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There is a rarely-discussed trade-off of changing from sole proprietor to LLC/S-Corp. When I was weighing the choice, no one on FW mentioned it, and none of the tax/accounting professionals I talked to mentioned it either.

Background: Sole proprietors may be able to save money by forming an LLC and electing to be taxed as an S-Corp. This is because an LLC allows you to pay yourself a reasonable wage that is less than the full net earnings, which can reduce payroll tax. (Sole proprietors are taxed as if all profit is wages.) Payroll tax is 15.3% on the first $118,500 of wages. So if your business earns $100k, and a reasonable salary for your involvement is $50k, you can save $7,650 by forming an LLC. [edit: Actually the $7,650 savings is wrong. The employer half of FICA is a deductible expense, so the savings is actually ~$5,700 to $7,000, depending on your tax bracket]

One caveat I have seen mentioned is that by decreasing your wages, you may be decreasing your social security payout. However, the social security payout tapers off with increasing wages, and some people think social security payouts will decrease in the future.

The thing that I did not see mentioned, and only encountered after forming my LLC, is that by reducing your wages you also reduce how much you can contribute to a 401k. If you're under 50, a 401k allows you to contribute up to $18,000 as an employee, and then up to another $35,000 as an employer. (In this setup you are effectively both employee and employer.) The employee contribution is limited to 100% of your wages, but the employer contribution is limited to 25% of wages. This means that in the above example of the $100k earnings, the sole proprietor can contribute $43k to a 401k, whereas the LLC owner can only contribute $30.5k.

The big question is, how much more valuable are funds held in a 401k than funds held in a taxable account? This is a tricky question with many variables. I have not seen a great discussion of it. If anyone knows of any good resources, or if you've reasoned through it yourself, I'd love to hear.

In my situation, income is high enough that the LLC definitely makes sense, but there is still the question of whether I set my wages to the lowest reasonable amount, or high enough to maximize my 401k contribution. Since I'm in a high tax bracket now, and expect to have much lower income in retirement, a 401k is appealing. But it is not clear if it's worth paying the extra FICA taxes now or not.

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ssgcinty made a useful spreadsheet to calculate this stuff: https://www.fatwallet.com/forums/finance/1528227
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I'm assuming that the $33675 S-Corp profit (=100K revenue-50K wages-3825 half of FICA-12.5K employer's 401k contribution) will be distributed to owners (yourself) as a dividend? Dividend tax rates are currently the same as federal income tax rates, and I think most states tax dividends as regular income.
frankot said:   But it is not clear if it's worth paying the extra FICA taxes now or not.You're not paying 7.65% FICA on just the additional 401k contribution as a sole prop. You're paying 7.65% on your total wages in order to defer income tax on just 12.5% of those wages. All other income will be the same between the two schemes. The result is:
Sole prop: defer $12,500, saving a bit on taxes now to pay them in retirement, or
S-corp: pay fed+state / dividend income taxes on the extra $20150 in dividends (= 7650 FICA savings + 12500 not deferred) and keep the rest. In your example that's probably $14K or more after-tax, depending on your personal deductions, exemptions, and your state's tax rates.

Unless I made a huge mistake somewhere, it's a choice between $12,500 tax-deferred in 401k as a sole prop or > $14K after-tax in your pocket as LLC .

Two prior discussions that might be useful.  For valuing retirement dollars vs taxable ones (but don't bother with the discussion),

https://www.fatwallet.com/forums/arcmessageview.php?catid=52&threadid=278889 

for getting around the limitations of 401k contributions, see tip#7 in tripleB's good post and some good discussion,

https://www.fatwallet.com/forums/arcmessageview.php?start=1&catid=52&threadid=953923

Broadly, it depends on a lot of assumptions about your investment performance, time horizon, and tax rates, but I think using $1.30 value for a $1 Roth contribution in terms of present value might be reasonable for someone saving for their retirement.  If you trade actively and successfully (high taxes,high returns), the value could be several times that, more like $2-10.  

Look into after tax employee contributions to fill out the max allowed under your 401k.  You may need to switch TPAs and pay a bit more to one who understands this esoteric but valuable option.  If everything can be worked out, you can essentially fill out the "lost" difference with a contribution that ends up in your personal Roth taxfree (but nondeductible). 

scripta said:   I'm assuming that the $33675 S-Corp profit (=100K revenue-50K wages-3825 half of FICA-12.5K employer's 401k contribution) will be distributed to owners (yourself) as a dividend? [Yes] Dividend tax rates are currently the same as federal income tax rates, and I think most states tax dividends as regular income. [That's right, except California has an extra 1.5% tax on the business income.]

You're not paying 7.65% FICA on just the additional 401k contribution as a sole prop. You're paying 7.65% on your total wages in order to defer income tax on just 12.5% of those wages.
[Actually, it's 7.65% for employee portion, plus 7.65% for employer portion, minus (marginal tax rate)*7.65% because employer portion is a tax deductible business expense. And it's paying FICA on wages for 25% of those wages going to 401k.]
All other income will be the same between the two schemes. The result is:
Sole prop: defer $12,500, saving a bit on taxes now to pay them in retirement,
[In this example, Sole Prop can defer more, because the employer portion is based on the full 100K, not a smaller wage amount. I don't understand why, but for sole proprietors, I believe it's 20% instead of 25% of compensation for Corporations. So this would be a $20,000 deferral.]
or
S-corp: pay fed+state / dividend income taxes on the extra $20150 in dividends (= 7650 FICA savings + 12500 not deferred) and keep the rest. In your example that's probably $14K or more after-tax, depending on your personal deductions, exemptions, and your state's tax rates.
[Not sure why your S-Corp example isn't making the 401k contribution anymore?]

Unless I made a huge mistake somewhere, it's a choice between $12,500 tax-deferred in 401k as a sole prop or > $14K after-tax in your pocket as LLC .
 

xerty: Thanks for those links. That first formula neglects dividends in a buy-and-hold strategy though. It might be easiest to just calculate them in a spreadsheet.

I think I would probably do best with the after-tax 401k contributions/Mega backdoor Roth and minimal W2 compensation. Not sure if it's worth the extra hassle though. For anyone else considering a Mega Backdoor in a solo 401k, I found what looks like a good resource over on The Finance Buff.

yeah, you know best your personal situation, likely investment horizon, likely investment style, etc, so you can put in dividends, tax on capital gains from turnover, and the like however you see fit.  Put it all in a spreadsheet and see what comes out.

you still need enough W2 income for your employee contributions, both elective and after-tax (not sure about employer side contributions), so make sure you pay yourself enough.  If you made a mistake and underpaid yourself and had some disqualified 401k contributions, it would be pretty annoying to unwind if you'd already rolled out and converted the after tax portion to your Roth.

frankot said:   scripta said:   S-corp: pay fed+state / dividend income taxes on the extra $20150 in dividends (= 7650 FICA savings + 12500 not deferred) and keep the rest. In your example that's probably $14K or more after-tax, depending on your personal deductions, exemptions, and your state's tax rates.
[Not sure why your S-Corp example isn't making the 401k contribution anymore?]
It still is, but 12,500 less. Based on your own example.

You're right. It's 7.65% for 12.5% contribution in your example of 50K, but the math for any amount is you pay 15% FICA in order to contribute 25% to 401k pre-tax. The proportion is the same (15/40 towards tax to save 25/40). It doesn't make sense to make the pre-tax contribution as a sole prop any way you calculate it, and much more advantageous to just pay the tax and keep almost the same amount after tax as S-corp.

scripta, I got mixed up at the end of your original calculation; now I understand what you wrote.

I'm not understanding the last thing you wrote though. I don't know what the 15/40 and 25/40 are, and I'm not sure I understand your last statement. My guess is that you're saying that paying extra FICA to make the extra 401k contribution is worth it? If so, I've come to the same conclusion.

Here are my current formulas for a marginal dollar going into a 401k (and having to pay extra FICA) vs going into a taxable account, with M = Marginal tax rate:
401k&extra FICA = 1 - 4(.0765 + .0765M)
taxable                = 1 - M

Those are equal when M = 44%, with the taxable greater with M < 44%, and 401k&extra FICA greater with M>44%. Of course comparing 401k and taxable accounts requires the full set of inputs of return, plus the qualified and regular tax rates before and after retirement. I'm now feeling like my earlier intuition to pay extra FICA to max out the 401k is correct (especially with the extra 1.5% tax that California charges on business profit).

As for the Mega backdoor Roth, by my spreadsheet calculations, it does not look like it's actually much better, and may end up worse, depending on the tax rates in retirement. Add in whatever extra benefit I get from paying more into social security, and not having to bear the extra expense and hassle of a new 401k plan that would allow the backdoor, and I'm feeling like sticking with maxing out the traditional 401k is the way to go.

I'd love for someone to validate my formulas. If they are correct, I think my question is answered. But this should also serve as a warning to anyone considering switching to an LLC/S-Corp, as it's not as simple as a pure 15.3% savings on decreased wages that some people make it out to be.

Frankot,
It seems you have built a worksheet yourself. Can you please check my worksheet and see if our numbers match?
Thanks

Unfortunately I can't do a direct comparison, because your spreadsheet looks at the total tax rate, and mine uses the marginal rate to calculate the value of a marginal dollar. I haven't gotten a chance to check it fully, but on the surface, it looks right. The one thing it really needs (and I guess you mentioned this) is a function for the tax rate. Because as you fiddle with the salary and contribution amount, the average tax rate will change (even if you don't change tax brackets).

(All the numbers below assume that the business profit is such that the higher salaries are necessary)

The first $24,000 gives you the best bang for the buck.
So at least take a $24,000 salary. Then add spouse up to 24k too if you can.

After that, let's say you want to know the impact of the next $100 increase in salary.
Change the tax bracket to your marginal rate.
Change column N5 from $18,000 to 0
And make your salary $100.

That should give you the impact of the next marginal dollar.

What about folks with full-time jobs (in high tax brackets) who have a part-time business on the side? Is there anything you can do besides a SEP IRA that might lower your taxable income on the part-time gig? Creating an LLC doesn't seem to make sense in these circumstances (except to shield yourself against liability), but I'm open to suggestions.

Appreciate the input!

How much is the part-time income?

For those with already high salaries, taking a higher salary from the part-time business is not all that bad because they only have to pay additional medicare. They have already reached the SS limit.
So that is one more reason to keep it simple and go S corp.
The only issue (as you identified) is liability protection.
Can you employ spouse?

ETA: As btuttle points out, you avoid only the employee portion of FICA.  You still have to pay the employer portion.  Thanks btuttle.

ssgcinty said:   How much is the part-time income?

For those with already high salaries, taking a higher salary from the part-time business is not all that bad because they only have to pay additional medicare. They have already renached the SS limit.
So that is one more reason to keep it simple and go S corp.
The only issue (as you identified) is liability protection.
Can you employ spouse?

Actually, this is generally bad advice based on an incorrect assumption.

All corporations (including S-Corps) must withhold full FICA taxes (including SS up to $118.5K) regardless of FICA withholding from other employer(s). While an employee can recover excess SS taxes paid to more than one employer, there is no provision to recover the employer portion.

On the other hand, a sole proprietor only pays SE tax on self-employment income after taking into account W-2 earnings subject to SS taxes. So, it is generally much better for someone who will exceed the SS max wage base (>= 118.5K) to be a sole proprietor for the side business.

 

btuttle said:   
ssgcinty said:   How much is the part-time income?

For those with already high salaries, taking a higher salary from the part-time business is not all that bad because they only have to pay additional medicare. They have already renached the SS limit.
So that is one more reason to keep it simple and go S corp.
The only issue (as you identified) is liability protection.
Can you employ spouse?

Actually, this is generally bad advice based on an incorrect assumption.

All corporations (including S-Corps) must withhold full FICA taxes (including SS up to $118.5K) regardless of FICA withholding from other employer(s). While an employee can recover excess SS taxes paid to more than one employer, there is no provision to recover the employer portion.

On the other hand, a sole proprietor only pays SE tax on self-employment income after taking into account W-2 earnings subject to SS taxes. So, it is generally much better for someone who will exceed the SS max wage base (>= 118.5K) to be a sole proprietor for the side business.

 

  

Thank you, it sounds like sole proprietor is the way to go...  If it helps, our full-time gigs put us in a high tax bracket, and the part time (self-employed) gig are about 10-20% of the full-time amount.  We do meet the SS max wage base with the full-time gig.  

 

ssgcinty said:   Frankot,
It seems you have built a worksheet yourself. Can you please check https://www.fatwallet.com/forums/finance/1528227 and see if our numbers match?
Thanks

I checked my worksheet, and I found a few errors. As far as I can tell, yours is correct. After fixing mine, I can now get it to agree with yours for marginal value. (Changing N5 to zero did not work for me, so instead I just used what you had and flipped between 100k salary and 101k salary, and examined the rest.) Unfortunately this is not a full validation of yours, since I did not come to the same answers fully independently.

The one thing that my sheet has that yours does not is a treatment of dividends in a taxable account. I'm not sure how to code that without doing it iteratively (to sum up the cost basis of the dividends at the end), which means that in my sheet you can't change the compounding period with a single cell.

That said, for my situation, adding in that detail wouldn't change the outcome. As far as I can tell, I'm almost always better off maxing out the 401k. The main thing that would make it not worth maxing out is if my regular tax rate goes up significantly in retirement. The same goes for adding in a tax calculator: I was tempted to try coding it, but I realized that fiddling with it wasn't going to change my answer. (And coding it to be broadly applicable for different states, single vs married, plus AMT considerations, etc., sounds like a lot of work.)

I guess it would be nice to have some sort of marginal analysis built into your sheet. Or maybe a plot of NPV of future total value versus salary(s).



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