LLC Partnership vs. S-Corp In 2019 With Qualified Business Income Deduction

Question

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?

Answer 1

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.

Answer 2

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.