S-Corp, Solo 401(k)s And Optimizing Your Taxes…

You own a business so you decide to set it up as an S-Corp. And frankly, this is one of THE ways to setup your business as you get to classify some of the income from that business as a W2 salary with the remaining as distribution. Why do it that way? Because there are no FICA (Federal Insurance Contributions Act) taxes to be paid on income that is derived as a distribution from that S-Corp. FICA = Social Security + Medicare tax. FICA taxes are technically not taxes as they are contributions to a benefits pool that would ‘likely’ come back to you later in life but who knows. So let’s call it what it is for now, a tax. And how much is that tax? 12.4% in Social Security tax on W2 wages up to $127,000 for the 2017 tax year + 2.9% in Medicare tax on all W2 income. There is a 0.9% Medicare tax surcharge on W2 income above $250,000 for married filing jointly filers. FICA taxes are split 50:50 between the employee receiving W2 wages and the S-Corp paying those wages.

So naturally, if you own an S-Corp, why not take the entire income as distribution from the business and zero as W2 wages and in that process, avoid those killer FICA taxes? You could but then there is this thing called the IRS and they hate it when you do this. In fact, IRS sets guidelines for an S-Corp to pay a salary that is reasonable to their active owners depending upon the market rate for the kind of work the owners do. Plus you can only contribute to a 401(k) plan with income from W2 wages. No contributions are allowed with income as distribution from an S-Corp. And that is a big deal because you get to shelter up to $54,000 each ($18,000 as employee contribution with the remaining as profit sharing) for you and your spouse in your respective 401(k)s, an amount too big to pass up on and forego all that tax-deferred growth on those contributions for decades to come.

But it’s not a slam dunk to decide and you need to tune, you need to optimize the split between the incomes you take as W2 wages and the income you take as distribution from your S-Corp to minimize the amount you pay in taxes in the current tax year as well as in the years to come. We’ll run through a few hypothetical scenarios for a couple who are 50:50 joint owners of an S-Corp generating an after-expense taxable income of $400,000.

Strategy 1 is where no contributions to 401(k) plans are made and a W2 wage of $100,000 is drawn from that S-Corp for both the employee and the spouse.

Strategy 1 –

  1. S-Corp earnings = $400,000
  2. W2 wages = $100,000
  3. Social Security tax paid by the employee (capped on wages up to $127,000) = 6.2% of $100,000 = $6,200
  4. Medicare tax paid by the employee = 1.45% of $100,000 = $1,450
  5. Social Security tax paid by the employer (capped on wages up to $127,000) = 6.2% of $100,000 = $6,200
  6. Medicare tax paid by the employer = 1.45% of $100,000 = $1,450
  7. Spouse’s W2 wages = $100,000
  8. Social Security tax paid by the spouse (capped on wages up to $127,000) = 6.2% of $100,000 = $6,200
  9. Medicare tax paid by the spouse = 1.45% of $100,000 = $1,450
  10. Social Security tax paid by the employer on spouse’s behalf (capped on wages up to $127,000) = 6.2% of $100,000 = $6,200
  11. Medicare tax paid by the employer on spouse’s behalf = 1.45% of $100,000 = $1,450
  12. Additional Medicare tax on W-2 income above $250,000 for a couple using MFJ tax filing status = 0.9% of $0 = $0
  13. Net taxable S-Corp earnings = 1 – 2 – 5 – 6 – 7 – 10 – 11 = $184,700
  14. Employee 401(k) contribution = $0
  15. Profit sharing contribution to 401(k) for the employee = $0
  16. Spouse’s 401(k) contribution = $0
  17. Profit sharing contribution to 401(k) for the spouse = $0
  18. Total taxable earnings = 2 + 7 + 13 – 14 – 15 – 16 – 17 = $384,700
  19. Total taxes paid = 3 + 4 + 5 + 6 + 8 + 9 + 10 + 11 + 12 + ($102,168, calculated tax on the  line 18 amount) = $132,768
  20. Effective tax rate (ex-State taxes) = $132,768 / $400,000 = 33.2%

Strategy 2 uses the same income breakdown of $100,000 in W2 wages for each owner with the rest as distribution from the S-Corp. Of that $100,000 in W2 wages, $43,000 in 401(k) contributions are made in each of their plans.

Strategy 2 –

  1. S-Corp earnings = $400,000
  2. W2 wages = $100,000
  3. Social Security tax paid by the employee (capped on wages up to $127,000) = 6.2% of $100,000 = $6,200
  4. Medicare tax paid by the employee = 1.45% of $100,000 = $1,450
  5. Social Security tax paid by the employer (capped on wages up to $127,000) = 6.2% of $100,000 = $6,200
  6. Medicare tax paid by the employer = 1.45% of $100,000 = $1,450
  7. Spouse’s W2 wages = $100,000
  8. Social Security tax paid by the spouse (capped on wages up to $127,000) = 6.2% of $100,000 = $6,200
  9. Medicare tax paid by the spouse = 1.45% of $100,000 = $1,450
  10. Social Security tax paid by the employer on spouse’s behalf (capped on wages up to $127,000) = 6.2% of $100,000 = $6,200
  11. Medicare tax paid by the employer on spouse’s behalf = 1.45% of $100,000 = $1,450
  12. Additional Medicare tax on W-2 income above $250,000 for a couple using MFJ tax filing status = 0.9% of $0 = $0
  13. Net taxable S-Corp earnings = 1 – 2 – 5 – 6 – 7 – 10 – 11 = $184,700
  14. Employee 401(k) contribution = $18,000
  15. Profit sharing contribution to 401(k) for the employee = 25% of W2 wages = 25% of $100,000 = $25,000
  16. Spouse’s 401(k) contribution = $18,000
  17. Profit sharing contribution to 401(k) for the spouse = 25% of W2 wages = 25% of $100,000 = $25,000
  18. Total taxable earnings = 2 + 7 + 13 – 14 – 15 – 16 – 17 = $298,700
  19. Total taxes paid = 3 + 4 + 5 + 6 + 8 + 9 + 10 + 11 + 12 + ($73,788, calculated tax on the  line 18 amount) = $104,388
  20. Effective tax rate (ex-State taxes) = $104,388 / $400,000 = 26.1%

But we know that the maximum allowed in a Solo 401(k) for the 2017 tax year is $54,000 for each of the participants. To avail of that, this couple would have to jack up their W2 wages from the S-Corp and assuming they do that, what does the new tax burden look like?

Strategy 3 – 

  1. S-Corp earnings = $400,000
  2. W2 wages = $144,000
  3. Social Security tax paid by the employee (capped on wages up to $127,000) = 6.2% of $127,000 = $7,874
  4. Medicare tax paid by the employee = 1.45% of $144,000 = $2,088
  5. Social Security tax paid by the employer (capped on wages up to $127,000) = 6.2% of $127,000 = $7,874
  6. Medicare tax paid by the employer = 1.45% of $144,000 = $2,088
  7. Spouse’s W2 wages = $144,000
  8. Social Security tax paid by the spouse (capped on wages up to $127,000) = 6.2% of $127,000 = $7,874
  9. Medicare tax paid by the spouse = 1.45% of $144,000 = $2,088
  10. Social Security tax paid by the employer on spouse’s behalf (capped on wages up to $127,000) = 6.2% of $127,000 = $7,874
  11. Medicare tax paid by the employer on spouse’s behalf = 1.45% of $144,000 = $2,088
  12. Additional Medicare tax on W-2 income above $250,000 for a couple using MFJ tax filing status = 0.9% of $38,000 = $342
  13. Net taxable S-Corp earnings = 1 – 2 – 5 – 6 – 7 – 10 – 11 = $92,076
  14. Employee 401(k) contribution = $18,000
  15. Profit sharing contribution to 401(k) for the employee = 25% of W2 wages = 25% of $144,000 = $36,000
  16. Spouse’s 401(k) contribution = $18,000
  17. Profit sharing contribution to 401(k) for the spouse = 25% of W2 wages = 25% of $144,000 = $36,000
  18. Total taxable earnings = 2 + 7 + 13 – 14 – 15 – 16 – 17 = $272,076
  19. Total taxes paid = 3 + 4 + 5 + 6 + 8 + 9 + 10 + 11 + 12 + ($65,002, calculated tax on the  line 18 amount) = $104,850
  20. Effective tax rate (ex-State taxes) = $104,850 / $400,000 = 26.2%

Say you want to get cheeky with the IRS and instead of splitting the S-Corp income between W2 wages and a distribution, you decide to take the entire amount as a distribution that flows to you. And you can’t contribute to a 401(k) with income from distributions and hence…

Strategy 4 –

  1. S-Corp earnings = $400,000
  2. W2 wages = $0
  3. Social Security tax paid by the employee (capped on wages up to $127,000) = $0
  4. Medicare tax paid by the employee = $0
  5. Social Security tax paid by the employer (capped on wages up to $127,000) = $0
  6. Medicare tax paid by the employer = $0
  7. Spouse’s W2 wages = $0
  8. Social Security tax paid by the spouse (capped on wages up to $127,000) = $0
  9. Medicare tax paid by the spouse = $0
  10. Social Security tax paid by the employer on spouse’s behalf (capped on wages up to $127,000) = $0
  11. Medicare tax paid by the employer on spouse’s behalf = $0
  12. Additional Medicare tax on W-2 income above $250,000 for a couple using MFJ tax filing status = $0
  13. Net taxable S-Corp earnings = 1 – 2 – 5 – 6 – 7 – 10 – 11 = $400,000
  14. Employee 401(k) contribution = $0
  15. Profit sharing contribution for the employee = 25% of W2 wages = $0
  16. Spouse’s 401(k) contribution = $0
  17. Profit sharing contribution for the spouse = 25% of W2 wages = $0
  18. Total taxable earnings = 2 + 7 + 13 – 14 – 15 – 16 – 17 = $400,000
  19. Total taxes paid = 3 + 4 + 5 + 6 + 8 + 9 + 10 + 11 + 12 + ($107,217, calculated tax on the  line 18 amount) = $107,217
  20. Effective tax rate (ex-State taxes) = $107,217 / $400,000 = 26.8%

Strategy 1 is out because that causes you to unnecessarily pay more in taxes plus you don’t get to participate in tax-deferred growth of your savings in a 401(k) type account. Strategy 4 sounds great because you avoid those FICA taxes but then the IRS would not like it. Plus there are no current year tax savings. That leaves us with Strategies 2 and 3, both with similar tax profiles but Strategy 3 really amps up the amount of money ($108,000) you can pump into your 401(k)s. So if we had a choice, Strategy 3 would be it.

Now this is all hypothetical and the actual numbers could be a bit different as we are not accounting for the deductions and the exemptions that you would have when preparing your returns. Your tax planner should be able to crunch the precise numbers for you but you do not and we say do not want to not maximize the 401(k) contribution benefits you have as a business owner even though that causes you to pay a bit more in FICA taxes in a given year so again, Strategy 3 would be the default choice for us.

Until later…

Image credit – RawPixel, Pexel