- Hi everyone.
I'm attorney Aiden Durham with 180 Law Co.
in Denver, Colorado.
And you're watching, All Up In Yo' Business.
(upbeat music)
In this episode of All Up In Yo' Business,
we're gonna talk about S corporations.
What is an S corporation?
What does it mean?
How do you become one?
But before we get into it, be sure to like, subscribe
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Also, if you've been watching
the last couple of episodes that I posted,
you know that I had some foster kittens running around,
who would make occasional guest appearances in my video.
We all loved them.
Well, it's with a very heavy heart that I must report,
the foster kittens are no longer with me.
Unfortunately, they came down
with a touch of ringworm over the weekend
and so I had to take them back to the shelter
so they can get treatment for a couple of months.
So I don't have any more fosters.
But you know what, it's okay.
You've still got me, and we've still got Rocky here.
We didn't forget about Rocky.
So even though there are no more kittens,
it's still gonna be a party.
And I can safely report I don't have ringworm.
Rocky does not have ringworm.
I spent the entire weekend disinfecting
and cleaning my whole house.
So we are ringworm free.
Okay, moving on.
S corporations.
What is an S corp?
An S corp is only a tax election that a business can make.
An S corporation is not a business entity.
So you don't form an S Corp.
You can form an LLC, or you can form a corporation,
and then either of those can elect
to be taxed as an S corporation.
The S corporation election is really a way to take advantage
of pass through entity taxation and avoid double taxation
like you would with a C Corp,
while still limiting the self employment taxes
and limiting your tax liability all together.
So what difference does it make,
what actually happens if you elect
to be taxed as an S corporation?
In a corporation, a traditional corporation,
the corporation has its own corporate tax.
It pays corporate tax on its income,
and then it pays dividends to its shareholders
and the shareholders have to pay income
on what they've received as dividends.
So, this is what we call double taxation
because essentially, the income is being taxed twice.
It's taxed to the corporation
and then it's taxed to the shareholders
when they receive dividends.
In an LLC there's no corporate tax.
LLCs don't pay their own corporate tax.
Instead, the members pay tax on their portion of the income.
They'll pay ordinary income tax
plus self employment tax on their income from the LLC.
However, with the S corp election,
the owners of the company whether
it's an LLC or a corporation.
The owners have to pay themselves a reasonable salary.
The term reasonable is very dependent
on specific circumstances and very fact dependent.
So there's no like hard and fast rule
about what a reasonable salary is in an S corporation.
There's a lot of different information
and guidelines on how to figure it out,
but for the most part, people are just kind of
going off of history with the IRS,
and the information that is available
to try to determine what a reasonable salary is.
But anyway, so that the owners pay themselves
this reasonable salary.
And the salary is paid through payroll because the members,
if we're talking an LLC, once the S corp election is made,
the members now become employees of the LLC,
and are paid on payroll,
just like any other employee would
or just like you would if you're an employee
for some other company, they pay you on payroll.
The you know, FICA and the taxes that we pay
when we get a paycheck from our employer,
those same things are taken out of
the members reasonable salary on their paycheck.
So instead of that self employment tax
being tacked on to the entire income of the LLC,
it's essentially just being tacked on
to that reasonable salary of the member.
So in order to demonstrate, let's do a little math
and kinda look at some of the numbers
and see how it actually breaks down
in an LLC versus an LLC taxed as an S Corp.
Let's pretend it's a single member LLC, so only one owner,
and the business generated $100,000 of income.
Now I'm completely making these numbers up,
these tax rates and stuff, don't depend.
I'm just using them for illustration purposes,
these rates that I'm using aren't exact.
And isn't exactly how tax rates work,
but just for illustration purposes, play along okay.
So $100,000 income, let's say the owner
is in a 25% tax bracket.
So their ordinary income is taxed at 25%.
And then on top of that, is that self employment tax
which is 15.3%.
So 25% plus 15.3% is 40.3%.
So essentially we're taking 40.3% of that $100,000,
and that's the tax bill.
So in $100,000, that single member LLC
is gonna have tax bill of about $40,000.
Versus in an S corporation, we're still making $100,000,
but instead, the member takes a reasonable salary
for the year that equals 50,000.
We'll just say her salary is 50,000.
That's what she and her CPA decided
would be a reasonable salary.
So now, it's only that reasonable salary
that has those self employment taxes applied to it.
So she's getting a paycheck and out of
that paycheck are the FICA taxes
that would be taken out.
Everything on top of that paycheck,
on top of her reasonable salary,
she can still take as a member distribution,
and that's only taxed at her ordinary income tax rate
without the self employment tax added to it.
So in total, she's paying about $32,000
in taxes instead of $40,000.
So in this instance, it's not a huge difference,
but again, I made up the numbers,
and this isn't exactly, exactly how they apply.
But general idea, it's the same.
So really, the ultimate goal is that
we're portioning out the income to the business,
so that only some of it is subject to self employment taxes,
instead of all of it being subject to self employment tax.
And then in the context of a corporation,
it avoids that double taxation that you would normally have.
So if you decide that the S corporation election
is the right thing for you,
when and how do you do it?
As an LLC, you can make the S corp tax election
on IRS Form 2553.
Now there are some time restrictions
on when you can do this.
You can't just make the election willy nilly,
whenever you feel like it.
You have to make the tax election
within two and a half months from the day
the business is formed in order
for it to be effective for that tax year.
So let's say you started
your business in, on, June 1, 2019.
If you want to be taxed as an S corp for 2019,
then you need to submit that S corp election by August,
middle of August, about August 15th.
That two and a half month mark after
is when your deadline is.
But if you don't want to do it for that given year,
you can make the S corp election within
the two and a half months of each beginning of the year.
So if you decide 2019, I don't wanna make the election yet.
I wanna wait until 2020, then I'll do it.
So then 2020 comes around you have to file
that S corp election by middle of March, March 15th,
in order to get it effective for 2020.
And you don't have to continue filing,
you just file it once, and the S corp election is,
it applies for every year thereafter until,
you know, the business closes, or the tax changes
or something like that.
Now, while there are certainly a lot of benefits
and advantages to being taxed as an S corp,
there are certainly disadvantages too.
It's not for everybody.
First of all, the IRS places restrictions
on who can make an election to be taxed as an S Corp.
The business, there can't be more than 100 shareholders,
so it's capped at 100 shareholders.
All of the shareholders have
to be US citizens or legal residents.
And the owners, the shareholders of the S corp
can't be entities like LLCs or corporations themselves.
So you can't have an LLC that is the member of an LLC,
that's taxed as an S corp.
And then S corps carry along with them more
administrative work, because you are
now setting yourself up as an employee,
you have to deal with payroll and payroll tax filings.
And then of course, determining that reasonable salary,
that's a huge issue that comes with S corporation election.
Making sure that reasonable salary is an appropriate amount,
because if you don't pay yourself enough
on a reasonable salary, then the IRS could come back later,
and they'll apply those self employment taxes
to what you should have paid as a salary.
And they'll tax on penalties and interest and stuff too.
So, I go so far as to say if you're not willing
to invest money into good CPA or tax advisor
who can really help you with this,
then don't bother with the S corporation election.
If you're not willing to, unless you yourself
are tax expert and you can figure it out.
If you're not willing to have an expert help you
with managing the S corp and the taxes and all of that,
then don't bother with it.
Because ultimately, if you're doing it wrong, it will,
it will end up working way against you
as opposed to being anything of a benefit.
And I'll pull back the curtain a little
and tell you guys about what I did.
So when I started my business, six years ago,
I did not make an election to be taxed as an S Corp.
I didn't know how much money
I was gonna be making in that first year.
And I didn't want to have to deal
with the hassle of being taxed as an S corporation.
I didn't wanna have to deal with the extra administrative
and payroll taxes and all that stuff, so I didn't do it.
But after the first year, I brought on a CPA to help me
with all my bookkeeping because I was destroying it,
and thankfully that CPA talked to me about
the S corporation election, and we determined
that based off of my business's income at that time,
we would make the S corp election.
And it started essentially in that
I think second year that I was in business.
And ever since then, I'll tell you exactly what I do.
About every other week, or maybe once a month,
my accountant, emails me and says,
"Here's how much we need to pay you."
And then I say, "Okay,"
and they brought in payroll,
and it gets direct deposited into my account.
I literally have no idea how much they're paying me.
I mean, that's not true.
I have an idea of where they're getting these numbers from
and what they're basing it off of,
but I do zero math in my head, they do it for me.
I'm not even going to pretend
to try to figure out what my reasonable salary
should be, because I have no idea.
And so it's really that kind of a situation
where I recommend the S corporation election
is if you have somebody who can guide you through
the whole thing, so that you're not in becoming
a business owner plus makeshift CPA,
trying to figure out how to do your own taxes.
And then I'll tell you guys
what I typically recommend to my clients.
If I'm talking to a client who
is a brand new business owner,
this is their first time starting a business,
their first foray into entrepreneurship.
I tell them, let's not think about S corp right away.
Let's take a year.
Let's go this first year,
see what your income looks like.
See how your business is going and see
if you actually enjoy being in business for yourself.
Because if you're not making any money,
then the S corp is not gonna do you any good.
And if you hate being in business,
then again the S corp is not gonna do you any good.
So unless you're like super certain that
you're gonna make a substantial amount
of income in your first year of business.
I'm talking like, I don't know close to six figures
in your first year of business.
If you're not pretty darn sure that's gonna happen,
then typically, don't worry about the S corp,
just stay taxed as an LLC for you know
that first year of business,
see how things go, and then you can always
make this S corp election for the following year.
Now, this, you know, this doesn't apply to everybody.
And that is why it is so super important
when you're considering starting a business
and making an S corporation election
or wondering if you should.
It is super important to talk to an attorney
and a CPA or a tax expert,
so they can in conjunction with one another
help to figure out if the S corp is the right way to go.
That's all for this episode, folks.
Drop a comment below and let me know what you think.
You'll also want to check the description,
I have a link to my blog where we go into
some more depth about myths
of S corporations and commonly
misunderstood things about S corporations,
so check there too.
Thank you all so much for watching.
I'm Aiden Durham, and I'll see you next time.