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Solo 401(k) Contributions for Sole Propietorship Owners and LLC Owners

We recently published an article about Solo 401(k) contribution rules and deadlines for S-Corporation Owners. That article can be found here. But what about a situation where the business that adopts the solo 401(k) is not taxed as an s-corporation? What if the business is taxed as a sole proprietorship (e.g., a single-member LLC) or a partnership, as is the case with most LLC’s? Does that change anything? According to the IRS, the answer is yes.

DO SOLO 401(k) CONTRIBUTION LIMITS DIFFER IF THE BUSINESS IS TAXED AS A SOLE PROPRIETORSHIP OR PARTNERSHIP?

In our prior article written by KKOS Partner Mat Sorensen there was an illustration of a business owner named Sally who owns an s-corporation and that article outlined what solo 401 contributions would look like for her based on net income of $120,000. For purposes of this article, we’ll call her “S-Corp Sally”. In order to highlight the differences in solo 401(k) contributions between an s-corporation versus a partnership or sole proprietorship, here’s an example of what solo 401(k) contributions would look like for a partnership or sole proprietorship using the same net income figures as Mat’s example with the s-corporation.

ILLUSTRATIVE EXAMPLE: “SOLE PROP SUSAN”

Susan, age 46, is a technology consultant who owns an LLC that has adopted a solo 401(k) in December 2015. She is the only owner/member of the LLC and since she has not elected to have her LLC taxed as an s-corporation, by default her business is taxed as a sole proprietorship. We’ll call her “Sole Prop Susan”. She has $120,000 in net income for the year, just like S-Corp Sally. All of Sole Prop Susan’s net income will be reported on Schedule C of her personal tax form 1040, i.e., no wage income / no W-2. If she decided to take the maximum allowable contribution based on her net income, it would look like this.

Employee Contributions (Elective Deferral) – The 2015 maximum employee contribution for Sole Prop Susan is $18,000. Since she has net income in excess of $18,000, she can contribute the maximum employee contribution of $18,000. This employee contribution amount will be combined with her employer contribution and reported on line 28 of her tax form 1040.
Employer Contributions – Calculating the maximum employer contribution for Sole Prop Susan is not as simple as with S-Corp Sally. S-Corp Sally’s employer contribution was computed by taking 25% of her wage/salary to arrive at the amount of her employer contribution. With Sole Prop Susan, there is a more involved computation to arrive at her employer contribution. A step-by-step calculation can be found in IRS Publication 560. In short, the IRS reduces net income by the deductible portion of her self-employment tax and also reduces the maximum percentage from 25% to 20%. There are about 20 additional steps or calculations that must be performed according to the worksheet provided in Publication 560 but basically, if Sole Prop Susan elected to make an employee contribution of $18,000 then her employer contribution would be limited to $22,200 because her overall contribution from both employer and employee contributions would be $40,200.
In the end, Sole Prop Susan would have contributed and saved $40,200 for retirement and reported it on line 28 of her tax form 1040. This is an above the line tax deduction. Not bad. If she were in a 20% tax bracket and a 5% bracket for state taxes that saves her approximately $10,000 in federal and state taxes.
Note: If Susan were in an entity taxed as a partnership rather than a sole proprietorship, and the net income allocable to her from the partnership on Schedule K-1 was $120,000 then the contribution amounts above would remain the same and she would still end up with a maximum contribution limit of $40,200.

WHY THE LARGER SOLO 401(K) CONTRIBUTION LIMIT FOR SOLE PROP SUSAN?

You may notice that Sole Prop Susan was able to make a larger solo 401(k) contribution than S-Corp Sally even though their net income was exactly the same. S-Corp Sally’s maximum contribution amount was $30,500. The difference was that S-Corp Sally took a wage/salary that was less than her net income, e.g. $70,000. Sole Prop Susan had to pay self-employment taxes on all $120,000 whereas S-Corp Sally did not. As an s-corporation owner, there are competing interests to pay the least amount self-employment tax as possible with making the maximum 401(k) contribution – by taking the smallest salary/wage possible (so long as it is reasonable), this reduces your self-employment tax liability but it also limits your solo 401(k) contribution, as was the case with S-Corp Sally. The IRS gets you coming or going.

IS ANYTHING ELSE DIFFERENT BETWEEN AN S-CORP SOLO 401(k) AND A PARTNERSHIP/SOLE PROP 401(K)?

Everything else about the solo 401(k) that is adopted by an s-corporation is the same as a solo 401(k) that is adopted by a sole proprietorship/partnership. First, the deadline to adopt the solo 401(k) and have contributions count towards 2015 is still December 31, 2015 regardless of how your business is taxed. Second, the total overall annual contribution limit is $53,000 in 2015 or $59,000 if you are age 50 or older. Finally, both employee and employer contributions can be made up to the company’s tax return deadline INCLUDING extensions. The only difference is that with a “sole proprietorship/partnership Solo 401(k)”, you don’t have the W-2 deadline.

In sum, when it comes to solo 401(k) contributions, all else being equal, how your company is taxed may affect the maximum 401(k) contribution you can make. Either way, the solo 401(k) contribution limits are very robust, especially compared to an IRA. Contact our office to find out more about setting up a solo 401(k) plan for your business.

By Kevin Kennedy, Associate Attorney at the Phoenix, Arizona office of Kyler Kohler Ostermiller, and Sorensen, LLP (“KKOS Lawyers”).