Consulting Partnership Saves $36K/Year with S-Corp Restructuring

The Problem

This two-partner management consulting firm generated $1.6M in annual revenue with $840,000 in combined net income ($420,000 per partner). As a general partnership filing Form 1065, all net income flowed through to the partners on Schedule K-1 and was subject to self-employment tax under IRC §1402. Each partner was paying approximately $28,600 in self-employment tax annually — $57,200 combined. The partnership agreement split profits 50/50 and had not been updated since formation eight years earlier.

The partners were unaware that converting to an S-Corporation could eliminate self-employment tax on the distribution portion of their income. Under partnership taxation, all income allocated to a general partner is subject to SE tax unless the partner is a limited partner under IRC §1402(a)(13). As general partners who both actively managed the firm, neither qualified for the limited partner exception. The prior CPA had mentioned S-Corp election once but never followed through with the analysis or filing.

AE Tax Strategy

1. Partnership to S-Corp Conversion Under IRC §1362

We dissolved the general partnership and formed a new LLC electing S-Corp status under IRC §1362. The conversion was structured as a tax-free contribution under IRC §351, with both partners contributing partnership assets in exchange for stock in the new S-Corp in proportion to their 50/50 interests. We established reasonable officer compensation for each partner at $155,000 based on BLS data for management consultants at the principal/director level. This removed $265,000 per partner ($530,000 combined) from the self-employment tax base.

2. Reasonable Compensation Analysis Under IRC §3121

The $155,000 compensation for each partner was supported by a formal analysis using Robert Half salary surveys, AICPA management consulting benchmarks, and comparable W-2 data from the Bureau of Labor Statistics for management analysts and consultants in the Chicago metro area at the 75th-90th percentile. Both partners' roles were documented: one focused on business development and client delivery, the other on operations and technical consulting. The compensation was set identically to avoid any disparity that could attract IRS scrutiny in a closely-held entity.

3. 401(k) Plan with Employer Match Under IRC §401(a)

We implemented a 401(k) plan for both partners with $23,500 employee deferrals each and employer contributions of 25% of W-2 wages ($38,750 each). Total retirement contributions of $124,500 combined sheltered income from taxation at the partners' 32% federal plus 4.95% Illinois marginal rates, producing incremental income tax savings of $6,100 per partner beyond the SE tax savings. Net savings after deducting $2,800 in annual plan administration costs came to $36,000 combined in SE tax reduction alone.

Before & After Comparison

Tax Category	Before	After	Savings
Partner 1 SE Tax	$28,600	$10,600	$18,000
Partner 2 SE Tax	$28,600	$10,600	$18,000
Total	$57,200	$21,200	$36,000

Key Takeaways

• General partnership income is fully subject to self-employment tax for active partners — the limited partner exception under IRC §1402(a)(13) does not apply to partners who materially participate in the business.
• Converting a partnership to an S-Corp can be structured as a tax-free reorganization under IRC §351 when done properly, avoiding any recognition of gain on the conversion.
• Both partners in a two-person S-Corp must receive reasonable compensation — setting one partner's salary low to save SE tax while the other receives market rate will invite IRS scrutiny.
• The annual compliance cost of running an S-Corp ($2,000-$5,000 for payroll, 1120-S filing, and plan administration) is typically less than 10% of the SE tax savings for qualifying firms.