Escaping the Partnership Trap

11/17/2025

It’s a juicy piece of low-hanging fruit: convert your LLC to an S corporation and save a ton on self employment taxes.

In many cases, this is excellent advice. But what if following that simple tip could trigger a six-figure tax bomb?

This isn't a hypothetical. This is a real case study of a client who came to us for tax planning, and it highlights the critical difference between generic tax advice and professional tax strategy.

Case Study:  When an S Corp Isn’t the Answer

Our client is a successful general partner in a family outdoor services business. He runs the day-to-day operations. His retired father owns the other half of the business as a limited (passive) partner.

 

Here’s the breakdown of his situation when he first walked into our office:

  • Business Structure: A General Partnership.
  • His Compensation: He receives $150,000 per year in guaranteed payments.
  • The Problem: Guaranteed payments for services rendered to a partnership are, in the eyes of the IRS, fully subject to self-employment (SE) tax.

What is Self-Employment Tax?

Before we go further, let's clear this up. When you're a W-2 employee, you pay a 7.65% FICA tax (Social Security and Medicare), and your employer pays the other 7.65%.

When you're self-employed, the IRS considers you both the employee and the employer. Therefore, you pay the entire amount: 15.3% (on the first $168,600 for 2024, then 2.9% on everything above that).

For our client, this was a significant, recurring hit: $150,000 (Guaranteed Payment) x 15.3% (SE Tax Rate) = $22,950

He was paying nearly $23,000 in SE tax every single year on top of his regular federal and state income taxes. His goal was simple: "How can I legally reduce this?"

The "Obvious" Solution (And Why It Was a Disaster)

The commonly recommended solution is, of course, the S-Corporation.

 

Here’s the S-Corp magic you hear about:

  1. Your LLC elects to be taxed as an S-Corporation 
  2. You put yourself on payroll as an employee.
  3. The IRS requires you to pay yourself a "reasonable compensation" salary (e.g., $70,000). This W-2 salary is subject to FICA taxes, just like any other job.
  4. All remaining profits from the business (in our client's case, $150,000 - $70,000 = $80,000) can be taken as distributions (also called dividends or draws).
  5. Here's the key: S-Corp distributions are not subject to the 15.3% self-employment tax.

The simple approach would be to have the partnership file Form 8832 or 2553 and elect to be treated as an S-Corporation. This would, in theory, save him 15.3% on $80,000 of income—a savings of $12,240 per year.

So, why didn't we do this?

 

Because we did our due diligence. We looked at the partnership's balance sheet. When we did, a massive red flag—a $1.4 million landmine—was staring us in the face.

The partnership had $1.4 million in negative equity.

The $1.4 Million Negative Equity Trap

 

What is negative equity (or "negative basis")?

Think of it like an underwater mortgage on your house. Imagine your house is worth $600,000, but you have a $2,000,000 mortgage on it (perhaps from a large, debt-financed cash-out refinance). You have $1.4 million in "negative equity."

In a business, this often happens when a partnership takes on significant debt to operate or buy equipment, and the partners take distributions or are allocated losses that are funded by that debt. Over time, their "skin in the game" (their tax basis) can drop below zero.

 

Here is the tax law that makes this so dangerous:  When you convert a partnership with liabilities (debt) to a corporation, the partners are "relieved" of those partnership debts. The new corporation assumes them. The IRS treats this "relief of debt" as if the partners were paid cash.

If the debt you are relieved of is more than your tax basis, the difference is instantly taxable as a capital gain.

 

For our client, converting the partnership to an S-Corp would have meant:

  • Deemed "cash" received: $700K (his share of the negative equity).
  • His basis: $0 (or less).
  • Result: An immediate capital gains tax bill of $105K (15% of $700K)

To save $12,000 a year, he would have had to pay six figures in taxes. It was a terrible trade-off. 

The Solution: Strategic Entity Structuring

This is where we add real value. The client was trapped. He couldn't convert the existing business. But he was still bleeding $23,000 a year in SE tax.

If you can't fix the old structure, you build a new one.

Instead of touching the partnership, we created a structure to work with it. Here was our recommendation, which we implemented immediately:

 

Step 1: The client forms a brand-new, 100%-owned Limited Liability Company (LLC). Let's call it "ClientCo, LLC."

Step 2: We immediately file Form 2553 to have ClientCo, LLC elect to be taxed as an S-Corporation.

Step 3: The client transfers his personal partnership interest in the services business to his new S-Corporation.

The New Structure:

  • The services business (the partnership) hasn't changed at all.
  • The father (passive partner) hasn't changed at all.
  • The only change is who the IRS sees as the general partner. It's no longer our client personally—it's his S-Corporation.

Following the Money (And the Savings)

Now, let's see how the money flows. Nothing has changed about the client's $150,000 compensation. But how it's taxed is completely different.

  1. The services partnership now pays the $150,000 guaranteed payments directly to its partner, ClientCo S-Corp.
  2. ClientCo S-Corp receives the $150,000 as its business income.  The SCorp is not subject to self-employment tax.
  3. Per S-Corp rules, ClientCo now pays our client a reasonable compensation salary. We worked with him to document a salary of $70,000.
  4. This $70,000 salary has FICA taxes (15.3%) withheld and paid, totaling $10,710.  This satisfies his IRS obligation to be paid as an employee.
  5. What's left inside the S-Corp?
    • $150,000 (Income)
      • $70,000 (Salary Expense)
    • = $80,000 (Net Profit)
  6. This $80,000 net profit flows to the S-Corp's owner (our client) as a K-1 distribution.
  7. This $80,000 distribution is NOT subject to self-employment tax.

The Final Tally

Let's look at the before-and-after.

  • Old Way: $150,000 income all subject to 15.3% SE tax = $22,950
  • New Way: $70,000 salary subject to 15.3% FICA tax = $10,710

By implementing this advanced (but 100% legal and IRS-compliant) structure, we:

  • Saved the client $12,240 in taxes this year.
  • Created a structure that saves him that amount every single year going forward.
  • Completely avoided the six-figure capital gains tax bomb.

This is the power of true tax planning.  It's about deeply understanding the Internal Revenue Code and designing a structure that legally achieves the best possible outcome.

Don't let so-called common knowledge guide your most important financial decisions.

 

Sign up today for a FREE discovery call.

 

Greg Tobias, Enrolled Agent

Admitted to practice before the Internal Revenue Service

Sources

  • Internal Revenue Code § 1402: Definitions of Net Earnings from Self-Employment.
  • Internal Revenue Code § 731: Extent of Gain or Loss on Distribution.
  • Internal Revenue Code § 752: Treatment of Certain Partnership Liabilities.
  • Internal Revenue Code § 1366: Pass-Thru of Items to S-Corporation Shareholders.
  • Treasury Regulation § 1.1402(a)-2: Computation of Net Earnings from Self-Employment.
  • IRS Publication 541: Partnerships.
  • IRS Publication 334: Tax Guide for Small Business (For Individuals Who Use Schedule C).

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