Here’s a surprising fact: the average American over the age of 50 has $8,000 in retirement savings. Yes…you read that correctly.
But if you are self-employed and have an S-Corp you can very quickly surpass that number and get into the six figures. With a little luck and some hard work, it might not be too tough.
S corporations have been the “bread and butter” entity structure for business owners for decades. But when the S corp structure is combined with a cash balance plan it becomes even more effective. In this post, we examine the how a cash balance plan works in an S corp tax structure.
These plans are excellent for S-Corps, but they also work very well with other entity structures. But in this article, we will look specifically at how they are structured for S-Corporations.
Table of contents
S Corporation Background
First, let’s talk a little about how S corps work. S Corporations have become one of the more popular entity structures in recent years. Most small business owners start as sole proprietor. S corporations are corporations that have elected to pass any corporate income (losses), deductions and/or credits through to the company shareholders for tax purposes.
The shareholders must then report the flow-through of income and losses on their respective personal tax returns. Because S Corporation profits or losses flow through to the shareholders, S Corporations avoid double taxation on corporate profits.
Even though losses flow through to the shareholders, this does not mean that they are allowed to take those losses on their individual tax returns. There are loss limitations that relate to: (1) stock and debt basis limitations; (2) at-risk limitations; and (3) passive activity loss limitations.
An S Corporation must file form 1120-S by March 15th of the year following the calendar year. The corporation is required to complete and file Schedule K-1 for each person who was a shareholder at any time during the year.
The K-1 is required to be filed with the IRS along with Form 1120-S and a copy of the K-1 must be provided to each shareholder so they can complete their personal return. Penalties for late filing of an S-Corporation tax return are $195 per month and per shareholder (capped at 12 months).
Cash Balance Plan for S Corp: Improve Employee Retention
Finding quality employees can be a challenge for many business owners. Most cash balance plan sponsors would like to maximize the savings for owners or partners. But others are looking to improve employee morale and retention. Improving a company’s retirement plan can be a great option.
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If a company is willing to contribute 5-7.5% to employees, then that is a good starting point. Motivating employees with a cash balance plan can be great for morale. Also, the owner can consider vesting options that can still improve retention while offering deductions for the plan sponsor.
Cash Balance Plan for S Corp: Owner Behind on Retirement
Let’s face it. Most people are behind on retirement savings. As they age, the try to get as much as possible contributed. But the problem is that life gets in the way. Kids need money for college – vacation plans get in the way. As human beings, we also can make every excuse possible to get behind on our retirement planning. Unfortunately, we need a plan to get more money contributed.
401k plans have maximum contribution limits of $62,000. This limit assumes that the participant is over the age of 50. Owners and partners who want to contribute more than this are typically stuck (including with a mega backdoor roth). A cash balance plan can be an excellent fit for these people.
Cash Balance Plan for S Corp: Maximize Tax Savings
Retirement savings is nice. But minimizing taxes is what drives the majority of business owners to cash balance plans. When combining the marginal federal tax rates (with state tax rates as well), it makes a cash balance plan a no-brainer for business owners looking for tax savings. Any cash balance contributions will come off at the owner’s marginal tax rate.
Most clients should save at least 40% in taxes when you consider their marginal rates. But in states like California where the top marginal income tax rate is 13.3%, a cash balance plan can be especially appealing. With the top federal rate at 39.6%, even employers who reside in states with no (or little) state tax it can make a big difference.
Assume that a business makes a $120,000 profit during the year before paying any compensation to its sole shareholder for services provided. Assuming the sole shareholder is paid a reasonable wage of $70,000 then payroll taxes are assessed on the wage but not on the remaining $50,000 of business profit that is available for distribution.
The sole shareholder is taxed on $120,000 which is a wage of $70,000 and S Corp pass through profits of $50,000. The shareholder is taxed on the entire amount of business profits regardless of whether or not the shareholder received any cash distributions. Accordingly, if the shareholder took no distributions during the year but took $50,000 during the following year there would be no tax due in the following year on the distribution because it was already taxed in the prior year.
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Obviously there is an incentive for the taxpayer to pay themselves a wage that is as low as possible in order to minimize employment taxes. But this does not make sense in all situations. There are a few circumstances and/or situations in which a higher wage might make sense:
- Pay in to social security
- As part of a retirement plan
- Lower audit risk
One other advantage to an S-Corporation is frankly that CPAs and tax professionals are just more familiar with doing the tax returns and dealing with any issues that arise. C-Corporations can be more complex tax returns and many CPAs just don’t do enough of them to be really competent.
The best candidates have a combination of all the characteristics noted above. But most importantly, they should be committed to the plan and all the benefits that come with it.