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I've got a small business (LLC, taxes as a partnership) with $700,000 of revenue and $500,000 of profit.

Company is a husband and wife combo (consultancy), with consultants for other expenses.

I've been thinking about moving over to S-Corp status and paying a steady salary to try to decrease overall tax burden.

I did a simulation in Excel for the S-Corp including payroll taxes on reasonable salaries plus capital gains on the excess distriubtions, and I came out with almost the exact same number keeping our LLC taxed as a partnership.

It's the QBI deduction that is helping us beat the S-Corp with reasonable salary approach. (Yes, if we paid ourselves $20,000 a year in salary the S-Corp would win, but I don't want to get audited, I'm keeping to the 40/60 rule).

Is anyone a tax professional whose run this simulation for a client in 2019 and seen similar results?

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For many people, the QBI deduction does make S-Corp less desirable because only the S-Corp profit is subject to the QBI deduction not the wage portion.

From the IRS:

QBI does not include items such as:
...
- Amounts received as reasonable compensation from an S corporation
...

At your income level you're likely in or beyond the phase out range for the QBI deduction, which also means you're likely poised to claim a pretty low salary to distribution ratio. S-Corp seems likely worthwhile for you, but worth consulting with a tax accountant in your region to make sure there are no issues at the state level that would eat away your federal tax savings.

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First, some corrections:

  1. S-Corp distributions are not taxed at all. Instead, S-corp profits are taxed as regular income to their shareholders as a percentage of their ownership. For example, if you and your wife each own 50% of the company, and there is $500K in profit, then each of you would have $250K in additional taxable income on your personal tax returns. (In addition to any other income you have from other jobs, interest income, capital gains, etc.) Note you pay income tax on the profits whether you take distributions or not. In your case, your tax rate on the S-Corp income will probably be higher than what you calculated for capital gains.
  2. The QBI deduction applies to S-Corps too, so there shouldn't be any advantage to the Partnership tax election due to this. Unfortunately though, it probably doesn't even apply to you since the QBI phases out once your combined income is over $415K, and it appears yours is at least $500K.

A note regarding the S-Corp salary to distribution ratio:

  • The 40/60 rule (or more commonly 50/50 or 60/40) doesn't really scale. For example, if your S-Corp profit is $200K before you pay yourself, and if it would be reasonable to pay yourself $100K salary to do your job, then you can distribute the rest if you wish (which might be $85K left after FICA). But if $100K is a reasonable salary when you make $200K, it doesn't suddenly become unreasonable if your profit is $1M. In that case you should still be able to pay yourself $100K and distribute the rest (perhaps $885K) without any additional worry of an audit. Furthermore, the main tax benefit of the S-Corp is the ability to reduce FICA taxes. If you salary yourself at the SS wage base (currently $132,900), medicare tax is the only burden beyond that, meaning a failed audit that reclassifies more of your income as salary can only "cost" you about 3% (or 3.8% for the additional medicare tax beyond $200K in salary). The reality is that documented S-Corp audits with salary reclassification are those with blatant lowball amounts, like $0 which still many people keep trying! Some accountants believe that if you salary yourself at the SS wage base you'll likely never be challenged.

My take:

  • Given that the tax rate on company profits will be your personal income tax rate for both a Partnership and S-Corp, and that the QBI deduction either applies to both or doesn't apply at all, the main variable I can think of is FICA taxes. I would guess that the S-Corp tax election will come out slightly ahead as long as you and your wife take a combined salary of less than the full profit amount. For example, if you both took a salary of $125K, you'd end up saving about 3.8% in medicare on the remaining $250K, or about $9500. That should be more than enough to cover any extra overhead costs associated with the S-Corp election, such as additional accounting fees.
  • interesting, I thought on the S-Corp you paid capital gains on the distributions? For the QBI, we're trying to some pretty aggressive retirement contributions to try to sneak under the threshold to trigger the QBI deduction. I can see a whole cottage industry of "tax planning" services now to try to get your income under QBI. If you are small enough like us, all of a sudden you want to lease everything and max out your 401k contributions like never before. It's bizarre -- I am not a trump fan, but the QBI really is a huge tax cut for small business owners. – Leroy105 Sep 28 at 14:55
  • @Leroy105 again, distributions are not taxed under normal circumstances. If you take distributions over your basis (if you take out loans to pay distributions and go into debt), then the distributions would be taxed as long term capital gains, but I hope you would never need to do that. – TTT Sep 28 at 18:25
  • Someone didn't like this answer, and posted a comment which I only saw part of before the comment disappeared. It was something about questioning my claim that FICA taxes are the main variable. The reason is that with an LLC taxed as a Partnership, you pay FICA taxes (Self Employment Tax) on all profits the company makes. Taxed as an S-Corp, you only pay FICA on the amount you choose to salary yourself. You save on the FICA taxes on the remainder of your income. (With either you still pay fed and possibly state income tax on all of the income, regardless of if you take distributions for it.) – TTT Sep 30 at 16:07
  • @TTT Sorry for the disappearing comment, wanted to edit it but was past the time. Your phrasing is odd because you said "S-Corp distributions are not taxed at all" followed by talking about how profits are taxed, but then later mention salary to distribution ratios that are acceptable. Since profits are distributed, that wording makes the answer feel wrong, but re-reading I understand the intent. Similarly QBI deduction is not treated the same since for an S-Corp it's only the profits that qualify not the wage income. – Hart CO Sep 30 at 16:18
  • @TTT Otherwise, good points about the ratio not scaling linearly and FICA tax savings, and the QBI deduction potentially being irrelevant. After my re-read I tried to remove my downvote, but I still think the wording could be edited for clarity (and an edit will let me swap my vote). – Hart CO Sep 30 at 16:19

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