by | Jun 17, 2024

S Corporation vs. Partnership: A Tax and Social Security Showdown for a Husband-Wife Team

A Case Study in the Age-Old Debate of S-Corporation vs. Partnership

This article dives into a case study comparing two business structures for a husband-wife team in their 40s: S-Corporations and partnerships. The primary focus is on the interplay between potential tax savings and the impact on future Social Security benefits.

The Scenario

Our couple, both 47 years old, runs a business with a net profit of $89,534. They’re looking to optimize their tax situation while keeping an eye on their future retirement income.

Tax Break with S Corp, But at What Cost?

The initial analysis reveals a potential tax advantage with an S-Corporation. By electing S corp status, the couple can take a salary, which reduces their net business income subject to self-employment taxes. Here’s a breakdown of the estimated figures:

Partnership

  • Net Profit: $89,534
  • Total Taxes: $17,541

S-Corporation

  • Salary to Owners: $56,000
  • QBI (Qualified Business Income): $11,305 (subject to lower tax rates): $17,541
  • Total Taxes: $14,216

Difference in Tax Savings with S-Corporation

  • ***Potential Tax Savings: $3,325

The Social Security Catch

Here’s where things get interesting. While the S-Corporation offers tax savings, it also reduces the amount of income credited towards Social Security benefits. Social Security taxes are only paid on the salary of an S-Corporation, not the entire net profit. This could potentially lead to lower Social Security benefits in retirement.

Social Security Benefit Formula (2023)

The Social Security Administration uses a formula to determine benefits based on average indexed monthly earnings (AIME). Here’s a simplified version for 2023 (applicable to individuals born in 1961):

  • Tier 1 (up to $1,174): 90% benefit
  • Tier 2 ($1,174 to $7,078): 32% benefit
  • Tier 3 (above $7,078): 15% benefit

Impact on Social Security

Using the Partnership

The additional income from the business opportunity falls primarily in Tier 2 ($32% benefit). This translates to a potential income of approximately $45,000 per year in Social Security benefits for the couple (based on the formula).

Using S-Corporation

The lower salary of $56,000 results in lower taxes paid into Social Security throughout the client’s lifetime. Which leads to potential income of approximately $34,270 per year in Social Security benefits (based on the formula). Which is $10,730 less a year than what the couple would receive in social security benefits if they chose the Partnership. This is a $268,200.00 difference over 25 years of retirement.

Hypothetical Social Security Difference: Simplified Method

$89,534
Net partnership profit
– $56,000
Gross Payroll (S-Corp)
= $33,534
Additional $ subject to FICA tax from partnership
x .32%
SSI Formula Tier
= $10,730
Estimated additional benefits per year

Is $3,325 in annual tax savings today worth forgoing $10,730 in annual Social Security benefits?

Let’s start simple. $10,728 in 20 years (age 67) is the present value equivalent of $5,892 given a 3% rate of inflation. Answer: NO

In addition, Social Security estimates are stated in present value terms. Meaning, estimates will rise with inflation as time passes. The projected increase of $10,730 would only get bigger as time passed with inflation adjustments.

What about forgone investment potential?

What if the client considers investing the tax savings generated by the business opportunity (estimated at $3,325 annually) in a Roth IRA? Here are two scenarios exploring potential returns:

Scenario 1: Investing the tax savings each year and start drawing income off in at retirement:

  • Invest $3,375 annually for 20 years at 8% growth.
  • Accumulate $158,626 at age 67
  • Withdraw $10,728 annually (equivalent to the Social Security lost using the S Corp).

This scenario depletes the investment within 15-20 years under most circumstances given the 6.7% annual withdrawal rate. Here, the guaranteed lifetime Social Security income might be more attractive.

If the couple was younger and had more time for compound interest, this might create a more interesting opportunity. For example, a couple in their early 30’s might be able to overcome the reduction in Social Security benefits with the power of exponential growth in a Roth IRA.

Practically speaking, we find it might be unrealistic to assume someone regularly invests the tax savings for 30+ years.

Scenario 2: Investing the tax savings each year and never drawing income from it:

  • Invest $3,375 annually for 20 years at 8% growth.
  • Accumulate $158,626.
  • Let the investment grow for another 20 years at 6% growth, reaching $508,735.

Given more time, the investment potential might outweigh the lower Social Security benefits; however, it results in lower retirement income might cause increased withdrawal elsewhere. A thorough financial plan would reveal whether this is worthwhile or not.

So, Partnership or S-Corporation?

The answer depends on the couple’s priorities. Here’s a summary:

Partnership

  • Pros: Higher potential Social Security benefits.
  • Cons: Higher overall taxes and more dependent on Social Security benefits.

S-Corporation

  • Pros: Lower taxes and less dependent on Social Security benefits (if you invest the tax savings)
  • Cons: Lower Social Security benefits.

For this specific scenario, with the couple nearing retirement, the partnership might be the better option. The potential loss in Social Security benefits might not be fully compensated for by investing the tax savings.

Conclusion

This case study highlights the importance of considering both Social Security benefits and investment potential when making retirement decisions. There’s no one-size-fits-all answer, and the optimal choice depends on individual circumstances and risk tolerance.

Key Takeaways

  • Social Security benefits are calculated based on average indexed monthly earnings.
  • Understanding the Social Security formula can help estimate potential benefit increases.
  • Investment returns can potentially outpace Social Security increases, but they are not guaranteed.
  • A holistic approach considering both guaranteed benefits and potential growth is crucial for effective retirement planning.

Additional Considerations

  • This case simplifies the Social Security formula for illustrative purposes.
  • Other factors like age at retirement and filing for benefits can impact Social Security amounts.

Beyond the Numbers: Other Considerations

  • Management complexity: S-Corporations require more paperwork and compliance compared to partnerships.
  • Profit distribution flexibility: Partnerships offer more flexibility in how profits are distributed among owners.

The Final Word: Talk to a Professional

This article provides a good starting point for understanding the trade-offs between S-Corporations and partnerships. However, the ideal structure depends on individual circumstances. Consulting a tax advisor and a financial planner is crucial before making a decision.

The opinions expressed in this program or blog are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security.

It is only intended to provide education about the financial industry. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. Any past performance discussed during this program is no guarantee of future results.

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