As 2015 comes to an end, it is critical that Solo 401(k) owners make year-end retirement plans. There are three important deadlines you must know if you have a solo 401(k) or if you plan to set one up still in 2015. A solo 401(k) is a retirement plan for small business owners or self-employed persons who have no other full time employees other than owners and spouses. It’s a great plan that can be self directed into real estate, LLCs, or other alternative investments, and that allows the owner to contribute up to $53,000 per year (far faster than any IRA).
NEW SOLO 401(K) SET-UP DEADLINE IS 12/31/15
First, in order to make 2015 contributions the solo 401(k) must be adopted by your business by December 31, 2015. If you haven’t already adopted a Solo 401(k) plan, you should be starting right now so that documents can be completed and filed in time. If the 401(k) is established on January 1, 2016, or later you cannot make 2015 contributions.
2015 CONTRIBUTIONS CAN BE MADE IN 2016
Second, both employee and employer contributions can be made up to the company’s tax return deadline INCLUDING extensions. If you have a sole proprietorship (e.g. single member LLC or schedule C income) or partnership then the tax return deadline is April 15, 2016. If you have an s-corporation or c-corporation, then the tax return deadline is March 15, 2016. Both of these deadlines may be extended 6 months by filing an extension and the date to make 2015 contributions will also be extended. This a huge benefit for those that want to make 2015 contributions but who won’t have funds until later in the year to do so.
W-2’s FORCE YOU TO PLAN NOW
Third, while employee and employer contributions may be extended until the company tax return deadline you will typically need to file a W-2 for your wages (e.g. an s-corporation) by January 31, 2016. The W-2 will include your wage income and any deduction for employee retirement plan contributions will be reduced on the W-2 in box 12. As a result, you should make your employee contributions (up to $18,000 for 2015) by January 31, 2016 or you should at least determine the amount you plan to contribute so that you can file an accurate W-2 by January 31, 2016. If you don’t have all or a portion of the funds you plan to contribute available by the time your W-2 is due, you can set the amount you plan to contribute to the 401(k) as an employee contribution and will then need to make said contribution by the tax return deadline (including extensions).
Now let’s bring this all together and take an example to outline how this may work. Let’s take Sally who is a real estate professional and who owns an s-corporation. She is the only owner and only employee and has a solo 401(k) established in 2015. She has $120,000 in net income for the year and will have taken $50,000 of that in wage income that will go on her W-2 for the year. That will leave $70,000 of profit that is taxable to her and that will come through to her personally via a K-1 from the business. Sally has not yet made any 2015 401(k) contributions but plans to do so in order to reduce her taxable income for the year and to build a nest-egg for retirement. If she decided to max-out her 2015 Solo 401(k) contributions, it would look like this.
- Employee Contributions – The 2015 maximum employee contribution is $18,000. This is dollar for dollar on wages so you can contribute $18,000 as long as you have made $18,000. Since Sally has $50,000 in wages from her s-corp, she can easily make an $18,000 employee contribution. Let’s say that Sally doesn’t have the $18,000 to contribute but will have it available by the tax return deadline (including extensions). What Sally will need to do is she will let her accountant or payroll company know what she plans to contribute as an employee contribution so that they can properly report the contributions on her payroll and W-2 reporting. By making an $18,000 employee contribution, Sally has reduced her taxable income on her W-2 from $50,000 to $32,000. At even a 20% tax bracket for federal taxes and a 5% tax bracket for state taxes that comes to a tax savings of $4,500.
- Employer Contributions – The 2015 maximum employer contribution is 25% of wage compensation for Sally. Since Sally has taken a W-2 wage of $50,000, the company may make an employer contribution of $12,500 (25% of $50,000). This contribution is an expense to the company and is included as employee benefit expense on the s-corporations tax return (form 1120S). In the stated example, Sally would’ve had $70,000 in net profit/income from the company before making the solo 401(k) contribution. After making the employer matching contribution of $12,500 in this example, Sally would then only receive a K-1 and net income/profit from the s-corporation of $57,500. Again, if she were in a 20% federal and a 5% state tax bracket that would create a tax savings of $3,125. This employer contribution would need to be made by March 15, 2016 (the company return deadline) or by September 15, 2016 if the company were to file an extension.
- In the end, Sally would have contributed and saved $30,500 for retirement ($18,000 employee contribution, $12,500 employer contribution). And finally, she would have saved $7,625 in federal and state taxes. That’s a win-win.
Keep in mind, you need to start making plans now and you want to begin coordinating with your account or payroll company as your yearly wage information and W-2 are critical in determining what you can contribute to your Solo 401(k).
By: Mat Sorensen, Attorney and Author of The Self Directed IRA Handbook
It’s time to start thinking about year-end tax planning and as every savvy business owner knows, effective 2015 tax planning happens before December 31, 2015. One of the most commonly used strategies for our clients is an s-corporation and a 401(k). A properly structured s-corporation is utilized best for tax purposes when the business owner adopts and contributes to a 401(k) plan as the contributions to 401(k) are tax deductible. Whether the business has only one owner/employee (or spouses only) or whether the business has dozens or even hundreds of employees, a 401(k) is a great tool to help defer taxable income. Simply put, a 401(k) plan can be used as a tool for putting the income of the business owner (and applicable employees) away for retirement with the added benefit of a tax deduction for every dollar that can be contributed. There are numerous benefits and options in a 401(k) plan. For example, you can do Roth 401(k) account, you can self direct a 401(k) account, and you can even loan money to yourself from your 401(k) account. While books have been written about all of these options and benefits, one of the most misunderstood concepts of 401(k) plans is how s-corporation owners can contribute their income to the plan. That is the focus of this article.
In order to understand how s-corporations income can be contributed to a 401(k) plan, you need to understand the following three basic rules.
- Only W-2 Salary Income can be Contributed to a 401(k). You cannot make 401(k) contributions from dividend or net profit income that goes on your K-1. See IRS.gov for more details. Since many s-corporation owners seek to minimize their W-2 salary for self-employment tax purposes, you must carefully plan your W-2 and annual salary taking into account your annual planned 401(k) contributions. In other words, if you cut the salary too low you won’t be able to contribute the maximum amounts. On the other hand, even with a low W-2 Salary from the s-corporation you’ll still be able to make excellent annual contributions to the 401(k) (up to $18,000 if you have at least that much in annual W-2 salary).
- Easy Elective Salary Deferral Limit of $18,000 or 100% of Your W-2, whichever is less. If you have at least $18,000 of salary income from the s-corporation, you can contribute $18,000 to your 401(k) account. Every employee under the plan is allowed to make this same contribution amount. As a result, many spouses are added to the s-corporation’s payroll (where permissible) to make an additional $18,000 contribution for the spouse’s account. If you are 50 or older, you can make an additional $6,000 annual contribution. Follow this link for the details from the IRS on the elective salary deferral limits. The elective salary deferral can be traditional dollars or Roth dollars.
- Non-Elective Deferral of 25% of Income Up to a $53,000 total Annual 401(k) Contribution. This is usually maximized best in solo 401(k) plans where you as the business owner decided to offer them most generous company match allowed by law (25% of wages). Rarely is this offered or maximized like this in a group 401(k) scenario where you have other employees because what you offer yourself, you must offer to all employees who qualify for the plan (full-time, worked for you a year, over 21). If you are in the solo 401(k) situation, this additional 25% deferral is an excellent tool because in addition to the $18,000 annual elective salary contribution, an s-corporation owner can contribute 25% of their salary compensation to their 401(k) account up to a maximum of a $53,000 total annual contribution. This non-elective deferral is always made with traditional dollars and cannot be Roth dollars. So, for example, if you have an annual W-2 of $100,000, you’ll be able to contribute a maximum of $25,000 as a non-elective salary deferral to your 401(k) account. If you have employees who participate in the plan besides you (the business owner) and your spouse, then the non-elective deferral calculation gets much more complicated because you’d have to offer it to those employees too. But for now, let’s assume there are no other employees and run through the examples.
Let’s run through two examples. The first is an s-corporation business owner looking to contribute around $30,000 per year. The second is a business owner looking to contribute the maximum of $53,000 a year.
Example 1, Seeking a $30,000 Annual Contribution.
S-Corporation Owner W-2 Salary = $50,000
Elective Salary Deferral = $18,000
25% of Salary Non-Elective Deferral = $12,500 (25% of $50,000)
Total Possible 401(k) Contribution = $30,500
Example 2. Seeking Maximum $52,000 Annual Contribution
S-Corporation Owner W-2 Salary = $140,000
Elective Salary Deferral = $18,000
25% of Salary Non-Elective Deferral = $35,000 (25% of $140,000)
Total Possible 401(k) Contribution (maximum) = $53,000
As a result of the calculations above, in order to contribute the maximum of $53,000, you need a W-2 salary from the s-corporation of $140,000. Keep in mind that if you have other employees in your business (other than owner and spouse) that you are required to do comparable matching on the 25% non-elective deferral and as a result such maximization is often difficult to accomplish in 401(k)s with employees other than the owner and their spouse. Consequently, the additional 25% non-elective salary deferral is best used in owner only 401(k) plans. If you do have employees though you can at least do $18,000 per year without having a matching requirement for your employees. That’s still three times what you can contribute to a traditional or a roth IRA. There are also common matching formulas used where you end up matching yourself and your employees contributions at a rate of 4% of salary (safe harbor).
Keep in mind that while 401(k) contributions can be made until the tax return deadline (personal, 4/15/16 and s-corp 3/15/16), including extensions, that the 401(k) must be established before the end of 2015 in order to later make 2015 contributions. As a result, you just need to establish the 401(k) before the end of 2015 and that will allow you to later make 2015 contributions prior to filing your 2015 returns.
By: Mathew Sorensen, Partner KKOS Lawyers
One of the most common tax minimization strategies used by operational small business owners is known as the salary/dividend or salary/net income split. This strategy can only be properly executed in an s-corporation where a business owner can pay themselves a portion of income in salary and a portion of income in dividend or net profit. The ultimate goal is to pay as little salary as possible (and therefore as much net income as possible) so as to minimize the amount of self employment taxes that are due.
This strategy cannot be utilized in a c-corporation nor can it be utilized in an LLC or sole proprietorship. It is only possible in an s-corporation as similar income running through a sole proprietorship or an LLC is entirely subject to self employment tax as income cannot be split between salary and net income in an LLC or sole proprietorship. Also, keep in mind that such a strategy is not utilized in passive business structures such as real estate businesses as rental income, interest income, and other passive income is exempt from self employment tax and therefore it is not necessary to implement the income splitting technique of the s-corporation.
In short, the strategy is implemented by “splitting” the income that is payable to the s-corporation owner into two categories: salary and net income (aka dividend). The reason this splitting of income is advantageous is that net income received by the s-corporation owner is not subject to the 15.3% self employment tax that is otherwise due and payable on salary. For every $10,000 of income an s-corporation owner can classify as net income as opposed to salary the business owner will save $1,530. Keep in mind that after about $100,000 of salary the savings of pushing additional income to net income is reduced as the self employment tax rate drops to 2.9%. It is still certainly worth implementing at higher income but the savings are then made at the 2.9% rate.
When this strategy was first utilized many years ago, some taxpayers decided to just pay all of their income out as net income and elected to take no salary or wages and therefore pay no self employment tax. This was quickly challenged by the IRS and Revenue Ruling 59-221 was issued which stated that a business owner who renders services to their business must take “reasonable compensation” for the services rendered. Over the years, the Courts have ruled on many cases of what is reasonable compensation but in 2012 the Courts made a significant ruling where they adjusted a business owners allocation between salary and net income in a case known as Watson v. Commissioner, 668 F.3d 1008 (8th Cir, 2012).
In Watson, the owner/employee Watson was a CPA and took $24,000 of salary a year and about $190,000 of annual net income. The IRS challenged the allocation of $24,000 of salary as being unreasonably too low. Watson lost in the District Court and appealed to the 8th Circuit Court of Appeals who re-characterized Watson’s income to $93,000 of salary and about $120,000 of net income. The case is an important one for properly understanding the factors that should be considered in all businesses when determining how much income a business owner can claim as net income instead of salary. Here are some of those factors.
– PROFESSIONAL SERVICE BUSINESSES SHOULD TAKE A LARGER PORTION OF SALARY TO NET INCOME THAN THOSE IN NON-PROFESSIONAL SERVICES. If the business is a professional services business (e.g. physician, dentist, lawyer, consultant, real estate broker, contractor, etc.) the IRS will more carefully scrutinize the services provided by business owners because the business provides a personal service.
– FULL TIME WORKING BUSINESS OWNERS SHOULD TAKE A LARGER PORTION OF SALARY TO NET INCOME THAN PART TIME WORKING BUSINESS OWNERS. If the business owner is involved full time in the business, more salary will be required. If the business owner’s involvement is part time or if they are involved in other businesses, a much lower salary can be justified.
– DON’T TAKE A SALARY THAT IS BELOW THE SALARY PAID TO LOWER LEVEL EMPLOYEES IN THE BUSINESS. In the Watson case the Court determined that a salary for Watson of $24,000 was not reasonable as new accountants salaries at his office were more than this.
– TAKE A SALARY THAT IS AROUND THE INDUSTRY AVERAGE FOR A PERSON OF SIMILAR EXPERIENCE IN YOUR INDUSTRY. In the Watson case the Court scrutinized the experience and training of Watson and determined that a salary of $24,000 was not reasonable as accountants with similar experience and training in the industry were paid at least $70,000.
In summary, the salary/net income split is a legitimate tax planning technique for business owners but it is not one in which a business owner making over $200,000 a year can justify taking about 10% of income as salary (as was the case in Watson). The Court disallowed the 10% salary level but did allow him to take about 43% of his income as salary (and almost 60% as net income). This still resulted in some excellent tax savings.
As a general rule, we recommend that business owners take at least 1/3 of their income as salary and pay self employment tax on those amounts. Many other factors should be considered, such as those outlined above, and every business has a unique situation. The good news is that taking a large portion of income from a business as net income as opposed to salary is alive and valid and there are plenty of taxes to be saved each year by using this strategy. A business owner just can’t get too aggressive and take salary levels that are grossly below what people with similar experience in the industry are paid.