S-Corporation Tax Scenarios

47 Replies

Hi guys, 

I've been trying to understand the tax implications of different entity types. I've developed a really short, brief model of how an S-Corp would be taxed, provided that it is 100% comprised of rental properties. My results came out quite counterintuitive; the higher the income, the lower the effective tax rate is (I assume this is because Social Security Tax becomes more and more insignificant, as it is capped at $128,000 of salary). 

Anyway, I attached the quick model. Not sure how accurate it is, if at all. Could you please take a look and vet it? 

Thanks everyone!

@Lance Lvovsky so I know that rental income itself isn't subject to social security tax, but here the social security tax is applied to the wages (not rental income) that I would pay myself. 

If wages earned are ultimately derived from rental income, I wouldn't be subject to social security? 

Originally posted by @Nur Al Sharif :

I think I have narrowed down my confusion - Is the 20% QBI deduction applied to Net Income, or to Retained Earnings? Nur, 

It is almost never good idea to run your rental activity via S Corp. 

People get S Corp to avoid SE taxes, but rental income is not subject to SE taxes anyway, so no need to get an S-Corp. 

Also even if you would get an s Corp, paying salary would subject Payroll tax on the income that would otherwise wouldn’t be subject to SE tax. SE and payroll tax are similar taxes named differently.

If you don’t have s Corp, then you don’t have to pay salary, the SE tax and payroll taxes are not relevant. 

Also you don’t need S Corp for 20%QBI deduction. The Retained earning has nothing to with tax so. QBI is one of the most complicated stuffs, so don’t tackle it yourself. 

Many other items could affect the calculation of the QBI deduction (other income sources, taxable income at the individual level, filing status etc.). But to assume simplicity for the sake of the model for a single taxpayer I would recommend factoring in the 'wage and capital' factor of the QBI limitation. This could have a large favorable impact on your models output depending on the tangible, depreciable holdings of this "model" S corp (aka rental properties, etc).

As I mentioned before, there are many other factors that could come into play, so in putting this model into practice it would wise to consult a CPA, especially with the many uncertainties surrounding the treatment of these reform items.

One of the major vague items I am curious to see play out is the IRS treatment of the wages used in your model. "Reasonable Compensation" is not a new subject for the IRS in regards to S corps, but it now could possibly be considered for partnerships and LLCs. Additionally, the IRS' view for Reasonable Compensation may now come with a new angle including a ceiling as opposed to just a floor.. Do any of you other CPAs or tax geeks out there have thoughts on this?

@Nur Al Sharif you really don’t want rentals in an S Corp for all the reasons already mentioned, plus if you ever needed to pull a property out of the S Corp and back into your personal name, it would be considered a sale and your S Corp would owe taxes on a property you effectively did not sell. S corps are primarily used in RE for flipping or PM businesses. Respectfully, it seems you are trying to “simplify” VERY complicated tax implications without a fundamental knowledge of the Code. I would consult your tax pro for further guidance.

If all of your income is from rentals, there's probably no benefit to an S Corp or LLC taxed as S Corp. Where the S Corp taxation helps is if you have significant other self-employed income like property management, realtor, consulting, etc. It can save you a ton on self employment taxes. But everyone's scenario is unique and you definitely want to consult a good CPA.

Originally posted by @Nur Al Sharif :

@Ashish Acharya wouldn't paying SE tax (12.8% Social Security, 2.9% medicare) be worth it, due to obtaining 20% QBI deduction at certain income levels? 

 You don’t need S Corp to get QBI deduction. 

There may other ways to treat your rentals like business being going to S-Corp that makes it tax disaster.  

Thank you all for your input! 

I have also just discovered that even in the best case, S-Corps cannot have more than 25% of their revenues come from passive streams for three years in a row; the IRS would automatically convert the entity to a C-Corp. 

@Ashish Acharya In your opinion what is the best way to run Flips ? Are we suppose to pay capital gains or SE ? I do both Rentals and Flips but haven't set up an entity yet.

Originally posted by @Nur Al Sharif :

Thank you all for your input! 

I have also just discovered that even in the best case, S-Corps cannot have more than 25% of their revenues come from passive streams for three years in a row; the IRS would automatically convert the entity to a C-Corp. 

 The passive income for a S Corp is not entirely the same as the passive income that you are talking about but it really doesn’t matter as you have seen S Corp isn’t not good for rentals. 

Originally posted by @Maugno M. :

@Ashish Acharya In your opinion what is the best way to run Flips ? Are we suppose to pay capital gains or SE ? I do both Rentals and Flips but haven't set up an entity yet.

Income from flips are always ordinary income that are also subject to the SE tax.  

Rental are also taxed at ordinary rate but are passive income so there is no SE tax. 

That is the reason running flip via S Corp saves you SE tax on your flip income because s Corp doesn’t pay we tax on its net income. 

There are other factors that come into play before getting a S Corp to save on SE tax such as making at least 40kto 50k. 

There are 100 other post on this. Or feel free to reach out. 

Interesting thread and everyone agrees to find a good CPA/tax person to help 

How do we interview them to determine which one actually is qualified?

@Jim C. I wouldn't be afraid to ask for past industry experience and references. A CPA title is a good indicator, but does not always mean they are qualified for your particular need. For instance there are of course many things outside of my realm of expertise as an accountant, and I would be the first to say it. However most good CPAs have a knack for finding the answer if they do not have it on hand. I would recommend finding someone you are comfortable having casual conversations with. We tend to be able to help in many areas outside of the tax department.

Shout out to Alaska - born and raised and currently expatriated to Portland.

Originally posted by @Lawrence Stepovich :

@Jim Chesmore I wouldn't be afraid to ask for past industry experience and references. A CPA title is a good indicator, but does not always mean they are qualified for your particular need. For instance there are of course many things outside of my realm of expertise as an accountant, and I would be the first to say it. However most good CPAs have a knack for finding the answer if they do not have it on hand. I would recommend finding someone you are comfortable having casual conversations with. We tend to be able to help in many areas outside of the tax department.

Shout out to Alaska - born and raised and currently expatriated to Portland.

 I used to think all CPA's were the same but found out quick that many will specialize in certain areas such as small business (retail), small business (service), etc... 

Since I dont know what I dont know, I dont know what questions to ask. 

@Jim C. I believe talking generally about your current income and asset scenario and future goals is a good starting point. That might get the conversation going on what past experience, insights, or resources the CPA might have that can best serve you.

You said it best yourself, you don't know what you don't know, so talk about what you do - your current situation; including any frustrations/pains or particular needs you may have. Hopefully the CPA can take it from there. If not, schedule the next interviewee.

Hope this helps

I don't like to assume, your best bet is to talk to a CPA on your scenario. They will have a lot of loop holes to avoid huge payments as you will have a lot of write offs. Best of Luck.

Originally posted by @Nur Al Sharif :

Hi guys, 

I've been trying to understand the tax implications of different entity types. I've developed a really short, brief model of how an S-Corp would be taxed, provided that it is 100% comprised of rental properties. My results came out quite counterintuitive; the higher the income, the lower the effective tax rate is (I assume this is because Social Security Tax becomes more and more insignificant, as it is capped at $128,000 of salary). 

Anyway, I attached the quick model. Not sure how accurate it is, if at all. Could you please take a look and vet it? 

Thanks everyone!

Remember, S-Corps' main disadvantage in a buy and hold rental context is the extra difficulty in exits. If, for example, you decide you'd rather transfer the property out of your LLC, live in it as primary residence for 2 years, and then avoid some capital gains tax, nope. You can't do that in an S-Corp without a taxable event. There are some other disadvantages when it comes to exits with an S-Corp. Partnerships and disregarded entities typically avoid these issues. As general rules of thumb, S-Corps for flips when flip income is over $40ish K per year, and disregarded/partnership entities for buy and hold.

@James Miller @Ashish Acharya @Lawrence Stepovich

I just had a consultation with a CPA. I just created two entities, one for my flipping side and one for my rental side. My cpa just told me that if i put my rentals into the llc i created, either way i'd be paying SE tax. Something about using depreciation so either way it comes out neutral. I didnt really understand that part. I always thought that my rentals were passive and wouldnt be charged SE. CPA thinks otherwise.

He told me not do to the scorp till my profits were over 128k or so cause then thats where id be maximizing tax benefits.

So for now, he said i'd do the LLC as a disregarded entitiy, and that all my profits from llc flow to my 1040. he said that each of my LLC's would have to be on schedule c, my flipping llc and my rental llc

Feedback ?

Originally posted by @Maugno M. :

@James Miller @Ashish Acharya @Lawrence Stepovich

I just had a consultation with a CPA. I just created two entities, one for my flipping side and one for my rental side. My cpa just told me that if i put my rentals into the llc i created, either way i'd be paying SE tax. Something about using depreciation so either way it comes out neutral. I didnt really understand that part. I always thought that my rentals were passive and wouldnt be charged SE. CPA thinks otherwise.

He told me not do to the scorp till my profits were over 128k or so cause then thats where id be maximizing tax benefits.

So for now, he said i'd do the LLC as a disregarded entitiy, and that all my profits from llc flow to my 1040. he said that each of my LLC's would have to be on schedule c, my flipping llc and my rental llc

Feedback ?

 Please consider getting a new CPA.  Either they don't know what they are talking about, or they are unable to teach you the basics so that you can repeat them here.  In my opinion, a CPA shouldn't just do the work for you, they should be educating you so that you know and understand how and why the strategies they are recommending will save you money AND conform to the tax code.

Rentals are only subject to SE Tax if they are short term rentals where the average stay is less than 7 days AND you also provide significant additional services.  The vast majority of rentals will not be subject to SE Tax.

S-corp benefits start at $128K?  Good grief.  No.....    

The issue with the S-Corp is the savings in Self Employment Tax, however there are Fixed Costs with an S-Corp as follows:

1.  S-Corp must file its own tax return.  For my clients, I charge between $350 and $600 for these returns, depending on several factors that aren't important for this purpose

2.  S-Corp must file quarterly payroll tax returns.  I charge $35/quarter for a basic 1 person payroll, but other services can be more or less.

3.  S-Corp officer must pay Unemployment Tax on their payroll.  Different states will have different amounts, but in general this should be no more than $350 for a 1 person payroll.

(Admins - I am not soliciting here - just showing the basic price structure of fixed costs that are involved in this calculation)

So fixed costs are somewhere around $1000.

In order to save that amount, you'd have to have Shareholder Distribution Income somewhere in the neighborhood of $6500.00.  (6500 x 15.3% = $995).  

I usually recommend something close to a 50/50 split between Distributions and Salary/Wages, so if your profits are anything up over about $13,000, then this strategy begins to save you money.  However, your mileage will vary depending on how much you're paying for tax prep, payroll tax prep and your unemployment tax rate. If you have a CPA that charges you $10,000 for these services, then your break even point will be much higher.

$128,000 is ridiculous and I think somebody is confusing this with the Social Security limitations.  The most difficult part of S-Corporations are trying to get a feeling for "reasonable" salary.

@Linda Weygant Yeah at first he said doing a Scorp would only benefit me if i was making over 300k in profits... and then changed it to 128k because of the social security thing.  With the scorp i have to pay myself every how often ?

Originally posted by @Maugno M. :

@Linda Weygant Yeah at first he said doing a Scorp would only benefit me if i was making over 300k in profits... and then changed it to 128k because of the social security thing.  With the scorp i have to pay myself every how often ?

The S-Corp salary has no rules for how often you need to pay yourself - just that you pay yourself a reasonable salary annually.  Some of my flipping clients only take a paycheck at the end of a project, others take a regular check monthly because they like to spread their liabilities out, some take only one paycheck at the end of the year.