth setting it up in advance this year. I'd email a CPA as most will give you a free consultation and you can explain your situation and get their opinion.

webguy

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Re: Solo 401K for sole proprietorship vs S-Corp
« Reply #5 on: August 27, 2016, 07:46:21 AM »
Oh and the solo 401k stuff is the same either way. I had a solo 401k as a sole proprietor and now I'm an LLC filing as an s-corp and the solo 401k hasn't changed. It only changes if you hire employees that aren't your spouse, then you no longer qualify for a solo 401k. My company is me and my wife as employees and then 3 part time contractors, which means I can still use a solo 401k and contribute the max.

TheSimpleLife

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Re: Solo 401K for sole proprietorship vs S-Corp
« Reply #6 on: August 27, 2016, 08:42:23 AM »
I made a little calculator that shows you the tax savings you can expect:

https://www.petekeen.net/how-much-can-you-save-with-an-s-corp

S-Corp makes sense if you can justify paying yourself $118,500 or less in "reasonable salary" or if you are making more than $250k. It does two things. First, it means you only pay Social Security and Medicare on your salary. Social Security currently only applies to the first $118,500 of income, however, so between that and $250k only Medicare (2.9%) applies.

At $250k (for MFJ filers) the additional Obamacare Medicare surtax kicks in, which is another 0.9% on top of the 2.9%. The second interesting thing about an S-Corp is that distributions aren't subject to this additional Medicare tax.


Really this is a question for a CPA, who will be able to look at your numbers and tell you if it makes sense in terms of the tax savings offsetting the additional tax prep work. My CPA charges a minimum $750 to prep an S-corp return, so the tax savings have to justify that. As well, a CPA will help you determine what your reasonable salary could defensively be. The IRS has a bunch of guidelines and you want to be able to point to them and say you meet one or more if you ever get audited. You'll have to work with them to balance tax savings against 401k contributions because you can only contribute 25% of your salary +$18k as an S-Corp owner up to the $53k cap, whereas if you're filing as a disregarded entity (sole prop or default LLC) you can contribute 20% of net income + $18k up to the cap.

Prostache has given some very good advice (I highlighted the important highlights IMHO).

In addition to the extra tax prep fees for the S-Corp, you will also pay unemployment tax on yourself to the IRS and possibly to your state. You will probably pay a payroll service or your CPA to file all the quarterly payroll tax forms on your behalf. All in, I'd plan on around $1K/yr in extra compliance costs (tax returns and payroll tax returns) plus the unemployment taxes (again, amount would depend on your specific state).

Also as stated by prostache, you will need to weigh how the "lower" salary restricts your ability to max out the solo 401(k).

A huge factor to "reasonable salary" is your profession. For some professions, anything under the FICA cap would be stretching it. For others, you might realistically be able to defend $40K of salary. Location matters as well. A software engineer in the Bay Area would obviously be expected to earn more than one in Cleveland, Ohio. I didn't read any of your previous posts so I'm not sure what your craft is.

The best approach to the reasonable salary question is this: If I were to hire someone to perform ALL of my work duties, how much would I have to pay them? That is a reasonable salary...

I'm a CPA with clients in your exact scenario, so I'd be happy to answer any basic questions you have (not going to provide specific tax advice). Honestly a forum isn't the best place for tax advice. Ha ha.

Laserjet3051

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Re: Solo 401K for sole proprietorship vs S-Corp
« Reply #7 on: August 27, 2016, 09:39:54 AM »
How much income are you making? An s-corp only starts to make sense financially with the tax savings if you're earning above 250k/year.

I realize every situation is different, but I would just point out that my single member LLC (filing as s-corp), gross annual income is well south of 250K, yet the total tax burden of said company is now much less than it was when I was initially operating it as a sole prop. There are probably several factors that contribute to this tax liability difference, but I just wanted to point out the above bolded quote may not necessarily be universally true in all cases.

Djeayzonne

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Re: Solo 401K for sole proprietorship vs S-Corp
« Reply #8 on: August 27, 2016, 12:28:33 PM »
Wow, thanks for the great responses.

Yeah, I should talk to a CPA. I have been trying to find recommendations for one in my area, but no luck so far.

Basically, I'm just a freelancer. The salary for someone working in-house would be around 40 K, but the truth is if I really ask myself about the value of replacing me, I'd have to hire two people. No one would work the way I do for just an average salary.

Is there some official irs info on salaries?

DavidAnnArbor

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Re: Solo 401K for sole proprietorship vs S-Corp
« Reply #9 on: August 27, 2016, 12:39:45 PM »
Medicare/Fica tax for employee/employer is 15.3%, so even if you were able to take 20K out of being considered your income, you save around $3,000 right there.

TheSimpleLife

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Re: Solo 401K for sole proprietorship vs S-Corp
« Reply #10 on: August 27, 2016, 01:52:13 PM »
Wow, thanks for the great responses.

Yeah, I should talk to a CPA. I have been trying to find recommendations for one in my area, but no luck so far.

Basically, I'm just a freelancer. The salary for someone working in-house would be around 40 K, but the truth is if I really ask myself about the value of replacing me, I'd have to hire two people. No one would work the way I do for just an average salary.

Is there some official irs info on salaries?

Here is some IRS links:

https://www.irs.gov/businesses/small-businesses-self-employed/paying-yourself

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

https://www.irs.gov/publications/p535/ch02.html#en_US_2015_publink1000208661

They aren't going to tell you exactly how much to pay yourself. That is usually decided by you with guidance from a professional.

What type of freelance work do you do? A freelancer who does graphic design would generally be able to pay themselves less than a freelancing software engineer all things being equal. In other words, freelancer just means you work for yourself, it doesn't describe what you actually do.

Hope that helps!

Djeayzonne

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Re: Solo 401K for sole proprietorship vs S-Corp
« Reply #11 on: August 27, 2016, 03:07:10 PM »

What type of freelance work do you do? A freelancer who does graphic design would generally be able to pay themselves less than a freelancing software engineer all things being equal. In other words, freelancer just means you work for yourself, it doesn't describe what you actually do.

Hope that helps!

Thanks, I will check those out.

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