Consider this Before You Give Yourself a Raise!Chia-Li Chien, Ph.D., CFP®, PMP®, CPBC
Chia-Li Chien, PhD, CFP®, PMP® Feb. 25, 2018
Figure 1. Types of U.S. Business Entities. Based on the number of returns, total receipts, business receipts, net income (less deficit), net income, and deficit by a form of business for tax years 1980-2013 (IRS, 2017a).
The recent tax reform bill passed into law on December 22, 2017. This tax reform was “the most significant tax change in the United States in more than 30 years,” according to Matthew Frankel from The Motley Fool (Frankel, 2017). There is a list of clear winners and losers from the recent tax reform. According to a recent webinar (The American College of Financial Services, 2018), the potential winners include C corporations that are taxed at the new flat tax rate of 21% and, more specifically, real estate related corporations.
Based on the number of tax returns filed in 2013, there were 33,423,187 business entities in the U.S. (IRS, 2017a). Figure 1 illustrates that only 5% of them are C corporations that can benefit from the new flat corporate tax rate of 21%. The remaining 95% of business entities may benefit from the new 20% deduction for certain pass-through business income.
A pass-through entity does not pay entity tax like C corporations do, rather, paying at the personal income tax level. Jeffrey Levine illustrated how this 20% deduction worked in his recent article (Levine, 2018). Take, for example, a sole proprietor who reported Schedule C income in his or her 1040 personal tax return. If the net income from the Schedule is $50,000, the 20% deduction applied to the Schedule C net income resulted in taxable income of $40,000. However, if the pass-through entity issues the owner a salary in an S corporation or a member guarantee payment in an LLC, the compensation needs to be added back into net income before taking the 20% deduction.
The majority of my business-owner clients don’t pay themselves much. They want to make sure they reinvest in their businesses to continue to grow equity value. Many of my clients are asking if they should give themselves a raise due to this 20% deduction incentive on the personal tax level.
Let’s walk through a case study to see if there is an incentive to give the owner(s) or yourself a raise with this 20% deduction incentive on personal tax. Figure 2 illustrates a husband and wife, each of whom owns 50% of either an LLC or S corporation business entity. This married filed jointly (MFJ) couples are below the income threshold (taxable income between $315k and $415k) from Section 199A. The line indicates that the net income of the entity in 2018 is estimated at $100,000. There are three salary scenarios: column x illustrates no salary changes; column y illustrates a decrease in salaries, and column z shows an increase in salaries. Lines b and c show the salaries of the husband and wife respectively.
Line i illustrates that the higher salaries (column z) resulted in higher adjusted gross income (AGI) on the form 1040 personal tax return. The lower salaries (columns x and y) resulted in lower AGI if the entity net income (line a) remains constant. Therefore, before you give yourself a raise at your own business, perhaps there are other options to consider such as retirement contributions.
For retirement or qualified plans sponsored by the employer, the employee and employer’s contributions are considered pretax and are reported on the year-end W-2. In other words, they reduce the overall salary or guarantee payments from the entity. There are many options for retirement plans available to all the business entities in the U.S. The employer-sponsored plans include 401(k), self-employed 401(k), Simple IRA and SEP IRA. Table 1 below compares different plan contribution limits.
|Qualified Plan||401(k)||Traditional IRA||Self-Employed 401(k)||Simple IRA||SEP IRA|
|Employee contribution limit||$18,500||$5,500||$18,500||$12,500||N/A|
|Catch-up contribution limit for individuals aged 50||$6,000||$1,000||$6,000||$3,000||N/A|
|Employer’s contribution||Up to 25% of compensation up to a maximum of $55,000.||N/A||Up to 25% of compensation up to a maximum of $55,000.||Either match employee contributions up to 3% of compensation (can be reduced to 1% in any two out of five years) or contribute 2% of each employee’s compensation, up to $5,500||Up to 25% of compensation up to a maximum of $55,000|
|Total employer or employee contributions limit||$55,000||N/A||$55,000||N/A||$55,000|
Let’s use the same ownership, entity net income, and salary figures as illustrated in Figure 2 column x, but instead of raising or lowering salary amounts, dollars will be applied to hypothetical retirement accounts. Assume there are no employees in the entity, and both husband and wife are younger than age 50. Figure 3 column y1 shows us the entity-sponsored SEP IRA and column z1 demonstrates the entity-sponsored Simple IRA. The corporate net income on line a1 in columns y1 and z1 are reduced based on the employer’s contribution to the qualified plan from lines l and m for the respective plans. The salary lines b1 and c1 are reduced due to the employee’s self-contributions assuming both husband and wife maximize the employee contribution as shown in lines p and r.
Figure 3 illustrates that column z1 Simple IRA provides the lowest AGI (line i1) for this couple when the entity contributes on behalf of the couple. With a SEP IRA, the couple resulted in 12.02% lower AGI than no qualified plan option (column x1). The highest AGI occurs when no contributions are made to a retirement plan through the entity or through traditional IRA contributions.
The conclusion is that before you consider giving yourself a raise through your business entity, consider taking advantage of the retirement savings either through entity contribution or self-contribution. Please note, there is a phase-out limit on AGI as well as salary amount when considering an employer-sponsored retirement plan. Further, many business owners have employees. The SEP IRA or Simple IRA may not make much sense if you don’t want the business to contribute on behalf of other employees. The best practice is to consult with your tax advisor and a Certified Financial Planner (CFP) for favorable solutions.
Frankel, M. (2017, Dec 29). Your Complete Guide to the 2018 Tax Changes. Retrieved from The Motley Fool: https://www.fool.com/taxes/2017/12/29/your-complete-guide-to-the-2018-tax-changes.aspx?source=isesitlnk0000001&mrr=1.00
IRS. (2017a, Nov 20). SOI Tax Stats – Integrated Business Data Tax Year 1980-2013. Retrieved from IRS Tax Stats: https://www.irs.gov/statistics/soi-tax-stats-integrated-business-data
IRS. (2017b, Dec.). 26 CFR 601.602: Tax forms and instructions. Retrieved from IRS: https://www.irs.gov/pub/irs-drop/rp-17-58.pdf
IRS. (2017c, Oct 19). IRS Announces 2018 Pension Plan Limitations; 401(k) Contribution Limit Increases to $18,500 for 2018. Retrieved from IRS IR-2017-177: https://www.irs.gov/newsroom/irs-announces-2018-pension-plan-limitations-401k-contribution-limit-increases-to-18500-for-2018
Levine, J. (2018, Jan. 17). The New 20% Pass-Through Tax Deduction: An Advisor’s Guide. Retrieved from ThinkAdvisor: http://www.thinkadvisor.com/2018/01/17/the-new-20-pass-through-tax-deduction-an-advisors
TaxAct ®. (2018). Self Employment Tax Calculator. Retrieved from TaxAct ®: https://www.taxact.com/tools/self-employed-calculator#
The American College of Financial Services. (2018, Feb 6). Understanding Tax Reform’s Impact on Financial Services in 2018 and Beyond. Retrieved from The American College of Financial Services: https://www.webcaster4.com/Webcast/Page/108/24257