Everything You Need To Know About S Corporations

Everything You Need To Know About S Corporations

We get so many questions on S Corporations so we decided to do a 6 part series on everything you need to know about them, on both our Blog and Small Business Tax Savings Podcast.

Outlined below is an easy access guide to each topic, blog post, and Podcast episode.

1. What Is a Pass Through Entity?

Initial introduction on entity types and how they are taxed.

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

Introduction to an LLC and how that relates to the S Corporation.

3. What Is An S Corporation and Why Should I Elect To Be One?

Introduction to S Corporations and why it may be beneficial for you.

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

We got through what the requirements are to be an S Corporation and how you go about electing to be taxed as one.

5. What Is A Reasonable Compensation For An S Corporation Owner?

As you may now know, owners of an S Corporation are required to take a reasonable compensation. We discuss how you can go about determining that and running payroll.

6. I Have An S Corporation, Now What Do I Need To Know?

Now that you understand the S Corp and have it setup and are running payroll, we discuss what else you need to know!

That’s it! Hope you found that helpful.

 

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

I Have An S Corporation, Now What Do I Need To Know?

I have an S Corp, Now What Do I Need To Know?

This is Part 6 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?

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

What Is A Reasonable Compensation For An S Corporation Owner?

In this article we are going to talk about what you need to know now that you are organized and operating as an S Corporation.

1. Recap

Lets recap where we have been the past couple weeks.

  • Pass Through Entity: An S Corp is a pass through entity meaning that you pay taxes on the profit from the business on your personal return.
  • Annual Business Tax Return: You file S Corp activity on Form 1120S which will have a K1 to report that activity on your personal return.
  • Benefit of the S Corp: Eliminate a portion of the self employment tax you pay. Instead of paying self employment tax on 100% of your income you only pay it on your salary.
  • Electing S Corp Status: To elect S Corp status you would need to meet a few requirements and then file Form 2553.
  • Reasonable Salary (Payroll): The owners of an S Corporation are required to take a reasonable salary (W2 Payroll as an Employee)

2. S Corporation Owner Health Insurance

As the owner of an S Corporation you need to treat health insurance payments for yourself in a special way to ensure you get the deduction.

  • Step 1 – Have The S-Corp Pay the Insurance: This should be done directly out of the business bank account. You will deduct the expense as wages on the business side.
  • Step 2 – Gross Up Payroll: You will take that insurance expense paid and gross up the payroll wages for the owner(s). If the plan is non-discriminatory then no FICA needs to be withheld. This will also help you hit that reasonable salary amount. Note: You will need to ensure your payroll provider knows about this so it can be included in your W2. Typically we make this adjustment at year-end.
  • Step 3 – Deduct On Personal Tax Return: Finally, that income that was reported to you in wages for the insurance will now be deducted on your personal tax return.

As you can tell there are a few hoops you need to jump through but the net result is you get a deduction for it.

You deduct on the business side, include in wages on payroll, and then deduct on the personal side.

3. Accountable Plan (aka Reimbursement Policy)

A way to get a business deduction for expenses paid personally or expenses that are a mix between both business and personal.

  • Expenses that are 100% business related, simply run them through the business.
  • If you mistakenly run a 100% business expense on your personal account, use the accountable plan to reimburse yourself.
  • For items that are not 100% business related (Example: Home Office, Automobile, Travel, etc) you use an accountable plan to reimburse yourself for the business portion (Business Use Percentage x Amount).
  • To implement an accountable plan you just need to create a plan agreement and put it on file for your business.
  • We also recommend using an accountable plan worksheet to help track those items that are business and personal mix.

It is important to reimburse yourself through an accountable plan because if you do not, that money may be considered taxable income.

That’s it! This concludes our series on S Corps where we walked through all aspects surrounding this tax election and what you need to know.

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

What Is A Reasonable Compensation For An S Corporation Owner?

What Is A Reasonable Compensation For An S Corporation Owner?

This is Part 5 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?

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

In this article we are going to talk about the reasonable compensation aspect of electing S Corporation status.

1. What Is A Reasonable Compensation For An S Corporation Owner?

That is the $1,000 question. Unfortunately the IRS does not give us clear guidance in this area but they are able to point us in a direction at least.

The IRS states this:

  • S Corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee.
  • The key to establishing reasonable compensation is determining what the shareholder-employee did for the S corporation by looking to the source of the S corporation’s gross receipts.
    • Services of shareholder
    • Services of non-shareholder employees or
    • Capital and equipment
  • Some factors in determining reasonable compensation:
    • Training and experience
    • Duties and responsibilities
    • Time and effort devoted to the business
    • Dividend history
    • Payments to non-shareholder employees
    • Timing and manner of paying bonuses to key people
    • What comparable businesses pay for similar services
    • Compensation agreements
    • The use of a formula to determine compensation

As you can tell the IRS is not very clear as to what constitutes a reasonable salary but based on the information made available, along with court cases we studied, we have determined some optional methods for determining this reasonable salary.

2. Strategies To Determine S Corporation Owner Reasonable Salary

There is no magic bullet to determine a salary that the IRS will label as reasonable but here are two options we often discuss as starting points with clients.

  • Option 1 – Easy Method but Harder to Defend: Use a percentage of net income prior to owner salary. This percentage should be at a minimum 30%, but can often range from 30%-50%+. Example: Net income prior to salary of $100k, using this method you would be in the $30k-$50k range for a reasonable salary, with closer to 50% being less risky.
  • Option 2 – Harder Method but Easier to Defend:
    • Determine the amount of hours you spend doing various tasks in your business, on a yearly basis: Your Specific Job (Lawyer, Marketer, Plumber), Administrative Duties, and Marketing Duties
    • Find the rate someone doing those various tasks in your city and state gets paid (You can use BLS data from the government here).
    • Multiply that rate by your yearly amount of hours worked.
    • Add in any adjustments for special training, licenses, certifications, etc that you have.
    • Add in any other special considerations (highly compensated, non owner employees, etc).
    • Take all of that data and land at your final reasonable salary.

Option #1 is obviously easier to complete but the biggest downfall is you do not have any substantiation to back up your salary in the event of an audit. Option #2 take a little more leg work but in the event of an audit you have backup to support your determination of your salary. We have a calculator for Option #2 that you can reach out to us for if you would like a copy for yourself.

Note: Both options are simply starting points to figuring a reasonable salary. Each tax payer is different and you’ll want to sit down with a tax professional to really drill down to the salary that makes sense for you and your business.

3. What Happens If I Take Too Low Of A Salary?

The IRS has the authority to reclassify payments made to shareholders from non-wage distributions (which are not subject to employment taxes) to wages (which are subject to employment taxes).

  • Basically in the event of an audit you would need to provide support that backs up the salary you took as a business owner.
  • If the IRS determined your salary was too low, they would reclassify distributions you took into wages and you would need to pay back taxes, interest, penalties, and fees.
  • Example: You take a reasonable salary of $50k but the IRS determines $80k is reasonable and you had distributions of $60k. The IRS would take $30k of your distributions and reclassify them as wages.

Note: If you took zero distributions in a specific year there would be nothing to reclassify. However if you took a distribution the next year the IRS would require you to pay the salary you should have taken in the prior year when you took no distributions.

4. How Do I Run Payroll To Myself?

We recommend a payroll software called Gusto for your payroll processing needs because they handle all tax payments and filings on your behalf.

If you need an introduction to our rep over at Gusto, contact us and we can invite you into the software!

When it comes to running payroll you have a few different options:

  • Option 1: Setup a regular payroll schedule (weekly, bi-weekly, monthly, etc) and run payroll to yourself on a normal basis.
  • Option 2: Take distributions as you need money and then at the end of each quarter run an off-cycle pay-run for your reasonable compensation amount. This will move a portion of distributions that you took into wages and you can then just pay the tax portion at that time.
  • Option 3: If you elected a late election you will need to get caught up on payroll for the part of year already missed. In that case you can run an off-cycle pay-run for the tax portion and then move to Option 1 or 2 moving forward.

In our next article we are going to discuss “So I am an S Corporation, Now What?”.

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

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.

What is a Pass Through Entity?

Pass Through Entity - What is it and what does it mean?

Most businesses do not have to pay income taxes on the corporate level. Instead the profits from their business flows through (or passes through) to the owners of the company where it is eventually taxed.

Types of Pass Through Businesses

  • Sole Proprietor
  • Partnership
  • Single Member LLC
  • S Corporation

An example of a non pass through entity would be a C Corporation. In a C Corporation the company pays taxes on the profit of the business at the corporate level.

Basic Concept: If you have a pass through entity you have income and expenses related to the business that are reported on the business tax return (Schedule C, 1065, 1120S). The profit from those businesses are then reported on a personal return where the taxes are paid.

Here is the tax treatment for the various entity types:

Sole Proprietorship or Single Member LLC

File business information on a Schedule C on a personal tax return (Form 1040).

Partnership or Multi Member LLC

File business information on Form 1065 and then each partner will receive a K1 with their share of activity which will be used to report and pay taxes on the business activity on a personal tax return (Form 1040).

S Corporation

File business information on Form 1120S and then each owner will receive a K1 with their share of activity which will be used to report and pay taxes on the business activity on a personal tax return (Form 1040).

C Corporation (Not Pass Through Entity)

File business information on Form 1120 and then pay taxes at the corporate level.

Now you know what a pass-through entity is. Majority of small business owners in the US operate using a pass-through entity.

Check out our episode on the Small Business Tax Savings Podcast for more on this topic!

JETRO Goes Gusto Gold

JETRO Goes Gusto Gold

When JETRO started way back in 2013 we were looking for a modern, cloud based solution for the payroll side of our business.

We spent time researching and testing all the various options out there and just could not find a good fit that matched our model: modern, robust, and simple to use.

Luckily in 2014 we got introduced to Gusto and have not looked back since. Based on our research and experience, it is by far our preferred choice for payroll. Whether we are doing the payroll on behalf of clients or clients are handling it themselves we know they are in good hands when using Gusto.

As part of this journey we are proud to announce that we are now a Gusto Gold Partner!

Thank you Gusto for continuing to innovate and provide such an easy to use payroll solution for both JETRO and our incredible clients.

Want to learn more about Gusto? Reach out to us!

How should I structure my business with multiple owners?

How should I structure my business with multiple owners?

We often times get business owners that reach out to us that have multiple owners in their company, wondering what the best way is to structure their business.

In this specific article we are assuming an S Corp structure is desired prior to it reaching the owners personal tax return. If you don’t know what an S Corp is, we will dig into that in future post but in a nut shell it is a tax strategy to help limit the amount paid in self employment taxes.

With that assumption there are two main options we typically suggest. Note that this also assumes that all owners are going to be active within the business (not just silent investors).

Option 1

Setup company as an S Corporation with each owner as a shareholder in the business personally.

  • Advantages
    • One company, one tax return, one payroll account
    • Easier to setup and less maintenance
    • Cheaper
  • Disadvantages
    • Various owners cannot take advantage of tax strategies that help them but not other owners.
    • If you have multiple businesses you may need multiple S Corps.
    • Less Flexibility

Option 2

Parent company is a partnership with each owner having their own S Corp that owns their percentage in the partnership.

  • Advantages
    • Each partner can utilize tax strategies as they see fit (hire kids, business automobile, etc).
    • If they own multiple businesses their personal S Corp can hold the ownership in those and all business income will flow through their S Corp prior to reaching them.
  • Disadvantages
    • Multiple companies, multiple tax returns, multiple payroll accounts
    • More to setup and maintain
    • More expensive

 

With that being said, lets run through some scenarios.

Scenario 1: Two owners and one wants a Mercedes for his business vehicle and the other wants a Prius. In option 1, there could be some conflict because the price for these are vastly different and the person with a Prius does not get as much out of the tax strategy. However in option 2, it doesn’t matter because they can hold the vehicle ownership in their personal S Corp and do whatever they want with affecting the other owner.

Scenario 2: Two owners in which they are 100% active in the business with no other ventures. In option 2 they would have to pay for a tax return for the partnership and then two S Corps. They would also have to run two separate payrolls for each S Corp. Rather if they chose option 1 it would be one business return and one payroll which means it is more cost effective.

Generally if the owners have multiple businesses they participate in, we will suggest option 2 since they will want all income to pass through an S Corp anyways so they can avoid a portion of self employment taxes.

If the owners are on the same page as far as spending and tax strategies, we typically say option 1 is fine for them to help minimize costs and maintenance.

Either way, there is no one size fits all for every situation so be sure to discuss with a tax professional to ensure you get things right from the beginning.

Check out our episode on the Small Business Tax Savings Podcast for more on this topic!

Company Retreats – Connect w/ Your Employees or Clients

On June 29th and 30th here at JETRO we held our annual team retreat. Typically we get our staff together in a city for a few days to hang out but due to COVID we were limited to a virtual retreat this year. Given the circumstances our staff made the best of it and we had a great time and covered a lot of ground.

Retreats are important not only for us but for you in your business. Here is why we hold an annual retreat:

  • Get to know each other on a more personal level
  • Be transparent and update your team on the company vision and what the future looks like
  • Make important decisions and involve everyone
  • Show appreciation and how much the team means to you and your company

Whether you bring everyone together or hold a virtual team retreat I encourage to make it happen as you will see it truly unites your team.

On the Small Business Tax Savings Podcast below we share more information on this!