S Corp with mega back door question

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birdec
Posts: 39
Joined: Fri Jul 11, 2014 10:44 am

S Corp with mega back door question

Post by birdec » Wed Nov 07, 2018 5:14 pm

We'll be getting $50,000 in 1099 income starting next year and our goal is to save the whole amount if possible. Initially I thought Solo 401k --> $19,000 employee Roth contribution (2019 limits), ~$9,000 employer pre-tax contribution (18.6% * $50,000) + $22,000 after-tax employee contribution then mega back door the after-tax money into the Roth account.

However, if I elect S Corp on the 1099 income I could save about $3,500 in taxes according to some online calculators BUT I wouldn't be able to mega back door Roth that $22,000 after-tax amount because you can only contribute earnings from salary (my salary would be $28k, distribution/dividend would be $22k).

My options are:

1) Not elect S Corp on the 1099 income and save the whole $50k via Solo 401k + mega back door Roth = $50,000 savings
2) Elect S Corp, save $3,500 in taxes, contribute from 1099 income: $19,000 as Roth (employee), ~$9,000 as pre-tax (employer); live off some of the 1099 income and instead max out wife's 401k = $50,000 savings

Now that I've typed it out, Option 2 probably sounds better even though it's messier. The S Corp tax savings would also help offset the taxes I'd pay on Roth dollars.

Also, to be able to do MBD Roth with Solo 401k I'd have to pay $750 + $125/year to get a custom plan document that allows after-tax contributions. Is the breakeven point to where it's not worth it ($55,000 annual limit - $19,000 employee contribution) / 18.6% employer contribution = ~$200,000 self employment income. After $200k self employment income you can just max out the employer contribution and not worry about after-tax employee contributions right?

Appreciate any thoughts you may have.

Spirit Rider
Posts: 8895
Joined: Fri Mar 02, 2007 2:39 pm

Re: S Corp with mega back door question

Post by Spirit Rider » Wed Nov 07, 2018 7:31 pm

birdec wrote:
Wed Nov 07, 2018 5:14 pm
We'll be getting $50,000 in 1099 income starting next year and our goal is to save the whole amount if possible. Initially I thought Solo 401k --> $19,000 employee Roth contribution (2019 limits), ~$9,000 employer pre-tax contribution (18.6% * $50,000) + $22,000 after-tax employee contribution then mega back door the after-tax money into the Roth account.

However, if I elect S Corp on the 1099 income I could save about $3,500 in taxes according to some online calculators BUT I wouldn't be able to mega back door Roth that $22,000 after-tax amount because you can only contribute earnings from salary (my salary would be $28k, distribution/dividend would be $22k).
Some questions:
  • When you say we'll, am I to understand that this is a married couple?
  • If so, is one, the other, both combined or a jointly owned business receiving the 1099?
  • Is this the only income for one or both of you?
  • What are the Social Security (SS) wages and MFJ taxable income?
This is relevant, because:
  • When an individual's primary W-2 SS wages + 92.35% of net profit is >= the SS maximum wage base. They will pay more not less net FICA taxes as an S-Corp shareholder-employee than they will net SE taxes as a self-employed individual.
  • The new Section 199A 20% QBI deduction is only available on an S-Corp's distributions, where a sole proprietor's is available on their full net self-employment earnings. However, if this 1099 business is a specified service trade or business (SSTB), the 20% QBI deduction is phased out for MFJ from $315K - $415K.
Finally, assuming you have $50K in net self-employment earnings. You will not be able to contribute the full amount to a one-participant 401K if you make employer contributions. This is because for a self-employed individual the employer contribution itself reduces the compensation available for annual additions.

The maximum employee after-tax contribution would be $50K - $19K Roth - ($10K employer * 2 = $20K) = $11K for a total of $10K pre-tax and $30K post/after tax = $40K total contributions

You would be better off doing $50K - $19K deferral = $31K after-tax for a total of $19K pre-tax and $31K after-tax = $50K contributions.

birdec
Posts: 39
Joined: Fri Jul 11, 2014 10:44 am

Re: S Corp with mega back door question

Post by birdec » Wed Nov 07, 2018 11:44 pm

Thank you for the detailed reply, Spirit Rider.
Some questions:
When you say we'll, am I to understand that this is a married couple?
Yes MFJ
If so, is one, the other, both combined or a jointly owned business receiving the 1099?
The 1099 income is attributable to me alone
What are the Social Security (SS) wages and MFJ taxable income?
Not sure about taxable income but wife's gross income is 100k, my gross will be 50k self employment income only, so 150k total MFJ
So I think I'll be below the SS max wage base as well as the 20% distribution deduction phase out.
The maximum employee after-tax contribution would be $50K - $19K Roth - ($10K employer * 2 = $20K) = $11K for a total of $10K pre-tax and $30K post/after tax = $40K total contributions
Can you explain the math here: ($10K employer * 2 = $20K)? I'm guessing "$10K employer" is 20% of income but why is it multiplied by 2?
You would be better off doing $50K - $19K deferral = $31K after-tax for a total of $19K pre-tax and $31K after-tax = $50K contributions.
This is much simpler, thanks.

Doing it this way would allow me to contribute a full $50k per year but couldn't I pay less in taxes by taking a smaller salary and a larger S corp distribution? For example, take a $19k salary and defer $19k, take a $50k - $19k = $31k distribution. To make up $31k in tax-deferred savings, just defer more of wife's salary into her work 401k (max out Roth portion then the remainder would be after-tax contributions for a total of $31k).

Spirit Rider
Posts: 8895
Joined: Fri Mar 02, 2007 2:39 pm

Re: S Corp with mega back door question

Post by Spirit Rider » Thu Nov 08, 2018 7:34 am

birdec wrote:
Wed Nov 07, 2018 11:44 pm
The maximum employee after-tax contribution would be $50K - $19K Roth - ($10K employer * 2 = $20K) = $11K for a total of $10K pre-tax and $30K post/after tax = $40K total contributions
Can you explain the math here: ($10K employer * 2 = $20K)? I'm guessing "$10K employer" is 20% of income but why is it multiplied by 2?
Many people know about the statutory annual addition limit, but there is a second limit of 100% of compensation. The employer contribution is multiplied by 2, but because it is not compensation, reduces the annual addition limit and is also subtracted from the annual addition limit leaving the remainder for total employee contributions.
Doing it this way would allow me to contribute a full $50k per year but couldn't I pay less in taxes by taking a smaller salary and a larger S corp distribution? For example, take a $19k salary and defer $19k, take a $50k - $19k = $31k distribution. To make up $31k in tax-deferred savings, just defer more of wife's salary into her work 401k (max out Roth portion then the remainder would be after-tax contributions for a total of $31k).
IRS guidance requires an S-Corp shareholder-employee to be paid "reasonable compensation". It depends on circumstances, but in most cases should be at least 50% of net bussiness profits.

Doing the math. A $25K salary and a $25K distribution would only save you $25K * 15.3% = $3825 FICA - the $420 UI would have to pay = $3405. Your employer contribution would be limited to the lesser of $25K * 25% = $6.25K and $25K - $19K = $6K.

The QBI deduction is not available on the shareholder-employee's W-2 wages only the distribution. Your distribution and QBI would be $25K - $6K employer contribution = $19K. You would have $50K - $19K = $31K less QBI deduction. At your likely marginal tax rate that will = ($31K * 20% = $6200) * 22% = $1364.

If I have done the math correctly an S-Corp will save you a net $3405 - $1364 = $2041 in FICA/income taxes. That is before any state/local S-Corp fees and/or taxes and any extra accounting, payroll and tax filing fees. Not to mention the significant additional hassle.

When all is said and done, you may not save enough with an S-Corp to justify the added complexity and reduced contribution space.

jacoavlu
Posts: 562
Joined: Sun Jan 06, 2013 12:06 pm

Re: S Corp with mega back door question

Post by jacoavlu » Thu Nov 08, 2018 8:38 am

Spirit Rider I’m not sure your QBI and QBI deduction math is correct

As an S Corp with a 50/50 split I believe QBI would be $25k. Not sure why employer profit sharing, which only comes from wages, would reduce QBI. In this case QBI deduction should be 20% of 25k = $5k, saving estimated $1,100 federal tax

As a sole prop QBI may be $50k but I’m not sure of the interplay between QBI (and resultant QBI deduction), comp, and profit sharing.

Spirit Rider
Posts: 8895
Joined: Fri Mar 02, 2007 2:39 pm

Re: S Corp with mega back door question

Post by Spirit Rider » Thu Nov 08, 2018 9:19 am

In an S-Corp, employee elective contributions are deducted from the shareholder-employee's W-2 wages. However, employer contributions are a business deduction on Form 1120S Line 17 Pension, profit-sharing, etc., plans. Thereby reducing Ordinary business income available for distribution. Lower S-Corp distributions, lower QBI.

The various draft 2018 Instructions, Worksheets and Forms are out. A sole proprietor's QBI is equal to their business profit with an enumerated list of exclusions on the 2018 draft Form 1040 Instructions, pages 34 and 36. There is no interplay between the QBI deduction, compensation or employer contributions.

jacoavlu
Posts: 562
Joined: Sun Jan 06, 2013 12:06 pm

Re: S Corp with mega back door question

Post by jacoavlu » Thu Nov 08, 2018 9:57 am

Spirit Rider wrote:
Thu Nov 08, 2018 9:19 am
In an S-Corp, employee elective contributions are deducted from the shareholder-employee's W-2 wages. However, employer contributions are a business deduction on Form 1120S Line 17 Pension, profit-sharing, etc., plans. Thereby reducing Ordinary business income available for distribution. Lower S-Corp distributions, lower QBI.

The various draft 2018 Instructions, Worksheets and Forms are out. A sole proprietor's QBI is equal to their business profit with an enumerated list of exclusions on the 2018 draft Form 1040 Instructions, pages 34 and 36. There is no interplay between the QBI deduction, compensation or employer contributions.
Ah, makes sense, thanks!

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