# Converting to an S-Corp — The QBI Deduction Complicates the Choice

The decision to be an S-corporation might be a bad thing for the overall tax picture of a small business right now, in light of the qualified business income deduction. Like everything with taxes, “it depends.”

I am not a huge fan of S-corps, and quite frankly there’s nothing wrong with being a sole proprietor. There are times where you will actually save money by being a sole proprietor instead of an S-corp. What sort of blasphemy is this???? It has to do with the QBI deduction.

Let’s examine.

## Example Where It Makes Sense

There are a lot of words below, so let’s put the comparison right here, and then if you want to walk through the mechanics, you can read the section. We’re saying this proprietor has net income from their Schedule C of \$100,000 per year, and their spouse makes \$60,000 from a W-2 job, and they take the standard deduction. In the S-corp example, we are saying the proprietor is taking a salary of \$60,000 out of the business.

The all-in tax hit is:

• \$29,662 as a sole proprietor
• \$27,787 as an S-corp
• S-Corp wins by \$1,875; converting to an S-corp makes sense as long as the compliance costs (corporate tax preparation, cost of payroll services, etc. are less than \$1,875)

### Sole Proprietor

The self-employment tax hit is: \$100,000 net income from the sole proprietorship x .9235 = \$92,350 x .153 = \$14,130. They get a deduction equal to 1/2 of that, so \$7,065.

Their taxable income before QBI, for income taxes is: \$100,000 net income + \$60,000 W-2 income – \$7,065 deduction for 1/2 of SE tax – \$25,100 standard deduction = \$127,835.

The QBI deduction is: \$100,000 of self-employment income – \$7,065 deduction attributed to that income = \$92,935 x .2 = \$18,587

Taxable income after QBI is: \$127,835 – \$18,587 = \$109,248

Income tax = \$15,532 + \$14,130 of self-employment tax = \$29,662 total tax liability.

### S-Corporation

This self-employed person has no doubt heard from their neighbor/parent/brother-in-law in Las Vegas with a drywall business/plumber/hair dresser/etc. (a client really did opine to me one time about tax advice they got from their brother-in-law who runs a drywall business out of the back of his pickup in Las Vegas) that smart people form an S-corp.

And tax pros (CPAs in particular) have adopted as common wisdom (with no backing in actual proof) that 60% of your profit is what your salary should be. Some say 50%.

Before we go further: the “pay 60% in salary and 40% in distributions (or 50/50)” thing that so many tax pros give as “advice” is not based on any kind of IRS-blessed guidance at all. There is no such formula despite what so many tax pros say.

But since I am in the minority, tilting at windmills on all issues S-corp related, I’ll say: fine, I’ll give into peer pressure and let’s set this person’s salary at 60%, so \$60,000.

Off of their business income of \$100,000 they’ll subtract \$60,000 for the salary. Also subtract out 7.65% of the salary for employer-side FICA taxes (\$60,000 x .0765 = \$4,590). So the business income passed through from the S-corp is \$100,000 – \$60,000 – \$4,590 = \$35,410. (NOTE: I am purposely leaving out state unemployment taxes here to keep it somewhat simpler.)

How does this impact the tax return?

\$60,000 salary to the “S-corp spouse” + \$60,000 to the other spouse + \$35,410 pass-through S-corp income – \$25,100 standard deduction = \$130,310 taxable income before the QBI deduction.

QBI deduction: \$35,410 from the S-corp x .2 = \$7,082.

\$130,310 – \$7,082 = \$123,228 taxable income. The tax on this is \$18,607 income tax liability. But we can’t forget about the FICA taxes, which are a similar concept to self-employment tax. The FICA is not computed on the tax return; it runs through payroll instead and is taken out as withholding but it’s still there. \$60,000 x .153 = \$9,180.

\$18,607 + \$9,180 = \$27,787 total tax hit.

## When it Doesn’t Make Sense

In this example, we’re playing with bigger numbers now and saying the proprietor has net income of \$300,000, they’re married but have no other income, and they take the standard deduction still.

On the S-corp side, the proprietor again decides 60% is the way to set salary, so they take 60% of \$300,000, or \$180,000 as a salary.

The all-in tax hit is:

• \$63,823 as a sole proprietor
• \$68,950 as an S-corp
• This proprietor is \$6,027 worse off by being an S-corp

### Sole Proprietor

The SE tax calculation is a little different here because \$300,000 is over the Social Security wage base. Start with \$300,000 x .9235 = \$277,050. The Social Security wage base is \$142,800 for 2021, so the SS piece of SE tax is based on \$142,800 x .124 = \$17,707. Medicare tax is based on \$277,050 x .029 = \$8,034. \$17,707 + \$8,304 = \$25,741, and the deduction for 1/2 of SE tax is \$25,471 / 2 = \$12,871.

\$300,000 – \$12,871  – \$25,100 standard deduction = \$262,029  taxable income before the QBI deduction. This is less than their QBI of \$287,129, so their QBI deduction is \$262,029 * .2 = \$52,406.

\$262,029 – \$52,406 = \$209,623 taxable income. The tax on this is \$38,352 + SE tax of \$25,471 = \$63,823 total tax.

### S-Corp

FICA taxes on \$180,000 of salary are: \$142,800 x .062 = \$8,854 Social Security tax owed by the employee and that same amount owed by the corporation; and \$180,000 x .0145 = \$2,610 Medicare tax owed by the employee and that same amount owed by the corporation. Deduction to the S-corp is: \$8,854 + \$2,610 = \$11,464. The total FICA tax here is \$22,928.

S-corp net income: \$300,000 – \$180,000 – \$11,464 (the employer side of FICA) = \$108,354.

On the shareholder’s return: \$180,000 salary + \$108,354 pass-through from S-corp = \$288,354 – \$25,100 standard deduction = \$263,254 taxable income before QBI deduction.

QBI is \$108,354, the income from the S-corp. \$108,354 x .2 = \$21,671.

\$263,254 – \$21,671 = \$241,583 taxable income. The tax on this is \$46,022 + FICA taxes (employer and employee) of \$22,928 = \$68,950.

### Why is This Worse?

This example turns out the way it does because of the QBI deduction. The self-employment taxes the proprietor saves are wiped out by the increase in income taxes because of the decrease in the QBI deduction. As income gets close to the phase-in thresholds for QBI (but still below the threshold), it’s better to be a sole proprietor. Once income gets past the phase-in level, then it’s better to be an S-corporation because W-2 wages become a part of the calculation.

### It Depends

The old “wisdom” of tax pros saying to form an S-corp any time a sole proprietor showed a profit equal to what they could pay as a reasonable salary no longer holds true. For example, I have seen tax pros opine that “all” sole proprietors should form an S-corp once net income hits \$40,000 (I’ve seen \$30,000 and even \$20,000 thrown out too). As with the “60% as your salary” thing, you can’t break this stuff into magical formulas because no such magical formulas exist.

It really depends. Higher-income proprietors who are still below the QBI phase-in/phase-out thresholds might be better off staying a sole proprietor, as in our second example here.