Don't Form an S Corporation Until You Watch This

so the llc is one of the most flexible business entity structures you can have because you can actually choose how you want it to be taxed and probably one of the most popular things to do with your llc is elect it to be taxed as an s corporation and this is something that many accountants and attorneys recommend but listen there are some major and i mean major disadvantages of s-corporations that many people don't talk about and sometimes i find myself having to tell new entrepreneurs no don't do it please don't do it because even though s corporations are very popular it doesn't mean that you should rush to become one so in this video what i want to do is cover the differences between a default llc and an s corp the major disadvantages of an s corporation and why you should wait to elect to become one and so if you watch this entire video until the end then i'm very confident that you're going to learn how to avoid some costly mistakes and save yourself thousands of dollars in taxes so if all that sounds good to you then all i ever ask is for you to hit that like button for the youtube algorithm that way other people like you can find this video and learn about the s corp disadvantages and also subscribe for more videos like this stay tuned [Music] hey there and if you're new welcome to our channel i'm sean with life accounting the accounting company that helps you save on taxes and build more wealth and as always what i'm going to do is put the timestamps for this video somewhere down in the description below so that you can skip to the parts that you want to learn the most about but look this is definitely going to be one of those videos that you want to watch entirely and maybe even multiple times all right let's go ahead and get this party started with number one what is an s corporation also known as an s corp so technically an s corporation is not a business entity that you set up or register with your secretary of state but rather it is a tax election and so you can elect to have your llc or your corporation be taxed as an s-corp usually through filing irs form 2553 now with all this i assume that you already know what an llc or limited liability company is but if you don't then in one sentence i would say that an llc is a very popular business entity because it separates your personal assets from your business assets which of course can then protect your business from affecting you personally now if you'd like to learn more about locs the advantages the disadvantages then what i'll do is i'll link a video at the end of this one so you can watch it right after you finish this video but anyway since s corpse are often tied to an llc or a corporation they also have limited liability protection which again protects your personal assets from your business liabilities so that is not on my list of disadvantages but before we dive deeper into my list let's get back to the original question of what is an s corporation okay so here's how the irs defines it s-corporations are corporations or other entities that are eligible to be treated as a corporation that can elect to pass corporate income losses deductions and credits through to the shareholders for federal tax purposes now i know after reading that that average entrepreneur is probably like okay that makes sense but what exactly does that mean okay so let's break this down a little bit more so when you're looking at different entities or tax structures there are generally two types you either have a pass-through entity or you have a taxed entity so when you make business income with a pass-through entity like a sole proprietorship or a general partnership or even a default llc then what happens is your business income passes through your entity and goes straight down to you as an individual on the other hand when you have business income in a tax entity like a c corporation then the income is taxed at that entity level or at that corporate tax rate and if the shareholders or owners want to take income then they would need to take a distribution as dividends and pay taxes on that dividend income which also describes double taxation because you pay taxes once at the entity level and then again at the personal individual level which can easily make your tax rate more than 40 percent okay all that was important to note because people often confuse s corporations with c corporations but i need you to understand that s-corporations are treated as pass-through entities whereas c-corporations are tax entities okay so the irs is basically saying that any profits and losses from a s corp will flow down to the individual and would be subject to individual tax rates now if all of this is still a little bit confusing then you can consider working with us one-on-one through our tax services and programs if you're interested in learning more then just click the first link down in the description below cool now let's move on to number two and talk about some of the advantages of an s corporation now before i get into the disadvantages and why you should hold off on becoming an s corporation i want you to be aware of and know that i'm aware of some of the major advantages of an s corporation okay so number one you can avoid double taxation because again s-corps are pass-through entities now while this may be an advantage for many new businesses and entrepreneurs there are definitely times when it makes a lot of sense to become a c-corporation for tax purposes even in the face of double taxation and i have an entire video where i break down the benefits of a c corporation which i'll link down in the description below the second advantage is number two legal separation and asset protection since s-corps are legally separate from its owners only corporate assets not the owner's personal assets face exposure in the event of a lawsuit or some other liability situation this separation also gives another advantage which is what i would call advantage 2.5 which is the ability to build business credit faster okay the third advantage and probably the most popular advantage of an s corporation is number three reduce self-employment taxes since the irs views s-corp owners as employees they only need to pay self-employment taxes on the salary that they receive from their corporation but they do not need to pay self-employment taxes of 15.3 percent on dividends and distributions they receive as shareholders which can dramatically reduce their tax bill for example if you made two hundred thousand dollars in business profits and you gave yourself a reasonable salary of a hundred thousand dollars then hypothetically you could have one hundred thousand dollars in dividend distributions that aren't subject to self-employment taxes and that could easily save you fifteen thousand three hundred dollars in taxes which is a hundred thousand profit times fifteen point percent which is why so many people love the idea of becoming s corporations but these tax savings don't happen for everyone and we'll talk about why going into number three the disadvantages of an s corporation all right now you should have enough context to be on the same page with me when i say i don't think you should form an s corporation starting with the biggest reason you must take a reasonable salary yes the irs forces s-corporations to pay a reasonable salary to all employee shareholders or owners who are actively working in the corporation and a reasonable salary is considered to be compensation that you will pay someone else to do the exact same job that you are doing and the thing that gets many business owners in trouble is that they are usually juggling multiple things and working many hours a week right you may be doing sales and marketing and recruiting and operations and servicing clients and customer service billing and a lot more and you may only pay yourself a reasonable salary based on maybe some entry-level sales tasks that you do but someone who is in a role where they're juggling a lot of stuff may be more comparable to something like a general manager or operations manager's salary and this makes a reasonable salary problematic for three big reasons starting with number one your income can be reclassified as wages okay this is likely to happen when you have a one-person company and you're doing all of the work and to highlight this let's look at a tax court case a real tax court case called glass block unlimited versus commissioner of internal revenue so a man named frederick bauglett was the president and sole shareholder of his s-corporation where he sold and distributed glass blocks now the s-corp had no full-time employees and mr baldwin was responsible for all the operations of the corporation aka he was a one-man show now during the tax year he did not pay himself a reasonable salary and received distributions of 31 644 that were not subject to self-employment taxes however the irs spotted this and the court found that any officer who performs more than minor services for a corporation and receives compensation in any form is considered to be an employee in his or her wages are subject to employer payments of federal employment taxes in other words the court found that under his s corp the 31 000 distribution was instead a 31 thousand dollar salary because he was the sole employee responsible for all the business operations so he had to go back and pay self-employment taxes on that full 31 thousand dollars now there are other tax court cases where shareholders did not pay themselves enough salary and the irs determined a reasonable compensation for them which by the way if you want to see me review more irs court cases in my videos then please tell me in the comments section below because i definitely don't want to keep referencing these court cases if you don't find them to be helpful okay the second problem with a reasonable salary is number two a reasonable salary can stifle business growth because listen with an s corp you should be paying yourself regardless of how much profit you make okay even if you are making a small profit where you can't afford to put yourself on a reasonable salary yet it is still recommended that you use the 60 40 rule where you pay at least sixty percent of your profits as a salary in the other forty percent as a distribution so hypothetically if you made fifty thousand dollars in business profits then with the sixty forty rule you would pay yourself a reasonable salary of thirty thousand dollars which leave you with only twenty thousand dollars to reinvest back into your business so if you want to grow aggressively and you're willing to reinvest or heck even if you just wanna make sure that you maintain a healthy cash flow then putting yourself on a reasonable salary can obviously stifle your growth and could compromise that a lot so that's big okay the third problem is that you don't have enough income to justify an s corp reasonable salary because to put yourself on a reasonable salary your s corp needs to okay cover half of your payroll taxes they must send you as an employee a w-2 form the s-corp will also need to pay unemployment taxes and your company may have to provide workers compensation coverage depending on the state that you live in your company may also have to pay state disability insurance as well and look all these things take time they take money and they take research to successfully set up so going back to my last example if you are making fifty thousand dollars in profit and you pay yourself a thirty thousand dollar reasonable salary and you had distributions of twenty thousand dollars then maybe you could save about three thousand dollars in taxes but then you have to ask yourself is it really worth it because now you're going to have to spend more time setting things up you may also have to hire a professional and you're going to have to file a separate tax return for tax purposes many tax preparers will charge you two thousand dollars to file an s-corp tax return which wipes out more than half your savings already now of course when you start making more than fifty thousand dollars in business profits then the tax savings can start to outweigh the cost in the time that it takes to elect to become a s corporation especially if you are not doing a lot of reinvesting but look there are still some more disadvantages of an s corp that you want to be aware of starting with number four more irs scrutiny and rules to follow the irs tends to look at s corporations a little bit more carefully because they know many business owners will elect to become an s-corp since it can reduce their self-employment taxes and heck i personally think that they may even set up systems one day to automatically check the salary to distribution ratios to trigger an irs alert on top of the extra scrutiny s-corporations must follow additional rules that don't apply to a default llc and sole proprietorships for example s-corporations must have a board of directors and hold formal management meetings like annual shareholder meetings they must issue stocks and shares to the owners instead of a flat ownership percentage and like we talked about in dev they must also take a reasonable salary as an owner employee and there are other regulations to follow around dividends around tax filing requirements recording meeting minutes and so on and so if the company fails to follow any of these rules then it can lose the s corporation status and be reverted back into a default llc which means any income would pass through to the actual owners and be subject to self-employment taxes so of course you don't want to go through all the hassle of starting your s corp and losing the status so following the rules are super important another disadvantage to consider is comparing an s corp to a c corp which is number five less ability to raise capital because when it comes to raising capital s corps can only have one class of stock and have no more than 100 shareholders so this basically decreases the ability for an s-corp to raise funding and find investors compared to c corporations who have unlimited classes of stock and unlimited amount of shareholders also s-corps can only have shareholders who are u.s citizens or at least u.s residents which furthers limits their ability to raise money for business growth now i should mention that s corporations still have a slighter edge on raising capital than a default llc but barely okay let's bring this all together and talk about the fourth part of this video number four when should you become an s-corporation well as it is with most things when it comes to taxes and business it depends on your financial numbers and your long-term business goals and the two variables that you're going to want to play with are okay how much profit do you anticipate having and then number two what are your goals with that profit for example if you are making over 50 000 and you are not aggressively reinvesting profits then maybe you can consider becoming an s corporation on the other hand if you are making more than 50 000 in business profits and you plan to aggressively reinvest those profits for more business growth then maybe you can consider a default llc or a c corporation or maybe you're making less than fifty thousand dollars and you're not sure if it's worth your time to make the switch then you could consider a default llc or even a c corp but overall deciding to become an s s-corporation or really any business entity has many different pros and cons so it's really up to you to carefully map out what it is you want to accomplish for your business thinking about both the short-term and long-term potential outcomes which is why i created a video on how to choose the best business entity for you coming up next or you can check out another video that i mentioned i will link at the end and i'll see you over there

Channel: LYFE Accounting

Views: 15,266

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Id: UphKDTt8tFQ

Length: 16min 35sec (995 seconds)

Published: Sat Apr 30 2022