S corporations: logic and illogic

I’ve been doing a deep dive lately into one-participant 401(k) plans, which has caused me to observe that people are often extremely unclear about what they are talking about when they talk about one-participant 401(k) contribution limits. The reason is that multiple types of legal entities can sponsor one-participant 401(k) plans, including unincorporated sole proprietors (like your humble blogger).

This led me to the further observation that many self-employed people seem to prefer S corporations to sole proprietorships. There is a very specific logic to this preference, but if you don’t understand the logic, you’re unlikely to correctly decide which is right for you.

Self-employment income versus S corporation distributions

As an unincorporated sole proprietor, I report all my net profit on schedule C, pay 15.3% in self-employment tax, and then deduct half my self-employment tax to calculate my earned income for IRS form 1040.

As an S corporation employee-owner, you pay reasonable W-2 income to yourself, with the corporation paying (and deducting from profit) 7.65% and you, the recipient of the income, seeing another 7.65% deducted from your paycheck. The remainder of the S corporation’s profit is issued as “distributions,” which are subject to ordinary income tax but not the 15.3% FICA tax.

For this reason, many people believe they are “saving” 15.3% of the amount they receive as distributions, since neither the S corporation nor they themselves pay FICA tax on it.

This is an error. Consider someone who, for 35 years, earns $100,000 in 2016 dollars. They have the option of receiving $100,000 of it in self-employment income reported on schedule C, or $50,000 in W-2 income and $50,000 in S corporation distributions, taxed at their ordinary income tax rate but without paying any FICA taxes.

At full retirement age, the person receiving $100,000 in self-employment income will receive a monthly Social Security benefit of $2,670.

Reducing their FICA contributions 15.3% of $100,000 to 15.3% of $50,000 will receive that monthly benefit to $1,845.

At full retirement age, our sole proprietor will receive $825 fewer 2016 dollars per month.

The next question is, how much will she have saved in the 35 years of shielding her income from FICA taxes? The answer is 15.3% of $50,000, or $7,650 per year, for a total of $267,750.

The “breakeven” point in this case is roughly 27 years: if you live that long, you’ll collect more in wage-inflation-adjusted Social Security benefits than you “saved” in FICA taxes.

Eligibility for tax-advantaged retirement savings accounts

Of course, as a self-employed person, hopefully you’re also saving for retirement, and you’d think those unpaid FICA taxes could help.

Both sole proprietors and S corporation owner-employees are eligible for retirement savings accounts, but in slightly different ways.

To calculate their earned income for purposes of contributions to retirement savings plans like 401(k)’s, an unincorporated sole proprietor uses 92.35% of their net self-employment income. Of that total, the first $18,000 can be contributed to either a traditional or Roth 401(k) account, and up to $54,000 total can be contributed on self-employment income of a little over $190,000.

Owner-employees of S corporations can only make employee elective and employer non-elective retirement savings contributions based on their W-2 income, not their S corporation distributions. Of course, you’re free to save rather than spend your S corporation distributions, but those savings won’t compound tax-free and will be subject to capital gains taxes upon sale.

While non-elective S corporation retirement plan contributions aren’t subject to FICA taxes, the employee-owner’s W-2 earnings are. This creates a tension: the point of the S corporation is to minimize your W-2 income subject to FICA taxes, but minimizing your W-2 income reduces your capacity to defer taxes on retirement savings. You can raise your W-2 income in order to contribute more to a one-participant 401(k) plan, but your increased W-2 income will then be subject to FICA!

Squaring the circle

All of this is to say that while many self-employed people and finance hackers treat an S corporation election as a no-brainer or default option, your decision on how to organize your business depends on several factors. Here are a few:

• for businesses with net income below about $22,077, there’s zero justification for incorporation, since you can contribute your entire net business income to a 401(k) and pay no federal income tax on it at all (an $18,000 elective deferral and $4,077 non-elective deferral).
• for businesses with net income substantially above $180,000, and for business owners with more than $127,200 in W-2 income from another employer, an S corporation election is, ignoring setup and maintenance costs, tax-advantaged compared to sole proprietorship, since you can maximize your Social Security wage base ($127,200) and defer the maximum $54,000 into a one-participant 401(k) by paying $144,000 in W-2 income and making an $18,000 elective contribution and $36,000 non-elective contribution. Distributing profit in excess of $180,000 will avoid the 2.9% Medicare tax. Note: that is just $2,900 for each $100,000 in additional S corporation profit, so if your setup and ongoing maintenance costs are high they could take years to recoup, if ever.
• For businesses in the middle of that range, the question comes down to what you actually intend to do with the FICA taxes you avoid with a S corporation distribution. If you’re simply going to invest the money in a taxable brokerage account, you’re trading one investment, an inflation-indexed annuity (Social Security), for another less tax-advantaged one. On the other hand, there are investments that are difficult or impossible to make in a retirement savings account: real estate, futures, private equity, or even more creative options. A high level of confidence in your ability to deftly manage the money you save on taxes could alone justify taking the money as a taxable distribution instead of squirelling it away in a tax-advantaged account.