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Scenario: In the United States. Software Developer who performs consulting for other businesses. Paid an hourly rate of $150 per hour for full time work (1860 hours). Additionally, the software developer creates software products, and lets say, on average sells $400,000 in company created software tools and products in the calendar year.

Does it make sense to create an S-Corp and set the reasonable salary at the $150*1860 rate, and then be able to take the $400k in software sales as a distribution?

Is there any way to keep some of the money in the business to allow, for example, to hire additional software developers for internal R&D, or to make up for years where there is no software product sales, or the consulting hours are significantly cut?

Thanks

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  • The S-corp salary should probably be 60% of corporate profit. To retain investment, the S-corp distribution would simply be less than the dividend but taxes are due on the dividend amount. Otherwise, new paid-in-capital can go into the company at any time. Some sources say that a single-shareholder S-corp could be considered to be a disregarded entity while others claim the advantage of converting a single-member LLC to S-corp. The owner of a disregarded entity receives self-employment income only.
    – S Spring
    Commented Nov 27, 2022 at 4:05

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Does it make sense to create an S-Corp and set the reasonable salary at the $150*1860 rate, and then be able to take the $400k in software sales as a distribution?

How is it reasonable? You'll need to explain that to the IRS if audited. There's no clear rule on what "reasonable" is, obviously, but did the software that the owner sold for $400K come out of thin air? Based on your salary definition, the owner either didn't spend any time on writing it, or he had someone else do it, or the company doesn't pay him for his work (which makes the salary unreasonable).

You would probably want to talk to EA/CPA licensed in your State who has experience working with software consulting businesses. Ask for a professional advice, if you want to shield $400K from payroll taxes you most definitely can afford that.

Is there any way to keep some of the money in the business to allow, for example, to hire additional software developers for internal R&D, or to make up for years where there is no software product sales, or the consulting hours are significantly cut?

Absolutely, but it would still be taxed.

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  • In this case, the software was developed before formation of the LLC in "free time" - only modifications and customization would be billed hourly.
    – Derek
    Commented Nov 27, 2022 at 22:36
  • Also, I have been working with a CPA, but I am unsure of his experience with consulting businesses that sell products, so I am trying to educate a little to be able to ask the right questions of him.
    – Derek
    Commented Nov 27, 2022 at 22:41
  • @Derek The general rule of thumb is that organization doesn't matter for taxation. LLC/SCorp is a pass-through entity and doesn't change the characteristics of the income. The "earned" vs "distribution" in S-Corp is usually due to having employees, outsourcing some of the actual earning, or charging excessive hourly rates due to your goodwill. $150/hr for a software consultant is not an an excessively high rate. The $400k income, however, is strange and would require some explaining....
    – littleadv
    Commented Nov 27, 2022 at 23:56
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    ... It may be that it's actually licensing income and not earned income, and in that case it is perfectly fine to take it out as distributions. It then wouldn't be earned income on Schedule C as well. You may even have basis in your SCorp due to contribution of assets (the existing software). But that's what CPAs are for, you won't get a better advice here from us amateurs than from someone whose livelihood depends on knowing this. If you don't trust your CPA - find the one you trust.
    – littleadv
    Commented Nov 27, 2022 at 23:57
  • The money you save/protect by getting expert advice tailored to your specific case is likely to be greater than the cost of that advice, for numbers in that range. I tend to agree that Derek can't afford not to hire a pro at least long enough to get the process set up correctly.
    – keshlam
    Commented Dec 27, 2022 at 7:53

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