Employer vs Employee Solo 401K contributions

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Topic Author
kardan
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Employer vs Employee Solo 401K contributions

Post by kardan » Fri May 31, 2019 12:04 pm

I may have missed it, but I haven't seen this discussed anywhere.

Given that an S-Corp owner (no employees) wants to contribute $10,000 to a solo 401K plan, aren't they better off having all contributions as employer contributions with no employee contributions since FICA/SE taxes will be saved (permanently)?

I'm probably missing something, but appreciate any input.

DSInvestor
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Re: Employer vs Employee Solo 401K contributions

Post by DSInvestor » Fri May 31, 2019 12:11 pm

kardan wrote:
Fri May 31, 2019 12:04 pm
I may have missed it, but I haven't seen this discussed anywhere.

Given that an S-Corp owner (no employees) wants to contribute $10,000 to a solo 401K plan, aren't they better off having all contributions as employer contributions with no employee contributions since FICA/SE taxes will be saved (permanently)?

I'm probably missing something, but appreciate any input.
When organized as an S-Corp, employee contributions to solo 401(k) must be withheld from your paychecks during the year. Once withheld, the S-Corp makes the employee contribution on your behalf. Employer contributions are made by the S-Corp outside of the paycheck but are limited to 25% of your S-Corp W-2 salary. Say you pay yourself 60K (5K/month) and did not make any employee contributions from JAN-NOV. Your last paycheck of 5K for december is not large enough to support a 10K employee contribution to solo 401k so you can take advantage of employer contribution which can be made outside of your paycheck but still from company accounts. On 60K salary, employer contribution can be up to 15K (25% of 60K). This requirement to withhold employee contributions is a big difference between S-Corp and sole proprietor. Sole proprietors can make employee contributions after year end after their numbers come in for net business income. We have had many posts over the years from folks new to S-Corp and Solo 401k looking to max out but missed the opportunity to make employee contributions.

Your FICA is calculated based on your W-2 salary and neither employee or employer contributions will affect FICA. Employee contributions to Traditional solo 401k will reduce your W-2 box1 but it does not reduce the social security wages (w-2 box 3) or medicare wages (w-2 box 5). Employer contributions to solo 401k reduce the net income for your S-Corp which reduces the amount of income on your S-Corp tax return (1120S) and K-1 that flows into your personal tax return.
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fyre4ce
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Re: Employer vs Employee Solo 401K contributions

Post by fyre4ce » Fri May 31, 2019 1:05 pm

That's a great answer; here's another way to look at it. FICA taxes are a function of your salary, and your salary is limited by the "reasonable compensation" requirement. Without getting into the weeds of how that requirement gets met, your salary gets set first and is unaffected by either employer or employee contributions. If you contribute $10k out of your paycheck, it doesn't affect your salary or your FICA taxes due; 401k contributions are not FICA tax-deductible.

Here's a reason to possibly prefer employee contributions: if you're able to deduct business profit as QBI through the new TCJA Section 199A deduction, then making an employee contribution will not reduce this deduction, whereas making an employer contribution will.

Topic Author
kardan
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Re: Employer vs Employee Solo 401K contributions

Post by kardan » Fri May 31, 2019 1:13 pm

DSInvestor wrote:
Fri May 31, 2019 12:11 pm
kardan wrote:
Fri May 31, 2019 12:04 pm
I may have missed it, but I haven't seen this discussed anywhere.

Given that an S-Corp owner (no employees) wants to contribute $10,000 to a solo 401K plan, aren't they better off having all contributions as employer contributions with no employee contributions since FICA/SE taxes will be saved (permanently)?

I'm probably missing something, but appreciate any input.
When organized as an S-Corp, employee contributions to solo 401(k) must be withheld from your paychecks during the year. Once withheld, the S-Corp makes the employee contribution on your behalf. Employer contributions are made by the S-Corp outside of the paycheck but are limited to 25% of your S-Corp W-2 salary. Say you pay yourself 60K (5K/month) and did not make any employee contributions from JAN-NOV. Your last paycheck of 5K for december is not large enough to support a 10K employee contribution to solo 401k so you can take advantage of employer contribution which can be made outside of your paycheck but still from company accounts. On 60K salary, employer contribution can be up to 15K (25% of 60K). This requirement to withhold employee contributions is a big difference between S-Corp and sole proprietor. Sole proprietors can make employee contributions after year end after their numbers come in for net business income. We have had many posts over the years from folks new to S-Corp and Solo 401k looking to max out but missed the opportunity to make employee contributions.

Your FICA is calculated based on your W-2 salary and neither employee or employer contributions will affect FICA. Employee contributions to Traditional solo 401k will reduce your W-2 box1 but it does not reduce the social security wages (w-2 box 3) or medicare wages (w-2 box 5). Employer contributions to solo 401k reduce the net income for your S-Corp which reduces the amount of income on your S-Corp tax return (1120S) and K-1 that flows into your personal tax return.
Thanks for the response, but I'm not sure my question was answered, perhaps because my question wasn't clear.

Assume the S-Corp pays enough wages and has enough income that the owner can make either a $10,000 contribution via payroll deduction or via employer contributions. I believe there is some tax advantage to make the contribution via employer contribution due to the employer contribution not being subject to FICA taxes. You stated that neither employee or employer contributions effect FICA, but also stated that employee contributions do not impact W-2 box 3 or 5 which means FICA taxes would be paid on employee contributions. They are not paid on employer contributions, hence, my question.

niceguy7376
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Re: Employer vs Employee Solo 401K contributions

Post by niceguy7376 » Fri May 31, 2019 1:18 pm

So, are you ok with no SS and medicare contributions as employee and not get SS credits?

How much company revenue are you talking about?

Topic Author
kardan
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Re: Employer vs Employee Solo 401K contributions

Post by kardan » Fri May 31, 2019 1:28 pm

niceguy7376 wrote:
Fri May 31, 2019 1:18 pm
So, are you ok with no SS and medicare contributions as employee and not get SS credits?

How much company revenue are you talking about?
I don't understand your point. There are still SS and medicare contributions on the owner's salary. My premise is there would be no SS or medicare contributions on the employer 401K contributions and I would be absolutely fine with that.

Topic Author
kardan
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Re: Employer vs Employee Solo 401K contributions

Post by kardan » Fri May 31, 2019 1:37 pm

fyre4ce wrote:
Fri May 31, 2019 1:05 pm
That's a great answer; here's another way to look at it. FICA taxes are a function of your salary, and your salary is limited by the "reasonable compensation" requirement. Without getting into the weeds of how that requirement gets met, your salary gets set first and is unaffected by either employer or employee contributions. If you contribute $10k out of your paycheck, it doesn't affect your salary or your FICA taxes due; 401k contributions are not FICA tax-deductible.
I see your thought process, but here is the way I am thinking about it. Assume the business is already paying the owner a reasonable salary. Assume further that from that reasonable salary, the owner has elected to NOT make any employee contributions to a 401K. Now assume that the business has a further $10,000 available and the owner would like to contribute that to their 401K. One way to do that is increase the owner's salary by $10,000 and pay income taxes (in the future, upon 401k withdrawal), current FICA taxes, etc. The other way is for the business to fund the 401K and only pay income taxes (in the future, upon 401k withdrawal), but no FICA taxes.

fyre4ce wrote:
Fri May 31, 2019 1:05 pm
Here's a reason to possibly prefer employee contributions: if you're able to deduct business profit as QBI through the new TCJA Section 199A deduction, then making an employee contribution will not reduce this deduction, whereas making an employer contribution will.
Good point, but since the only employee is the owner, it would raise the possibility, at least marginally, of an IRS challenge to the reasonable salary assumption if the IRS contended that the business profit was too high, right?

DSInvestor
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Re: Employer vs Employee Solo 401K contributions

Post by DSInvestor » Fri May 31, 2019 2:27 pm

kardan wrote:
Fri May 31, 2019 1:13 pm


Thanks for the response, but I'm not sure my question was answered, perhaps because my question wasn't clear.

Assume the S-Corp pays enough wages and has enough income that the owner can make either a $10,000 contribution via payroll deduction or via employer contributions. I believe there is some tax advantage to make the contribution via employer contribution due to the employer contribution not being subject to FICA taxes. You stated that neither employee or employer contributions effect FICA, but also stated that employee contributions do not impact W-2 box 3 or 5 which means FICA taxes would be paid on employee contributions. They are not paid on employer contributions, hence, my question.
It's the same either way. Let's say you have 60K salary and 40K S-Corp net income without any 401k contributions.

Scenario 1: Employer contribution of 10K. This results in W2 box 1,3 and 5 of 60K and 30K net income from K-1 giving you AGI of 90K.

Scenario 2: Employee contribution of 10K. This results in W-2 box 1 of 50K and box 3/5 of 60K and 40K net income from K1 giving you AGI of 90K.

In both scenarios, your FICA is paid on 60K salary. Employee contributions reducing W-2 box 1 by 10K vs Employer contribution reducing K1 by 10K. This assumes the same salary in both scenarios. As a self employed person, I chose to max out employee and employer contributions to solo 401k.

The advantage of solo 401k over SEP-IRA is the ability to make much larger contributions on lower income. For 60K salary, SEP-IRA allows for only 15K contribution. Solo 401k would allow 15K employer + 19K employee + catch up (age 50+).
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fyre4ce
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Re: Employer vs Employee Solo 401K contributions

Post by fyre4ce » Fri May 31, 2019 2:42 pm

kardan wrote:
Fri May 31, 2019 1:37 pm
fyre4ce wrote:
Fri May 31, 2019 1:05 pm
That's a great answer; here's another way to look at it. FICA taxes are a function of your salary, and your salary is limited by the "reasonable compensation" requirement. Without getting into the weeds of how that requirement gets met, your salary gets set first and is unaffected by either employer or employee contributions. If you contribute $10k out of your paycheck, it doesn't affect your salary or your FICA taxes due; 401k contributions are not FICA tax-deductible.
I see your thought process, but here is the way I am thinking about it. Assume the business is already paying the owner a reasonable salary. Assume further that from that reasonable salary, the owner has elected to NOT make any employee contributions to a 401K. Now assume that the business has a further $10,000 available and the owner would like to contribute that to their 401K. One way to do that is increase the owner's salary by $10,000 and pay income taxes (in the future, upon 401k withdrawal), current FICA taxes, etc. The other way is for the business to fund the 401K and only pay income taxes (in the future, upon 401k withdrawal), but no FICA taxes.

fyre4ce wrote:
Fri May 31, 2019 1:05 pm
Here's a reason to possibly prefer employee contributions: if you're able to deduct business profit as QBI through the new TCJA Section 199A deduction, then making an employee contribution will not reduce this deduction, whereas making an employer contribution will.
Good point, but since the only employee is the owner, it would raise the possibility, at least marginally, of an IRS challenge to the reasonable salary assumption if the IRS contended that the business profit was too high, right?
You need to look at it from the perspective that the business and employer are separate. I'm a W-2 employee and I get paid a fixed salary. I have the option to contribute up to $19,000 of that pay to a 401k. If I want the money now, I don't contribute. If I want the money later, I contribute. Either way, it's my decision. If I went to my boss and asked for a $19,000 raise because I want to put $19,000 into my 401k, I'd get a quizzical look. Even though you're acting as both the employee and employer, the tax code is still written to make a distinction between the two.

The IRS does not consider elective deferrals when they're determining the reasonable-ness of your compensation. Your salary is supposed to be what you could pay someone to do the work for you. Whether that other person contributes to a 401k or not doesn't affect whether their pay is reasonable.

It's probably OK for you to take at least a little bit of compensation on a K-1 as opposed to W-2 wages. If certain conditions apply, you can deduct K-1 income through Section 199A. For a fixed salary, more employer contributions reduce your K-1 income, whereas employee contributions do not. That's why I recommended leaning toward employee contributions. There are situations that would make that undesirable though, like if you had a second job as a W-2 employee and you wanted to max out your elective deferrals into that 401k. In that case it would be better for you to do all employee contributions in your Solo 401k.

Topic Author
kardan
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Re: Employer vs Employee Solo 401K contributions

Post by kardan » Fri May 31, 2019 3:02 pm

fyre4ce wrote:
Fri May 31, 2019 1:05 pm
Here's a reason to possibly prefer employee contributions: if you're able to deduct business profit as QBI through the new TCJA Section 199A deduction, then making an employee contribution will not reduce this deduction, whereas making an employer contribution will.
Turns out there isn't much impact on QBI for an S-Corp.

S-Corp deducts the $10,000 as either owner compensation or 401K contribution, so no difference to S-Corp income. FICA taxes paid by the S-Corp will change by 7.65% x $10,000 or $765 depending on whether additional owner compensation is paid or an employee 401K contribution is made. Impact on the owner's taxable income will be $765 * (1-.2) or $612, so owner will pay $612 x their marginal income tax rate (assume 22%) in additional income taxes which is $135.

Since the change in combined S-Corp and employee (Owner) FICA taxes is $10,000 * 7.65% * 2 or $1,530, there is a net savings of about $1,400 ($1,530 - $135) by having the S-Corp make an employer contribution instead of paying additional wages to the owner and having the owner make an employee contribution.

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kardan
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Re: Employer vs Employee Solo 401K contributions

Post by kardan » Fri May 31, 2019 3:09 pm

fyre4ce wrote:
Fri May 31, 2019 1:05 pm


You need to look at it from the perspective that the business and employer are separate.
Except in this case, the business and owner/employee are one in the same at the end of the day. Within reason and IRS regulations, the owner can choose to increase compensation or have the S-Corp make the 401K contribution directly. It may as well be done as tax effectively as possible.

It seems that if the owner is already paying themselves reasonable compensation, they would be better off making any 401K contributions (subject to IRS limitations) via employer contributions rather than increasing their compensation and making an elective employee contribution.

The math seems so compelling that I want to be sure I'm not missing something. Haven't heard anything yet that refutes the basic point.

fyre4ce
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Re: Employer vs Employee Solo 401K contributions

Post by fyre4ce » Fri May 31, 2019 3:22 pm

kardan wrote:
Fri May 31, 2019 3:02 pm
fyre4ce wrote:
Fri May 31, 2019 1:05 pm
Here's a reason to possibly prefer employee contributions: if you're able to deduct business profit as QBI through the new TCJA Section 199A deduction, then making an employee contribution will not reduce this deduction, whereas making an employer contribution will.
Turns out there isn't much impact on QBI for an S-Corp.

S-Corp deducts the $10,000 as either owner compensation or 401K contribution, so no difference to S-Corp income. FICA taxes paid by the S-Corp will change by 7.65% x $10,000 or $765 depending on whether additional owner compensation is paid or an employee 401K contribution is made. Impact on the owner's taxable income will be $765 * (1-.2) or $612, so owner will pay $612 x their marginal income tax rate (assume 22%) in additional income taxes which is $135.

Since the change in combined S-Corp and employee (Owner) FICA taxes is $10,000 * 7.65% * 2 or $1,530, there is a net savings of about $1,400 ($1,530 - $135) by having the S-Corp make an employer contribution instead of paying additional wages to the owner and having the owner make an employee contribution.
I don't agree with the assumptions in your analysis. You're assuming a fixed salary AFTER 401k contributions are deducted. You need to assume a fixed salary BEFORE 401k contributions are deducted. Again, think of the example with my own 401k. My employer isn't going to pay me an extra $19k if I make $19k of elective deferrals to their 401k. My salary is fixed before I decide how much I want to contribute to my 401k.

I understand that in this case you're acting as both parties, but ultimately it comes down to the method the IRS uses to determine reasonable compensation. If a $60k salary is the lower limit of what's reasonable for the work you do, and you pay yourself only $50k and the IRS audits you, it's no defense to say "but I didn't make any elective deferrals to my 401k." That's the whole point of elective deferrals - they're elective to the employee.

That said, I am in favor of pushing your salary as low as possible under the "reasonable compensation" rule. It doesn't have to be a 50th percentile salary, it can be less. But whatever that number is, it gets set, and then you decide your 401k strategy later.

Redoing your analysis with the "fixed before 401k" assumption, contributing $10,000 from the employer side would cost you a $2,000 Section 199A deduction (20% * $10,000), which in the 22% tax bracket is worth $440. FICA taxes would be unchanged.

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kardan
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Re: Employer vs Employee Solo 401K contributions

Post by kardan » Fri May 31, 2019 3:35 pm

DSInvestor wrote:
Fri May 31, 2019 2:27 pm

Scenario 1: Employer contribution of 10K. This results in W2 box 1,3 and 5 of 60K and 30K net income from K-1 giving you AGI of 90K.

Scenario 2: Employee contribution of 10K. This results in W-2 box 1 of 50K and box 3/5 of 60K and 40K net income from K1 giving you AGI of 90K.

There is a Scenario 3. The S-Corp increases the owner's compensation by $10K and the owner uses the additional $10 of comp to make the contribution.

Scenario 3: Employee contribution of 10K. This results in W-2 box 1 of 60K and box 3/5 of 70K and 30K net income from K1 giving you AGI of 90K. In this scenario, additional FICA tax would be due as a result of the higher W-2 Box 3/5 amounts.

While the "real" numbers are different than your scenario, I'm making the assumption that Scenario 2 isn't really an option as it drives up business profit to the point that the IRS may challenge the reasonableness of the compensation. My understanding is the IRS can take the position that while owner compensation on a standalone basis may appear reasonable, if business profits are too high, they could argue that the compensation isn't in fact reasonable. I realize this is a bit of a fine point, but I think it is a real concern with single employee (owner) S-Corps. I've seen some argue that a single employee (owner) S-Corp should have no business profit and all should be paid as comp, but I believe the IRS would allow a profit to be earned on the investment in the business up to a point.
Last edited by kardan on Fri May 31, 2019 3:48 pm, edited 1 time in total.

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kardan
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Re: Employer vs Employee Solo 401K contributions

Post by kardan » Fri May 31, 2019 3:47 pm

fyre4ce wrote:
Fri May 31, 2019 3:22 pm

I understand that in this case you're acting as both parties, but ultimately it comes down to the method the IRS uses to determine reasonable compensation. If a $60k salary is the lower limit of what's reasonable for the work you do, and you pay yourself only $50k and the IRS audits you, it's no defense to say "but I didn't make any elective deferrals to my 401k." That's the whole point of elective deferrals - they're elective to the employee.

That said, I am in favor of pushing your salary as low as possible under the "reasonable compensation" rule. It doesn't have to be a 50th percentile salary, it can be less. But whatever that number is, it gets set, and then you decide your 401k strategy later.
Thanks for continuing to push my thinking on this.

I agree with what you've said as quoted above. However, in a growing business with a single owner/employee, the reasonable salary number can be a bit fluid as revenues come in higher or lower than anticipated. In the specific example I'm analyzing, revenues are coming in higher than anticipated driving business profit up. The owner's compensation is defensible as reasonable in my view, but since the IRS doesn't provide any specific guidance on what reasonable is, it seems that the higher the business profit gets, the more likely it is to be challenged. One option is to increase owner's compensation (and pay higher FICA taxes per my analysis above). Another is to have the S-Corp make employer 401K contributions (up to IRS limits) which would lower business profit to a more reasonable/defensible level while saving FICA taxes as compared to raising compensation.

Looking at it from a different perspective, I think the FICA savings would drive you to conclude that to the extent an owner wants to contribute to a 401K through an S-Corp, they would be better to make 100% employer contributions (up to IRS limits) than to make any employee contributions, unless their reasonable compensation is high enough that they want to make elective deferrals to lower income taxes (this is particularly relevant to the extent eligible for the QBI deduction as the deferral benefit is effectively reduced by 20%.)

DSInvestor
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Re: Employer vs Employee Solo 401K contributions

Post by DSInvestor » Fri May 31, 2019 3:58 pm

kardan wrote:
Fri May 31, 2019 3:35 pm
DSInvestor wrote:
Fri May 31, 2019 2:27 pm

Scenario 1: Employer contribution of 10K. This results in W2 box 1,3 and 5 of 60K and 30K net income from K-1 giving you AGI of 90K.

Scenario 2: Employee contribution of 10K. This results in W-2 box 1 of 50K and box 3/5 of 60K and 40K net income from K1 giving you AGI of 90K.

There is a Scenario 3. The S-Corp increases the owner's compensation by $10K and the owner uses the additional $10 of comp to make the contribution.

Scenario 3: Employee contribution of 10K. This results in W-2 box 1 of 60K and box 3/5 of 70K and 30K net income from K1 giving you AGI of 90K. In this scenario, additional FICA tax would be due as a result of the higher W-2 Box 3/5 amounts.

While the "real" numbers are different than your scenario, I'm making the assumption that Scenario 2 isn't really an option as it drives up business profit to the point that the IRS may challenge the reasonableness of the compensation. My understanding is the IRS can take the position that while owner compensation on a standalone basis may appear reasonable, if business profits are too high, they could argue that the compensation isn't in fact reasonable. I realize this is a bit of a fine point, but I think it is a real concern with single employee (owner) S-Corps. I've seen some argue that a single employee (owner) S-Corp should have no business profit and all should be paid as comp, but I believe the IRS would allow a profit to be earned on the investment in the business up to a point.
Scenario 2 to make employee contributions is a valid option. If we assume the S-Corp takes in 100K of revenue and the only expense is 60K salary, then net profit is 40K whether the employee makes employee contributions of 0, 10K or 19K. Nothing in this scenario to raise a red flag with IRS. If you have 500K revenue, 60K salary/expenses and 440K net income, that may be a problem.

Scenario 3 to increase salary by 10K to cover an employee contribution is less attractive in that it costs extra FICA.

My recommendation is to set salary that is reasonable and then make retirement contributions with that salary.
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Topic Author
kardan
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Re: Employer vs Employee Solo 401K contributions

Post by kardan » Fri May 31, 2019 4:12 pm

DSInvestor wrote:
Fri May 31, 2019 3:58 pm


Scenario 2 to make employee contributions is a valid option. If we assume the S-Corp takes in 100K of revenue and the only expense is 60K salary, then net profit is 40K whether the employee makes employee contributions of 0, 10K or 19K. Nothing in this scenario to raise a red flag with IRS. If you have 500K revenue, 60K salary/expenses and 440K net income, that may be a problem.
I agree Scenario 2 is valid. I've never read anything definitive about what the IRS will accept, but have read that as it relates to the reasonableness of business profit, two things they look at are if there are employees that helped generate the profit (not in this case) or if the investment justifies the business profit. I'm concerned that a Scenario 2 example might raise a flag if there are no additional employees and only 40K of investment (for example), implying a 100% return on investment which would likely be deemed unreasonable. It is my understanding the both comp and business profit need to be looked at simultaneously, not one to the exclusion of the other.
DSInvestor wrote:
Fri May 31, 2019 3:58 pm

Scenario 3 to increase salary by 10K to cover an employee contribution is less attractive in that it costs extra FICA.

My recommendation is to set salary that is reasonable and then make retirement contributions with that salary.
Correct, that is my point. In my example, I am choosing between Scenario 1 vs 3 and excluding 2 for the reasons indicated.

fyre4ce
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Re: Employer vs Employee Solo 401K contributions

Post by fyre4ce » Fri May 31, 2019 4:31 pm

kardan wrote:
Fri May 31, 2019 3:47 pm
fyre4ce wrote:
Fri May 31, 2019 3:22 pm

I understand that in this case you're acting as both parties, but ultimately it comes down to the method the IRS uses to determine reasonable compensation. If a $60k salary is the lower limit of what's reasonable for the work you do, and you pay yourself only $50k and the IRS audits you, it's no defense to say "but I didn't make any elective deferrals to my 401k." That's the whole point of elective deferrals - they're elective to the employee.

That said, I am in favor of pushing your salary as low as possible under the "reasonable compensation" rule. It doesn't have to be a 50th percentile salary, it can be less. But whatever that number is, it gets set, and then you decide your 401k strategy later.
Thanks for continuing to push my thinking on this.

I agree with what you've said as quoted above. However, in a growing business with a single owner/employee, the reasonable salary number can be a bit fluid as revenues come in higher or lower than anticipated. In the specific example I'm analyzing, revenues are coming in higher than anticipated driving business profit up. The owner's compensation is defensible as reasonable in my view, but since the IRS doesn't provide any specific guidance on what reasonable is, it seems that the higher the business profit gets, the more likely it is to be challenged. One option is to increase owner's compensation (and pay higher FICA taxes per my analysis above). Another is to have the S-Corp make employer 401K contributions (up to IRS limits) which would lower business profit to a more reasonable/defensible level while saving FICA taxes as compared to raising compensation.

Looking at it from a different perspective, I think the FICA savings would drive you to conclude that to the extent an owner wants to contribute to a 401K through an S-Corp, they would be better to make 100% employer contributions (up to IRS limits) than to make any employee contributions, unless their reasonable compensation is high enough that they want to make elective deferrals to lower income taxes (this is particularly relevant to the extent eligible for the QBI deduction as the deferral benefit is effectively reduced by 20%.)
I may see a bit more where you're coming from. Because employer 401k contributions are deductible, the net business profit is reduced, and if salary is a fixed percentage of business profit, you can pay your self a lower salary. There's some weight to that. But if you're going down that road, I would assume salary is a fixed percentage of business profit, then run it both ways.

edit: elaborating a bit. It depends partly on the nature of the business whether the fixed-percentage or fixed dollar value is more appropriate. If you're in a profession like plumbing where the more calls you make, the more you earn, earnings are a direct product of your labor, I would say a fixed percentage would be better. But if it's something like writing software or blogging, where you put in a fixed effort, and then your income depends on how many copies you sell or how many clicks you get, I think a fixed-dollar salary is more appropriate.

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Re: Employer vs Employee Solo 401K contributions

Post by niceguy7376 » Fri May 31, 2019 4:48 pm

kardan wrote:
Fri May 31, 2019 3:47 pm
Another is to have the S-Corp make employer 401K contributions (up to IRS limits) which would lower business profit to a more reasonable/defensible level while saving FICA taxes as compared to raising compensation.
For employer contributions to reach IRS limits (56K), you need to have employee salary of 56*4 = 224K.

S Corp employER contributions are 25% of salary run on employEE.

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kardan
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Re: Employer vs Employee Solo 401K contributions

Post by kardan » Fri May 31, 2019 5:33 pm

niceguy7376 wrote:
Fri May 31, 2019 4:48 pm
kardan wrote:
Fri May 31, 2019 3:47 pm
Another is to have the S-Corp make employer 401K contributions (up to IRS limits) which would lower business profit to a more reasonable/defensible level while saving FICA taxes as compared to raising compensation.
For employer contributions to reach IRS limits (56K), you need to have employee salary of 56*4 = 224K.

S Corp employER contributions are 25% of salary run on employEE.
Understood. "Up to the IRS limits" meant to the limits based on compensation and the regulations, not up to the maximum possible.

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kardan
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Re: Employer vs Employee Solo 401K contributions

Post by kardan » Fri May 31, 2019 5:44 pm

fyre4ce wrote:
Fri May 31, 2019 4:31 pm

I may see a bit more where you're coming from. Because employer 401k contributions are deductible, the net business profit is reduced, and if salary is a fixed percentage of business profit, you can pay your self a lower salary. There's some weight to that. But if you're going down that road, I would assume salary is a fixed percentage of business profit, then run it both ways.

edit: elaborating a bit. It depends partly on the nature of the business whether the fixed-percentage or fixed dollar value is more appropriate. If you're in a profession like plumbing where the more calls you make, the more you earn, earnings are a direct product of your labor, I would say a fixed percentage would be better. But if it's something like writing software or blogging, where you put in a fixed effort, and then your income depends on how many copies you sell or how many clicks you get, I think a fixed-dollar salary is more appropriate.
It's more the plumber scenario.

I think the logic to my suggestion makes even more sense if the S-Corp employer contributions count as employee compensation for the purposes of the reasonable compensation test. It would seem like they should since most people would consider company contributions to a 401K plan as part of their compensation package. I've never seen a definition of what is considered compensation (wages, company 401K contributions, company paid health insurance, other company paid benefits??) for "reasonable compensation" purposes. Anyone know?

fyre4ce
Posts: 222
Joined: Sun Aug 06, 2017 11:29 am

Re: Employer vs Employee Solo 401K contributions

Post by fyre4ce » Fri May 31, 2019 6:06 pm

kardan wrote:
Fri May 31, 2019 5:44 pm
fyre4ce wrote:
Fri May 31, 2019 4:31 pm

I may see a bit more where you're coming from. Because employer 401k contributions are deductible, the net business profit is reduced, and if salary is a fixed percentage of business profit, you can pay your self a lower salary. There's some weight to that. But if you're going down that road, I would assume salary is a fixed percentage of business profit, then run it both ways.

edit: elaborating a bit. It depends partly on the nature of the business whether the fixed-percentage or fixed dollar value is more appropriate. If you're in a profession like plumbing where the more calls you make, the more you earn, earnings are a direct product of your labor, I would say a fixed percentage would be better. But if it's something like writing software or blogging, where you put in a fixed effort, and then your income depends on how many copies you sell or how many clicks you get, I think a fixed-dollar salary is more appropriate.
It's more the plumber scenario.

I think the logic to my suggestion makes even more sense if the S-Corp employer contributions count as employee compensation for the purposes of the reasonable compensation test. It would seem like they should since most people would consider company contributions to a 401K plan as part of their compensation package. I've never seen a definition of what is considered compensation (wages, company 401K contributions, company paid health insurance, other company paid benefits??) for "reasonable compensation" purposes. Anyone know?
I don't think those other factors count, but it's an interesting question and if someone knows otherwise, I'd love to hear them weigh in. I read some case law at one point on reasonable compensation, and to my recollection the issues revolved entirely around base salary. My guess is that the IRS considers non-wage compensation like health insurance and matching "in the noise". IRS rules limit matching to 25% of wages, and health insurance can only be so expensive, etc so they can only swing things so much. It could partly depend on what's customary in your industry. Full benefits and some kind of retirement contribution are pretty standard in my industry, but I suppose it's possible that an auditor who really didn't like you could argue that while your salary itself is reasonable, your employer contributions are more than is customary for employed plumbers (or whatever else you do). This seems unlikely to me.

In any event, Section 199A complicates things. I did an analysis for my spouse a while back, where I fixed the gross receipts for the business and looked at every possible salary within a certain range in $1,000 steps, calculating FICA taxes, possible 401k contributions, and Section 199A deductions. I then put a multiplier on pre-tax and after-tax dollars and calculated a "total value" function for each combination. If I recall, there were a few peaks and valleys but in general, lower salary was better overall, despite lower 401k contributions. I ignored the effect of reduced future benefits due to lower SS taxes, because she'll be well above the upper bend point, but if you expect your lifetime wages will be lower, you may want to put a multiplier on SS taxes too and factor that in. I wanted her to take 50/50 wages and K-1 income but her accountant thought that was too aggressive so we increased it to 60/40.

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