Incorporating yourself is a good way for many doctors to save themselves a few thousand dollars in Medicare taxes. The reason why is that once you incorporate, some of your take-home is salary (which is subject to Medicare tax) and some of your take-home is business profit, (which is not). At 2.9%, every $100K you call business profit instead of salary is worth $2900 off your tax bill.
A Reasonable Salary
So the temptation, of course, is to call all your take-home money business profit and NONE of it salary. As you might imagine, that's not going to fly with the IRS. The IRS expects you to pay yourself a reasonable salary, or one for which you'd go do the same job for someone else. Unfortunately, that's about the only guideline they give you. Apparently, people are willing to do the same job as me for a wide variety of salaries. For example, in the military, I did the job for a taxable salary of something like $80,000 a year. A recent emergency medicine salary survey of physician employees showed the 10th percentile at $205K and the 90th percentile at $384K. That obviously leaves a very broad range of the number you want to use for your salary. If your group also hires moonlighters, you could also use the rate at which you hire them for your salary. Basically, the key is that whatever figure you use, you have to be able to justify it to the IRS.
The 50% Rule
I met with a CPA recently, and she notes that auditing of an S Corp is pretty darn rare and she's never heard of a doctor being audited on this particular point. But she recommended that you pay yourself no less than 50% of your take home as salary and suggested a range of 50-70% of your take-home should be salary. The theory, she stated, was that some of your income is from being a prudent manager of the business and for taking on that business risk. But in emergency medicine, most of your income comes directly from your own patient care fees, not from other business income. I think if you were a family practice doctor with 3 PAs working for you and selling some supplements on the side, you could justify a lower percentage of your income being salary than a shift-worker like an emergency doc could. But the point is that whatever you pay yourself, you'd better be able to have some kind of data to justify that number if the IRS comes asking. When they do audits, they start with those people who pay themselves 0% in salary and work their way up from there.
Retirement Plan Effects
A more important factor for me was the effect on how much I could sock into a retirement plan. Business profit can't be used to determine the amount you can contribute to your 401K or SEP IRA, only salary can. If I want to max out my 401K with $50K ($55K if over 50), then I need a salary to justify that contribution. You have to do some calculating to figure out the exact amount. For a self-employed doctor, it turns out the number is higher if you use a SEP-IRA than a solo 401K. That's because with a SEP-IRA you can only contribute between ~19% of your salary to a retirement plan. With a solo 401K, you can contribute $17K as the employee contribution, and then ~19% of your salary can be contributed as an employer contribution
If you run the numbers for 2012, it turns out that if you want to maximize your SEP-IRA, you need an income of $259,717 ($21,643.08 per month). For a 401K, that number is $173,564 ($14,463.67 per month). Although a Solo 401K is a little more complicated to use than a SEP-IRA, for an incorporated doctor making more than $259,717, there is a possible tax savings of $2498 a year for doing so. Not to mention the opportunity to use a Backdoor Roth IRA that you can't do with a SEP-IRA. If you'd like to do these calculations yourself, use the worksheet in Pub 560, page 22. An easier way is to use this handy calculator which for any given income, will tell you how much you can put into a 401K/profit-sharing plan and how much you can put into a SEP-IRA.
It turns out my situation gets even more complicated. Since my corporation would be a partner in a partnership, my corporation would have to use the partnership's 401K plan. So I am subject to the partnership 401K rules, which, although still a little unclear, probably means I would need to pay myself a salary around $250K in order to max out the 401K, dramatically decreasing the benefits of incorporation for me.
[Update 1/17: If your entity is an S Corp or an LLC filing as an S Corp, your business can make an employer contribution to a 401(k) of 25% of your W-2 wages. While this means the business needs to make just as much money as a sole proprietorship in order to max out a 401(k), the employer contribution is not subject to payroll taxes, so there is a savings there of about $1000 a year in Medicare tax for most docs.]
Obamacare Tax
One other great reason to keep your salary down is to avoid the new 0.9% “Obamacare” additional Medicare tax on high earners. It is levied as 0.9% of every dollar you earn (as salary) over $200K ($250K married). If your salary is $173K, you won't have to pay any of that tax, even if you take home an additional $150K as “business profit.”
Incorporation isn't necessarily the huge tax savings it is sometimes cracked up to be, but for many doctors, the benefits outweigh the costs in time and money. This is obviously all pretty new to me, so post in the comments below how you decided how much to pay yourself as salary and why.
Have you incorporated? What do you consider a reasonable salary? Have the benefits outweighed the costs? Comment below!
My CPA says the IRS has used salary.com as a reference in cases and that as you mentioned they are really targeting the people who pay themselves next to nothing in salary. When you have your yearly S corp meeting, likely you should make it clear all the things the company is doing besides you just getting reimbursed for seeing patients. I think the problem with the % example is that it appears you only came up with the % as a way to avoid the IRS and without any real evidence of what the salary should be.
Obviously the “percentage answer” isn’t going to fly with the IRS. I participate in a salary survey for my specialty each year and I’d use data for that to “defend my salary.” Unfortunately I could defend a salary that is far less than I’d need to max out my 401K.
of course that isnt really unfortunately….
the question actual becomes how comfortable is one paying him/herself a salary of lets say 300k if they make 900k? Is it still defendable when you have evidence that you have paid yourself what by the evidence available is a reasonable salary?
I dont have an answer to that question.
WCI can you explain where you get the “possible tax savings of $2498” for an incorporated Doc who chooses solo 401k option? I am an ER doc paid as a contractor. This is my first year out of residency. I setup an S-corp for myself and am choosing between SEP IRA and solo 401K for retirement savings. I know there was another thread dedicated to this exact decision but I only find mention of this extra tax savings from the 401k option on this page. Saving over $2000 in taxes seems to justify the extra paperwork needed for 401k.
Thanks!
It comes down to your income. If your income (AGI) is under $250K you can put more into a Solo 401K than into a SEP-IRA. The more you put in, the more you save in taxes in the year you put it in.
If your AGI is $300K, then there’s no difference. I’d still do the Solo 401K though, to allow you to do Backdoor Roth IRAs, which you can’t do if you’re using a SEP-IRA.
If I were an independent contractor, I would DEFINITELY do the Solo 401K, no matter what my income. The only reason to do the SEP-IRA is less paperwork.
So with an S-corp could you technically pay yourself under the maximum for being roth-IRA eligible and then contribute to a roth as well?
No. That wouldn’t work because the S-corp non-salary income still counts against you. You do know about a backdoor Roth IRA, right?
WCI, did you end up incorporating?
Not yet. Still considering it and will probably do it at the end of the year.
Thank you- as a new physician- I find your website/blog very helpful. I read the article on S corporations you wrote in 2011 and it seems your opinion has changed. Is there any reason for that… or just an increase in income to justify switching over for the 3%?
I’ll be honest. I haven’t gotten around to doing it yet. There’s definitely a trade-off, more hassle for slightly more income. I really wanted to say where my income hit this year as my first full year as a partner before running the numbers and deciding if it was worth the hassle.
So to revive this thread, and based on your experience over the past few years, for retirement plan contribution purposes and to maximize tax avoidance, is it a smarter decision to form an LLC with an S-corp tax structure or to just form a single member LLC? My understanding is that under a single member LLC, “earned income” refers to all the money coming into the business entity even before business expenses are taken out, which can really maximize contributions to a solo 401k, whereas for an LLC with an S-corp tax structure, retirement contributions are calculated from the paid salary and not the distributions. So to maximize tax avoidance, one has to pay out a higher salary, which would take away the self-employment tax savings inherent to the S-corp concept. It seems to me that it’s best to have a single member LLC tax structure. What are your thoughts?
You form the same LLC either way. You either pay taxes as a sole proprietor or as an S corp. Which is better depends. There is additional hassle and expense with being a corporation, but it may allow you to save some Medicare taxes.
So here’s the way I look at it, assuming you only have one job. If you make ~ $200K, might as well be a sole proprietor. You’re going to need all that income as salary to max out an individual 401(k). At $250K, the hassle is more than the tax savings of incorporating. At $300K, I think the hassle is probably worth the $3K off your taxes. Above there, sure, go for the corporation. At $600K, you can call it $300K salary and $300K distribution. You save $8700 on your Medicare taxes and can still easily max out your individual 401(k).
So to revive this thread, and based on your experience over the past few years, for retirement plan contribution purposes and to maximize tax avoidance, is it a smarter decision to form an LLC with an S-corp tax structure or to just form a single member LLC? My understanding is that under a single member LLC, “earned income” refers to all the money coming into the business entity even before business expenses are taken out, which can really maximize contributions to a solo 401k, whereas for an LLC with an S-corp tax structure, retirement contributions are calculated from the paid salary and not the distributions. So to maximize tax avoidance, one has to pay out a higher salary, which would take away the self-employment tax savings inherent to the S-corp concept. It seems to me that it’s best to have a single member LLC tax structure. What are your thoughts?
Question, I am s neurologist doing Locum work as an S-Corp. I work 5 months a year and make ~$385k a year. After reading this tread and other of your comments, since the average neurologist salary working FULL TIME Is $230k, I was wondering if I can justify a salary of $115k (half of a full time/part -time )shot even $140k to deduct student loan interest of husband and I.
What are you doing to make $385K a year as a neurologist in just 5 months? I’m sure there are a lot of neurologists that would be interested in THAT.
My general rule for S Corp salary is to take at least half your income as salary. Besides, you’ll need almost $200K in order to max out a solo 401(k). That’s a much bigger deduction than the student loan interest deduction.
Thanks for your reply WCI. I contract directly with hospitals for a flat fee- I am making the same amount of money in 5 months as when I was working full time Since I am technically working half-time, and I seen part-time jobs posted for $130k, can I justify that salary to the IRS?
BTW, I don’t do 401k ( I read your book etc and I understand the tax savings ) but my strategy is buy and hold real estate- I been getting 15%–22% cash in cash returns since I started 5 yrs ago, but this is a different topic.
20% cash on cash is pretty incredible actually. Nice job. Not sure why you’re doing neurology at all! You ought to be doing real estate.
If you aren’t going to use a 401(k) (and I think you should since you can use a self-directed individual 401(k) to invest in real estate) then the goal is to get your salary as low as you can without the IRS caring. Again, I think half is a reasonable amount, but the main thing is to be able to justify it to the IRS. My understanding, however, is that you rarely would have to do so. Especially if you’re maxing out your SS taxes, which you would be at $130K. Worst case scenario- they audit you and say no dice and you end up having to pay some more with some penalty and interest. They’re not going to throw you in jail for something like this.
I love these posts, so here is a question and I apologize if it is a repeat of what others have asked or written. That said, I may be receiving wages for medical work paid to me on a 1099 basis, or alternatively paid entirely to an S corp that I set-up/own. I live and work in California.
Assuming yearly total wages of $365,000, the highest tax bracket (my wife earns some income), and assuming I make an employee contribution of $18,000 to my 401k:
– What is the approximate self-employment tax if I am paid the wages as a 1099?
– What is the approximate self-employment tax if my S corp pays me a salary of $250,000 and an income distribution of $115,000?
– I chose the S corp salary/distribution amounts somewhat arbitrarily- in my area over the last 5 years I have seen starting salaries for my specialty range between $240,000 – $280,000. Would it be very important to set the S corp salary at the higher end at or near $280,000?
– What would the approximate California state tax charged to the S corp amount to assuming a net S corp income of around $325,000?
– About how much of a 401k employer match could I make in the 1099 situation? In the S corp situation?
Would really appreciate help with the number crunching. Thanks!
1. You pay SS tax on the first $118,500 (12.2%.) You pay Medicare tax (2.9%) on everything.
2. You pay SS tax on the first $118,500 and Medicare tax on the first $250,000, essentially saving a little over $3K in medicare tax.
3. Seems like a reasonable amount to me. I’d be very surprised to hear the IRS having an issue with that salary. The only reason to increase salary is to increase individual 401(k) contributions, but assuming this is your only 401(k), you should be able to max that out on even less than $250K.
4. I’m not familiar enough with California tax law to answer that. But you’re going to pay at your regular brackets on all of the income. The state income tax probably (and I say probably just because who knows what they’re doing in California, but in Utah this would be the case) doesn’t change by running it through the S corp.
5. 20% of the net self-employment income not counting the distribution. So if you just want to max out a single individual 401(k), you should be able to do that on ~ $190K of salary since $18K is employee distribution and $35K/0.20 = $175K.
Hey WCI,
At risk of making myself look silly here, I’m not sure how you’re figuring the Solo 401(k) salary.. You mentioned it a couple of times in the post and the comments.
For an S Corp, isn’t $140K enough to get $53K deferred?
$18K EE
$35K ER derived from 25% of $140K
I think you’re mistaken, but if you can cite a reputable source showing I’m wrong I’d love to see it.
Lots of people get confused by the 20%/25% thing, but it’s really the same number. With 25%, it doesn’t include the contribution. With 20%, it does. If you work through the IRS table in the instructions, you can see that.
So no, $140K isn’t enough to defer $53K. It’s more like $175K, and that assumes you can use the employee contribution in that 401(k). (That can be an issue if you have more than one 401(k).)
I don’t see anywhere that being an S Corp instead of a sole proprietor or other business structure gives you a free pass, but would love to be wrong since that would actually save me a lot of money.
Here’s the example I was looking at:
Example: Ben, age 51, earned $50,000 in W-2 wages from his S Corporation in 2016. He deferred $18,000 in regular elective deferrals plus $6,000 in catch-up contributions to the 401(k) plan. His business contributed 25% of his compensation to the plan, $12,500. Total contributions to the plan for 2016 were $36,500. This is the maximum that can be contributed to the plan for Ben for 2016.
From this, the calculation is $12,500 from a W2 of $50,000 or 25%. Therefore, if the W2 was $140,000 it would be $35,000?
(Source IRS One Participant Plans: https://www.irs.gov/retirement-plans/one-participant-401k-plans)
Right. It’s 25% of his compensation NOT 25% of his compensation plus the contribution his business is making. So it’s 20% of that total. I know this is tricky to wrap your head around because it took me a long time.
So, let’s say his S Corp makes $140K total. His business contributes $35K to the 401(k). Now the money left to pay him is $105K. 25% of $105K is $26K, so he overcontributed by $9K.
Now, let’s assume he’s trying to set his salary at the minimum required to max out the 401(k) and take the rest as a distribution of profits so he doesn’t have to pay Medicare tax on it. Let’s assume the business made $250K. He declares his salary to be $175K ($175Kish, it’s actually a little more if you run the calculations as they’re net of the employer share of payroll taxes.) $175K – $35K = $140K. 25% of $140K is $35K. So he’s good. The last $75K is distribution and he save 2.9% *75K = $2,175 on his taxes.
The IRS isn’t going to let you contribute money into a 401(k) on which payroll taxes haven’t been paid.
Again, I would like nothing more than to be proven wrong on this and soon so I can form S corps for this year. So if you can, please do. But I would advise you to read Pub 560, the paragraph on the right on page 15, and then go to the “Rate Worksheet for the Self-employed” in Chapter 5 (page 23 and especially the rate table on the upper left of page 24) and actually work through it. It will help you see where the 25% becomes 20%.
Please, please, please show me I’m wrong.
I think you’ve got it wrong, if you read the cited example again:
25% of W2 Compensation ($50K) = $12.5K [example]
25% of W2 Compensation ($140K) = $35K [same math]
Therefore W2 Compensation to max out a 401(k) is $35K, because the balance of $18K is via Employee salary deferral.
The company needs enough additional cash to pay that $35K, plus pay taxes, plus other expenses, but there’s no logical reason to set a salary of $175K and pay additional payroll tax on that $35K.
There’s two rules for 401(k) calculations, 20% and 25%. The 20% calculation is based on the Self Employment status which stems entirely from the person with a Schedule C, not a W2. If you read that Chapter 5 page 23,24 you will see the line items all ask for these 1040/Schedule C data points, not W2 income… it’s a different scenario from the S corp example cited on the IRS website I linked to.
If you have an S Corp, you don’t have Schedule C data – that worksheet isn’t for you.
I’m pretty sure I’m right about this the more we discuss it…
Obviously the business has to earn the income to contribute either way. If the business doesn’t earn $175K, you can’t max out the 401(k). The only question is whether you have to pay payroll taxes on that last $35K.
You’re saying that you do not have to pay payroll taxes on employer contributions to a 401(k). I can’t seem to find a reputable source as to whether that is true or not, but it doesn’t seem to pass the sniff test. Do you have a good source for that particular question?
This article suggests you’re right: https://www.bloomberg.com/news/articles/2014-08-13/why-your-companys-401-k-match-is-worth-less-than-cash
but it’s not quite what I’d call a definitive source.
I was actually planning to file taxes as an S Corp with the blog for 2017 anyway, but if this really flies it’ll save us about $2K in Medicare tax. Beats a kick in the teeth.
I cited an example from the IRS website (which also isn’t necessarily a definitive source) that shows W2 income of $50,000 allowing a $12,500 contribution from the employer.
We need to agree on that fact before continuing.
If we do agree, then $50K equating to $12.5K is the same as $140K equating to $35K.
But you’re suggesting that in order for the $12.5K to be allowable as employer side it must be added onto the $50K (same as $35K being added onto $140K to be allowed as employer side).
If that were the case, the example cited on the IRS website would be incorrect, as $50K wouldn’t be sufficient in terms of payroll to facilitate $12.5K.
My cites are the IRS website, and me being an Enrolled Agent, neither of which mean I can’t be wrong, but I think there’s too much evidence here to suggest I’m correct.
Just talk it through outloud:
If $50K gets me $12.5K
What does $140K get me?
Sure, I agree on your first point.
I’m saying the business must make $62.5K in order to pay the employee $50K and make a $12.5K employer contribution. I doubt you disagree with that.
The only question left for me is whether or not the business and/or the employee must pay payroll taxes on that $12.5K.
It must make more than $62.5K since there are payroll taxes due on the $50K, which would make required income higher.
It’s hard for me to show you something that doesn’t exist… if you want, I could share some redacted payrolls as examples of how taxes work for S Corps with 401(k), via email.
The interesting thing is that FICA is due on Salary Deferred portions of the 401(k) but not the employer portion – so if you ran side gig business and had no other plan in place, you could pay $18K salary, $6K employer, but you’d need more than $24K to run it since FICA is due on the $18K, even if reduced to zero salary for Fed/State/City tax.
That would be great. My email is editor (at) whitecoatinvestor.com
Edit – sorry, $18K would be $4.5K employer. Too early for complicate divide by four maths. 🙂
Hello! I am new to the forums. If I am paying myself a salary of 60K and taking a distribution of 40K can I contribute that total into a sep IRA? Or can I only contribute a percentage of the 60K? I set up a sep IRA today but am having difficult trying to determine how much I can invest. I have about 30k I would like to invest but not sure what other avenues I can use to invest that. I was going to start with a SEP. can I not just put all 30 into a sep?
Thanks
No. You can only contribute ~$60K * 20% = $12K into a SEP IRA. If you used an individual 401(k) you could contribute $18K + $12K = $30K though. You could also use a taxable account or a Roth IRA.
Awesome thanks! I’ll tell my financial guy to do both a sep and the 401K. Is it best to use a financial advisor for this stuff? Mine charges me 1percent to do the sep and its through fidelity. Not sure how much opening a 401K costs. Is it best to do everything through him or can I just do it myself through fidelity?
It can all be done yourself. But that means you do need to spend a little time learning how things work and figuring it out. 1% is a lot of money to me. If you’ve got $2 Million invested, 1% is $20K a year. So I do it myself. Maybe it’s worth $20K to you, I don’t know. You can also use an advisor for a while and then move into doing it yourself. Lots of options.
Hey WCI, Thanks for the awesome content here. Very useful. I am soon going to be leaving my w2 job for a 1099 gig in another state, so this is all very new to me. I have done some calculations based on the posts and wanted make sure I have a good grasp on things. So here we go….
Salary: $384K 1099
S corp
Pay myself 192k (50%) and Distribute 192K (50%)
Max SEP-IRA contribution 20% of 192k = 38.4K
Max Solo 401K contribution 38.4k + 18k = 56.4k
Medicare Savings on Distributions:
2.9% of 192k = 5.5k
My last question is in terms of how the distribution money is handled.
I assume that I will pay myself a reasonable salary of 192K per year.
So my question is…How is the other 192k(distribution) used. Does it just go into a separate bank account that I can deduct money from at anytime. Does it go into a business account or regular checking account. Are there any restrictions on what it can be used for. Etc etc…any insight would be greatly appreciated.
A couple of things.
# 1 You know you can’t do both a SEP and a Solo 401(k) in the same year, right?
# 2 You could have an even lower salary and still max out a Solo 401(k). Whether you want to go below 50% or not is your call. I don’t think I would.
# 3 Remember that half of Medicare tax is deductible, so you’re not really going to save $5.5K. More like $4K. Still better than a kick in the teeth.
# 4 The distribution money is just like bank interest. You pay taxes on it at your full marginal tax rate, but no payroll taxes, and you can spend it on anything you like. Your business just transfers it from the business account to your personal account.
Do you have any good recommendations on available resources to help a beginner like me learn the in’s and out’s of setting up an S corp for an upcoming switch to IC status.
https://www.whitecoatinvestor.com/incorporate-and-grow-rich-a-review/
Most ICs don’t set up an S corp.
Hello! I have a question regarding what my cpa has recommended. I’m a independent contractor pediatric dentist, my S-corp makes 500k.
My cpa has recommended me to give myself a huge bonus check at the end of the year and send all of it as a tax deposit. This increases my salary and taxes, but brings me up so I can max my SEP IRA.
After reading this thread I’m convinced I should switch to a 401k and decrease my salary increase distributions?
Yup, little reason for an independent contractor doctor to use a SEP over a solo 401(k). That would be a fireable offense for me. You can max it out on less income as well, allowing you to save a little more medicare tax too.