[Editor's Note: This is a guest post from W. Devin Wolf, CFP®. a financial adviser in Washington State. I have written before about incorporating. There are both pluses and minuses to doing so. This post primarily discusses the downsides. We have no financial relationship.]
Conventional wisdom encourages small business owners to form an S Corporation to reduce the amount of self-employment taxes they owe. The goal is to reduce your wages and pay profits out through a profit distribution that is not subject to the 15.3% (employee and employer combined) self-employment tax. For high earners with a willingness to save I would argue this isn’t always a good strategy.
W. Devin Wolf, CFP
Consider this simplified scenario:
You have an Orthodontist that owns her own practice and makes $250,000. For simplicity sake, let’s assume no itemized deductions or other income, and she files her taxes Married Filing Jointly with 2 exemptions. She has structured the company’s 401(k) with a 13.8% match to maximize how much she can save each year. Her tax advisor recommends she quits filing as a sole proprietor and becomes an S Corp to save $14,108 in self-employment taxes this year. Everyone likes paying less tax, but let’s look at how this really plays out.
| Sole Prop | S Corp. | Difference | ||
| Orthodontist Salary | $250,000 | $50,000 | ||
| Profit Distribution | $200,000 | |||
| 401(k) Contribution | $17,500 | $17,500 | ||
| 401(k) Employer Match (13.8%) | $34,500 | $6,900 | $27,600 | |
| Taxable Income | $198,000 | $225,600 | ||
| Social Security Tax | $14,508 | $6,200 | $8,308 | |
| Medicare Tax | $7,250 | $1,450 | $5,800 | |
| Total Self-Employment Taxes | $21,758 | $7,650 | $14,108 | |
| Income Taxes | $37,003 | $44,731 | $7,728 | |
| Total Taxes Paid | $58,761 | $52,381 | $6,380 | |
| Total Tax Deferred Savings | $52,000 | $24,400 | $27,600 | |
| Total Household Inflow | $139,239 | $173,219 | $33,980 | |
| Annual Social Security Received at FRA | $31,704 | $16,596 | $15,108 |
The good news is the tax advisor was right – she does save $14,108 in self-employment taxes. The bad news is her 401(k) match is limited to her $50k salary so she saves $27,600 less, which also results in $7,728 more income tax owed. The astute reader realizes she still paid $7,728 less in tax in 2014 and brought home $33,980 more – the advisor was right!
However, there are three reasons why this strategy may not be as good as it seems.
# 1 Failure to Save
The additional $27,600 that was saved in the 401(k) each year equals roughly $3.4m after 35 years at a 6.5% compound annual rate of return. When a plan is set up to maximize 401(k) contributions each year most clients stick to the plan and won’t rob from their retirement accounts for other wants and needs. The additional $33,980 in take home income could be saved in a non-qualified (taxable) account, but from a behavioral perspective it is much more difficult for clients to both save the money and keep it invested.
# 2 Loss of tax deferral
The 401(k) account has tax deferral, which essentially allows taxes in the account to be deferred until a later date. For high earners this can significantly reduce returns. Assuming the loss of tax deferral results in a 1% reduction in the annual after-tax rate of return, saving $33,980 annually for 35 years at 5.5% actually results in having $16,816 less in the account than saving the $27,600 at 6.5%. Once again the questioning observer might point out tax is still owed on the 401(k) account. Retirees are typically able to drop their tax bracket in retirement. Assuming they want to pull out $100,000 net of taxes each year and this requires $117,647* (15% effective tax rate) from the 401(k) and $103,092 (3% effective tax rate) from the non-qualified account, the reduced return from the loss of tax deferral still results in having $1.7m less after 30 years of retirement.
Below is a graph depicting the scenario above. 
# 3 Loss of Social Security
Although we think of Social Security contributions as a tax, in reality, the more we contribute the more we will eventually get back. In the example of the Orthodontist, by keeping her salary high she would qualify for the maximum Social Security benefit of $31,704 in 2014 at age 66. By only contributing an inflation adjusted amount equivalent to $50,000 a year in today’s dollars over her career I estimate she would only receive about $16,596 at age 66. To purchase an inflation adjusted annuity equivalent to the lost $15,108 in annual income it would cost a 66 year old female around $310,000. Social Security also offers spousal and survivor benefits that might benefit her family further.
Other considerations:
The IRS requires you pay yourself a reasonable salary. In the case mentioned above, the median income for an Orthodontist appears to be around $125,000, so only paying themselves a $50,000 salary might put them at risk for an audit.
The Social Security tax wage base in 2014 is $117,000. Setting a salary at or near this level will maximize your future social security benefit, but you will also erode most of the tax savings associated with this strategy. Medicare tax is not limited to a wage base and an additional 0.9% surtax is added to income above certain limits. Very high earners may be able to structure an S Corp and their 401(k) plan to get the best of both worlds. A properly structured plan may allow the owner to contribute the maximum $52,000 ($57,500 with age 50+ catch-up contribution) and reduce Medicare taxes. For every $100,000 in income reported as a profit distribution above $250,000 a married filing jointly S Corp shareholder will save $3,800 in Medicare Tax.
There may be additional costs, complexities, and advantages associated with incorporating your business which are not addressed in this analysis. Forming an S Corp (full disclosure: we actually operate as an S Corp) can be a great strategy; however, you should look beyond the immediate tax savings to see if it is right for you.
What do you think? Are you incorporated? Why or why not? Comment below!
Why is the 401(k) match percentage held constant? If it’s her corporation and she’s making the rules I don’t see why this should hold. Set the match such that she maxes out at $52k including her contribution (or at least stays constant with the comparison) and much of this post’s argument falls apart.
Sorry, the government sets the percentage. It’s 20% or the net salary. You don’t set the percentage, you set the salary.
Got it. After a bit of digging it’s buried here:
http://www.irs.gov/publications/p560/ch05.html
“*The deduction for annual employer contributions (other than elective deferrals) to a SEP plan, a profit-sharing plan, or a money purchase plan cannot be more than 20% of your net earnings (figured without deducting contributions for yourself) from the business that has the plan.”
As you and others note below setting salary at $175k, match at 20%, and maxing out the individual contribution seems a saner way to go, not to mention that it’d meet the sniff test for reasonable salary level with higher probability. This assumes no employees other than oneself, of course.
The problem with this math is the 401k employer match under the S-corp is listed as $6,900 but in reality the limit is 25% of salary or $12,500.
Many, especially wealthy and conservative investors, would benefit from minimizing social security taxes, as there is a high likelihood of means testing or other future restrictions on collecting public retirement benefits from social security, especially if one has a 6 or 7 figure retirement fund, which, if you are saving $30,000+ a year for retirement, you will have.
I love the benefit of a large retirement account, but I’ll take a savings in payroll taxes first. Even under scenario B, one could still save $30,000 in the 401k plus another 5 or 6k in a Roth IRA, all while saving about $7,700 in taxes versus scenario A, with the only downside being $30,000 is the maximum retirement savings they could contribute that year. How much more would one have to save to make up the $7,700 in additional taxes it will cost you ?
An excellent point. One must weigh the guaranteed payroll tax savings (Medicare tax mostly for docs) against the higher retirement account contributions.
Remember that your match applies to your employees as well and this is based on w2 income. The lower your w2, the closer your salary is to your employees. I am not sure if the author is referring to a match or profit sharing. Either way, whatever you do for yourself, you will have to do very similarly for your employees. There are a number of formulas that can hedge in your favor depending on your age, your employees age, etc., but the bottom line is that you will have to make a very similar contribution for your employees on a percent basis.
In addition, you can only deduct employer contributions up to a certain percent of w2 salary — I
believe it is 25% of the w2 salary.
Interesting post. Perhaps you could discuss at which point as a high income earner you could have the best of both worlds i.e. max 401 k while still avoiding significant self employment taxes. Is that S corp salary 200 k, 250k etc? And at what total compensation would the tax saving make sense?
If you can use the employee contribution, that point is ~ $180K. If you used that in your 401(k) at work, it’s around ~$275K.
Very interesting analysis…and especially that Devin takes a thoughtful stab at “accepted financial wisdom” on the subject. But a foundational question: Why would a $50K salary for an Orthodontist (earning $250K) fly with the IRS? It’s my understanding that any salary in an S Corp salary/dividend split must represent “reasonable” compensation. $50K doesn’t seem remotely defensible to me in this case and is likely to invite IRS scrutiny. Of course, if salary was bumped up to something more “reasonable” then you’d probably be approaching the cap on the Social Security wage base, so tax savings would mostly accrue on the Medicare side. Any CPAs reading this who could weigh-in on the “reasonableness” matter? Kudos to Devin for a great article and interesting topic.
It won’t. I generally recommend no less than 50% of your income be designated as salary. And yes, as a doctor your savings ought to be all Medicare taxes.
Exactly, it will not fly with IRS at all. I have an S Corp and my accountant suggested we split 50-50. The bottom line is it should a fair salary in the industry. In other words, it should be what it would cost to pay an associate doctor. You also save on payroll taxes on your dividends too.
Very timely article. I am in the process of setting up my own private practice and my attorney told be about LLC vs selecting S.
You can go from an LLC to an S but the reverse is not true. If you close down an LLC it’s not as big of a deal as closing down an S. any appreciated assets in the closed S would be taxable even if you haven’t sold the assets.
He is advocating starting as an LLC and after a year re evaluate and see how things are going and can always switch to an S as there is a 75 day window.
You can’t hold appreciated assets in the S. All income is passed through to you. LLCs can be taxed as a sole proprietorship or an S corp.
WCI, I know you talked about doing this and went back and forth, did you ever decide to file as an S corp?
You can have an LLC taxed as an S corp and you can change your election every year. The best of both worlds.
I’m confused but maybe it’s just because I am a lowly W2 employee. If my salary is $250k and I contribute $17.5k to my 401k, my taxable income is $232.5k. In other words, the employer match on my 401k doesn’t reduce my taxable income. Is this different as a sole prop or S-corp?
Your match DOES reduce your income. It might not have even showed up on your W-2 on either side. It’s no different for an S Corp or Sole proprietorship.
Or you’re making after-tax contributions to your 401(k). Those aren’t deductible unless you’re a military member who is deployed.
So, a deployed military member can make contributions to a Roth and deduct them from his tax return?
No, a deployed military member gets tax free income to start. That money can be used to fund a Roth IRA or TSP. But he “gets the deduction” whether he blows the money on vacation or saves it.
If you were self employed, the employee contribution (17.5k) and the employer contribution match (up to ~33k) that YOU would put into the 401k would be tax deductible.
Whatever employer match is if you are W2 employee is paid out from your employer’s profits, and it becomes tax deductible to THEM, not to you.
You can only tax deduct what you contribute yourself (if self employed or partner, then contribution plus match; if employed W2, then only the contribution).
I think we’re just talking past each other here. It’s not like you pay taxes on the employer contribution (at least until withdrawal.)
The analysis you give seems more about structuring the retirement account and payroll allocation than structuring the corporation as an S corp. The article title was misleading. There are many good articles about whether to incorporate as an S Corp. C Corp. or LLC.
The title is mine. I feel the most serious downside of incorporating is that you can’t set your salary too low or you can’t max out your retirement plan. Not sure why that’s misleading. There are a few other downsides mentioned at the end.
What about legal advantages? I thought the most important benefit of an S-Corp over sole proprietorship was helping protect personal assets in the event of a malpractice lawsuit?
It won’t help with that. Sorry. Buy malpractice insurance.
Speaking from experience, it is an audit risk. The IRS has no issue with saying you aren’t paying yourself a competitive salary, computing what they think it should have been and hit you with back taxes with penalties/interest.
California also has a tax on S Corps.
Not surprised about California. Surprised any docs live there.
Trackjunke,
In 2015 the maximum individual 401K contribution is $53K. $18K is funded by the employee and the rest $35K is funded by the employer. The maximum employer contribution is 25% of salary. Therefor the salary needs to be $140K (35K / 25% = $140K) to maximize contributions for 2015.
20% for the self-employed, not 25%.
This article has to one of the most bias ones I’ve seen in a while here on WCI. He took every variable and tilted it to prove his point. He conveniently left out the 13.8% match that he would need to contribute to his employees if they also participated in the 401K. I might not be a saver, but an almost 14% increase in my benefits would be hard to give up! If his salary is 250K then their salaries will be about 160K if he has an average practice. The 13.8% match could cost him over 22K in staff 401K matching (likely lower due to lower participation, but since we are cherry picking I’ll say that everyone contributes the max). It would be interesting to see this scenario run with a more realistic match and justified salary. An orthodontist making 50K is the definition of low hanging fruit.
The one point that this article bring up is that there are lots of variables and tweaking one will affect another. You can’t do everything to pay less taxes and not plan on it messing something else up.
Lots of docs don’t have employees.
True, thanks for that clarification. I just don’t know any owner/ortho that doesn’t have 10 employees. Good thing that most are under 30 and could care less about retirement, so that makes the match easy.
I just read that article and was thinking the entire time how much it reminded me of the illustrations I was given for whole life. From the examples they game me I was insane not to buy it, and the more the better. Also, the idea that if it’s not taken out before coming home it never makes it into saving is another one the whole life people harp on. I can still save even if it makes it to my bank account, just takes some discipline, which bogleheads and WCI readers should have! It’s a good article to pint out complexities and how everything is connected, but still feel it’s slanted.
Nonetheless, keep them all coming. Keeps me focused!
I’m not sure biased or slanted is quite the right description. It’s not like Wolf is making any money from forming S Corps or something. Less complete than you would like seems a better description.
I’ll go with that! Thanks again for all you do, just sorting through the guest post submissions would be a full time job!
Its not unreasonable that an ortho could be an independent contractor in someone elses practice and have no employees whatsoever. At any rate it was sole proprietor vs. S corp, which frames it very narrowly.
Ricky – good point. The article does only consider one scenario, but the goal wasn’t to prove a point. It was to provide education, so readers can then figure out what is right for them (I actually operate as an S Corp). In regard to your questions: 1. Many employers want to provide a solid retirement benefit for employees so the match could be considered an advantage for retention, acquiring talent, etc. 2. If you don’t want to match employees consider using a plan that classifies employees differently.
Many of the points you discuss have been written about extensively, but I find people ignore the future social security benefit, tax deferral advantages, and the simple fact people have a tough time leaving the money alone in non-qualified accounts.
Thanks for the reply. I understand the point and you make a great one about it not being for everyone. I also agree with the SS, tax deferral and regular investing accounts.
It was probably just me over-reacting. I saw the match % and his w2 salary and saw red flags fly, losing the overall point that jumping through hoops to save taxes may not be the best thing, especially if you don’t have employees and are not maxing out your 401k yet. (we pay higher than average salaries so a 14% match would be rough when there are other ways to save and 50K on a W2 for a dentist is asking for an audit). Thanks for the guest post.
I have the same reaction. This was a scenario recommended to a friend by their tax advisor – pretty aggressive strategy to avoid payroll tax (note the article says a $50k salary risks an audit). In their case it made sense to leave as a sole prop and modify the 401k plan to cross test employees.
You would be surprised what I see. Not that long ago a client had hundreds of thousands of capital loss carry forwards. When I reviewed the old returns the cost basis was entered, but they said they sold Apple for $0/share…
Sometimes I can’t believe the amount of money people spend, just not to spend money on taxes.
Employer match for employees never ends up being as high as 14%. At a minimum it’s 2-3%, and if the plan is structured to allow for the max 53k contribution for the employer, then the max for employees is still usually no higher than 5-6% combined. They can make plans with several “tiers” of contribution types, hence allowing for higher % for employer. I’ll post a link if I find later today, to an example. Majority of employees do not max out their 401k’s either, many even contribute nothing. It never ever ends up 14% match for employees
Hmm, I’m not sure what plan allows the HCE to save a higher percentage than the non-HCE. If you have a link I’d like to see it.
I understand that not everyone will do the plan so the chance of maxing the employee contribution is low, but it’s a possibility that you are hoping doesn’t, and most likely won’t, happen.
http://www.slideshare.net/raperry6073/advanced-safe-harbor-401k-plan-designs-for-the-financial-advisor-13842397
there is some background info first, then there are several examples of structuring a 401k.
i was wrong about 5-6%, the max for employees is more like up to 7-8% match. the only HCE’s typically in these situations are the practice owners, not employees. the reason that there are some required matching percents is in order to not discriminate against the non-HCE’s in favor of HCE’s. from those rules it seems that discriminating against HCE’s is allowed – so potentially there could be a situation where an HCE who is employed (not practice owner) could have lesser allowed contributions or eligibility to participate in the retirement plan than employed non-HCE’s.
In a typical scenario, the HCE’s are the practice owners who are looking to max out their contributions, while keeping the cost of the plan low (therefore trying to keep matching for employees as low as allowed by law).
This is not entirely correct. Not all owners of small practices can get a cross-tested plan. Many young owners with older employees might need a different plan design, under which the total match can be as high as 14%. Again, this might work out very well for the owner of a small practice, so this is not a big deal. This type of design won’t work for a larger practice (but for that type of practice a cross-tested one might work just fine).
There are a ton of different rules with a 401k. My company has a safe harbor 401k so that the HCE can still put money in and get a match even if the non HCE don’t save anything. The max match allowed by law for us is 100% of the first 6%, but we don’t do that much matching right now.
Since I’ve totally got this post off subject, I apologize and will try to no longer comment of the 401K thing. The point of the post is 100% correct, the s-corp isn’t for everyone and all the variable need to be looked at as the point isn’t to pay less taxes, it’s to have the most money after all is said and done, even if that means paying more taxes to get there.
This is why most plans for small practices do a discretionary 3% Safe Harbor match with profit sharing (because many employees simply won’t contribute and the plan will fail testing). Then HCEs can max out their plan but the employees will also get something whether they contribute or not.
You could set a 14% match if you wanted to. And if you had no employees, why not? Just because some other business owner isn’t doesn’t mean you can’t.
WCI,
Here is a link to IRS.gov describing 25%
http://www.irs.gov/Retirement-Plans/One-Participant-401%28k%29-Plans
Where do you see 20% for self employed?
It is a calculated amount. Use this calculator:
https://personal.vanguard.com/us/SbsCalculatorController
Then on the bottom, click how did we get these figures. You’ll see how the 20% comes about.
This works best when you have no employees and the amount you are making is substantially more than the average salary on salary.com or some other source that you could show as reasonable. For instance, if your S corps brings in 600k and you pay yourself 300k then this starts to look good. People talk about % of amount but really none of that involves paying yourself a reasonable salary which seems to be what they actually are looking for.
A reasonable salary for an independent contractor physician who just opened a practice can very well be $60K for the first year then $100K the next, then $140K the year after and so forth. This is not how I structured my S-corp wages, but I know docs who do.
I think it is very difficult to say what exactly is a reasonable salary. Maybe it is reasonable for an independent contractor family practice doc working as a hospitalist making $300K a year pay himself a salary of $140K.
Sure, but you can’t say it’s $60K the first year and take $300K in S Corp distributions.
Right. The IRS regulation is reasonable salary. In practice, however, I think if you’re trying to justify a reasonable salary that is less than 50% of what you’re bringing home, I think that’s going to be tough. Best to use a salary survey of some kind. This does work best for a specialist making well over $275K than a primary doctor making $200K who has to decide between lower payroll taxes + lower 401(k) contributions or higher payroll taxes + higher 401(k) contributions.
Average orthodontist salary is closer to $250k, so this is either a very poor orthodontist, or a startup practice/solo 1099 contractor. He can get away with a low salary, but as soon as his income starts going up, the salary has to increase dramatically to what’s reasonable.
WCI,
I have perused nearly your entire sight trying to find a similar situation to mine. Me and my wife are both family doctors working for same clinic. We are both IC’s right now but forming LLC now (wish I had done last year since made a lot more $ this year). What would be best way to form our LLC, 50-50% co-owners, or should I have 100% ownership and make her an employee?? Thinking the latter since then we would have more flexibility to set her “reasonable” salary (esp since she works about 18 hours per week). Your site has been invaluable to me helping to navigate the IC world over past few years (and the lessons on saving!). Thanks
Why are you forming an LLC? Is the plan to have it taxed as an S corp? How much are you expecting to be salary vs distribution? Is there some other benefit you’re trying to get that you can’t have as sole proprietors?
Right, as WCI said, you might want to have your LLC taxed as S-corp to pay yourself a salary plus distributions, especially if your income will be high ($300k or above). As far as the ownership, I’d consult an attorney on that. A two-member LLC might be more preferable to a one member. Owners don’t have to set their salaries to be the same though. You can also set your salary to be just enough to max out a 401k plan ($140k or so), and distribute the rest. Just remember that if you are netting $400k or more, $140k might not be a reasonable salary. In that case, you can set the salary to $265k especially if you want to maximize your contribution to a 401k + DB plan.
A two owner LLC gets more asset protection in many states. Not sure that really matters in your situation though, as it provides zero malpractice protection.
The lawyers point about appreciated assets were that if for some reason the s corp were closed and you had an asset that had appreciated in value even if the gain wasn’t realized yet you would owe taxes. If for example you had a piece of property that you bought for 100k and at time of close it was worth 200k, you owe tax on 100k even if you didn’t sell the property yet. Pretty crappy.
Also you can’t ever switch back from selection to non s selection within an LLC.
That is a definite downside, but how big a deal is it to not close the S Corp prior to the sale of the property it holds?
Anyone telling you to hold appreciated property inside an S corporation should be fired immediately. Additionally, a CFP should not be giving advice on entity structure. I am not telling anyone what they should/should not do but it scares the crap out of me to see some of the comments. Additionally, for disclosure I don’t provide services to any clients but rather manage a fairly significant tax department at a public company but there are some very large holes in the comments on this topic.
It would be helpful if you would point out the “holes” you see as well as the issues with property in an S Corp.
That is a very valid point and I will work on putting together a well thought out response to hopefully help out any readers. By the way, I respect your site and recommend any doctor/dentist/professional read your site as I believe it is very educational and empowering.
It might make a good guest post.
https://www.whitecoatinvestor.com/contact/guest-post-policy/
I believe there are pro’s and cons to both side of the S Corp debate but I chose to leave that up to CPA’s to figure out. I challenge this article b/c the author spends the whole article focused on what government plan we can benefit from. Shouldn’t we be trying to think outside the box?
What happens if the government changes the rules. See: tax code. 1100 pages of exceptions. Social Security is currently cash flow negative and the IOU, I mean Trust Fund is expected to run dry in 2033. Why make decisions on Social Security? Plan not to take a check from the government will serve you better. That goes for today too. If you will eliminate Medicare and Medicaid from your practices you will find freedom and the end of the tunnel. It’s not easy but it can be done. Not to mention in the future when they change the rules on what procedures are not financially prudent for seniors you will not be committing Medicare fraud when you allow them to pay cash. Let that set in.
Tax deferral is great until…..
Betting on the market? Read this article on 401(k)’s going cash flow negative in 2016. http://www.moneynews.com/Personal-Finance/Cerulli-401k-cash-flow/2014/06/09/id/575978/
Quiz: What happens to price when more people are selling than buying?
Solution: Read more business books, E-Myth Revisited is a great start. Dentistry and Medicine is wide open for those with a financial mind. Save heavily in liquid assets that will give you control and opportunity when the market tanks again.
P.S. The best thing he said in this post is that it went against conventional wisdom. I always consider that a plus and not a negative.
Russ, I’ve warned you before about plugging cash value life insurance on posts that have nothing to do with cash value life insurance. I’m going to block your comments if you keep this up.
WCI, you missed the point totally.
I’ve got a small subset of commenters on this site that are fixated on a certain subject (different for each of them). It doesn’t matter what I write about, they make similar comments on every post. Sometimes it’s advertising their firm’s services, sometimes it is simply trolling. I’m trying to keep you from going down that road.
Quiz – How is it ever possible for more people to sell than the number of people buying??
Aaron, read the article. Also see redeeming mutual funds. The majority of all money in 401ks are in mutual funds. When you redeem mutual fund shares, you are selling them back to the fund (this creates the infinite supply).
What about a defined benefit plan? Is this something that can only be run with an S-corp, or can this be done as a sole prop? A DB plan allows you to put away significantly more in addition to you 401k, so can you just get that through each corporate setup?
Yes, you can do a DB with sole proprietor income, you just need a lot more of it to max out the plan vs. giving yourself a W2.
You can do a solo defined benefit plan as a sole proprietor. You can probably do one for your employees too if you want. No corporation required.
With an S corp, I am able to fund both a solo DB AND solo 401k, albeit with limits on the latter. The amount you can fund in total depends on the reasonable wage you pay yourself. It’s over my head but that’s why you pay actuaries and accountants. The end result is a lot more tax deferred savings.
You don’t need an S Corp to do an individual DBP nor a Solo 401(k) nor both of them together. You are correct that the amount you can fund depends on the reasonable wage you pay yourself. With regards to the DBP, it also depends on your age and how much you’re putting into the 401(k). That’s where the actuaries come in.
Very interesting article. I’m a bit confused now however. I’m in California, where the weather is nice and taxes are high. Most MDs in my area formed S-corps for their practicies, including myself. That is why I did so, not knowing the many intricacies at the time and simply trusting my peers. I pay myself a reasonable W2, and then pay the rest as a dividend. I do have a DB + profit sharing + 401k, which allows 100+k contributions yearly. It sounds like I did not need an S-corp to do all this. Are there additional benefits of incorporating that I’m missing? Is there a certain amount of 1099 income per year when it becomes worth it to incorporate, and below this it is not worth it?
The main benefit is to avoid paying Medicare tax on the dividend/distributions. If that benefit is worth it to you, then it’s worth it.
Once you give yourself $100k+ salary, there is no point in holding back anymore because the retirement plan contribution maximization will require a $250k salary, which is not an issue at all since the extra taxes paid by going from $100k to $250k are small compared to tax savings from being able to contribute $53k ($73k or so with spouse employee) into your retirement plan. And of course, for any type of DB plan you will need to give yourself the full salary.
Having LLC taxed as an S corp will be more than adequate for a small practice.
What makes anyone think that social security benefits will be available or at least not means tested by the time the subject retires (i.e., ‘you doctors are too rich too need or deserve this’ say the Democrats)?
What makes anyone think ISIS won’t have snuck a nuke into Manhattan by the time I retire? The likelihood seems about the same to me. It’s not zero, but it is low risk. And SS is already means tested. Were you not aware of that? A higher earner not only gets a worse return on his contributions than a low earner, but he pays more in income tax on the payments too.
I’m a sole proprietor (expecting $36k per year) in addition to my full-time W2 job ($178k per year) and I’ve debated incorporating before. My understanding is that if I pay myself a salary of 50% of the proposed S corp revenue then I’m only saving 2.9% medicare taxes on the other half of the revenue since I’ve already maxed out the social security tax on my W2 income. So incorporating would only save me $417 in medicare tax. Though since in both cases I’d be contributing ~20% to a tax-deferred account, as a sole proprietor I’d be contributing $3,600 more to a retirement account which at a 28% marginal income tax rate would save me $1,008 in income taxes. So in my case incorporating would actually have me paying $591 more in taxes, plus the costs of incorporating and the opportunity cost of less tax-deferred savings. I’ll continue to stick to my guns about how in my situation incorporating isn’t worth it when people tell me I should.
Below are links to two articles written by Andrew Schwartz, CPA who specializes in tax planning for medical professionals. Although one is very old, the premise is still the same.
http://www.mdtaxes.com/news0312.html
http://www.mdtaxes.com/news0705.html#1
While your conclusion is probably right, keep in mind you’re only deferring taxes on the 401(k) money (although there may be an arbitrage and there is a benefit to decades of tax-protected growth) but are actually eliminating taxes with the corporation, even if the taxes are lower.
This is a really good analysis. Thank you.
What about the issue of professional liability? Do you feel that an S Corp. provides an extra layer of protection against lawsuits?
Not against malpractice, but other professional liability such as an employee suing you.
For what’s it’s worth, our accountant who handles a large numbers of doctors, recommends always paying yourself enough in salary to max out social security tax. He says he’s never had any issue with the IRS when a doc is paying themselves a 5 figure salary monthly. This is a guy with 20 years experience. The IRS has limited resources and there are plenty of people that are dumb enough to try to pay themselves a salary of zero or next to zero and take everything as a distributions. They start there and work their way up. It’s going to be a lot of time and resources arguing a gray area that you should have paid yourself 260k or whatever instead of 150k for a pretty minimal gain on their part.
I agree that is a good idea and have written that before.
Understood. Thank you. And does it provide protection against lawsuits unrelated to professional practice or employment, such as business vendors (contractors, etc.)?
It doesn’t really “protect against lawsuit.” It protects your personal assets from a judgement made against the corporation.
Yes, I see the difference. Thank you for the clarification.
Thank you to everyone for the discussion. Although I read most of the posts, I did not read all and apologize for any redundancies. From my own personal experience, I have regretted setting up a S-Corp last year. There are additional expenses that one may not consider such as, costs to the accountants, attorneys, and payroll. An increase in fees for local, state, federal are possible. My situation was really fairly simple (an independent contractor) and was advised by some friends as well as attorneys and accountants that it would be very important to set up a S-Corp for the tax saving and legal liability. In hindsight, I do not feel that I am getting any value added; I am only getting headache and frustration. I am hoping to learn from the experience and would advice others that if you feel that a S-Corp is right for you to discuss it with a physician in the same field, doing the same type of practice that you envision, who has formed a S-Corp and discuss the pros and cons in that situation.
This is a great topic and literally a life changing website. Thank you WCI!
I have a question. What if the orthodontist owner of this S corp opened a SEP IRA instead of a solo 401k? “Reasonableness” of salary aside for a minute, wouldn’t she still be able to put away the max 52k/year, or at least much closer to it? She could equal the amount saved in the 401k example if her net profit is high enough. This would negate the loss of saving and tax deferral arguments in the post. Plus, she would still pay less in payroll tax. She might also set aside additional income in an HSA.
Yes, her monthly SS check would potentially be be smaller during retirement, but as others have mentioned, social security law (and personal longevity to benefit from it) are not guarantees set in stone.
You can’t use distributions to determine how much you can put into a SEP IRA or Solo 401(k). Only salary, on which payroll taxes are due, is used for either. You can’t max out a solo 401(k) (or a SEP IRA) on any amount less than the maximum income on which Social Security tax is assessed.
You can max out a solo 401k with a much lower salary (~$140k vs. ~$212k for a SEP if I remember the numbers correctly). Also, if the owner does not participate in any other retirement plans, why SEP? This will not allow backdoor Roth contributions. If the owner does not have any employees, a solo 401k would be so much better.
Your numbers are too low. At best you’re going to need at least $35K/0.20 = $175K to max out an individual 401(k) and at least $53K/0.20 = $265K to max out a SEP-IRA.
If you are a sole proprietor, then yes. If you are an S corp or an LLC taxed as an S-corp then my numbers are correct, I believe. I think that an LLC that is taxed as an S-corp can be a good idea in some circumstances.
Are you saying you can use the 25% multiplier available to employees as an employee of an S Corp you own? That would be news to me. Do you have a source/link?