Partnerships and S-Corporations | Like Oil and Water, they don’t Mix

I make it a goal with every client to make his or her entity structure as simple as possible. However, there are times when a little bit of structural complexity pays huge dividends on a tax return.

If you are reading this article, you are probably already familiar with the S-Corp strategy for self-employment tax savings, but I will summarize it here:

A small business owner has several taxes to navigate through in their business. Sales tax, property tax, franchise tax, state and federal income tax, and not least of all – the self-employment tax. While there are several strategies for lowering the other taxes on this list, the S-Corp focuses on saving self-employment tax.

So what is the self-employment tax?

Also known as FICA, the self-employment tax (SE tax) is a combination of Social Security and Medicare taxes. The combination of these two taxes equals a whopping 15.3% of the first $137,700 of a self-employed individual’s taxable income, then 2.9% of any taxable income over that amount and below the additional Medicare Threshold, which is $200,000 for single filers, and $250,000 for married filers in 2020 (92.35% of all net self-employment income is taxable at these rates).

How does the S-Corp help reduce self-employment taxes?

The S-Corp reduces SE tax by reducing the amount of SE taxable income. In an LLC, partnership or sole proprietorship, business owners calculate SE tax as a percentage of net income. In an S-Corp, business owners are able to bifurcate their income into two pieces, salary and dividends, and only pay SE tax on the amount they pay themselves in salary; effectively cutting their SE tax by more than half in most situation.

It is helpful to run the math on this, although I will be estimating and simplifying the math to keep it simple. Take a taxpayer running a small consulting business earning $100,000 in net SE taxable income. If this taxpayer is not in an S-Corp, she will pay 15.3% on all of the $100,000, or an estimated $15,000 in SE tax. If this taxpayer set up an S-Corp and did the same amount of business with a net income of $100,000, we would likely advise her to set a salary of around $40,000 and to pay the rest to herself as dividends or owner distributions. After filing the S-election, this business owner will only pay the 15.3% tax on the $40,000 salary, or approximately $6,000. This is a possible savings of to $9,000 in SE tax! That would make a huge difference to this taxpayer as we likely just increased the bottom line (after taxes) by over 10%.

S-Corps are great for individuals and work similarly for partnerships to save SE taxes, so why would I not recommend my clients to partner together in an S-Corp?

The short answer… the S-Corp partnership acts like a pair of handcuffs when it comes to tax strategy.

In an S-Corp, any deductions for business vehicles, home office, healthcare, etc. are all taken on IRS form 1120-S. This means that you and your partner have to agree on every tax strategy you want to implement. This would be OK, if both partners are the same age, with the same family situation, the same taste in vehicles, are in similar health condition, and have similar feelings about reasonable salaries.

Even if this is true at the date of inception, what is the likelihood of that being the case over the entire course of a partnership? What happens when one partner wants to buy a new GMC Duramax 1-ton for $80,000 and write it off in the business and the other wants to keep driving a 2010 Prius? What if one partner or his/her family develops health issues they want to deduct in the S-Corp?

Additionally, S-Corps can only issue one type of shares and are required to share profits in accordance with the ownership shares. This means that if one partner works more in the business and both partners agree that partner deserves more pay, the only way to do that is with additional W-2 income, which will increase that partner’s SE tax. Again, the partners may be putting in equal work in the beginning, but again what if something changes? What if one partner develops health issues and can’t work? What if one partner wants to phase out of the company and work less, but still wants to have the same voting shares?

In all these situations, the owners sacrifice tax strategy for simplicity. Sometimes a little complexity can save us thousands in taxes.

If you are in a partnership taxed as an S-Corp, a somewhat simple change could save you thousands year after year.

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