SPEED ROUND: Entity Selection: S Corporations

Dark Horse CPA

Learn what you need to know about S Corporation taxation before you decide on which entity type is best for your business. Join Dark Horse CPA, Erik Hegstad, as he takes you through the quick & dirty on S Corps.

Podcast Transcript

Hello and welcome. You’re tuned into taxes. Made simple for a speed round on S  corporations. My name is chase Berkey, CEO of dark CPAs, and I’m joined by Colorado’s very  own Eric KCStat who runs a dark horse CPA practice in Fort Collins. You may remember him  from our conversation on entity selection, which was the second episode we did for the  podcast.

So what we decided to do on this episode was create a speed round series on  entity selection to break down each of the major entity types, to give you a little more depth  on the advantages and disadvantages of each. So, as I mentioned before, this episode is  going to be on S corporations. Eric, welcome back to the show and thanks for being here.

Thanks for having me. I’m happy to be back and excited to take a quick dive into  the world of S corporations. Awesome. Well, as we do on this show, it’s time for you to show  me your cup of coffee and let me know what you’re drinking. Well, this is just your basic  Americano. Um, no cream, no sugar, just straight to the point.

Like I intend to be with our discussion today. Mm, sounds more tasty. Well, let’s  start the clock for five minutes. Eric. Tell us what an S-corporation is. I’m actually going to  flip this one around and tell you what it’s not, because it’s easier to understand this way. You  did not form an S corporation with your secretary of state.

You either form an LLC or a corporation and then make the S election. Well, you  probably just blew some of our listeners minds right off the bat there, but what do you  mean by an S election? You file a form with the IRS to elect for that LLC or corporation to be  taxed as an S-corporation. It’s just a tax designation, not a type of legal entity.

You’re still an LLC or a Corp, depending on which you formed with your state of  incorporation. Well, the natural follow-up question then is why would you do this? As  corporations enjoy certain tax benefits as compared to other entity types, like a partnership  or LLC, you only have one level of tax. Since the income flows through to the owners, by the  percentages, this would be an advantage against a C corporation that pays tax at the entity  level and the shareholder level.

Unlike a partnership. However, the income that flows through to you on your K  one is not subject to self-employment tax, which can save you up to about 15% on that  income. So this is the main differentiator that leads just about everyone to think that the S corporation is the way to go hands down, but Eric I’m sure you’d agree that there are many  more considerations at hand here other than just the self-employment tax issue.

Right. 100%, one consideration off the top of my head is that you have to run  payroll, maintain a set of financial statements and file a separate tax return, which you don’t  have to do when you’re a single member LLC. So there’s a cost associated with that. Also the  payroll that you’re required to run for yourself, which is called officer compensation, does  not qualify for the 20% QBI deduction.

On the other hand, those W2 wages could unlock some of this 20% QBI deduction  that you’d otherwise forgo. If you were taxed as a partnership, I’m going to spare our  listeners from the agony of going into further depth there. But I will say it’s this sort of  nuance that Eric helps his clients work through on the daily to make sure they’re being as tax  efficient as possible.

So let’s talk about the restrictions imposed on S corporations to maintain their tax  status. Absolutely. So you can’t have a shareholder that is an entity or someone who is not a  us citizen or permanent resident. You can’t have more than one class of stock and you can  not have over 100 shareholders. So there are a lot of restrictions on ownership further.

These owners, at least the ones that operate in the business must be paid a  market salary for their services. All distributions paid to shareholders must be done to their  percentage of stock ownership. There are also a number of corporate formalities that you  must adhere to such as holding certain meetings and keeping minutes on those meetings.

If you run a foul of any of this, the IRS can strip you of your selection. And what  happens if they do that? Well, you revert back to the tax status of the entity type that you  created. So corporations, for example, would have all of their income, double tax back to the  date. The election is revoked. That sounds like an absolute migraine.

So what else should our listeners be thinking about? One thing would be how  their state taxes and S-corporation versus an LLC. In California, for example, S corporations  pay a tax of 1.5% on their net income. Whereas an LLC pays a tax based on their gross  receipts. High revenue, low margin businesses are typically negatively impacted by being an  LLC in California compared to being an S corporation.

And. As I mentioned before, they’re just a lot less flexible than an LLC, which can  cause operational challenges for a business. And they can cause problems in attracting  investment capital from those who would be ineligible to own the stock or those who simply  don’t want a K one. For these reasons, a number of escorts become C corpse when they seek  investment to scale the business.

And boom goes the dynamite. Eric very informative. And I think we flirted with  the five minute Mark there to our listeners. If you have any questions on entity formation, or  if you just need a new CPA and you like what you’re hearing from Eric, you can email him at  Eric at dark horse dot CPA. Once again, that’s Erik with a K at dark horse dot CPA.

So as always, we’d like to thank you for tuning into TMS, or if you’re not into the  whole brevity thing, taxes made simple because there’s TMI and then there’s TMS. Yeah.

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