The COVID pandemic and subsequent societal shifts stemming from the lockdowns have caused many people to rethink what work looks like. New business applications rose by about 47% from 2019 to 2022 compared with the previous four years, and more than 5 million new businesses have been created in the last year. People are venturing out on their own.
Being able to give expert advice to small business owners and “solopreneurs” is vital for a healthy financial advisory practice. These clients need guidance in different areas than the about-to-retire baby boomers that claim so much of our industry’s attention.
Choosing the best entity for a business
Most small businesses are solo operations, meaning it’s just the owner with no employees. Although it’s the simplest form of business, it offers an array of financial planning opportunities. Deciding how to legally form a one-employee business can have a big impact on the financial and tax planning options available to the business owner. The two most used one-person business entity types are sole proprietor and single member LLC.
Earnings from both sole proprietor and single member LLC business are paid to the owner’s Social Security number and she is responsible for the full amount of self-employment taxes as well as federal and state income taxes.
LLC lowdown
An LLC is a legal entity separate from the owner. Registered with and regulated in a particular state, it has a unique federal employer identification number and can shield the owner from certain legal liabilities. For tax purposes, an LLC is considered a “pass-through entity,” meaning its net income flows to the owner and is taxed just like a sole proprietor.
Forming an LLC comes with extra costs and layers of complexity. Forming and filing an LLC in any state brings up-front legal fees. Many states also require annual informational filings.
Since none of this is required for sole proprietors, many new businesses start and remain as sole props for too long. However, because income from a single member LLC is taxed the same as a sole prop, there is no financial reason to remain a sole prop. The added liability protections afforded by LLCs make the upfront costs of formation well worth it, even for the newest or smallest of businesses.
The S-Corp dilemma
Once a one-person business decides to form an LLC, they face another decision — one which can have a big impact on their finances. They can either choose to be taxed as a sole prop, as noted above, or as a sub-chapter S corporation.
An S-Corp is an LLC that elects a tax treatment different than a sole proprietor by filing IRS form 2553. The main difference between an LLC taxed as a sole proprietor and one taxed as an S-Corp is that the owner’s income from an S-Corp will come in two forms: W-2 wages that are subject to the entire amount of payroll taxes, and profit distributions (sometimes called dividends). Profit distributions are not subject to any payroll taxes, but they are taxed as ordinary income.
Electing S-Corp tax status forces the owner to run payroll. An LLC must also file its own tax return, in addition to the owner filing a personal tax return. These requirements add more layers of complexity and tax-prep costs. As such, the decision on when to switch to S-Corp status can be arbitrary. However, many advisors believe business owners should at least consider the switch when annual revenue approaches $100,000.
Let’s consider an example* in which a single business owner earns $240,000 in net income and look at how the business entity she selects can affect her tax situation:
This solopreneur saved nearly $13,000 in taxes by making sure her business-formation decision and the use of a reasonable salary was the correct one for her type of business.
The most effective way to save
Small business owners are on their own in many ways. First, they aren’t getting any “free money” in the form of employer-matching contributions into their retirement accounts. It’s all up to them, so it’s vital that planners help them maximize the amount they can save each year.
The primary kinds of retirement accounts used by solo business owners are the SEP IRA and the individual 401(k), which is also referred to as i401(k), and Solo 401(k).
The downside of SEP IRAs
For decades past, the SEP IRA was dominant — mostly because prior year’s contributions can be made until the tax filing deadline the following year. Tax professionals preparing the returns of business owners would tell them they needed to make SEP IRA contributions to knock down their tax bill, often without an eye toward the client’s overall financial strategy. This is backwards-looking planning.
A more proactive approach
Instead, business owners deserve a proactive approach. This should begin with making annual revenue projections that will inform how much salary to take, the amount of retirement contributions to plan for, the amount of estimated tax payments to expect, etc.
We end each calendar year by walking our solo business owner clients through the projection exercise for the upcoming year, so that they can have, to the extent possible, maximum control over what their financial picture looks like.
SEP IRAs do not accept employee deferrals, only employer contributions, which are capped at 25% of compensation. However, the individual 401(k) does allow the employee — who is also the business owner — to contribute up to the standard 401(k) employee deferral limits. The individual 401(k) also allows the “employer” to make profit sharing contributions of up to 25% of compensation.
Revisiting our business owner
Using our business owner from the previous example, and assuming she chose to be taxed as an S-Corp, let’s look at a scenario* where good planning allows her to maximize her retirement contributions just by choosing the best retirement plan type.
The decision to go with the Individual 401(k) versus the SEP IRA allowed this business owner to nearly double the amount she was able to contribute to her retirement account. The only difference is the type of retirement account she was advised to go with. And if she is age 50 or over, she could make a catchup contribution of $7,500 in 2023, for a maximum retirement contribution of $59,500.
When SEPs make sense
But SEPs aren’t always a bad choice. One scenario where a SEP might make sense is if the business must hire an additional non-spouse employee. As their name states, Solo 401(k)s only work for one employee businesses. If only a spouse is employed, they are able to have their own solo 401(k) under the business. But if additional employees are needed, the lower regulation, cost and reporting requirements of a SEP IRA could make it easier to administer than a regular multi-employee 401(k).
The power of planning
Finally, let’s compare the outcomes for a business owner with no planning help with one who has a great advisor on their team. We’ll assume the sole proprietor from our first example is going it alone. We’ll also assume that the other business owner, who elects an S-Corp and saves in an Individual 401(k), has guidance from an advisor:
These calculations were done using ProSeries® Tax Software and are much more detailed than this article has room for. I’ve highlighted the main points of the comparisons. The taxpayer is assumed to be a single filer under 59 1/2 and, since I live in Florida, no state income taxes are assessed.
With a little guidance, changing nothing but her tax entity formation and adding a Solo 401(k) she was able to save over $26,000 in taxes and put $52,000 into a retirement account. And that’s only one year.
There are literally millions of small business owners who desperately need the guidance of financial planners who understand the intricacies of small business ownership. Let’s be the advisors they need.
DJ Hunt, CFP is a fee-only financial advisor with Moisand Fitzgerald Tamayo, LLC. in Melbourne, Florida. His clients include working professionals, business owners and retirees. DJ can be reached at dj@moisandfitzgerald.com.
