Changing Sole Proprietor to S-corp

[vp230]

I am thinking of changing my business from a Sole Proprietor to S-Corp but having second thoughts if I really should do this and hopefully the feedback from this forum will help me. My reason for staying as an Sole Proprietor is I think I will be exiting the business in the next 2-3 years and my business is slowing down. I have ample liability insurance and solely looking to change business format for tax savings especially the 2.9% Medicare tax that is applied to earnings over $110,100. I also believe there is 0.9% Medicare payroll tax on wages & self employment income above $250K. Can someone confirm this?

Here is some info you'll need about my situation.

I have been in business for the past 15 years as Sole Proprietor. The business is operated by myself with no other employees. The business sells test equipment for the scientific industry. I purchase the test equipment from the manufacturer and resell the product.

Total gross receipts $2.1M, gross income $530K. I have a DBP and Solo401K qualified plan that lets me contribute $223K and $49K respectively. After additional expenses the net profit is $240K.

S-Corp allows any profits flow through on a K1. Changing to a S-Corp requires me to get workman's comp and pay SUTA, FUTA which I don't need as a sole proprietor. Plus the corporate filings and extra tax filing for the S-Corp.

Since the business is just one person I'll need to assign a reasonable salary for a comparable position, not compared to business income. I think I'll contacting the Bureau of Labor Statistics for Massachusetts to help come up with a market salary for my position and then tack 10% on top of that.

My accountant said with S-Corp I'll have a low salary, probably 50-100K, so I will lose my large DBP contribution. To max the contribution for the DBP and Solo401K I need an income of $240K.

Having a salary of $100K and my DBP and Solo401K contribution will be much smaller so I am unable to defer the profits to qualified plan, thus paying more federal and state taxes today verses when I retire.

I expect to close down my business in the next 3 years. My business is more and more competitive, demand is shrinking and my sales and margins are falling every month. I would guess I'll the business would generate a profit of $350K in 2013, $250K in 2014 and $100K in 2015. When I do close my doors in 2015 I really don't expect to sell my business since the business is basically my hard work. There is no real estate or manufacturing equipment connected to the business. I rent business space, buy a widget from the manufacturer and then resell the widget to the end user.

Is it really worth changing to the S-Corp? I only see taxes going up so I feel changing to the S-Corp is the right decision and I probably should of done it 5 years ago. I just hate all the extra work changing all my accounts with vendors, merchant accounts, liability insurance policy and workers comp. Plus being an S-Corp is more prone to an audit which will only cost me more money for my accountant to represent me. Since the business is just one person I always need to worry about the IRS questioning what is reasonable salary. It seems the government is always trying to make earnings from the S-Corp also subject to SE tax which would effectively make no tax difference if I am a sole proprietary verses S-Corp if tax law ever changes.

Thanks for your thoughts and if you can give pros and cons it would be extremely helpful.

[Business Attorney]

Your analysis is very good. You've discussed all of the significant pros and cons. The one thing you have not done is to convert the pros and cons to real numbers. If you are cutting your contributions to your defined benefit plan, you are essentially increasing your taxes today and in the future (since you will not be able to reinvest your income tax free). Most retirees also benefit from moving income from their high earning years to lower earning years post retirement, but if you have substantial retirement assets and are nearing age 70 1/2, those benefits may not be that great for you. Also, if you expect tax rates to go up on whatever bracket you are in, the deferral may end up actually moving the income into a higher tax rate.

The only way to really tell whether the change is worth making is to run the numbers with a few different assumptions. Even if we knew what you were going to set your "reasonable compensation" at, since we don't know at what age you are retiring or the size of your distributions from your retirement plans, we can't possibly tell you whether it is worth making the switch. I suspect that you'll find that the numbers are not really enough to justify the trouble for the next three years, but the numbers will tell the story.

[vp230]

As of today I am a Sole Proprietor(SP) and it is a nice simple business format, no workers comp, no payroll with all the deductions (SUTA, FUTA), profits from the business just get entered on the 1040. DBP and Solo401K are a nice vehicle to defer income plus one is investing pre taxed dollars resulting in greater compounding yield.

Downfall is all remaining profits are subject to SE and the 2.9% Medicare tax.

So I'll make some forecasts for 2013 business profits saying the business generates say $400K. I'll be more conservative on the maximum DBP since this is depend upon the actuary calculation based on asset value as of December 31 and time until retirement. The Solo 401K contribution is not dependent upon NAV.

As an SP with $400K I can sock away $150K in DBP and $49K and Solo401K. So that results in $201K subject to SE tax and 2.9% Medicare.
If I use 2012 Social Security tax rates for calculation - 10.4% on your first $110,100 of wages and Medicare 2.9% on all your wages
Social Security: $11,450
Medicare: 5,383
Federal Tax on $201K is about $50,858
Massachusetts 5.3% Income Tax on $201K is $10,653
Total taxes paid $78344
----------------
Now if I am an S-Corp and I use 100K for reasonable compensation
The $400K becomes $100K salary and $300K distributions. Since wages are only 100K I'll assume the most I can sock away for the DBP is $30K and for Solo401K $20K.
So SE tax on $100K is
Social Security: $ 9,604
Medicare: 2,678
But now I am paying Fed & State tax on $350K
Federal Tax on $350K is about $100,028
Massachusetts 5.3% Income Tax on $350K is $18,550
Total taxes $130860

So it is hard to say since there are many variables. When I pay SE tax part of this is deducted from the Schedule A. If I stay SP then I have a higher salary resulting in a larger contribution to the DPB and the payout at 59 yrs old.

My tax bracket is always going to be the top tax bracket since I also have a lot of investment income.

Again going with the S-Corp I am always afraid the IRS can look at my past 10 years of tax returns and say you were always a SP and now you change to an S-Corp just to lower your SE tax. They can fight over reasonable compensation. I am don't like a doctor the makes his/her income from seeing patients where a doctor would probably be in trouble trying to run as an S-Corp. Instead I resell product so the profits in not all wages. Still with the government in so much debt and all the IRS agents being hired for Obama Care I say is it really worth it. For whatever I save as an S-Corp I am sure my accountant will charge me $3K-$4K to represent me in an audit plus all my time gathering papers. I am saying to myself just forget the hassles and pay the extra taxes the government wins.

[Evan]

First, I think David provided some excellent advice. In addition, you do seem quite knowledgable about your numbers, so I commend you for that.

Right now, you're saying your net profit is $240K after all of the extra "perks" you get, most of which is subject to SE tax. In 2013, under the new rules (whether you agree with them or not), a salary or SE earnings over $250K (if married filing jointly) or $200K (if single) are subjected to the extra 0.9% medicare tax. In my opinion, that is all peanuts in comparison to what you could be losing.

But as an S-Corp, it sounds like you're going to lose a significant portion of your DBP, which quite frankly is going to benefit you significantly for retirement in addition to the 401k. If you lost a lot of that, the amount of money you'll be paying in income tax will go up. In addition, on your salary, as you noted, you will be paying FUTA and SUTA, which are quite significant expenses. In MA, look to pay approximately 3-4% of SUTA, and about 0.6% to FUTA. I don't know the latest status, but last year MA didn't have a FUTA credit reduction, meaning they didn't borrow from the federal government to pay unemployment at their state level like neighboring CT and RI did. If they had, it reduced nearly all of the FUTA credit and businesses were paying upwards to the 6% on at least 7K of wages. MA unemployment taxes have a much higher "base" which they're applied to, not just 7K. Additionally, the cost of selecting a payroll provider and dealing with payroll isn't always inexpensive (and sure, you can get it relatively "cheap"), but when you start tacking it on, why bother paying for it at all when what you're doing is working well?

Considering you only have a few years you plan to have this business continuing, I don't think it'll be worth the expense of setting up this entity, nor do I think it'll give you a tax benefit. If a legal protection was a concern, an LLC would be fine, but you seem focused on this solely for tax, so that's not a significant concern.

[vp230]

Thanks to both Mr. Tax Man and David

In regards to your comments on "$200K (if single) are subjected to the extra 0.9% medicare tax."

So when the AGI is over $200K the 0.9% Medicare surtax kicks in. So first question is the surtax applied to only those earnings over $200K. Example 210K only the 10K has the 0.9% surtax while the $200K has no surtax, correct? So to any business income reported on line 12 of the 1040 as a Sole Proprietor and I assume if an S-Corp the K1 is reported on line 9a as a non qualified dividend would be hit with the 0.9% Medicare surtax, correct.

From what I read even if Obama Care is repealed this Medicare surtax stays.

Therefore staying as a Sole Proprietor I can sock more money away in my DBP verses if I was an S-Corp. Making me think staying as a Sole Proprietor is the smart way especially when my business is falling apart fast and I plan to shutdown in the next 3 years.

[Evan]

The tax is only on the difference (so $10K if you earned $210K, assuming single).

You wouldn't experience that with an S-Corp's pass-through income, as you are actively earning it. So if you had taken wages of $100K, and had pass through of $300K, you wouldn't be subjected to any additional Medicare tax.

I'm not certain, but I do believe that the Medicare supplemental tax was part of the Affordable Healthcare Act. But don't buy much of the political hype about it being repealed without a substitute right behind it. Congress wouldn't likely "repeal" it, they'd just try to amend it significantly, and just tout it as being a "repeal" of it.

Being a bit more conservative, I'd plan for that provision to remain in place even if the political landscape changes. It is unlikely Congress would consider it until well into next year.

[Evan]

You're combining two supplemental taxes under the Affordable Care Act.

There is a 0.9% supplement on Medicare for salary/wages. This would have an influence on the self-employment tax rate, and this is what we talked about above.

You're now mentioning the 3.8% medicare surtax on interest, dividends, and from passive pass-through entities (e.g. an investor in a limited partnership, an investor in an S-Corp who does not materially participate). If you had $900K from a W-2, let's say... the amount over $200K would have been subject to the 0.9%. But let's say you also had dividends and interest of $320K as well. As you're already over $200K of wages, all $320K of your investment income would be subject to the 3.8% tax. If your wages were $100K, then $220K [$200K threshold, less wages of $100K, less investment income of $320K] would be subject to 3.8%.

Hope that "makes" sense. But don't confuse both of them, as they're both separate and affect different things.

[Evan]

There isn't any ambiguity.

Self-employment tax is a combination of social security and Medicare, and you will be paying the 0.9% surcharge if your self-employment income is > $200K.

The 3.8% relates SOLELY to INVESTMENT Income (e.g. dividends, capital gains, income from pass-through entities).

You're refering to an article which is referring solely to the second thing. Just because the 3.8% tax doesn't apply because it isn't investment income doesn't mean the other one won't because you are actively earning it.