To S-Corp or not to S-Corp. To 401k or not to 401k

[marbar]

Hello, our financial position has recently changed in that my wife is now employed as a contractor. I am a W2 employee and have a small side hustle as well. We get healthcare through my job.

If all goes accordingly to plan, she will net about $200k from her single-person software/data business, and I will net about $30k from my business, on top of my W2 income.

Q1: S Corp
For my business, I don't see a world in which it makes sense to establish a S-corp given the need to file an additional tax return. For hers, I am not sure how to make the assessment. I assume the added expense of corporate tax return prep + payroll will be at least $2.5k. I am not sure if the tax benefits will warrant making the s-corp election. Can anyone provide insight?

Q2: Individual 401(k)
I am using my employer's 401k to max out employee contributions because the fees are low and funds are great. I also do a backdoor ROTH contribution. I haven't been making employer contributions to my business's i401k for fear of lowering my 199a deduction, but I am not sure if that is appropriate. I also didn't agonize over the decision much because the allowable employer contributions were pretty small, so I took the bigger 199a deduction.

Now that my wife will have a lot of business income, the calculus of 199a deduction vs pre-tax 401k contributions becomes much bigger! Can anyone give any insight into how to make the decision? We assume we will have much lower income in early retirement.

Thanks in advance.

[Michael in ABQ]

Generally, S-Corp election makes sense at $50-100k/year income level. At $200k/year it would almost certainly save her money.

I'm sure @SeattleCPA can provide a more detailed explanation.


Frankly this is where talking to a CPA to run through your specific scenario is very valuable. Even if you're just paying for an hour or two of their time it could potentially save you thousands.

[SeattleCPA]

@marbar here's a blog post that explains math: https://evergreensmallbusiness.com/tax-strategy-tuesday-one-person-s-corporation/

BTW I think you're right that it doesn't make sense to setup an S corporation for a sideline or PT venture. Though maybe you'd be able to combine your and your spouse's activities?

FYI, you are surely too late to do this for 2022. And the labor shortages in the world of tax mean you should not try to make contact with CPA firms until after they come back from their post tax season breaks. So May? June?

[dandarc]

For your side business, a sep-ira probably makes the most sense since employee side is well covered through your W2 job.

For your wife, there is an interaction with the s-corp decision - if she goes s-corp, v the employer contribution to a 401k will be limited to 25 percent of whatever w2 income she takes. Vs 20 percent of self employment income less 1/2 self employment tax if she chooses to be taxed was a proprietor. S-corp and solo k probably does make a ton of sense though with that much income.

[marbar]

This thread is already very helpful. Great link @SeattleCPA! Also, I agree talking to an accountant would be worthwhile @Michael in ABQ. That's just hard to do this time of year, and we need to make the S-corp election within a couple months.

I'm exploring the benefits of the S corp below:

Self-employment taxes
I used a spreadsheet from Gusto to estimate tax savings for S-corp LCC vs LLC without S-corp. I assumed W2 wages of 100k. The result is attached. You can find the spreadsheet on this page.

The S-corp status appears to save many thousands on this front!

Section 199a deduction
Our taxable income should be below the lower threshold amount ($364,200). I think we can use deductible retirement contributions to make sure we're below threshold if we aren't.

S-corp:
For simplicity, assume
Net income: $200k
W2 wages: $100k

So, QBI is $100k and the 199a deduction amount is 0.2*100k = 20k
The deduction should save $4.8k in taxes (24% tax bracket)

LCC without S-corp:
QBI is $200k and the 199a deduction amount is 0.2*200k = 40k
The deduction should save $9.6k in taxes (24% tax bracket)

Overall S-corp advantage
In summary, without accounting for the additional overhead of an S-corp, it looks like the S-corp approach wins by

~$12k-$4.8k = $7.2k

----

I'm no tax expert, so hopefully I haven't bungled the math. Does this look correct? @SeattleCPA

Since we're both doing software work (although of different kinds), maybe it would be helpful to do my work under the S-Corp too. I think that eliminates filling out a Schedule C for my business? Again, not a tax expert!

If this analysis is looking good, I'll start thinking about the effects of additional pre-tax retirement contributions...

[trollwithamustache]

The other benefit to an S-corp is now many medium/big companies will view you as a "real" company and it is way easier to get contracts. At least this is true in the traditional energy/chemicals world. 

Alas all that extra revenue does mean you pay more taxes. 

[SeattleCPA]

This thread is already very helpful. Great link @SeattleCPA! Also, I agree talking to an accountant would be worthwhile @Michael in ABQ. That's just hard to do this time of year, and we need to make the S-corp election within a couple months.

I'm exploring the benefits of the S corp below:

Self-employment taxes
I used a spreadsheet from Gusto to estimate tax savings for S-corp LCC vs LLC without S-corp. I assumed W2 wages of 100k. The result is attached. You can find the spreadsheet on this page.

The S-corp status appears to save many thousands on this front!

Section 199a deduction
Our taxable income should be below the lower threshold amount ($364,200). I think we can use deductible retirement contributions to make sure we're below threshold if we aren't.

S-corp:
For simplicity, assume
Net income: $200k
W2 wages: $100k

So, QBI is $100k and the 199a deduction amount is 0.2*100k = 20k
The deduction should save $4.8k in taxes (24% tax bracket)

LCC without S-corp:
QBI is $200k and the 199a deduction amount is 0.2*200k = 40k
The deduction should save $9.6k in taxes (24% tax bracket)

Overall S-corp advantage
In summary, without accounting for the additional overhead of an S-corp, it looks like the S-corp approach wins by

~$12k-$4.8k = $7.2k

----

I'm no tax expert, so hopefully I haven't bungled the math. Does this look correct? @SeattleCPA

Since we're both doing software work (although of different kinds), maybe it would be helpful to do my work under the S-Corp too. I think that eliminates filling out a Schedule C for my business? Again, not a tax expert!

If this analysis is looking good, I'll start thinking about the effects of additional pre-tax retirement contributions...

You're over-estimating the 199A (aka QBI) deduction for an LLC treated as a sole proprietorship. The 199A deduction will be lesser of QBI...or your taxable income. Also your QBI won't be $200K if you load up your tax return with pensions, SE health insurance etc. That means you're underestimating the attractiveness of an S corporation. You're probably more like $10K ahead once you make those fixes.

[marbar]

Now to the pre-tax retirement contribution calculus:

• Will salary deferral contributions to an individual 401(k) (up to $22,500) lower the 199a deduction for both the S corp and the LLC? In the S corp case, I would think the QBI has already been reduced by the wages, so no additional 199a deduction hit occurs. [EDIT] The internet confirms this... these employee contributions will not further decrease QBI and thus not decrease the deduction for the S corp case. [/EDIT]
• Will profit sharing contributions to an individual 401(k) lower the 199a deduction for both the S-corp and the LLC? I realize the profit sharing contribution limits are calculated differently for the two entity kinds. I assume the 199a deduction will be lowered in both cases.

... I think I'm getting close to understanding the factors at play!

[marbar]

For your side business, a sep-ira probably makes the most sense since employee side is well covered through your W2 job.

For your wife, there is an interaction with the s-corp decision - if she goes s-corp, v the employer contribution to a 401k will be limited to 25 percent of whatever w2 income she takes. Vs 20 percent of self employment income less 1/2 self employment tax if she chooses to be taxed was a proprietor. S-corp and solo k probably does make a ton of sense though with that much income.

That is an interesting callout r.e. the increased employer contribution limit of the sep ira. Definitely will keep in mind for my side hustle.

[dandarc]

I missed that you've already got the solo k set up. Sep-ira is equivalent to employer-only 401k, but a little simpler to set up / administer.

[SeattleCPA]

@marbar here's a slightly simplified example. Consider these numbers as an illustration of how calculations work. Not what the numbers should be.

The big picture: A business that makes $200K.

Further assume $30K in itemized deductions, $20K in SE health insurance, and a 401(k) with $20K elective deferral and $25K employer match. We'll also need to adjust for the employer half of the FICA and Medicare.

The disregarded entity LLC calculates its QBI as $200K profit minus $20K SE health minus $20K elective deferral minus $25K employer share and also minus roughly $12.5K SE tax adjustment. QBI then equals $122,500. And QBI deduction potentially equals of 20% of $122,500 QBI so roughly $24,500... But you need to look at taxable income because QBI deduction can't exceed 20% of the taxable income. That taxable income probably equals $92,500. Twenty percent of that taxable income equals roughly $18,500. Thus, that $18,500-ish deduction is what you get when the LLC treated as disregarded entity.

If you elect S corp status and pay shareholder $80K in base wages, add $20K of health insurance which counts as wages, do a $25K employer match, and pay roughly $3K in employer FICA, your QBI is roughly $72K. You get a QBI deduction equal to the LESSER of 20% of the $72K or roughly $14K... OR 20% of the roughly $102K of taxable income (the QBI plus the wages minus the elective deferral minus the itemized deductions) which means a QBI deduction of potentially $20K-ish. The QBI deduction with an S corporation is the lesser of the $14K or the $20K so you're talking a $14K QBI deduction.

But look at the delta: With the LLC treated as a disregarded entity, you get $4K more... which at 24% marginal rate saves you maybe $1K in federal income taxes. That's the incremental federal tax savings from bigger QBI.

So the $64 question at this point: How much FICA and Medicare does the S corp save with above numbers?

Well 15.3% of the interval between the $80K in base W-2 wages and the $160K FICA limit. That's roughly $12K. And then you pick up roughly another $1K in Medicare on the rest of the income. So now you're at 13K in total savings.

An S corp will push you to outsource your 1120S return and probably your 1040 too. You'll also need a real accounting system and a real payroll service like Gusto. Figure all that stuff costs $3K annually? So you maybe you're basically $9K a year ahead when you net EVERYTHING? Something like that.

Lots of the people who bash S corporations don't understand the above accounting. Which is too bad. Because the compound benefits snowball.

I did this blog post years ago to show this can be a million dollar missed opportunity: https://evergreensmallbusiness.com/million-dollar-s-corporation-mistake/

[SeattleCPA]

I missed that you've already got the solo k set up. Sep-ira is equivalent to employer-only 401k, but a little simpler to set up / administer.

I know people often get really stoked about 401(k) plans because they make it easier to Roth and you can do bigger contributions at lower income levels. (Thus very FIRE-friendly at first glance.)

But I really like SEP-IRAs for a handful of reasons. First, they are almost always free. Second, you have way simpler compliance and don't need to file a 5500. (Screw that up and you can get with catastrophic penalties.) Third, your plan doesn't immediately break if you add an employee the way a solo 401(k) plan does.

[dandarc]

I missed that you've already got the solo k set up. Sep-ira is equivalent to employer-only 401k, but a little simpler to set up / administer.

I know people often get really stoked about 401(k) plans because they make it easier to Roth and you can do bigger contributions at lower income levels. (Thus very FIRE-friendly at first glance.)

But I really like SEP-IRAs for a handful of reasons. First, they are almost always free. Second, you have way simpler compliance and don't need to file a 5500. (Screw that up and you can get with catastrophic penalties.) Third, your plan doesn't immediately break if you add an employee the way a solo 401(k) plan does.

So yeah along these lines - last year, in July I logged in to the EFAST2 system, filled out my 5500EZ, electronically signed it. In October I had a moment of panic that I had forgotten to do the 5500, so I logged in to double check and found that I had missed the very last step to actually submit the form. I filed immediately because why wouldn't that be the best thing to do? Managed to rack up a $19,500 penalty ($150 or $250 / day or whatever it is adds up quickly). Had I not filed, I could have sent in via snail-mail a voluntary compliance form with $500 payment ($750? in any event a lot less than $19,500), but I filed, so that's not an option. I sent in a request for abatement with "hey I tried" as my reason - I just received a letter requesting another 60 days to consider my request. If they rule against me, I'll probably set up a payment plan if that's available.

Funny thing - I had terminated the plan, so this form for 2021 was the very last 5500 I should need to file, and I didn't forget to do it and I still managed to screw it up. Tax savings over about 10 years do swamp that penalty, but will still be a tough pill to swallow.

[sonofsven]

I missed that you've already got the solo k set up. Sep-ira is equivalent to employer-only 401k, but a little simpler to set up / administer.

I know people often get really stoked about 401(k) plans because they make it easier to Roth and you can do bigger contributions at lower income levels. (Thus very FIRE-friendly at first glance.)

But I really like SEP-IRAs for a handful of reasons. First, they are almost always free. Second, you have way simpler compliance and don't need to file a 5500. (Screw that up and you can get with catastrophic penalties.) Third, your plan doesn't immediately break if you add an employee the way a solo 401(k) plan does.

I do both a SEP-IRA  and a Roth solo 401k. And a t-IRA.