Question

Mackenzie is considering conducting her business, Mac561, as either a single-member LLC or as an S corporation. Assume her marginal ordinary income tax rate is 37 percent, her marginal FICA rate on employee compensation is 1.45 percent, her marginal self-employment tax rate is 2.9 percent, and any employee compensation or self-employment income she receives is subject to the 0.9 percent additional Medicare tax. Also, assume Mac561 generated $200,000 of business income before considering the deduction for compensation Mac561 pays to Mackenzie and Mackenzie can claim the full qualified business income deduction on Mac561’s business income. Determine Mackenzie’s after-tax cash flow from the entity’s business income and any compensation she receives from the business under the following assumptions: (Do not round intermediate calculations and round your final answers to the nearest whole dollar.)

a. Mackenzie conducted Mac561 as a single-member LLC.

After-tax cash flow (The answer is NOT $134,772)

b. Mackenzie conducted Mac561 as an S corporation and she received a salary of $100,000. All business income allocated to her is also distributed to her.

After-tax cash flow (The answer is NOT $130,929)

c. Mackenzie conducted Mac561 as an S corporation and she received a salary of $20,000. All business income allocated to her is also distributed to her.

After-tax cash flow

d-1. Which entity/compensation combination generated the most after-cash flow for Mackenzie?

Single member LLC

d-2. What are the primary contributing factors favoring this combination?

• a small amount of payroll tax on the low salaryunanswered
• a relatively large QBI deduction because of the low salaryunanswered
• a relatively small QBI deduction because of the low salaryunanswered
• a huge amount of payroll tax on the low salaryunanswered
• none of the relatively large business income allocation was subject to FICA or self-employment tax.

Answer 1

Answer:

a)

	Amount	Description
(1) Business income	$200,000
(2) QBI deduction	(40,000)	(1) × 20%
(3) Deduction for 50 percent of SE tax	(2,678)	(1) × .9235 × .029 × .5
(4) Net income taxable business income	157,322	(1) + (2) + (3)
(5) Income tax paid by owner	58,209	(4) × .37
(6) Self-employment tax	5,356	(1) × .9235 × .029
(7) Additional Medicare tax	1,662	(1) × .9235 × .009 additional Medicare tax
(8) Total tax	$65,227	(5) + (6) + (7)
After-tax cash flow	$134,773	– (8)

b)

	Amount	Description
(1) Business income before comp.	$200,000
(2) Salary	(20,000)
(3) FICA deduction	(290)	(2) × .0145 employer’s portion
(4) Business income allocation and distribution to owner	179,710	(1) + (2) + (3)
(5) QBI deduction	(35,942)	(4) × 20%
(6) Net taxable business income	143,768	(4) + (5)
(7) Income tax on net business income	(53,194)	(6) × .37
(8) Salary received	20,000	(2)
(9) Income tax on salary	(7,400)	(8) × .37
(10) Additional Medicare tax on salary	(180)	(8) × .009
(11) FICA tax paid	(290)	(2) × .0145 employee’s portion
After-tax cash flow	$138,646	(4) + (7) + (8) + (9) + (10) + (11)

c)

	Amount	Description
(1) Business income before comp.	$200,000
(2) Salary	(20,000)
(3) FICA deduction	(290)	(2) × .0145 employer’s portion
(4) Business income allocation and distribution to owner	179,710	(1) + (2) + (3)
(5) QBI deduction	(35,942)	(4) × 20%
(6) Net taxable business income	143,768	(4) + (5)
(7) Income tax on net business income	(53,194)	(6) × .37
(8) Salary received	20,000	(2)
(9) Income tax on salary	(7,400)	(8) × .37
(10) Additional Medicare tax on salary	(180)	(8) × .009
(11) FICA tax paid	(290)	(2) × .0145 employee’s portion
After-tax cash flow	$138,646	(4) + (7) + (8) + (9) + (10) + (11)

d)

The S corporation with the low ($20,000) salary was the best. The factors favoring this were (1) a small amount of payroll tax on the low salary (2) a relatively large QBI deduction because of the low salary, and (3) none of the relatively large business income allocation was subject to FICA or self-employment tax. The IRS could potentially evaluate the salary Mackenzie performed and determine that it was unreasonably low. If so, the IRS could possibly reclassify some of the business income as salary. The single member LLC was a close second because it provided for a larger QBI deduction. However, this advantage was offset by the fact that the entire income was subject to self-employment tax (92.35 percent of it, anyway).