How would you like to contribute an extra $100,000 to retirement this year? Well, a defined benefit plan for an S-Corp just might be the answer.
Let me be clear. Defined benefit plans aren’t for all business owners. They are more complex than other retirement plans. But in the right situation, they are one of the most powerful tax strategies.
Why does a Defined Benefit Plan work great for an S-Corp?
With an S Corporation tax structure, the defined benefit plan contribution can exceed the business net income. This creates a business loss that is subject to basis limitations. Because it is a pass-through entity, the loss can offset other income sources. That’s why this strategy is so powerful.
Not many other plans out there allow you to make annual contributions over $100k. In this post, we will discuss this strategy and show you how to set up a plan.
Table of contents
The Best Strategy
Defined benefit plans are less popular than defined contribution plans. They provide for a fixed employee benefit to be paid at retirement. Employees enjoy knowing that they are to get a set amount and the employer bears the risk under the plan. The company can typically take a tax deduction for amounts contributed.
One of the most popular defined benefit plans in the cash balance plan. We have discussed the pros and cons extensively. In contrast, 401(k) plans are a type of defined contribution plan. There are four major differences between typical defined benefit pension plans and 401(k) plans:
- Participation – Participation in typical cash balance plans generally does not depend on the workers contributing part of their compensation to the plan; however, participation in a 401(k) plan does depend, in whole or in part, on an employee choosing to make a contribution to the plan.
- Investment Risks – The investments of cash balance plans are managed by the employer or an investment manager appointed by the employer. The employer bears the risks of the investments. Increases and decreases in the value of the pension plan’s investments do not directly affect the benefit amounts promised to participants. By contrast, 401(k) plans often permit participants to direct their own investments within certain categories. Under 401(k) plans, participants bear the risks and rewards of investment choices.
- Life Annuities – Unlike 401(k) plans, cash balance plans are required to offer employees the ability to receive their benefits in the form of lifetime annuities.
- Federal Guarantee – Since they are defined benefit plans, the benefits promised by cash balance plans are usually insured by a federal agency, the Pension Benefit Guaranty Corporation (PBGC). If a defined benefit plan is terminated with insufficient funds to pay all promised benefits, the PBGC has authority to assume trusteeship of the plan and to begin to pay pension benefits up to the limits set by law. Defined contribution plans, including 401(k) plans, are not insured by the PBGC.
Benefits of an S-Corporation
There are many benefits of S-Corporations as compared to other tax entities. However, one of the main advantages is that profits are not subject to employment taxes, unlike partnerships and sole proprietorships. As a shareholder of an S-Corporation you are entitled to a wage for the work you perform for the entity and a return on your investment (assuming there are profits).
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Under current tax law, employers must withhold 7.65% of employee wages for Social Security and Medicare. This represents 6.2% for Social Security and 1.45% for Medicare. Most people realize this when they take a look at their paystub.
However, what most people don’t realize is that employers need to pay 7.65% as well, which represents the employer portion. For a self-employed person this represents 15.3%, which can feel like quite a tax hit.
So let’s assume that a sole proprietorship earns a profit of $100,000. The owner will have to pay approximately $15,000 in self-employment tax, plus federal and state income taxes. But if that same business was an S-Corporation then there would be no employment taxes, so one would think that they just saved $15,000.
But not so fast. Even though S-Corporations are not subject to employment taxes, shareholders who work in the business are required to pay themselves a reasonable wage for the work that they perform in the business. So let’s use the same example as before and assume that the owner paid themselves a fair and reasonable wage for the work performed of $50,000.
This amount would be subject to 15% or $7,500, but the remaining $50,000 of profit will flow through to the shareholder avoiding employment taxes. In this situation, the taxpayer saved $7,500. Take a look at our calculator for the specifics.
So what are the restrictions?
But not every corporation can elect to be taxed as an S Corporation. It is important to take a look at a few of the S Corporation restrictions:
- They must have 100 shareholders or less.
- They must have individuals as shareholders. However, there are special rules relating to trusts and disregarded entities that are beyond the scope of our discussion.
- They cannot have nonresident aliens as shareholders.
- They are not permitted to have more than one class of stock.
But lowering employment taxes is just one of the benefits of an S-Corporation. Let’s spell out here some of the advantages of S-Corporations relative to other tax entities:
- The income in an S-Corporation flows-through to shareholders and is not generally subject to a corporate level tax. Thus avoiding any double taxation issues.
- For individuals in relatively lower tax brackets, overall effective tax rate will normally be lower.
- Since an S-Corporation is a flow through entity, allocated losses can be deducted by shareholders (assuming no basis limitations).
- S-Corporation shareholders may take money out of the corporation with greater ease and do not pay a dividend tax.
- There is no accumulated earnings tax or personal holding company tax in an S-Corporation.
- Since there is no corporate level tax there is no alternative minimum tax.
- For professionals, they do not have the limitations of personal service corporations.
- S Corporations are audited substantially less than sole proprietorships who file a Schedule C to his or her personal tax return.
- S-Corporations may generate passive income, which can be used by shareholders to offset other passive losses.
What about S-Corporation distributions?
S corporation distributions are actually different from the net income that the S Corp generates. When we say “pass through” we are referring to the corporation’s income, deductions, losses, and/or credits that are reported on his or her Schedule K-1, not to the actual cash that is distributed to shareholders.
In general, a distribution to a shareholder is not taxable because the shareholder is already taxed on the business profits. However, a distribution that is in excess of the shareholder’s basis is taxed to the shareholder as capital gain.
S corporation distributions are often called “dividends”. But in reality they are not considered dividends from a tax perspective. Qualified dividends are only issued by C Corporations. Beginning in 2013, the rates on qualified dividends are 0%, 15% and 20% depending on the tax bracket. The 20% rate is now reserved for taxpayers in the 37% tax bracket.
Pension Plan for S-Corp: Tax Treatment of S-Corp Wages
Typically, S corporation shareholders also perform services for the company. We have already established that S-Corps must pay a reasonable wage to shareholders who work in the business. These wages should be paid prior to any payment of non-wage distributions to the shareholder-employee. The amount of reasonable compensation will not exceed the amount received by the shareholder either directly or indirectly.
The S corporation issues a W-2 to the shareholder-employee just as it would to any employee. The shareholder-employee must include the wages on his or her federal income tax return. The company can then set up a defined benefit plan for employees of the corporation.
The S corporation deducts the gross wages it pays to its employees, including any shareholder-employees, in determining the amount of net income that will be passed through to the S corporation’s shareholders. Wages paid to shareholders and/or officers of the company will be reported under “Compensation of Officers” on the 1120-S tax return.
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I will provide some guidelines for reasonable compensation, but please understand that each company and situation is different. In addition, corporate officers bring different skills and expertise to their companies and compensation would vary accordingly.
Your accountant should help you assess reasonable compensation based on your situation, but ultimately it is up to you to determine proper compensation.
S-Corp defined benefit plan
How to make the most of your defined benefit plan and S-Corp:
- You can combine with an existing 401k
Remember that you can combine a defined benefit plan with a 401k plan. Your employee deferral is not restricted, but you are limited to 6% on the profit sharing portion. Probably 90% of our plans are combined with 401ks as this is the preferred retirement structure.
- Determine your marginal tax bracket
Your S-Corp will save you employment taxes, but it won’t help you with your income tax. Determine your federal and state tax bracket and make sure that your contribution makes sense in light of your tax rate. Federal and state rates often change, so make sure you use current applicable tax brackets.
- Verify annual compensation
Defined benefit plan contributions are based on W2 compensation and NOT on on flow through profits on the K1. This is a common misconception. Compensation should be reviewed with your CPA to make sure it is reasonable. While you can have an S-Corp loss, you could have basis limitations that would limit deductibility.
- SEP plans cannot normally be combined
You can combine a SEP and a defined benefit plan. But only if the SEP is non-prototype. In reality, this won’t work with most SEPs. So don’t fund your SEP until you determine is a defined benefit plan is right for you. People often find that they fund their SEP first and then must do an error correction to get the funds distributed out.
- Don’t forget plan permanency
Remember that the IRS deems these plans as permanent. So make sure that you want to have the plan for at least a few years. Once you terminate the plan you can roll the funds over into an IRA or another qualified plan.
|Creative Plan Structure ✅||IRS Requires Permanency|
|Tax Deductible Contributions ✅||Conservative Investment Profile|
|Contributions Often $300k+||Expensive to Administer|
|Funding Range = min/target/max||Requires Careful Planning|
How is an S-Corporation Taxed?
An S corporation, also known as a “pass-through” entity, is not subject to federal income tax at the corporate level. Instead, the S corporation’s income, deductions, and credits are passed directly through to the shareholders, who report their share of these items on their individual income tax returns.
The S corporation itself files an annual tax return on Form 1120S to report its income, deductions, and credits, but this return is primarily informational and does not result in the payment of federal income tax.
Instead, the S corporation provides each shareholder with a Schedule K-1, which shows the shareholder’s share of the S corporation’s income, deductions, and credits. The shareholder then uses the information on the Schedule K-1 to prepare and file their individual income tax return.
It’s important to note that S corporations may be subject to certain state and local taxes, such as state income taxes and franchise taxes, so it’s essential for S corporations to understand and comply with all related federal and state tax laws and regulations.
You know by now that defined benefit plans are very complex. In addition, they are more expensive to establish, annual administration is more complex, and employees typically have a tougher time understanding them. But an S-corp defined benefit plan can be an excellent structure in the right situation.
The key to establishing reasonable compensation is determining what the shareholder-employee did for the S corporation. So if he or she walked away from the business, what would they need to compensate a person to come in and perform their job. This ideally would meet the criteria based on labor market conditions.