I have a meeting with a few of my law partners to discuss a few items tomorrow, and I wanted to run a tax strategy by them. But before I do I wanted to make sure I fully understood everything, and there wasn't anything I was missing.
Background
In January of 2016 I became an income partner of a small law firm. Before that I was an associate, getting paid w2 earnings. The law firm is set up as a LLP and pays its partners a semi-monthly salary, equal to 65% of a yearly agreed to amount, with the other 35% paid in quarterly installments (typically referred to as the "tax draw" which is paid at the time of, and used to pay the quarterly estimated tax payments to the fed and state). At the end of the year, anything left over in the firm gets divided among the partners in accordance with the partnership percentages.
Last year I learned the "joy" of paying quarterly taxes, and having to pay Self Employment Tax. I got a small distribution at the end of last year, but no year is a guarantee. A big case could walk through the door tomorrow and $100,000 distribution could be generated by year end, or there could be none. Because the year end is so questionable, in order to avoid penalties on estimated taxes you need to pay the lesser of: a) 90% of the tax on what you think you'll earn this year, or b) 100% of last year's tax. Each year is a giant question mark on what you'll earn, so the only way to avoid penalties is to go with option "b."
Going into year two, I realize how incredibly inefficient this system is, mainly for two reasons: One - I'm paying high SE tax, and Two - I'm always stuck with either paying a large tax at the end of the year (because the distribution was larger than last year's, meaning I under estimated in quarterly taxes) or overpaying in taxes (because the distribution was smaller than last year's, and I had to pay 100% of last year's taxes in quarterly installments). This year, I'm not likely to receive a year end distribution (based on current calculations) but I still have to pay 100% of last year's taxes in quarterly installments (in the event a distribution does come), which ends up being greater than the 35% "tax draw." This puts me in a little bit of a crunch quarterly at the moment (which I can cover by being frugal, but still).
Strategy
To avoid these issues, I'd like to propose that each member set up their own "S Corp" and have those S Corp entities be partners of the LLP. The semi-monthly distributions would remain the same, but would be paid to each S Corp instead of to each partner. Each S Corp would be responsible for paying each partner their own "reasonable salary" which could be equal to the 65% regular payments (conceivably) through a payroll service (which would probably cost about $25 a month). At the end of the year, anything the S Corp would have can be turned over to the individual partner (which should equal the 35% estimated "tax draws"). In the end, each partner should save a boatload in taxes in the form of:
1. We'll still be paying the 15% "SE Tax" on the regular 65% (or 7.5% FICA/FUTA and 7.5% SSI/Med with holdings), but wouldn't pay any on the 35% tax draw.
2. The 35% tax draw would be subject to long term capital gains tax as a distribution, subject to 15% taxes rather than ordinary income tax (28% for most of us) AND wouldn't be subject to SE Tax. Tax savings on that amount should be equal to approximately 28% (15% SE savings, plus 28%-15%).
3. You'd avoid the "float" of making estimated taxes on last year's distribution not knowing what this year's distribution is. Instead, if a large distribution comes in, you just pay LTCG tax. If not, you didn't pre-pay anything.
Potential Fights Against
Less money would be generated each month for each partner under this strategy, although significant savings would happen at the end of the year. Using real world numbers:
Old System With No Distribution (using rough numbers)
Draw = $100k ($65k semi monthly, or $2,708.33 per paycheck, and $35k quarterly, or $8,750 each).
Each paycheck = $2,708.33
Yearly tax = $15,000 SE + tax of $16,315 (AGI = $82,150 after Standard Deduction, 1/2 SE tax deduction and 1 exemption)
Total tax = $31,315
Old System with Distribution
Just pay (rough) 43% of any addition distribution in taxes on top of above (15% SE tax, and 28% Ordinary Income) (yes it will be less with deductions, but still)
Distribution = $10,000
Total tax = $35,615
New System With No Distribution (using rough numbers)
Draw to S Corp = $100k ($65k semi monthly, or $2,708.33 twice monthly, and $35k quarterly, or $8,750 each)
Each paycheck before payroll deductions = $2,493.64 ($25 /m payroll service fee + 7.5% FICA/FUTA)
Each paycheck after payroll deductions (of 7.5% SS/Med + Fed Withholdings) = $1,859.62
Year End Distribution = $35,000
*Edit* By not having to pay SE taxes on the $35,000, you save $5,250 in SE taxes, but you lose the 1/2 SE tax deduction on it, meaning you increase your taxes by ~$735, for a net savings of $4,515 (plus not having to worry about the float) or approximately 4.5% of earnings.
New System with Distribution
Just pay 28% of any additional distribution (again looking past any tax deductions)
Distribution = $10,000
Total Tax Savings = $6,750 in SE Taxes (less $945 tax gain) for a net gain of $5,805 or approximately 5.8% of earnings. *End Edit*
I've searched around and can't find anything from the bar association that says it can't be done this way. There might be some legwork that needs to be done with the state privilege license department, and our malpractice insurance carrier, but shouldn't be too difficult.
Does it sound like I have everything about right? Did I miss anything (positive or negative)?