What Are The Requirements For An S Corporation and How Do I Set One Up?

What Are The Requirements For An S Corporation and How Do I Set One Up?

This is Part 4 in a series of ours. If you have not read our previous articles do that first:

What is a Pass Through Entity?

What Is An LLC and How Is It Different From An S Corporation?

What Is An S Corporation And Why Should I Elect To Be One?

In this article we are going to talk about what the requirements to be an S Corporation and how you set one up.

1. What Are The Requirements For An S Corporation?

To be classified as an S Corporation there are a few requirements that must be met.

  • Must be organized initially as an LLC or Corporartion. Remember this is simply a tax election so you must first have a company open. If you are currently operating as a Sole Proprietor you will need to open an LLC or Corporation and then elect S Corp status. Any activity under the sole proprietorship will need to be filed as such and cannot be claimed under the S Corp.
  • Shareholders may be individuals, certain trusts, or estates. May NOT be a: partnership, corporation, or non-resident alien.
  • Cannot have more than 100 shareholders.
  • Can only have one class of stock.
  • All shareholders must consent to the election.

Although these requirements may seem scary, the majority of clients we talk to do not run into any of these issues.

You may have noticed that partnerships or other corporations cannot be shareholders. If you are in a situation where you are working with other owners with various corporate setups, check out our article: “How Should I Structure My Business With Multiple Owners?

2. How Do I Elect S Corporation Status?

To elect S Corporation status you will need to file Form 2553.

  • Form 2553 must be filed within two months and 15 days from the date your business starts or if you already have an existing business within two months and 15 days from the beginning of the tax year you wish S Corp election to be effective.  Example: You want S Corp status effective tax year 2021 would need to file Form 2553 by 3/15/2021.
  • If you do not file Form 2553 in the required time frame you can request relief for a late election by:
    • 1) Writing on top of Page 1 of Form 2553 “FILED PURSUANT TO REV. PROC. 2013-30”
    • 2) Filling out Section I of Form 2553 for reason of request.
    • Note: The IRS typically accepts late relief in the majority of cases as long #1 and #2 are completed.
    • Example: It is August 2020 and you want S Corp status effective 1/1/20. You can still request relief for a late election and then just get caught up on the payroll since the beginning of the year.

Note: To obtain S Corp tax treatment for state taxes, you may need to file additional documents with your state.

You’ll notice that Form 2553 is a pretty straight forward form to fill out, just ensure you fill it out completely included signatures and information from all owners.

In our next articles we are going to discuss what a “reasonable salary” means and how you can go about setting this up.

If you don’t have a tax advisor (or you need assistance with this election), click here to book your complimentary strategy session with JETRO.

What is an S Corporation and Why Should I Elect To Be One?

Why S Corporation

This is Part 3 in a series of ours. If you have not read our previous articles do that first:

What is a Pass Through Entity?

What is an LLC and How Is It Different From An S Corporation?

In this article we are going to talk about what an S Corporation is and why you may want to elect to be taxed as one.

1. What is an S Corporation?

An S Corp is a way to be taxed. It is not a entity type at the state level. In order to be an S Corporation your business must be an LLC or Corporation. You then elect for that business to be taxed as an S Corp.

This is important, in order be an S Corp you need to have an entity structure already setup. If you are operating as a Sole Proprietor you would not be able to elect S Corp status, you would first need to open an LLC or Corporation.

If you elect to be taxed as an S Corp it does not change your entity structure at the state level. If you are an LLC and elect to be taxed as an S Corp you remain an LLC with your state, nothing changes on the entity setup level.

2. Where do I report activity from a S Corporation?

As discussed in our previous article a S Corp is considered a pass through entity. You report the business activity on a business tax return (Form 1120S) which would include a K1 that you use to bring it to your personal return.

Note: As a Single Member LLC you simply file your business activity on your personal tax return (1040) via a Schedule C but with an S Corporation you are required to file a separate business tax return which will then flow to through your personal return.

3. Payroll Requirement for S Corporations

The IRS requires owners of an S Corporation to take a “reasonable salary”. This means you will be an actual W2 employee of your business. If you have other employees this is not a huge deal but if you are a solo business owner you will need to implement a payroll service to help make sure this is done quickly and easily. We recommend Gusto for a painless payroll experience.

4. How is a S Corporation taxed?

As a S Corporation there is no federal income tax at the corporate level instead your pay taxes on the business income on your personal tax return. You will pay your normal income tax rate on the income from the S Corporation and you will pay “self employment taxes” on your salary from the S Corp.

Regular Income Tax Rate: This would be your normal rate that you pay on all ordinary income including a W2 from an employer.

Payroll “Self Employment Tax”: With an S Corp you pay self employment taxes on the payroll you take as an employee. They do not call it self employment tax directly but that is essentially what it is because you pay social security and medicare taxes as both an employee and then you as an employer matches it.

If we compare this to a Sole Prop or SMLLC you can see the advantage is that instead of paying self employment taxes on 100% of your income, you only pay it on the payroll portion but any other earnings from the business are just taxed at your normal income tax rate.

Essentially you split your business income into two: Payroll and Dividends (or owners draw)

Lets put this in an illustration:

S Corporation Tax Setup

5. Let’s see an example!

Everything makes more sense when you put some numbers to it. So lets look at an example. In this example we are using business profit of $80,000 and we are assuming a reasonable salary would be $36,000.

Sole Prop/SM LLC vs S Corporation

In this example with $80k of business profit if you were setup as a SMLLC you would pay $11,304 in self employment taxes, again this is in addition to your normal income tax rate.

However, with an S Corporation we are only paying self employment taxes on our payroll of $36k which would be $5,508. The remaining $44k from our profit would not be subject to self employment taxes, leading to tax savings of $5,796.

Note: The remaining $44k you would pay your normal income tax rate on and take (if you wish) as a dividend simply by transferring the funds (or writing a check) from the business account to your personal account.

This self employment tax savings is one of the main reasons we look to an S Corp for small business owners.

6. When does it make sense to elect to be taxed as an S Corporation?

An S Corporation is not right for everyone. Typically we say if your business profit is roughly $40k or more the S Corporation could make sense for you. The reason we set this threshold is because there are some added costs to an S Corp (which we discuss below), that will eat into your tax savings if below this amount.

We would never advise someone to rush into an S Corp if the additional costs to maintain it will wipe out the savings.

Note: Some cities and states (New York City, Tennessee, etc) are not friendly to S Corporations, so double check an S Corp makes sense in your specific situation prior to making any changes. There are also some requirements that need to be met in order to elect S Corp status which we will discuss in a future article about setting up the S Corp.

7. What are the downfalls to being an S Corporation?

As mentioned above if you are not profiting $40k+ some of the costs of an S Corp could eat up your tax savings. Here are the two main downfalls of an S Corporation:

  • Separate Business Tax Return is Required: Unlike a Sole Prop or SMLLC which are simply filed on your personal tax return via a Schedule C, with an S Corp you have to file a separate S Corp Business Tax Return on Form 1120S. This tax return is more complicated than a Schedule C and thus costs more to prepare. Fortunately, all of our packages includes the S Corp tax return in them.
  • Payroll (Reasonable Salary) is Required: If you already have employees adding another one (yourself) is not a big deal. However if you do not currently have employees you would need to setup a payroll system so you can properly withhold taxes, file payroll tax returns, and pay the respective taxes to the government agencies. This brings a hard cost which typically ranges from $50-$120 per month.

Assuming you live in an S Corp friendly city and state (most are) these would be the only main downfalls.

Another nice feature of the S Corp is that the audit rates are significantly less compared to a Schedule C filing.

In our next articles we are going to discuss what a “reasonable salary” means and how you can go about electing S Corp status for your business.

If you don’t have a tax advisor, consult with one prior to make this change to ensure it makes sense for you and your business. Click here to book your complimentary strategy session with JETRO.

What Is An LLC and How Is It Different From An S Corporation?

Sole Prop/LLC vs S Corporation

If you have not already read our article “What is a Pass Through Entity?“, do so now and then come back here!

This is one article in a multi part series we are doing on S Corporations. Before we dig too deep on S Corps we need to discuss the alternative options. Many people start their business as a Sole Proprietor or LLC. Lets discuss the tax piece of this setup.

1. Where do I report activity from a Sole Prop or LLC?

As discussed in our previous article a Sole Prop or LLC is considered a pass through entity. You file the activity from a Sole Prop on your personal tax return (Form 1040) via a Schedule C.

If you are a Single Member LLC you would do the same, report activity via the Schedule C.

If you are a Multi-Member LLC you would report the activity on a business tax return (Form 1065) which would include a K1 that you use to bring it to your personal return.

Again, these are considered pass through entities so if you haven’t read our first article, check that out first to understand this concept further.

2. How is a Sole Prop or LLC taxed?

As a Sole Prop or Single Member LLC (SMLLC) you pay your normal income tax rate on the income of your business as well as self employment taxes.

Regular Income Tax Rate: This would be your normal rate that you pay on all ordinary income including a W2 from an employer.

Self Employment Tax (15.3%): This is broken into two separate pieces, Social Security and Medicare. Social Security is 12.4% on your first $137,700 (2020) of business income. Medicare is 2.9% on your total business income. The total combined is 15.3%.

Again, with a Sole Prop or SMLLC self employment tax is over and above your normal income tax rate, so you pay both. There are no deductions or credits to offset self employment tax.

3. Let’s see an example!

Everything makes more sense when you put some numbers to it. So lets look at an example. In this example we are using business profit of $80,000.

Sole Prop/LLC Taxed

In this example with $80k of business profit you will pay $11,304 in self employment taxes, again this is in addition to your normal income tax rate.

Note that it does not matter whether you are a Sole Prop OR a SMLLC, for tax purposes they would both be treated the same. Thus, by simply creating an LLC you are not creating any tax advantages.

This self employment tax is one of the biggest disadvantages to a Sole Prop/SM LLC setup.

4. So now what do I do?

Fortunetly there is a tax strategy we can utilize to help eliminate a portion of your self employment tax and that is by utilizing an S Corporation. In our next article we are going to dig deeper into what an S Corp is and how it can potentially bring tax savings to you!

If you don’t have a tax advisor, you’re paying way more than you should be. Click here to book your complimentary strategy session with JETRO.

7 Biggest Legal Loopholes For Attorneys & Law Firms In The New Tax Law

7 Biggest Legal Loopholes For Attorneys & Law Firms In The New Tax Law

We could all stand to pay less in taxes, right? Fortunately, the new tax law has given law firms plenty of opportunities. There are seven major ways to slash your taxes and put more profit in the bank each year. I call them “loopholes” because so few people know about them but all seven are perfectly legal tax strategies provided for in the new tax law.

You can make a few adjustments to how your business is set up or how you handle your expenses and save big at tax time. Whether you’re able to take advantage of one, two, or all seven of these strategies, it’s well worth your time and effort to implement them. Without further ado, here are seven legal tax loopholes for law firms:

1. The August Rule

This loophole allows you to literally pay rent to yourself, tax-free, and we owe it all to golf in the 1970s.

If you’re a golfer, you know the Masters Tournament is held every year in Augusta, Georgia. Like the Superbowl or the Olympics, the Masters draws a lot of visitors who are always looking for lodging nearby. Wealthy home-owners near the course rented their homes during the tournament and lobbied for that income to be tax-free since they weren’t full-time rental homes.

The result? When you rent your personal home for up to 14 days per year, that income is not taxable. This is true even if you rent the home to a business you own.

Next time you need to hold a corporate meeting or a staff off-site, hold it in your home rather than a hotel or another rental. You can claim the rental expense for your business, as long as you document the business use and confirm that it was a reasonable rate (find comparables by getting quotes from hotels or even Airbnb rentals in the area).

Tax-deductible for your business and tax-free for your personal income taxes equals and win/win.

2. Mixing Business and Pleasure

If you’re as busy as most law firm owners, finding time for a vacation is a challenge. Your best bet may be to fit business and vacation time into the same trip.

Thankfully, that can mean a lot of vacation expenses are picked up by your business, completely tax-deductible.

In order to deduct a trip as a business expense, you need to be conducting business the majority of the time. The IRS measures in days, meaning you’d need to spend at least 4 days out of a one week trip mainly on business (business needs to be 25% of your trip if it’s outside of the U.S.). Traveling to and from your destination is considered part of the business trip, so that already gives you two days. Plus, if you’re in meetings or attending
a conference from 9-5, there’s no reason you can’t enjoy some R&R after hours.

Travel expenses for flights, car rentals, or vehicle expenses (you need to leave your tax home to incur business travel expenses) can all be deducted. So can lodging and 50% of meals expenses related to your business transactions.

If you’re bringing the family along on the trip, just make sure your expenses are “necessary and ordinary.” You can deduct the cost of a single room, but not the cost of a family-sized suite, for example. As long as you document, feel free to rent the suite and only deduct the portion that coincides with a single-room rate.

3. Learning the Value of Work has Tax Benefits

Do you want your children to learn the value of a hard-earned dollar and maybe even take in interest in the family business?

The new tax law makes it better than ever to hire your children.

If your firm isn’t incorporated, there are some great perks to hiring your own dependent children. Instead of giving them an allowance or paying them to mow the lawn, why not pay them a reasonable wage to work around the firm? Their income will be exempt from Social Security, Medicare, and federal unemployment tax withholdings. They’ll also be able to shelter a significant amount of that income with their standard deduction since it’s earned income.

On your end, the wage expenses are fully tax-deductible, just as they would be if you hired someone else. Depending on your child’s age, this is a great way to get cleaning and lawn care, light office work, or some computer support at your firm.

4. Get More Mileage out of Your Vehicle Expense

If your firm uses a vehicle at least 50% for business purposes, you can deduct a number of expenses. The big decision is whether you’ll track those expenses one by one (actual expense method) or simply multiply the miles driven by the predetermined rate (standard mileage rate method). The standard rate has always been popular because it’s easier to track, but the Tax Cuts and Jobs Act just made the actual expense method much more appealing.

The actual expense method allows you to include depreciation on your vehicle. Under the newest tax update, the limits on vehicle depreciation were greatly increased and bonus depreciation can be applied to many vehicles. Bonus depreciation allows a business to take additional depreciation expense deduction when a vehicle is first put
into use.

Additionally, if you have a more expensive vehicle with higher than average repair and maintenance costs, the actual expense method is likely going to be your best bet.

5. Shrinking Meals Expense Deductions

Client networking and employee fringe benefits have been a part of professional businesses for years. Recent tax changes have cut back on the deductibility of a lot of these expenses, making it harder to justify those expenses. The changes have also made the details so complicated that even the IRS isn’t quite sure what they mean.

What was once meals and entertainment expense deduction now excludes entertainment. Taking a client or prospect out for lunch or a round of golf used to be deductible expenses. The golf is now off the table. Eating in a setting that includes entertainment (like a dinner theater or club) is also disallowed, although some CPAs
would argue for the deductibility of the eating portion.

Another big change is the deductibility of fringe benefits such as an employee cafeteria. Unless they’re part of an event like an employee Christmas party, these items are now 50% deductible instead of fully deductible as they were before. Don’t worry, the morning coffee and donuts should be considered a “de minimis” expense that’s not big enough to be consequential for tax purposes.

6. The Hidden (Fringe) Benefits of Hiring Your Spouse

If you have a small, family-owned practice, there could be big tax incentives for hiring your spouse. Hiring them on a part-time basis and paying them in the form of fringe benefits can be both a deductible expense for the business and a tax-free source of compensation for your family.

A Section 105 medical reimbursement plan can form most or all of the reasonable compensation paid to your spouse for their work, as long as it is within limits. These contributions are a wages expense for the employer and can be used by the employee to cover out of pocket medical and dental expenses and insurance premiums.

There are a few words of caution on this loophole. In order to be allowed by the IRS, the Section 105 plan needs to be carefully planned out and documented. Make sure the compensation you provide to your spouse isn’t too much or too little and that they are actually performing a necessary job in your firm.

Also, if you have multiple employees in the firm, you need to be careful. Since this is a health care expense reimbursement plan, you can’t discriminate between employees and offer it only to one, even if the one is your spouse and even if it’s their only form of compensation.

7. The Perfect Business Structure for Your Firm

Choosing the ideal business structure for your firm effects both your liability and your tax situation. As a law firm, you’re fully aware of the liability issues but the Tax Cuts and Jobs Act has just had a huge impact on the tax implications of your structure.

Pass-through entities such as S-corps and LLCs may qualify for a 20% deduction on qualified business income. This helps to balance the tax cut given to corporations, but it’s limited in availability. SSTBs (Specified Service Trade or Business) can only take the deduction is income is below $207,500 for individuals and $415,000 for couples. At the higher end of this limit, the deduction starts to phase out.

If your income is higher than the limits, you may want to look into becoming a C-corp. Although C-corporations face double taxation (paying at both the corporate and personal levels) the corporate tax rate has been reduced to a flat 21% across C-corps. Consider the necessary steps and hoops and talk with your tax advisor about which entity would give you the best results.

These 7 tax law loopholes can save you thousands at tax time. You just need to know which ones are a fit for you and how to fit them into your overall tax strategy.

If you don’t have a tax advisor, you’re paying way more than you should be. Click here to book your complimentary strategy session with me.