Welcome to Part 3 of the FIRE small business series.
You can see the Introduction and summary of what we are talking about here. You should also read the disclaimer:
WTF is a shareholder distribution?
Let’s back up a minute. An S-Corp is like any other company you see on the stock exchange, meaning there are shares of the company that are distributed to investors as proof of ownership.
So, like any company, the management can choose to pay some of the company profit on a per share basis to the stock holders. That, is what we know and love in the FIRE community as a stock dividend.
These dividends are slightly different than a shareholder distribution, but the idea is the same. This is a distribution of the profit of the company to stock holders based on share ownership, not payment through wages.
This is what is known as shareholder distribution.
Great… so what?
In our case, we’re management and we own 100% of the shares, but we’re also the only employees. Isn’t that convenient?
So, why would you want to distribute profits opposed to pay yourself as an employee to max out that lovely 401k we set up last time. You know, the one with the glorious 25% match?
Well, these distributions are not subject to payroll tax! They are subject to your standard income tax, so don’t get too excited. But, this does mean that you can skirt the whole 15.3% of the self-employment tax on these distributions.
Another new and interesting part is that pass-through income was a major portion of this new tax law. Pass-through income is now subject to a new deduction!! HOORAY!!
Here’s the basics:
The deduction is the LESSER of:
20% of the distribution OR
50% of the W-2 income paid
This is also fresh off the press, so no one is really sure how this is all going to be applied or enforced, so take it with a grain of salt.
You can see the whole complicated mess here, but basically:
If you take a distribution of $60K & wages of $0, you can deduct $0. (20% * $60k = $12k > $0 / 2 = $0)
If you take a distribution of $30K & wages of $30K, you can deduct $6K. (20% * $30K = $6K < $30K / 2 = $15K)
Now, we’re not only skipping out on the payroll tax, but we’re also allowed to deduct 20% of the value of the distribution. Wow, there’s really a definite advantage to these distributions. There are some limits to this, like if your income level is over $315k these deductions start phasing out. But, if your income is over $315K, good on you… go hire an accountant!
Let’s take a look…
We have our good ole scenario:
- $100 in income
- $40k in deductible expenses
But, now we are going to take the entire thing as a distribution opposed to wages.
Draw vs W-2
Whoa… ok… if we pay the entire thing through distributions, we end up with even more coming into our pocket, because we’re not subject to payroll tax. But, we don’t take advantage of our 401k (as we have no wages), nor do we take advantage of that new deduction ($0 wages/2 = $0 deduction). But, we’ve upped our total take home from ~$51K (no draw) to ~$54K (all draw).
Well, what if we adjust this some and push some of the income through wages and some through the distribution?
Turns out, if you pay yourself ~40% as wages, and the rest as a distribution, you end up maxing out your take home pay & max out your solo 401k to the tune of ~$55.8K:
Takehome & Tax Rate vs % Wages Paid
Not bad. Now we’re paying a 4.2% tax rate on $100K in income. The reason why is you end up paying nothing in income tax on your wages because it all drops into your 401k. Then you avoid some payroll taxes through the distribution on top of that:
40% Paid as Wages
Let’s compare this to our company from last time. The same default ($100k income & $40K deductible expenses) but with no 401k & with a 401k but no draw.
SE Take Home + 401k ($0K personal + 0% Match): $45,907
SE Take Home + 401K ($18K Personal + 25% Match): $51,438
SE Take Home + 401K ($18K Personal + 25% Match) + Draw: $55,819
So, by opening the 401k and having your company match 25% and optimizing the distribution you end up keeping ~$4,500 more dollars (Almost $10K more than both a SE without the 401k & $15k more than the W-2 sap). Would you look at that?
Before you get all excited, Hang on!!
Not so fast!!! The IRS is more clever than you might think. They are wise to this ruse and have made rules that state you must pay yourself a “reasonable” salary before you can pull distributions from your company. Reasonable is subject to debate, and if you have further questions about it ask a professional. It would make this post about 15,000 words long, but think market rate for the position.
So, in our case above, the market rate of your “job” better be $18K a year or you run the risk of Uncle Sam sending you a nasty gram. I got one of those before. I’d rather avoid another, if at all possible.
Do some research, check out Indeed.com or Salary.com to see what the going rate for your position would be, then pay yourself at the bottom of the range. At least that way it’s justifiable.
For us…
We actually paid everything out as wages and didn’t take a distribution for a couple reasons:
- I don’t have access to a 401k at my employer, so this is my only access to one.
- It’s >$45k ($18k * 2 + 25% match of wages) that’s all tax advantaged. Eliminating payroll tax & income tax on the match and income tax on the contributions.
- We needed to make sure we paid a “reasonable wage”. We don’t feel like messing with the IRS again.
- Up until a few weeks ago, that pass-through deduction didn’t exist.
Trust me, this is something we are definitely keeping an eye on, so that we can take advantage of it in the future. Especially, if I end up at a company that matches 401k contributions, then we can eliminate my needing to be on the payroll.
Alas, if there’s one constant in life, it’s change. We hired someone (yay!), but now we have to open up a standard big boy 401k (boo!). The solo 401k isn’t going to cut it, and any matching we do is going to have to be done to everyone. A 25% 401k match to everyone is great, if you can afford it, but we really can’t at the moment.
Regardless… tune in next time as we walk through all the steps to set up a big boy 401k, as it’s a bit more involved than the solo one we’ve been dealing with so far.
Another excellent post! The business series has been been super helpful, thank you!
You’re welcome! If there’s anything else more detailed you’re wondering about, just let me know.
“Turns out, if you pay yourself ~40% as wages, and the rest as a distribution, you end up maxing out your take home pay & max out your solo 401k to the tune of ~$55.8K”
Nice! That’s some nice optimization you did there. I didn’t know the IRS requires you to pay yourself a “reasonable wage” though. That’s kind of open to interpretation, because depending on your role that range could vary a lot. But yeah, definitely better to play it safe than to mess with the IRS.
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I figured you would enjoy this.
The reasonable wage thing is interesting. And really you get to splitting hairs. I don’t know that it’s worth shaving 10 basis points off your tax burden to piss off the IRS.
Maybe if the company grows to the point where we have a substantial overage, we’ll dig into this more, but at the moment it’s not a huge deal to pay all wages, especially since most of it drops straight into the 401k anyway.
Well, I certainly can’t call you an idiot over this post! I’m the idiot because I have trouble following you.
I think it’s great you’re looking at all the angles. Some scenarios will test the IRS when new rules come into play– but you don’t want to be part of a test case!
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Thanks, I guess!
It’s not that hard. There’s two ways to pay yourself from a company… Wages and Distributions. Wages have payroll tax & you can put into a 401k. Distribution has NO payroll tax & cannot put into a 401k. The idea is to balance the two ways to make it work in your best interest.
Just leave it to Uncle Sam to make it so unbelievably complex that you need 5 PhD’s to figure it out!!! BLAH!!!!
Another informative post. I hate it though that they’re making tax laws with highly subjective and debatable things in them, like “reasonable wage”. That just requires more bureaucrats paid with taxpayer money to interpret all this stuff case by case. We could be far more efficient.
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Yeah, lovely huh? I can see why they did it, how can you compare a Doctor to a flower salesman? When they both own a company and both are trying to do this. It just sucks that it’s fully left to the interpretation of a judge.
This was a hard one to write, it’s so complex and full of nuance. I hope it was somewhat clear.
I was thinking about converting to S corp, but I’m sticking with sole proprietor for now. It seems like once you make more income, S corp is the way to go.
In 2016, I made just $30k. That was fine as sole proprietor. In 2017, I made $65k and the tax bill was much higher.
The tax reform should help a bit this year.
However, if my income increase more, then I really should change to S corp. Is that sound reasoning? This tax stuff is so complicated.
I do think there are some distinct advantages you can gain from an S-Corp (LLC taxed as one) vs the Sole Proprietor. I know it’s not as easy to set up, and that’s probably why most people go the simple SP way.
It does get a lot more complicated, so you might come out even based on effort/accountant fees, etc. But yeah, there are certainly some other things you can do.
I think it’s certainly worth a consultation with a professional to walk through your specifics, especially if your income through the company is continuing to grow. I think it also depends on the type of business: https://www.legalzoom.com/articles/is-it-time-to-convert-your-sole-proprietorship-to-a-corporation-or-llc
And yeah, I have no idea why it is so complicated. It’s unbelievably complicated. It keeps entire armies of accountants and lawyers employed. I learned a lot just going through the little bit that we went through so I’m hoping that I can share some of that with everyone.
Thank you, Mr. WoW. I’ve heard of the dreaded “pass through,” of course, but I really didn’t know what it meant. This helped. I now go to bed a little smarter.
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I don’t know that “dreaded” is a word I’d use for it. It can be quite an advantage if you use it properly.
I’m hopefully that this will help folks understand and be able to ask the right questions. That’s really the point, isn’t it?
I’m a full time real estate investor and real estate broker with an S Corp and my adjusted gross income varies year to year (Commission income in the S corp and income on my rental properties). I’d love to see more analysis on this for somebody who gets the passive 20% deduction on the S corp (but you don’t get it on the w2 wages as you pointed out) at different income levels for the S Corp (50k, 100k, 150k, 200k, 350k, 500k, etc). It also matters if you’re married or single (18.5k deferral for 1 versus on 2 If you’re married for 37,000 in just deferral) as you pointed out and what tax bracket you’re in and what state you’re in for state income tax purposes / treatment. I would love to see a more detailed treatment on optimizing this…. yours is the only / best one I’ve seen so far! Thank you so much for this great post!
I appreciate the comment. I wanted to keep the article fairly generic since there are tons of specifics that are unique to each individual situation. Between all the various state laws and every possible different scenario I would still be trying to get this written.
On the flip side, I can always give allow you to download the sheet and you can begin to build out additional features if you are interested.
Just let me know.
I was thinking about it on my way into the office this morning. I think you always want to pay yourself the amount you will contribute to the 401k, then take the rest as distributions.
The reason why is the FICA taxes. Now you can run into issues with the “reasonable” salary requirements. But just thinking about it you’ll always want to push as much through distributions as you can, since you’ll save the 15% FICA and you’ll maximize this new 20% deduction.
Think about it this way… 401k personal contributions avoid personal income tax , but you pay employer FICA (~7.5%) so that’s the best bucket. Matches to that are an expense so that’s great too. Then you want everything to go through distributions because you’ll have personal tax rate alone plus the 20% deduction. The last resort should be salary, which is personal tax rate plus FICA, employer & employee (~15%).
I haven’t done the math, but im guessing that the 15% you add to the salary through FICA outweighs the savings of the 25% match, beyond the personal limit.
This is very helpful! That you so much for that analysis. That makes perfect sense to me. In the future, I plan to retire to Nevada but continue to run my real estate brokerage business in both states part time and have investments in real estate in both states so I will be curious to run the #s again when I relocate to NV but still have sales and properties in both states. I’m curious if this advice holds for salary..it might max sense to max out the S Corp’s salary expense to myself as an NV resident if it would be deemed reasonable to do so since it would not be subject to CA state income tax but the pass through income would on sales generated in CA. I will def check back in with you in 5-10 years when /if I RELO back to NV haha