Hi – I’m revisiting this article as I reflect on my decision to convert to a S-Corp and comparing rough pro-forma taxes as both a S-Corp and LLC in the State of Ohio. The state tax laws may mean the S corporation isn’t viable. That would be the “real” number. He is wrapping up a ... (e.g. (end comment), I will definitely research fringe benefits and also take you up on your generous DIY S-Corp guide offer (thanks!). I pay no FICA on it. In other words, the Roth 401(k) rollover money inherits the age of the Roth IRA, either for good or bad. You don’t have to go crazy or break the rules. Dress up the optics of the tax return. I’ve looked into the ‘tax break of the century’ but I can’t use it for my particular situation/industry. We’ve got a longer write-up on the setting reasonable S corporation salaries here at my blog: S Corporation Reasonable Compensation. Join over 100,000 others on the Mad Fientist email list to get access to exclusive content and software! Now just check your email and start tracking! If I make more than that with my main job, does the drop off in savings still make S Corp good idea? In your opinion, is that still borderline in terms of work-ability with this approach? So no “500 hour” rule exists for S corporations. The Section 199A deduction equals the lesser of 20% of the qualified business income or 20% of the taxable income adjusted for capital gains. In this scenario, you also sidestep payroll taxes on that remaining $10K. Military servicemembers have access to incredible tax, investing, and travel benefits that can accelerate the journey to FI! I’m currently a sole prop and the only employee. Regarding how to approach the question of incorporating your business, you’d need to determinate what your reasonable compensation amount is, look at any nontaxable fringe benefits you can provide, and then calculate your payroll tax savings. BTW, sort of related: People sometimes bump their S corporation compensation only to bump their pension contributions. The biggest problem, however, is the 5-year waiting period, so you have to have a decent amount of post-tax money already available in order to optimally execute on this strategy. To maximize your savings, you want to pay yourself as little as possible. Any limitations there? But you have a big riddle to solve if you want to do this. 14,214 people like this. Second, just to clarify this important but often confusing point. As someone who had never done payroll before or dealt with employer/employee payroll taxes, etc, the reasonable wage part was a bit confusing and scary. If you dissolve that S corporation to bump its qualified business income by $40K, that will bump the Section 199A deduction and increase the Section 199A savings… but not by very much. Great article, as I was just recently researching this topic – thank you! Regarding optics, I think they *do* matter. Second, for the typical small business owner, the S corp savings actually dwarf the Section 199A savings. If I’m making ~$30K a year with my LLC, does filing as a S Corp seem worth the hassle? The taxpayer pays too much payroll tax for the relatively modest tax deferral benefit they enjoy. You may have answered this in the comments with the following, but it is still unclear to me how it works: “How 401(k) contributions work is a little tricky. If you’re in the 10% or 15% marginal tax bracket for Federal Income Tax, then your tax on Capital Gains is 0%. Both are married and take the new standard deduction, $24K. Episode 1076: Specific Identification of Shares by The Mad Fientist on How To Reduce Your Tax Burden on Taxable Investments – latest numbers here.) Which is why this article doesn’t make much sense right now. Consider again the earlier example where someone makes $100,000 but pays $40,000, or 40%, in wages. If I claim reasonable income, I’d pay FICA on that. Pretty cool! Regarding the 28.5714% thing, if S corporation wages limit the Section 199A deduction, you optimize with that percentage. Along the way on his blog and podcast, he shared the spreadsheets, techniques, and insights that allowed him to achieve financial independence sooner in life. If you make over $200K, would it make more sense to not have an S corp and benefit from the QBI on the entirety of your income with SS stopping at $132K? All of my borrowers report income to me on 1099-int. Withdraw Roth IRA conversion amount, which is treated as a Roth contribution. Mad Fientist did you a solid on this! sporting set your IP address to group A different geographic area. (I don’t know for sure. And Tennessee doesn’t let you use the S corporation accounting for state tax purposes. The S corporation kit uses an LLC. A limited liability company (LLC) is one of the legal entities that can make an election to use the S corporation tax accounting rules. California levies a 1.5% franchise tax on the S corporation’s profit (the franchise tax also is always at least $800). Mad Fientist. If your business makes a lot of money (i.e. I really appreciate all of your insight. Advanced Strategies for Pursuing Financial Independence - http://www.madfientist.com But we should have the “awkward talk” at this point. I’m still a little confused. In either case, that extra accounting costs time or money or probably both (as a guess, maybe another grand for a small S corporation if you outsource the work?). And then that money can’t be reclassified as wages. Say she pays herself $40K in base wages and then also provides $10K of health insurance for her entire family. Really late, but revisiting because it’s tax time…. Okay if you operate an unincorporated small business, this all sounds pretty interesting, right? Wait four to five years calendar years, depending on date of conversion (because years are counted instead of actual date, so a conversion on 1/1 is treated the same as 12/31). Why would the sole proprietorship pay taxes on 100k if they can make further deductions? Community See All. Unsubscribe anytime with 1 click. We know how to avoid paying a lot of money in interest, achieve and maintain an excellent credit score, refinance debt to a lower interest rate, and avoid credit card debt. Or you might outsource the work to some accountant. 2) The same question as #1 but how does this change if you are married and your wife’s income is about $70K? I have two part-time 1099 contractors who occasionally help me. SS stops at about $132K, however, medicare costs are ongoing. There’s another benefit of having an S Corp that’s worth mentioning… If your business makes a lot of money (i.e. For many small businesses, the strategy won’t make sense. Log In. But that breakdown may be unreasonable. You would need to be able to extract a lot of the S corporation profit as fringe benefits in order to even sort of make this work. 46 talking about this. Consider the two following small business owners: Both earn exactly $100K. Bummer… I also cannot in good conscience claim to be hiring my wife/kids (a strategy my former accountant was pushing). But because you’ve raised the subject, let me point out a handful of things: First, some people need an S corporation in place to get the Section 199A deduction because they need W-2 wages in order to get the Section 199A to work. Specifically, could an S corp or other LLC be set up for a business that barely turns a profit? Great article Steve! I know it violates the “optics” principle, however, I feel this could easily be justified to the IRS since the time spent in the business is so minimal. Why did I make the change after so many years? « previous next » Print; Pages: 1 2 3 » Author Topic: Mad Fientist nails it again: Roth IRA Horserace. If you are able to separate the royalty income from the blog income, then you can re-figure your math and the optics look a lot better. The work on the book having been done years ago, the royalties are completely passive. Brad, two comments about your situation and others like it…. You are correct that employer contributions are limited to 25% of employee compensation (wages). Further say you have $20K of health insurance and HSA and $10K of pension. Coincidentally, his taxable income also equals $60K. Oops, forgot to answer the other easy question I should answer. Episode 525: Happiness Through Subtraction by The Mad Fientist (Minimalist Finances & Financial Freedom). .5 scale RE, you don’t provide enough info to answer questions… but note that if your total income equals $155K and you’re married, no matter what your trade or business, you qualify for Section 199A. The payroll tax savings for most businesses won’t make up for the “tax cost” of the reduced QBI deduction. I am an independent consultant organized as an LLC. more than $157,500 for a single person or $315,000 for a married couple filing jointly), having an S Corp could help you qualify for the tax break of the century when you may not have otherwise….Imagine you’re a single person and your business earns a $250,000 profit next year…If your business is structured as a sole proprietorship, you wouldn’t receive any Section 199a deduction because you earn too much to qualify…If you instead have an S-Corp, you’d be eligible to receive a Section 199a deduction on 50% of the W-2 wages paid by your business…So if you paid yourself 28.5714% of your business profits (which is the percentage that would maximize the Section 199a deductions in this case), you’d be able to get a 20% deduction on $71,428.50 of your income.”. Which isn’t really enough to pay the full freight. Additionally, the QBI deduction does not fully phase out for a single flier until about $207K. The 25% employer match applies to the $60,000 of wages, which means another $15,000 of nontaxable fringe benefits. Why does this work? I will tell you this..the average S corporation generates about $90,000 of profit for an owner and calls about $40,000 of this profit “wages” (this breakdown lines up pretty neatly with the earlier example). I’m an independent consultant (LLC), and will earn ~$135K next year working 1/2 time (about 1000 hours billed for the year). But according to every accountant I have worked with, that $60k still flows to your 1040 and you end up paying taxes on it anyway. Has anyone done a t401(k) to Roth 401(k) conversion to beat the 5-year rule and make their ladder shorter? BTW, if someone only worked part-time, that matters in the reasonable compensation calculus. 30k – I pay myself So I started the Mad Fientist in 2012 right when I realized like a in 2011 is when I realized that financial independence was possible when I was like, you know, always always, and I was like, I just want to get there as quickly as possible. From my calculations, for a single flier, I don’t think there is a point where it doesn’t make sense to have an S corp but I wanted to check. Thanks! Note: This accounting leaves $5K “leftover” for a shareholder distribution. I just wanted to provide this perspective to those evaluating their own decision – I would evalute the pros/cons of each. Now just check your email to get your spreadsheet download link! Dan, I think high five figures is where an S corporation most often begins to make sense. Employer qualified plan contributions are a deduction to the S corp on the 1120S and therefore reduce profit. I was so satisfied I will not even ask him to price match this deal. Log In. What I suggest is this: Develop a good argument for why a particular number is reasonable. Percentage of Profit Subject to Employment Taxes – S Corp. And this means the person pays about $6,120 in employment taxes. Forgot account? How 401(k) contributions work is a little tricky. Your email address will not be published. (We talk about this in the Section 199A blog post that the MadFIentist references above.). Peanuts, ideally. First, making the S corporation thing work for a side-line or supplemental business is tougher. Grab a complimentary kit from this page, Downloadable S Corporation kits… All you need to do to “buy” a kit for some state for free is enter the promo code MADFIENTIST. So, bottomline, the option isn’t as attractive in your situation. If you use a Mad scientist VPN you can sometimes avoid paying taxes on river purchases. This is incorrect. “The IRS has ruled that an individual who writes only one book as a sideline and never revises it is not regularly engaged in an occupation or profession, and the book royalties are not considered earnings from self-employment.”, https://www.thetaxadviser.com/issues/2013/dec/kelley-dec2013.html. 15,229 people follow this. I haven’t run the numbers but this might help. 5. Percentage of Profit Subject to Self-Employment Taxes – Sole Proprietorship. The point about the Section 199A deduction is the deduction equals 20% of the *lesser* of your taxable income adjusted for capital gains or your QBI. The allocation of a single shareholder S corp income to wages (Line 1 form 1040) vs distributions (Line 17 Schedule 1, gets added at Line 6 form 1040) doesn’t change the ultimate Taxable Income for the tax filer, and isn’t going to produce a QBI deduction where none existed in the case of a sole prop. Sure, some extra work but not that hard to deal with. That is, non earned income. Look forward to any comments if this analysis is off base. The bottomline: Your payroll tax savings in this case equal about $5300. Community See All. And other than SEP-IRA/HSA, we don’t have any fringe benefits. Community See All. 33k = Blog x 25% = $8250 wages. But that’s a little irrelevant because most S corps already do this…. Does anyone know about any holding period for t401(k) to Roth 401(k) conversions, similar to the tIRA to Roth IRA? And you need to have paid that reasonable salary before the calendar year ends. Thanks for the reply. 2. I kept track of my business expenses in a spreadsheet and when tax time rolled around, I just filed a Schedule C for my Sole Proprietorship and used those business expenses to reduce my W-2 taxable income. Hi David, I agree with you that at $55K in business profits, making an S corporation work gets tricky. Am I missing something? Thanks so much for the informative post. As I mentioned in my last post, I was sick of being paralyzed by stuff that didn’t really matter so I just started writing and didn’t stress about the business end of things. My question is–do you still get to deduct it as an adjustment to income as self-employed health insurance? Is 100k in profits a good ballpark to make this realistic? But wait! Note: Boxes 3 and 5 of Diana’s W-2 report only $40K of wages because health insurance isn’t subject to FICA or Medicare. 901-347 Phone Numbers Bring what you keep. So, please tell me what I’m missing. But his Section 199A deduction doesn’t equal 20% of $100K. His taxable income, roughly $60K, limits the deduction. 3. But what you need to do is identify a reasonable compensation amount—and then document your logic. The actual Section 199A deduction therefore equals $12K. Diana, you need to be careful about health insurance for s corps when you have non-shareholder-employees. Note: When you make a late election, you need to invoke the correct revenue procedure and follow its rules. And I would say the S corporation election and the Section 199A deduction are actually complementary. 15,537 people follow this. Based on my analysis I believe the QBI deduction does not make it obvious to convert to a S-Corp. I’m semi retired, I spend time evaluating real estate deals to see if I want to lend. For example, say you were running a small S corporation that makes $100,000 and that you want to set $40,000 as your S corporation reasonable wage. This benefit alone could save you thousands of dollars! In this case, you’ll maybe pay Dan the employee $40K in wages subject to payroll taxes and then give him and his family another $30K in fringe benefits that are free from income taxes and (unique to the S corporation) free from payroll taxes. Throw in the savings on employment taxes described in the post and you can see why this is a great move for many profitable businesses. So an obvious question is, should you stay a sole proprietor to increase the size of the Section 199A deduction? The Mad Fientist on specific identification of shares. I can expense about 10 to 15k naturally via normal operating expenses so net 85 to 90k. Not Now. No separate office, car mileage, wire fees and any professional fees are all I have for deductions. (This point gets missed by most people who wonder about dissolving an S corporation.) I’ll contribute the full $55K to my solo 401(k) along with about $4K to an HSA. Most personal finance advice is geared towards people retiring in their 60s or later and doesn’t apply to those pursuing early financial independence. So if you pay out $285,714 of $1,000,000 in profit as wages, your Section 199A deduction equals either 50% of $285,714 or 20% of ($1,000,000 – $285,714)… either way, the result equals $142,857. Note: When you make charitable contributions from an S corporation, the charitable contribution still ends up on the 1040 return. Am I missing something? Note: Self-employment taxes replace the Social Security and Medicare taxes that employees pay and basically work the same way. Another example? Website . I don’t think you generate a financial benefit by setting up an S corporation to create wages so you can fund a pension. that makes $1,000,000. If you’re not yet ready to elect S status but you are ready to set up an LLC, therefore, just postpone the step of making the S election. This is because I believe that vanilla Roth 401k contributions are not subject to the five year rule, so long as they are rolled over to a Roth IRA that is five-years old. Mad Fientist is on Facebook. Create New Account. Most of the literature I’ve read says you can do it for health insurance, but I haven’t seen anything about the employer match. That means paychecks, quarterly federal and state payroll tax returns, tax deposits, etc. But it is only 8.25% of total income, far below even the 40% you suggest is borderline. The rule for S corporations says “reasonable compensation,” and really that just means what a similar employer would pay an employee for doing the job. Okay, a warning. The Mad Fientist Lab; Show Notes; The two biggest expenses in life are interest and taxes. Convert portion of tIRA during period of no/low income (taxed at reduced rate) to Roth IRA. Join over 100,000 others on the Mad Fientist email list and get instant access to my FI Spreadsheet! For these states, you need to double-check your math. That means this person pays about $14,130 in self-employment taxes. 6. (This means you postpone preparing and filing the 2553 form.). What about the example below…. The IRS audits about 12,000 S corporations a year, and nearly 6,000,000 S corporations exist. They set a salary artificially, often absurdly low. What are the benefits that prompted me to do it? To put all this together, a sole proprietorship making $100,000 a year might be able to pay a $40,000 wage, save nearly $8,000 a year in payroll costs, and then remove the risk of an audit by legitimately sculpting the tax return to bump compensation and fringe benefits and dial down the distributions. Regarding ‘reasonable salary’, if I determine $100K/yr is reasonable for my industry but I am only working 1/2 time, does that help my case to only claim $50K/yr as my salary? And people use two tricks here…. The amount paid is added to W2 Box 1 compensation, but not box 3 and box 5, therefore FICA tax exempt. Blame the brass? Website . I thought the 100k was profit after deductions. And usually they don’t work well for businesses unless you’re making high five-figure profits or more. That gambit also basically never makes financial sense. If so, did the IRS give any pushback or try to impose the 10% penalty? But… not if those gains and total taxable income are less than $78,750 (again, 2019 values, MFJ. So his QBI equals $100K. For 2018, FICA limit equals $128,400. For one thing, both the federal and state governments levy additional payroll taxes on the $40,000 of wages that they don’t levy on sole proprietorship profits. Over a year-and-a-half and two million plus downloads later, the Afford Anything podcast has hit another awesome milestone: the 100th episode! E.g., say you’re in Texas and you grab the Texas S corporation and follow its instructions. Brad, regarding interplay between QBI and S corp shareholder-employee wages, really what almost everyone wants to do is simply minimize the shareholder wages. After expenses, at least initially, there will be little left over to compensate the two owners/employees (maybe $5k to 25k a year). About See All. That 1% equaled about $250K and his profit equaled roughly $25,000,000. You really don’t. Someone working part-time would logically earn less than someone working full-time. Say you also run either a SEP-IRA or a solo 401(k) plan that provides a 25% employer match. E.g., say you run a one person S corporation (maybe a super-successful realtor?) But that doesn’t result in a higher Section 199A deduction. Convert t401k to Roth 401k within a 401k plan during periods of low income. You’re talking low to mid six figures for many FIers but for folks who work longer, the future value “S corporation” benefit probably grows into seven figures. The one other rule to consider: Once you operate your business as an S corporation, you must pay yourself a reasonable salary. Thanks to Steve for making these free for Mad Fientist readers and be sure to get your state’s kit before the end of the year because the code will expire on 12/31/2018! I don’t think it works to say you’re not a writer and so not in the business of writing and so can report book royalty income on Schedule E (which would be where it goes… but of course I know the specifics of your situation. The DIY kit also includes sample LLC operating agreements. 4. E.g., say you make $80K. If you already have a business, hopefully this post helps you save a big chunk of money on your 2019 taxes (remember, set up an LLC now if you want to make an S-Corporation election for the entire 2019 tax year). 4000 – 1099 worker https://www.madfientist.com/my-portfolio/, https://www.madfientist.com/scott-young-interview/, https://www.madfientist.com/happiness-through-subtraction/, https://www.madfientist.com/safe-withdrawal-rate/, How to Pick the Ideal Location For Investment Properties – a Comprehensive Guide, How to Run the Numbers For Rental Properties – Back-of-the-Envelope Analysis, The 35 Best Niches For Real Estate Investing (& How to Choose Yours), Enroll in Free 7-Day Course – How to Get Started (or Restarted) With Real Estate Investing, The Baby Steps to Your First Rental, Flip, or Wholesale Property (6 Case Studies), 85+ Recommended Tools & Resources For Real Estate Investors. My wife has a regular W-2 income of $30K and we have a reasonably priced HSA-eligible health plan (plus $2K HSA contributions) through her work. This ultimately reduces the QBI deduction. I work in the event industry as a video specialist, so I use gear provided for each show and only have a few things I own personally for work. If you instead have an S-Corp, you’d be eligible to receive a Section 199a deduction on 50% of the W-2 wages paid by your business. Your guidebook is the point. See more of Mad Fientist on Facebook. Same thing for HSA contributions if applicable. Possibly if you’re a one-person independent contractor, you will need to finesse the optics with fringe benefits to get the S corporation to really work safely. If I could peal that off self employment income, I might not need an S-Corp at all. Create New Account. Contribute money to t401k during periods of of high income. The S corporation tax strategy requires a bit of fiddling. Wouldn’t the deductions be on his tax return as well? Now just check your email to confirm! The employer match, which appears on the 1120S corporation tax return, reduces both QBI and the shareholder’s taxable income. It’s the Mad Fientist again. Thanks for the post, Steve! I simply pay my estimated taxes. Okay, I think I see where we’re disconnecting.The above statement is incomplete. To add: the only mention of the 199a deduction in the article provides factually incorrect information. I.e., maybe you should consider yourself a bank. But that’s a lot of fiddling. How common are plans allowing t401(k) to Roth 401(k) conversions? I see spreadsheets in my future…. Mad Fientist (rent, taxes, rates, account) User Name: Remember Me: Password Please register to participate in our discussions with 2 million other members - it's free and quick! Long story short, I recommend to just outsource it. BTW, in both the sole proprietorship and the S corporation format, you pay income taxes too. Very informative! I've found that as extendible as you are shipping within the Amazon Store's country, it will let you come down away with it. Probably the only truly useful “rule of thumb” is to run the numbers and look at both using an S corporation and not using an S corporation. It’s generally accepted that the following strategy has some popularity, otherwise known as the Roth ladder: Contribute money to t401k during periods of high income (asset accumulation phase). And if you’re just starting your business, hopefully this article gives you an idea of some of the other tax benefits you can look forward to when your business grows! In this case, the typical S corporation by dissolving would pay $6K to $7K more in taxes. I will definitely be looking into that more! In this episode of the BiggerPockets Money Podcast, the Mad Fientist shares 3 ways to access your retirement funds before the typical age of 59½. 1. For example, it seems hard to justify $100K of salary on $300K of business income but I think your comments on the “optics” and fringe benefits help paint the picture of how one might justify that. Read more → The post Military FIRE – The Tax, Investing, and Travel Benefits of Military Service appeared first on Mad Fientist. But the IRS says (and courts agree) that you need to pay something reasonable. That leaves $60,000 you pay out as a distribution to your owner—and on which you pay no employment taxes. I hope it’s okay to provide this link but if not, apologies and please delete: https://evergreensmallbusiness.com/subchapter-s-election-timing-tips-tricks/. Join over 100,000 others on the Mad Fientist email list and start tracking your progress in the FI Laboratory! Arbitrage ) to help people achieve financial independence as quickly and efficiently as possible call out a of. As compensation and benefits, that 15.3 % of $ 100K compared to an S corporation burdens with... Blog: S corporation kit for your state per instructions above. ) have paid that reasonable salary the! Long story short, I work less than 10 hours a week on.... Strategy won ’ t use an Scorp handlebar Stache ; Posts: 1913 Location! Very end corporation isn ’ t the deductions be on his tax return as well all 15,000... Afternoon, for example, the royalties are completely passive I don t... Your salary too low optics-wise make sense to cover this tax-avoidance topic before the year... Make this realistic ( Minimalist Finances & financial Freedom ) limited to 25 % of 100K. To incredible tax, Investing, and Travel benefits of military Service could that. Represent a menu that can accelerate the journey to FI also provides $ 10K of health insurance 100,000! Of our DIY S corporation burdens you with additional tax accounting that matters in the 199A! The 5-year rule through in-plan 401 ( k ) conversions qualified business income. ) only worked part-time, matters! 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