For 2017, The White Coat Investor, LLC is going to be filing taxes as an S Corp for the first time. We're not technically incorporating, since the LLC structure works well for us, provides similar liability protection, and is low cost. But the IRS allows an LLC to choose to be taxed as a sole proprietor (if one owner), a partnership (if more than one owner), or a corporation (any number of owners.) If you choose to be taxed as a corporation, you can do an “S Election” which allows you to be taxed as an S Corp (pass-through entity) instead of a C Corp (which has its own tax rates for any retained earnings.)
Saving Payroll Taxes
The first question that should go through your head is “Why is WCI doing this?” The answer becomes very obvious once you run the numbers. With an S Corp, you get to split the money you make into “Wages” and “Distributions”. You pay payroll taxes (Social Security and Medicare) on the wages but not the distributions. You pay regular ordinary income taxes on both wages and distributions (not the lower qualified dividend rates.)
WCI now makes lots of money, and will presumably continue to do so. So with an S Corp, we could pay ourselves salaries of perhaps $300K, then the rest can be a distribution. Since those salaries will be high enough to max ut the Social Security taxes (levied on the first $127,200 in 2017), we get to save 2.9% in Medicare tax plus the 0.9% special Obamacare tax on the distribution amount. Let's say WCI makes $800K next year. If $300K is wages, then $500K is distribution. $500K * 3.8% = $19,000. That's why we're doing this. $19,000 is two weeks in Italy for the entire family. Or a nice used car. Or three years of tuition at the local colleges. And it's not like paying more in Medicare tax gives me more Medicare later (as it would with Social Security, although the “investment return” is terrible on the last few dollars you pay in SS taxes.)
Choosing a Salary
While we're on the subject, I learned something new recently about setting your salary as an S Corp. I've written about this before years ago here and I had an enrolled agent point out a minor error I've been making for years recently in a conversation in the comments. I was more than happy to be corrected, as it'll save me a couple thousand dollars a year in taxes now that we're doing the S Corp thing.
Obviously, when setting your wages you want them to be as low as possible. The lower the wage:distribution ratio, the less you pay in payroll taxes. But there are two factors that should motivate you to keep your wages high. The first is that the IRS demands you pay yourself a reasonable wage. You can't just pay yourself $10,000 for a year's worth of work as a physician. So you need to have some evidence that your wages are at the going rate. For a typical doc, a salary survey would probably be sufficient. It may be a mistake for a doc working full-time to have wages set below $127,500 and a good rule of thumb to stay out of trouble with the IRS is to set wages to at least 50% of the total profit. However, what's a reasonable wage for a blogger? Heck, I basically did it for free for a couple of years and there are thousands of people doing it for a 3-4 figure salary. So I think you can make a pretty good case for a very low salary. Certainly setting wages at a six figure amount seems very reasonable, even if it is less than half the business profit.
The other factor that should motivate you to keep your wage high is that you only include wage income when calculating how much you can put in your retirement accounts. That's where I learned something new. If you're self-employed, have an individual 401(k), and have not used your employee 401(k) contribution in another 401(k), (if the idea of multiple 401(k)s is new to you, click here), then your business needs to make five times the employer contribution. If you are a sole proprietor, it works out that you can contribute 20% of your net income to the 401(k) as an employer contribution (in addition to the employee contribution.) If you are an S Corp, the corporation can contribute an amount equal to 25% of your wage as the employer contribution. That sounds like a different amount of business profit required to max it out, but it really isn't. Take a look.
An Example
Let's assume the business makes $100K.
If it is a sole proprietorship, the employer contribution can be about 20% of that amount. (Technically it is net of the employer portion of the payroll taxes on that, but we'll just use 20% to keep the numbers round.) So the employer contribution can be as much as $20K, in addition to the employee contribution of $18K ($24K if over 50), for a total of $38-44K.
If the business is an S Corp, it could pay you $100K in wages. (Technically it would be a little less due to the fact that the business half of the payroll taxes would have to come out first but let's keep the numbers round.) So while the business would qualify to make a contribution of 25% of your wages ($25,000) it doesn't actually have the money to do so, because it only made $100K and it already spent that. In fact, it doesn't have the money to make any employer contribution to the 401(k). So what does it do? It pays you less than the total profit as wages. In fact, ideally it pays you $80K in wages and makes a $20K employer contribution to the 401(k), exactly the same as the sole proprietor.
No big deal. I've been aware of that for a long time. What was new to me, however, was that neither the S Corp nor the employee/shareholder pays payroll taxes on the employer 401(k) contribution. How much savings can be found there? Let's add it up.
Smile pretty and I'll pay you a bunch of money you can put in a Roth IRA
Let's assume no other 401(k) and that the employee/shareholder (under 50) wants to max out an individual 401(k). For 2017, the maximum employee contribution is $18K and maximum total contribution is $54K, leaving an employer contribution of $36K. So what is the minimum wage that must be paid in order to max out the 401(k)? $36K/25% = $144K. The business still needs to make $180K (actually slightly more, but we're ignoring the employer portion of payroll taxes) but it need only pay $144K in wages, so the employee/shareholder gets to save the Medicare tax (remember he's already maxed out the SS tax since his wages are more than $127,200) on the difference between $180K and $144K, or about $1,044. In our case, my spouse is also an employee/shareholder, so we get to save another $1,044. $2,088 might not seem like much, but it beats a kick in the teeth.
Is $144K Really Enough?
Actually, you have to pay yourself slightly more than $144K. Here's how I did the calculation and what we decided to do:
You want to make sure you pay yourself enough to max out your retirement accounts. In 2017, our Individual 401(k) has a limit of $54K each. If we use our $18K employee contribution in this business, that leaves an employer contribution of $36K. That can be no more than 25% of net (of the employer share of payroll taxes) salary, so that means we need a salary of at least $144K. The payroll taxes on $144K are:
- Social Security Tax of $127,500 * 6.2% = $7,905
- Medicare tax of $144,000 * 1.45% = $2,088
- Unemployment tax of $7000 * 6% = $420 (Honestly, I couldn't really tell if this counted or not, I'm sure someone will tell me in the comments section.)
- Total of $10,413
Add $10,413 to $144K and round up a little to make the numbers round (and in case I screwed something up) and we're going to pay ourselves $156K a piece for 2017. That works out to exactly $13K per month.
What will that save us? Well, if our salaries are $312K and our profit is $1M (optimistic but possible for this year), then our distributions would total $688K. $688K * 3.8% = $26.144 in saved Medicare tax.
The Hassle Factor
Of course, to save all this money in Medicare tax, there is going to be a price to be paid. That price is primarily additional hassle and possibly some additional expenses. Let's look at some of the hassles and potential expenses.
- Fill out form 2553. This form is where you elect S treatment for your corporation, or in this case, an association taxable as a corporation. Both of these forms need to be filed by March 2017 (or 75 days after the start of your corporate tax year) or you'd better have a good reason to give to the IRS for not doing it. I thought at first you also had to do an 8832, which is used to declare your LLC to be a “domestic eligible entity electing to be classified as an association taxable as a corporation,” but apparently just the 2553 is adequate. (And the IRS agreed by sending us a letter saying we're now an S Corp.)
- Payroll hassle. When you go from simply being a partner in a partnership to an employee of a business, the business has basically just started hiring an employee for the first time. That means it has to file lots of forms both annually and quarterly. These include forms W-2 and W-3 annually and Form 941 quarterly. This is probably in addition to the personal estimated tax forms (1040-ES) that you were doing previously, although you could potentially increase withholding enough to make that unnecessary. In addition, I would have to start filing quarterly Utah State tax withholding forms (TC-941) and pay at least part of my Utah taxes early. (In Utah, a sole proprietor doesn't have to make quarterly estimated payments. He can pay his entire tax bill in April.) I would also need to fill out and keep W-4s for each employee and probably produce employment contracts to legitimize the employee relationship.
- Corporate Tax Return. I just learned how to do a partnership tax return last year. Now I've got to learn how to do a corporation one (Form 1120.) If you haven't broken down and hired professional help with tax preparation yet, now might be a good time. I'm really looking forward to figuring out that one next year. But wait, there's more. My state also has a corporate tax return, the TC-20.
- Payroll tax on child employees. I've hired my kids to be models for this site. As employees of a partnership or LLC taxed as a partnership where all owners are their parents, no payroll tax is due. Plus, since it is earned income, no kiddie tax is due. Also, since I don't pay them that much, no federal or state income tax is due. In addition, as earned income, that money can go into their Roth IRAs where it will compound tax-free for decades. Pretty sweet huh. Well, as an S Corp, neither the business nor the employee get out of those payroll taxes. It still makes sense to hire them to do legitimate work since that money would otherwise be taxed at my marginal tax rate (45%) and the total payroll tax burden for them is just 15.1%, but it is still painful to pay that extra money. There is a work around. I could create another sole proprietorship or partnership owned by me and/or my spouse (a model management or blog service company if you will), have WCI contract with that entity, and still avoid the payroll taxes. Again, hassle versus money. On a side note, paying payroll tax on a kid that may never otherwise get 40 quarters of paying into Social Security (because they become a stay at home parent or something) may help them get to 40 quarters. Remember in 2017 it takes $1,300 of wages to get a one quarter credit for Social Security, so to get four credits WCI would have to pay the kids $5,200 a piece, which seems a little high to me for their services. Frankly, if I don't form a blog service company, we'd be just as well off having the kids be independent contractors since the payroll taxes would have to be paid either way.
- Quarterly meetings. S Corps are required to have quarterly shareholder meetings and keep minutes from them. But an LLC, even one that elects to be treated as an S Corp of tax purposes, doesn't have to do that. One good reason to remain an LLC.
So, is all that hassle worth it to save $15K in payroll taxes? It is to me. Would I do it to save $2K? No way. A more rational person would probably spend that much just on additional accountant fees and a payroll service, not to mention the hassle.
What do you think? Is your business an S Corp? Why or why not? How do you weigh the benefits and hassles? Comment below!
I’m surprised you didn’t do this sooner. The great thing about setting it up now is that going forward (assuming WCI income stays the same or goes up), you’ll be saving multiples of $15K or greater each year, so it definitely seems worth it to me. I see this as more of a six figure savings for you and just more proof that being a business owner is the way to go.
Yes, I should have done it a year earlier, but probably not two. You’ve got to keep in mind, however, that the amount of income WCI makes now was a bit of a surprise to me (and many others apparently.) I didn’t really expect it to make this much. First world problem for sure, but it does make planning a little trickier. Plus there’s the whole inertia thing.
Just to provide a data point – your article has the tenor that your LLC is a “good enough” vehicle for your S-Corp. There are minor differences between LLCs and Corporations, but if you walked in to just about any law office and said “I want to set up a business entity taxed as an S-Corp” you would get an LLC. That is, unless you are able to articulate a reason to be set up as a Corporation (and those reasons do exist) then the LLC is actually the best vehicle for your S-Corp in nearly all circumstances.
Might be interesting to briefly list the reasons where a true S Corp might be a better idea than an LLC taxed as an S Corp.
As you and I have discussed in the past, I’ve never seen a good reason to set up an LLC before setting up the S-corp if your intent is to be an S-corp. Perhaps because the attorney can bill for an extra step?
I’d have to go look it up, but I have a vague recollection that the meeting requirements and filing costs were less with the LLC.
I think an LLC is the way better platform for an S corporation.
One reason is what WCI experienced… you get a limited liability entity for those startup years… but with tax accounting that’s simple enough you can often handle the returns yourself.
BTW, on the tail end of a venture–during the wind-down phase–you have the mirror image benefit… you get a limited liability entity for those low activity years… but with tax accounting that’s simple enough you can handle the returns yourself.
There’s also the charging order benefit which we’ve talked about before.
There’s also the easier governance of an LLC. (E.g., not annual shareholders meeting, not board, etc.)
The only reason I’ve ever heard to be a corp rather than an LLC (if you’re going to go “s”) is if you know you’ll someday go public.
“Going Public” is one. The rest are gimmicky type things like being able to generate expenses by paying yourself market rent for hosting the required meetings at your primary residence (which can be rented out 14 days or fewer without having to pay income tax on the rental income). You can also get $50k in term life insurance on a tax deductible basis.
The flip side of the coin is that complying with the corporate formalities is much more onerous, and if you fail to follow them you may lose the liability protection afforded by the entity in the first place. Thus, for simplicity sake, there is no compelling reason not to use an LLC. I would argue that entity selection and tax elections have very little to do with one another and they’re separate decisions to be made.
The Sec. 280A gimmick you refer to works the same way with either an LLC or a regular corporation S corporation.
Once the “S” election is made, the thing is an S corporation. Period.
When I was an independent contractor, I had an S-Corp. When I started out ten years ago, I could put $49,000 a year into a SEP-IRA (I would choose solo 401(k) now). I took a salary of ~$220,000 since the IRA contribution could not be more than 25% of the salary.
Income above $220,000 was taken as a distribution, saving the 2.9% medicare tax.
My website doesn’t make nearly enough for me to have to think about filing as an S-corp, but I’ll keep this post in my back pocket for someday. You’ve explained the rationale quite clearly.
Cheers!
-PoF
Thank you. The only thing missing from this article is a summary in a few words of who this would actually work for.
For example, my income as an independent contractor is significantly higher than other ER docs in my geographic area. I considered filing for my PLLC as an S Corp, but my accountant figured that doing so would only save me a few thousand dollars and the hassle wasn’t worth it. Maybe he was wrong though.
So for WCI himself, who has a very lucrative side gig, filing as an S-Corp is definitely worth it. For the rest of us, who might benefit? Would a high income relative to your peers be enough? How big of a side gig would you need to benefit? Would someone with income from rental properties be a likely candidate?
Maybe I’m just being lazy and you need to really do the math to determine if this is a course of action worth taking.
You definitely have to do the math on a case by case basis. There is no one-size-fits-all answer.
As we’ve discussed recently in a thread on the forum, using an S-corp to save taxes is not going to be beneficial until you have profits of $300k – $400k at a minimum (before your salary). The extra cost of compliance and administration (filing an 1120S will cost a minimum of $1,500 and payroll prep & filing another $150/mo minimum) otherwise overcomes any tax savings.
If you already have employees (i.e. not simply moonlighting or working IC for another entity full-time), the s-corp begins to make more sense because you already have to pay for payroll compliance. But you still need to be pretty profitable before I’d recommend.
See https://www.whitecoatinvestor.com/forums/topic/s-corp-additional-solo-401k-general-advice/
When you outsource all those items the price starts getting pretty high. One option is to do your own payroll. Some accountants can help you with that for a fee of course.
Realistically the more you are willing to do yourself the more cost effective the S-Corp option starts to make sense.
Let’s just assume You spend $3k/yr to do corporate taxes. And you decide to pay yourself $150K which is not unreasonable considering you will also get $36K in a 401k as well as health insurance benefits. Every additional $100K you make saves you $2,900 in medicare taxes plus another $900 in obamacare surtax after your income grows past $250K if married. Therefor if you make $350K a year it is already starting to be worth the minor hassle.
For sure. When it becomes “worth the cost and hassle” is going to be an individual decision.
I think the fact that I haven’t done it for my practice ($300-400K) but have for WCI ($600K-$1.1M) kind of gives you the right idea of who it works for.
Basically think about what the hassle and cost would be to do it for you (maybe $2-3K) and what the benefit would be ($2900 per $100K of distribution) and you’ll quickly realize if the distribution isn’t at least $200K or so, it just isn’t worth it at all.
Are you sure quarterly meetings are necessary? Our lawyer told us annual was enough. He set us up with an easy to follow template for the annual meetings. Takes me 10 minutes to help my husband have a meeting with himself every March.
Quarterly meetings are not necessary. Most people do well to have annual meetings. The most important activity is documentation of your meeting and proof that you have discussed any substantive issues that need to be decided upon. The purpose is to justify that you are actually operating as a separate business and not just designated as an S-corp and/or LLC for tax purposes.
Anyone considering an S Corp should not be scared off by an annual meeting. The lawyer who helped us incorporate set us up with an easy to follow kit to do the meeting and keep minutes. These kits are now available on line. We just fill in the blanks and sign each year.
Could these meetings be scheduled in Hawaii? (with the business covering cost of travel and maybe a night of accommodation?)
If there is a business purpose for Hawaii as opposed to, say, your living room. The test for a business deduction is that it be both “ordinary” and “necessary”. See http://bit.ly/2cFmGn2
I believe you can do one corporate retreat every year and have your meeting there.
I should have clarified. You “can” do anything you want. Whether it will pass muster with the IRS is another question. I do not believe the cost of a corporate meeting in Hawaii would be allowed if your business travel expenses were to be pulled for audit. Unless, of course, you live there or have another necessary reason for traveling there.
Are you positive you don’t avoid the 0.9% Obamacare tax on distributions as well? I know you have to pay it on “self-employment income” but I thought S corp distributions avoid it for a total of 3.8% savings.
Sounds like Stephen Nelson agrees with you, so you’re probably right. Cool for me.
Some clarifications…
1. S corp shareholders don’t pay the Obamacare tax if they materially participate. More detailed info here:
http://evergreensmallbusiness.com/small-business-net-investment-income-tax/
2. The IRS doesn’t really require you to have a good excuse to make a late election. Anything works. (You do need your LLC set up on January 1 to have an S corporation on January 1.
3. The form you file out is an 1120S. The 1120 form is for C corporations.
You’re talking the 0.9% tax not the 3.8% tax, right? And what do you mean they don’t pay it? You mean they don’t pay it on their dividends, or on their salary or both?
Sorry. Here’s better explanation. (I’m going to throw in IRC code sections because the tax guys and lawyers may want them.)
On your distributive share–this is the non-wages slice of the profits–if you or your spouse materially participate, you won’t pay the Sec. 1411 tax (which is the 3.8% net investment income tax… one of the taxes known as Obamacare tax.)
BTW, you will end up paying the .9% Sec 1401 Medicare surtax (another tax people refer to as the Obamacare tax) on the wages that flow out of the S corporation if your wages push you over the $200K or $250K thresholds.
Note: The .9% Obamacare tax and then the regular 2.9% Medicare tax add up to that 3.8% tax of Sec. 1411.
In WCI’s example, the wages paid out of the S corporation (but not the distributive share) are probably subject to that .9% because of the earned income WCI receives as a physician.
Cool, thanks for the explanation. I’ll adjust my calculations in the post.
If you decided to treat your LLC as a sole proprietor for tax purposes, wouldn’t your distributions be taxed as dividends at 20 % ? What am I missing?
Sole proprietors don’t pay dividends. All income is SE.
Yea not only can you not have distributions/dividends but they certainly would get the qualified dividend rate. That comes from C corporations.
Some of the older docs in our partnership group file as an individual S corp. I’ve never investigated as I always figured it would be too much hastle for not much tax savings, but if one could characterize 200k as non-wage distributions, it may be worth it.
I think I’ll wait to see how any potential Trump tax reform ends up taxing small business pass through entities before I make any changes. That is where the real bonanza could be.
Each year when the IRS puts out their limits on various retirement accounts, they also put out maximum salary amount to get the full benefit of the plan. For 2017, for 401k’s maximum salary needed/allowed is $270K:
https://www.irs.gov/uac/newsroom/irs-announces-2017-pension-plan-limitations-401k-contribution-limit-remains-unchanged-at-18000-for-2017.
That is what we use annually to set my husband’s salary. He runs his practice as an S Corp. Any profit above that is a distribution. We’ve been doing this for over 15 years now. It is easy once you get used to it. We also took into account how much his salary needed to be to get the maximum disability benefit as disability benefits are usually a percent of your wages. So, be careful from that end not to set them too low either. The IRS amount has always allowed the full disability benefit.
We also set up an LLC that owns all his ophthalmological equipment/toys. We pay ourselves rent to that entity monthly which also offers some tax benefit.
My understanding is that you DO NOT have to set your salary that high in order to max out a 401(k). That’s just the highest amount of income that can be used to calculate your contribution.
We have employees and offer them matching as well as profit sharing so that comes into play for us.
My spouse’s group 401k plan is similar and we plan to do the same thing, set the salary at the IRS 401k number.
Dear WCI and others – The WCI investor wrote that we “DO NOT” need to set our salary that high to max out our 401k. Looks like this wasn’t completely resolved in discussion. Do we need to set our salary at the IRS 401k number to max out our 401K? Also, how should we pay ordinary taxes on our “distributions”? Would it be best to pay quarterly estimated taxes to avoid an underpayment penalty? Or perhaps consider increasing the amount of taxes withheld from our “wages”? Thank you for all the great ideas and discussion!
How high salary must be depends on the type of contributions you are making. For instance, if you are only making after-tax (Mega Backdoor Roth IRA) contributions, you can put in $57K with a salary of only $62K. But if you want to max it out with 100% profit-sharing (employer) contributions, you’ll need a salary of nearly $300K. Everything else is in between.
Most in that situation pay quarterly estimated taxes to cover the tax bill. You can also increase withholdings.
Why don’t you set up a cash balance plan?
I’m starting to get worried about having a monstrous tax-deferred account in retirement and have even been giving consideration to switching to the Roth option for our employee contributions in the 401(k)s (and wishing I’d done that for the last however many years.) We’re already deferring $200K a year between 3 401(k)s and the cash balance plan I have. Plus the hassle and cost etc. At this point, I’m trying to grow my taxable account a little.
I would argue the cost and hassle are negligible. The cost is definitely negligible in relation to the amount of taxes that get deferred. Also, your taxable account is going to care of it itself with the projected and obvious extreme success of the WCI empire. When Buffett realized he had this problem, his objective shifted from becoming FI, to compounding the most money so that he could do the most for the civilization that produced that wealth. That is, what could be more gratifying than after your primary objectives are achieved, to compound the most money possible for the good of society? Buffett decided to give his money away later in life because he could compound it at a high enough rate such that he could give even more away and therefore benefit society that much more. Could I make a reasonable argument to (1) increase your taxable account at the expense of fewer charitable donations, (2) set up a cash balance plan, (3) and then make at least part of the beneficiary of the cash balance plan the charity of your choice—perhaps the Bill and Melinda Gates Foundation. Won’t that allow you to give even more to benefit the civilization that made you who your are today? There is an added benefit. Setting up a cash balance plan will give you even more experience and education for further posts, which will contribute to the profitability of the site. I would love to see a post entitled “The WCI experience with setting up his cash balance plan.”
The other issue is the rate of change around here. It makes lots of sense for a business like a practice that you expect to be reasonably stable for 5-10 years. Less sense for a business that was a sole proprietorship 5 years ago, a single member LLC 4 years ago, a multi-member LLC with employees the last 2 years, and now this year a corporation without any non-shareholder employees. Perhaps in the next year or two I add employees or sell the thing. Then I’ve got this cash balance plan hassle hanging over my head. But you’re right, the fees aren’t terrible on a personal DBP. I think Schwab charges $1500 to set-up and $1500 a year after that.
The word out on the street is that the IRS desires the cash balance plan to be around for 3 years before you shut it down. It has to be a benefit, not a tax shelter. Where is the Jim I know—the one that desires to lower his effective tax rate, and then do a blog post about it. Are you getting complacent in your competitive game with the IRS and TurboTax? When you see the time you spend in the “hassle” versus your tax savings, I think you would agree you are being extremely well compensated for your hassle factor. Think of me as your cheerleader down your journey from the Loop of Henle (sorry, I could not resist). I say go Jim, get that gold next year when you compete with the IRS. Don’t settle for an A- when you get can an A+. According to this calculator (https://www.cashbalancedesign.com/resources/calculators-tools/maximum-contribution-calculator/#) you can contribute $92,152 to a cash balance plan. And, I am not even including your wife. Don’t lose your mojo, let’s get the lowest effective tax rate possible!
44.6 percent (5 percent Utah State Tax plus 39.6 percent federal tax) of 92k is $41,032 that goes to the tax collector by not using a cash balance plan. And, that is not even counting your wife. Is 41k worth the hassle? I vote a resounding yes! Your books says you like competition just for the sake of competition. Thus, I know you want to compete against the IRS and win, don’t you? Do it for your fan club, Jim, do it!
You know not all of that is tax savings, only the difference between that 44.6% and whatever I can manage to get it out at (which is getting higher all the time- a real first world problem.) I still get the decades of tax protected growth and the asset protection of course.
Can you make DB plan contributions with distributions? They have to come from wages don’t they?
I’m also curious how the fact that I have another cash balance plan would work with another one.
True, but the 41k is not taken out all at once when you are 70.5. Only a portion of that money is taken out. Also, you will have the option of doing a partial Roth conversion. Additionally, you will then have the option of doing one of Jim Lange’s cascading beneficiary plans. More importantly, the 41k goes up substantially every year. For example, when you are 50, you can put away an additional $141,000 into the cash balance plan. That is an additional $62,886 that can be working for you (.446*141k). The payment into the CBP counts as a business expense, and therefore your distribution is simply lower because you have incurred additional business expense. And, don’t forget this money is additive. For example, for 2017, you could have an additional 41k, for 2018 an additional 43k, etc…I don’t know the answer to the question about how it works with your current CBP, but most actuary companies will give you a free estimate and answer that question. It could be similar to beating the 54k limit because you are not more than an 80 percent owner of the ED group. In your post you say that you are doing this to save $19,000. However, with a CBP I think you will save a lot more than that. On the flip side, I think the situation is complex enough where you are going to need an actuary. A typical fee might be $5500 per year, and another $5500 to set up your plan. With that said, it is still likely a slam dunk home run, especially as you get older. Even if you keep it for 3 years and then sell your company, the numbers likely work well in your favor. There is an esoteric benefit too. If you are slightly weighted to stocks versus bonds, and stocks go down, the CBP requires you to put more money in the plan. That is a beautiful thing because you are required to buy more stocks when they are down, and your distribution (from the WCI) is even lower! The system works in your favor in a major way. Although your “business expense goes up,” the business expense is your money that makes its way into the CBP that you own. Are you suffering from the endowment effect? That is, you value your current plan more simply because you already own it and have thought it out. Don’t let this common bias affect your decision to lower your tax bill in a major way. Do it for your groupies!
I set up a single-owner LLC taxed as S-corp for my wife, an EM independent contractor with gross annual income ~$400k. She takes about half in W-2 income (agrees with a typical EM physician salary in the area according to salary.com), is able to max out her solo 401k contributions, and ends up saving roughly $5k per year on medicare/omabacare tax. Might not be worth the hassle for someone making ~$200/hr, but I’m a stay-at-home dad making nothing, so if I put in, say, 40 hours over the course of the year to save us $4k that seems worthwhile to me (next year I expect to spend half as much time). I do all the accounting and payroll myself using quickbooks online. Once you figure it out (one full day) it’s really not difficult (1-2 hrs/mo), and $35/mo is a lot better than the $150+/mo mentioned above. 2016 being our first year doing this, we paid a CPA to do our taxes, and were charged $600 for the 1120S. Again, not as pricey as what was mentioned above. Mind you, I plan to use turbotax next year, which will bring it down under $100.
In figuring all this out for the first time, I found the following to be a *very* helpful resource:
http://www.watsoncpagroup.com/SubS.pdf
It’s a mistake, I think, to use Salary.com. First, in an audit, IRS won’t give that much weight as compared to bureau of labor statistics…. Second, the BLS numbers are often lower.
A couple other things to realize are (1) that you aren’t required to hit the median… you are required to be reasonable. (2) You want to look at fringe benefits. E.g., if your S corp provides (say) a 25% pension match, that’s significant.
BTW, you should be saving a lot more with your S corporation. It’s not worth it for $5K.
Thanks for the advice, Stephen.
Couldn’t find BLS data that was specific to both region and specialty, but the nation-wide mean wage for “Physicians and Surgeons, all Other” was indeed lower (by ~20%) than what I had found on salary.com.
And good points about not needing to match the mean salary, and about taking benefits into consideration. Perhaps next year we’ll ramp it down to the above-mentioned $144k (or $156k depending on how you look at it) and save a bit more.
I think can dial down…
If you are between the 25th percentile and the 75th percentile, it seems hard to say where you’re at is unreasonable… I mean, one in four people makes more or makes less…
For what that’s worth…
As a stockholder in a bank I fully supported a switch from a Corporation to an S-corp in 2007. It became a nightmare as a retired person as large amounts passed through my personal taxes but barely enough funds to pay the taxes due. Think through all the consequences before you act. New tax law should resolve our motive to switch the bank from Corp to S-corp to avoid double taxation. In retirement the taxes killed me, so I turned my bank investment into a charitable gift annuity and now receive mostly tax exempt income greater than the dividends I received prior to 2007 and far more than any benefits after 2007 other than a large tax bill. Beware of unintended consequences.
If you’re a shareholder in a multiple shareholder S corporation, you need a shareholders agreement that says the entity needs to at the very least make distributions large enough to pay the taxes on the distributive share.
This was a great post and some refreshingly new info. While not profitable yet, I have always wondered whether setting up an S corp or LLC would be the right answer when I do become profitable. It seems that an LLC is easier but the S corp allows for more growth later on. The hassel does not seem to be too great with an S corp.
Anyone have thoughts on the benefit of one versus the other in California? I know with an LLC there is a $800 a year franchise fee (even if set up in another state).
$800? That’s ridiculous. Mine is $15 a year in Utah.
California makes it really expensive to run the S corporation gambit. (Also to use LLCs which is another subject…)
You will save taxes with a California S corporation because the 1.5% California S corporation franchise tax is less than the 2.9% Medicare or 3.8% Obamacare taxes… but you won’t save much.
You probably want to be saving FICA (15.3%) therefore and not just Medicare or Obamacare taxes.
WCI, please feel free to delete this link if I’m just gone overboard with this post:
http://evergreensmallbusiness.com/california-s-corporations-save-taxes/
General comment: I think some of you guys think your salary needs to be higher than it does.
Two data points to reinforce this point:
1. Warren Buffet’s salary is $100K a year. (Recent news stories again reported this.)
2. John Edwards, the former Democracic VP candidate, paid himself around $250K a year his last year as a personal injury attorney… and then took a $25M distributive share.
A professional probably can’t avoid much FICA… but he or she can often sidestep much or all of the Medicare or Obamacare tax. More details here:
http://evergreensmallbusiness.com/safe-harbor-s-corporation-salaries/
The other thing to keep in mind is that there are fringe benefits that help you out here if you’re an independent contractor… WCI mentioned this in his post when talking about the employer pension contribution… and you can do things to get your distributions down (which matters because if you pay yourself an unreasonably low wage, the IRS’s recourse is to reclassify distributions as wages).
Example: WCI? Pay your charitable giving out of your LLC S corp… and voila you’ve just eliminated a bunch of distributions.
Explain exactly how you deduct a gift from a business. Where would you put that on Form 1065?
I’d love to do that because I’m getting partially phased out of my itemized deductions these days anyway. But my understanding is that a business cannot deduct charitable contributions that are not business related as per Pub 535.
This seems to suggest it just goes on to Schedule A. What’s the difference if the LLC or S Corp gives or if I give personally?
Good question and the answer is a little subtle but important when you start working with S corporations.
The key point is that while IRS requires you to pay your S corporation shareholders reasonable wages, they can’t force you to do that. So if you make $500K on your blog which you operate as an S corporation… but you don’t pay any wages and you also don’t pay any distributions, IRS won’t like it, But they can’t do anything. You will totally escape payroll taxes. At least for that year.
Though this is extreme example, it shows that one of the things you want to do with an S corporation is dial down your distributions. It’s not just about the reasonable wages number.
If you, for example, make $500K, pay the shareholder employee $100K and take $400K of distributions, they could reclassify that $400K or part of that $400K as wages. But if you give away $100K of that, so the distributions are now $300K, they can only reclassify (worst case) $300K as wages. (BTW your return has also suddenly become less interesting to the IRS…)
FYI, as you note or suspected, that $100K of charitable contribution doesn’t get deducted on the S corp return. The $100K shows up the K-1… and then the shareholder, when he or she folds the K-1 into their 1040, ends up putting the $100K onto their Schedule A.
But what this shows you, is that you want to really work the 1120S return and the K-1s. You can often create wiggle room for yourself if you do it right.
Thanks for this post. If you have a “day-job” 401k can you also contribute 18k salary deferral to an individual 401k?
No. Only 1 salary deferral is allowed across all 401k’s.
https://www.whitecoatinvestor.com/multiple-401k-rules/
You get $18K total employee contribution to all 401(k)s. But your employer can put in money if they want up to $54K per 401(k). Limits are higher if you’re over 50.
I have been using a single member s-corp for a number of years and doing my own 1120s and compliance with turbotax business. So far, so good. For the best time last year, I had an accountant review my taxes (not do) and only had minor suggestions such as the de minimis election. The most annoying thing was to learn to do the required balance sheet of the 1120s which required with profits over 250k. I max out an individual 401k for myself, which was 53k last year and will be 54k this year. My understanding is, that the minimum w-2 wage needed to be paid is 140k for 2016 and will be 144k for 2017. (I am psychiatrist and make 450k, but statistically, psychiatry salaries are still low) I am not sure you have to add the tax amounts you did above. See the calculator below. You should also not have to file personal estimated taxes if you can capture most of your taxes in your quarterly 941. Also, FUTA is not that high since you subtract SUTA from it.
Calculator:
http://www.bankrate.com/calculators/retirement/self-employed-401-k-calculator.aspx
*first time last year
Thanks for sharing your experience.
WCI – why don’t you lose money with this business? Meaning, why don’t you buy a building for some office space, have a huge cost (read: less earnings, thus less taxes), and enjoy the depreciation?
Why don’t I lose money? Seriously? That’s like paying $1 in interest to get a 45 cent deduction- never a winning strategy.
The key question is not how can I lower my taxes. The key question is how I can maximize my after-tax amount. Better to not have to pay for office space at all than to get the tax breaks from having one.
Besides, who wants to go down to the office when I can sit here in this recliner in a T shirt and scrub bottoms, watch my 22 month old play on the floor and type random stuff into the internet? If I had an office I’d feel like I had to use it every now and then.
If I’m going to buy an office building, I’m going to rent it to someone else. Then I get the rent and the tax break.
I don’t know if this is the right place to post this question, but I was hoping for some advice or a nudge in the right direction. I’m a partner dentist in a group practice. We are restructuring our group to have the main business which would employ staff and collect money etc. Then each doctor is forming an LLC that will file as an S corp. This should allow better retirement and tax planning. I hope to set up a 401k, and would like to get the benefit of increasing my pre-tax contribution opportunities. When adding my wife to the S-corp which is better, having her as an employee or a co-owner. I’m not sure in what form she would contribute to the S-corp other than maybe tracking things on quickbooks. I was wondering if being a partner of an s-corp getting equal distributions she could be allotted an equal portion of those from which to make the full employee and employer 401k contribution. I would love recommendations on who to get in touch with who could help me navigate the various plans to design (401k, cash balance plan, etc). Thank you!
So much wrong with that paragraph it’s hard to know where to begin.
First, just changing to this structure doesn’t allow you to not offer the same retirement plan you’re using to the employees of the practice.
Second, you can’t just hire your wife and pay her whatever you like. It has to be a reasonable wage for what she’s doing.
Third, money from S Corp distributions can’t go toward retirement accounts, only salary. So the less you pay yourself and your wife, the less that can go into a retirement account.
I would recommend some professional advice about small practice retirement plans. Kon Litovsky has written a bunch of articles on the site and is a paid advertiser. I’d include him in your search.
Thank you for putting it lightly. I am at the beginning of learning the ins and outs (for which I’m grateful for your site), and posted at the risk of sounding stupid. I will reach out to Kon for help in reorganizing the plan we have, or anything else he can suggest.
I have a couple of questions I’m not finding laid out well anywhere.
I’m a 1099 contractor who gets paid monthly. If I set up a sole-proprietor LLC to be taxed as an S-Corp, do I need to do official monthly payroll paperwork and banking transactionts, such as write myself a paycheck (or do direct deposit to myself)? Same for distributions? Or can the yearly W2/W3 and K-2 along with quarterly 941 tax payments be enough as they show the final accounting? I’d rather not jump through an extra hoop, and monthly one at that.
If doing official payroll is necessary, it would appear I need a separate business bank account? Can I transfer money from my business account to my personal account? Is that the equivalent of “direct deposit”? Or is something more official through payroll software needed?
I don’t think there is any requirement that your S corp pays you a salary every month. You only have to do paperwork when you pay yourself a salary.
I would get a separate business bank account though. I think a transfer from there to your personal bank account is plenty official. I don’t think you need a physical check.
Why not get an accountant to help you with it the first year and then you just carry on going forward as you’re taught?
With the upcoming tax reforms for 2018, is there a tax advantage of doing an LLC, s corp, or c corp (rather than just independent contractor) for locums tenens income in California?
Can’t say yet EXCEPT to tell you that doctors in CA cannot operate as an LLC. You must be a corp or a sole proprietor.
What did you end up doing for payroll on your S-Corp? I am currently electing to treat my LLC as an S-corp for 2019 and planning to pay myself a wage of ~50% of gross revenues with the rest as distributions. I am planning to pay myself 4 times a year for my salary and distributions as needed. It should be really simple, but I am going to also pay for dental/medical as an employer paid benefit and the profit sharing component of the solo 401k to avoid FICA on as much as I can. Any recommendations? I’d prefer to do it myself to learn, but not sure if I am over my head here. Thanks
I’m doing it myself. I don’t think I’m in over my head, but it’s close. I certainly would NOT blame someone for hiring this out. I also pay myself and my wife quarterly.
First, Quarterly Meetings are NOT required for “S” Corps — Just Annual Meetings and Special Meetings when appropriate.
Maintaining proper records/Minutes for an “S” corp is “not a lot of paperwork”; it’s a way to 1) meet the requirement of an “S” Corp but 2) when done well by a professional, provide custom documentation of the owners decisions and streamline an audit. Well-maintained corporate records can also prevent litigation situations from even getting off the ground (it’s very difficult to dispute something with your fellow shareholder(s) when everyone agreed upon AND SIGNED OFF on a decision in the first place!)
Second, a VERY important fact of a SMLLC vs. an “S” Corp. I don’t see mentioned (in addition to the owners of an “S” Corp. actually getting a W-2 which banks and financial institutions look at especially for business owners who want to secure or refinance a mortgage) is the finances of an “S” corp. are documented in a COMPLETELY SEPARATE tax return. Some may think is “a lot of paperwork” or “an additional expense” BUT it ensures you will never have to produce your PERSONAL tax returns when involved in a legal or audit situation or when applying for a business certification (i.e., Woman/Minority/Veteran-owned business); unlike a SMLLC where you’ll have to divulge everything (i.e., spouse’s income, personal investments, properties owned, etc.) which, really is none of anyone’s business if you are producing information for your BUSINESS!
Third, keeping detailed and well-organized Minutes is just a great way staying ORGANIZED and armed with documentation you’ll need in a variety of different situations while managing the day-to-day operations of your business and personal lives as well!
I’m confused about the distribution tax rate. For a single member LLC filing as S-Corp, I’m seeing on other blogs that the tax savings on distributions is 15.3%, WCI says 3.8%, substantially less. What’s the actual tax rate? Would appreciate any insight!
Well both are correct.
If you are low income (less than the SS Wage Limit of something like $142,700 in 2021), it’s 15.3% because you’re saving SS and Medicare tax.
If you have high income (>$200K, $250K married), it’s 3.8%, because you’re just saving Medicare and PPACA tax.
Hope that helps.
I am a Radiologist considering forming an LLC and taking an S Election. My total business income is $500,000 and I work from home and don’t have any employees. All of my income comes from my work as a Radiologist (interpreting MRIs, CTs, Ultrasounds, and X-rays).
Obviously, I would like to avoid running afoul of the IRS and being audited. Since my total business income is $500K, would it be legit to designate $250,000 as wages and $250,000 as distribution? Is it ok to take a $250K distribution even though all of my income comes from patient care and NOT from any other business income?
Could you hire another radiologist to do the reading for $250K and keep the $250K in profit? Could a full time radiologist legitimately work for $250K? I’m guessing not. Probably ought to bump that up a bit to at least a number you can support using a salary survey or something. But would the IRS come after you? I’m guessing not.
Thank you for the response! Is it safe to assume that a lot of physician independent contractors legitimately use S corporation taxation even though they have no employees and only receive income from their patient care?
Yes.
Great stuff! For a 2-physician household, married-filing separately for PSLF purposes, receiving 1099’s due to California’s non-W-2 rules, would we be able to use an LLC and file taxes as a S-corp or would it be considered a LLP which is not allowed in medicine in CA? Or is there no minimum number of owners required to utilize this technique? Thank you.
I don’t know about “CA LLP medicine” laws, but barring some law against it, you could do that. I would think the minimum number of owners would be 1.