April 29, 2022
A one-owner business often begins as a Sole Proprietorship. Other times, the business is set up as a Limited Liability Company (LLC) without any tax election. In either of these cases, the business would be taxed as a Sole Proprietorship.
However, as the business grows, the tax advisor may suggest converting the business to an S Corporation or at least making an election to be taxed as an S Corporation.
The purpose of this article is to explore the advantages of being taxed as an S Corporation for small businesses that sponsor a Defined Benefit Plan. Whether the entity sponsoring the Plan is an actual S Corporation or simply elects to be taxed as an S Corporation, the implications for the Defined Benefit Plan are the same.
Note, that we do not provide tax or financial advice. The purpose of this article is to explain the advantages of being taxed as an S Corporation only as it relates to Defined Benefit Plans. There are other important considerations when determining your entity’s structure and tax election.
Selecting or changing your entity’s structure or taxation election may have significant consequences. Therefore, we strongly recommend that you consult with your financial and tax professionals before selecting or modifying your business structure and/or tax election.
With regards to Defined Benefit Plan sponsorship, being taxed as an S Corporation has several advantages over being taxed as a Sole Proprietorship. These advantages are shown below. We will explore each of these items in more detail.
For entities taxed as Sole Proprietorships, the owner’s Defined Benefit Plan compensation generally is defined as net income less employer-provided retirement contributions and less one-half of self-employment tax. For this purpose, net income for Sole Proprietorships is shown on line 31 of Schedule C (Form 1040).
As an example, suppose a Sole Proprietor has a net income of $100,000, makes a Defined Benefit Plan contribution of $40,000, and one-half of self-employment tax equals $7,000. In this example, Plan compensation only is $53,000 ($100,000 – $40,000 – $7,000).
Conversely, the owner’s Plan compensation in an S Corporation simply is the owner’s W-2, which need not be a function of net income as long as it is reasonable compensation.
Importantly, Plan compensation is a key input in the calculation of the minimum required and maximum deductible contributions, as well as the owner’s lifetime limit. Because of this, when an owner has control over Plan compensation, they have more control over the contribution range and payout limit.
Because the owner’s Plan compensation in an S Corporation is W-2 and may be set without regard to net income, a higher Defined Benefit Plan deduction may be possible.
This is because an S Corporation simply can pay the owner the necessary W-2, as long as it is reasonable, such that the Defined Benefit Plan contribution is maximized for a given situation. On the other hand, a Sole Proprietor is constrained by net income, which is not as easily controlled.
Of course, net income can be “controlled” by delaying or accelerating revenue and/or expenses. However, this may be cumbersome and often inconsistent with the overall tax strategy. For example, if a Sole Proprietor wanted a higher Defined Benefit Plan deduction, they may need to increase net income by accelerating revenue or delaying the payment of expenses. And although increasing net income may support a larger Defined Benefit Plan deduction, the higher net income may offset the Defined Benefit deduction.
Additionally, recall that when determining Plan compensation for a Sole Proprietor, net income is reduced by employer-provided retirement contributions. Thus, taking a Defined Benefit Plan deduction actually reduces Plan compensation, and lower Plan compensation reduces the maximum permissible Defined Benefit deduction. Thus, Plan compensation for a Sole Proprietor is circular in nature and may result in a lower maximum deductible contribution.
Beyond the current year’s permissible Defined Benefit Plan deduction, S Corporations may provide higher contributions in future years as well.
For instance, suppose in its first two years that a Sole Proprietor has had two years of high profitability. Further suppose that based on their age and historical net income, for the current year, they can deposit a Defined Benefit Plan contribution such that net income essentially is zeroed out.
While this may sound appealing, note that the Defined Benefit maximum contribution is a function of the three-year consecutive average of historical Plan compensation. In our example, if the Sole Proprietor essentially were to zero out net income in the third year, the three-year consecutive average would be reduced when calculating the next year’s contribution maximum.
Additionally, the opportunity to string together three high consecutive net incomes would be lost. By breaking the string of high consecutive net incomes, the three-year average must be restarted. This may affect the ability to make large contributions in the future.
On the other hand, a business taxed as an S Corporation may determine a reasonable W-2 with current and future Defined Benefit Plan contributions in mind. That may mean not only paying a higher, reasonable W-2 to increase the current year’s contribution but also building on a string of consecutive
Thus, when compared to Sole Proprietorships, a business taxed as an S Corporation has more control, not only over current year contribution maximums but over future year contributions as well.
Another disadvantage of being taxed as a Sole Proprietorship is that the Defined Benefit Plan contribution is constrained by net income. More specifically, the Plan deduction cannot exceed net income less one-half of self-employment tax, even if the maximum contribution without regard to the limitation of the current year’s net income is ignored.
For instance, suppose a Sole Proprietor has strung together three consecutive years of very high net income in the past such that the current year’s maximum deductible contribution would be $200,000. However, suppose that in the current year, net income only is $100,000. Unfortunately, in this example, the Defined Benefit contribution would be limited to $100,000 less one-half of self-employment tax, rather than the $200,000.
If the business income was the only income received, the restricted deduction may not be an issue. However, if the business owner had other ordinary income outside their business, an opportunity is lost.
The same limitation does not exist when the business is taxed as an S Corporation. In an S Corporation, the Defined Benefit Plan contribution may exceed net income, creating a business loss. Because an S Corporation is a pass-through entity, the business loss may be able to be applied against other sources of ordinary income. This can be a powerful strategy. However, you would want to verify your situation with your tax professional.
As mentioned, the maximum deductible Defined Benefit Plan contribution is a function of the highest three consecutive years of Plan compensation. The lifetime limit, or the maximum lump sum that may be paid out from the Plan, also is a function of this average.
As expected, S Corporations may more easily increase the lifetime limit by simply paying higher W-2s, thereby increasing the three-year consecutive average. A Sole Proprietorship, on the other hand, is restricted by net income.
Being unable to easily increase the lifetime limit, as a Sole Proprietor, especially may be an issue if Plan assets have appreciated far in excess of the lifetime limit. Although other options may be available, soaking up excess assets by simply paying a higher (but reasonable) W-2, as the owner of an S Corporation, may be the most expedient alternative. In some instances, it may be one of the few options available to resolve an overfunded Defined Benefit Plan.
Thus, in terms of (rapidly) increasing the lifetime limit, an S Corporation provides much more flexibility than a Sole Proprietorship.
In addition to an S Corporation providing potentially higher maximum deductible contributions and lifetime limits than a Sole Proprietorship, it generally provides more flexibility to reduce the minimum required contribution.
This strictly is because of logistical reasons. More specifically, the prior year’s Plan compensation may be needed to calculate the current year’s contribution requirement. For an S Corporation, W-2s are available by January 31. However, for a Sole Proprietor, the prior year’s Plan compensation is not available until the prior year’s tax return is filed. Often, this return is filed in April at the earliest.
Thus, an S Corporation may know its current year’s funding minimum by mid-February. This gives the business time to decide if the minimum contribution is affordable, and amend the Plan, if needed, to reduce the minimum contribution. However, the amendment deadline is 15 days before participants meet the annual hours requirement, which generally is 1,000 hours.
On the other hand, if a Sole Proprietor files its prior year’s tax return on April 15, the Plan’s actuary may not be able to calculate the current year’s funding requirement until mid-May. Because the Plan must be amended to reduce the minimum contribution at least 15 days before participants work 1,000 hours, which often occurs in June, there may not be sufficient time to redesign the Defined Benefit Plan and draft a Plan amendment. Therefore, the Sole Proprietor either must file their taxes sooner or risk not having sufficient time to reduce a potentially unaffordable contribution requirement.
Thus, an S Corporation generally provides more flexibility with regards to the minimum contribution than a Sole Proprietorship.
When a business sponsors a Defined Benefit Plan, the 401(k) employer contribution may be reduced from 25% of Plan compensation to 6% of Plan compensation.
The maximum permissible 401(k) employer contribution may be calculated in early February for an S Corporation, because the prior year’s W-2s are available by January 31. However, for a Sole Proprietorship, the same calculation cannot be done until the prior year’s tax return is finalized (but not filed).
Additionally, while the calculation for an S Corporation is fairly straightforward, the same calculation for a Sole Proprietor may be more complicated and cumbersome.
For example, unless the Sole Proprietor has a very high net income, they must provide the Plan’s actuary a finalized (but not filed) version of the prior year’s tax return. The actuary then will calculate the maximum 401(k) employer contribution based on those finalized figures. The business owner then may deposit up to that maximum amount, have their tax professional update the return to reflect the additional 401(k) contribution, then file the return. All these steps may need to be completed in a couple of days, depending on how far in advance the tax return figures are finalized before the filing due date. And, of course, if the tax figures change at all, the 401(k) contribution may need to be recalculated, creating an even tighter timeframe.
Thus, businesses taxed as S Corporations generally will know their maximum permissible 401(k) contribution much sooner than Sole Proprietors. This helps avoid a compressed timeframe to deposit the contribution and file the tax return.
In conclusion, S Corporations may provide higher current and future year contributions, a higher, and more easily increasable, lifetime limit, as well as more flexibility and time to reduce the required contribution via Plan amendment and deposit 401(k) employer contributions.