The Essential Guide to S-Corporations | Christian Brim

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Welcome to another episode of The Profitable Creative, the only place on the interwebs where you will learn how to turn your passion into profit. I am your host, Christian Brim. Special shout out to our one listener in Mason, Ohio. No idea where that is, but thank you for listening, Mason. No guests today. This is only the second time that I am coming to you solo. But I want to talk to you about S corporations. Seems to be like a popular topic with a lot of creative entrepreneurs. We see a lot of people that come to us with that question. Should I be an S corporation? You know, should I not? What does that involve? And frankly, there's a lot of misinformation out there. You know, if you do a Google search or a ChatGPT search about you know, S corporation, should I be an S corporation? It just seems to honestly confuse people. Now, I dedicated a whole chapter in the book with an example laying it out in, in Profit First for Creatives. Um, by the way, you can download the entire book for free if you click on the link in the show notes, so you have no excuse for not going through the example and learning yourself. But I'm going to try and replicate that, um, here on this episode. So, um, let's lay some groundwork. Um, when you start a business, you do not automatically have a separate legal entity. You have to go to your state's Secretary of State and file to have a separate legal entity, be that a corporation, an LLC. Um, that's generally the, the two options that are available. There are other options, but really they're not applicable. Uh, so I don't want to confuse you. Yes, that you can form different, uh, legal entities besides an LLC or a corporation, um, but for our purposes, we're only going to discuss those. So why do you, why do you form a separate legal entity? Um, I would tell you that the best reason is not taxes. The best reason to form a separate legal entity is asset protection. Um, it separates your business assets from your personal assets. I'm not a lawyer, I'm not advising you on legal matters, I'm just talking from my own experience. When I have a business in, in activity, interest, uh, I, I put that into a separate legal entity because I don't want it to affect everything else that I own, be it personal or in another company. So you, you create a separate legal entity and that is where your business operates. You and the legal entity are distinct persons for, for the law. Now, again, I'm not a lawyer, but I can tell you that if you don't operate your business correctly in that separate legal entity, you can completely screw up any protection you have. Commingling of funds, not having your business bank account for instance, titled in the LLC's name and running it out of your personal bank account. That is, is, is a huge no-no. So just because you go to the Secretary of State and pay the fee and form an LLC, for instance, does not mean that's the end of it. It's just, just the very beginning, right? So the primary purpose is for that any business should do this regardless of size is to protect yourself. So if you have a lawsuit because of something you did in the business, they can only attack those business assets and they can't come after you personally or other businesses that you may own. So then that brings us to the question of the S corporation. And if you've been in business long enough, your colleagues have said, oh, you should check this out. I'm an S corp and it saved me a lot of money. Yes, it can save you a lot of money in certain circumstances, but it should not be something that you go and form an LLC just because you think that you're going to save taxes. You need to have somebody that knows what they're doing look at it, look at your business, look at your prior taxes, and do an analysis. You know, we get this question all the time: should I be an LLC? Should I be an S corporation? I don't know until I look at your stuff. I can't tell you whether you should or you shouldn't be. And sometimes even then I can say, well, you know what, you're right on the, on the cusp. I mean, here's the, here's the, here's the tax potential tax benefit, um, and here's what, you know, the additional cost and work is. And like, you're going to have to make the decision whether that makes sense or not. And that's only a point in time. Like, if you had an exceptionally good year and it's not a normal year and it would make sense to be an S corp that year, um, then, you know, it may not replicate in, in the future years. So anytime you make a change in your, your tax filing status, you need to consider it not just for the current year but for future years, because, um, that's something that you, you can change. You know, like, you can elect an S corporation and, and subsequently revoke it. But you don't want to do that willy-nilly because you can't go back and forth year to year. It's something that is essentially permanent. You should consider it permanent even though it's not exactly permanent. You should think of it of, of, okay, I'm going to be an S corp from here on. So, um, you have to involve a tax professional that knows what they're doing and is not just trying to sell you on being an S corp. Right? Because there, there are cases where I've advised a client like, you know, you're really on the border, and, um, you know, here's, here's the tax savings. Is it worth it? That's up to you. I can't answer that for you. It may be a wash. It may be like, well, the, the additional work and the additional tax filings and the cost of that, um, it's, it's a, you know, not going to offset completely the tax savings that I'm going to receive. So like it You know, do I want the effort? Do I not want the effort? Because again, going back to what I said, you have to operate the business differently than you're operating as a sole proprietor. You really have some additional work to do. You've got to keep things separate. And it is effort on your part. And, you know, the juice may not be worth the squeeze. So let's look at the mechanics of what an S corporation is. The first answer I would give is an S corporation has nothing to do with the state. It is the Secretary of State. When you go and file, except in a couple of states, I will give you that caveat, you don't get to make an S— you don't get to select an S corporation. It's like, okay, I'm going to be an LLC, I'm going to be a corporation, I'm going to be an S corporation. No, that's not the way it works. The S corporation is a designation by the Internal Revenue Service, and the S stands for small. So small business corporation, that's, that's what the election is. And so just because you go and file an LLC, obtain an LLC at your Secretary of State, you do not have an S corporation. You cannot do it without filing the appropriate paperwork with the IRS. That's the first thing. So if you think you have an S corporation and you haven't filed that, you don't. Now, the first step in that filing is a Form 2553, and that has to be filed with the IRS in a timely manner, meaning if you're going to use it for an applicable tax year, you've got to file it within a certain period of time. You can't do it necessarily retroactively in most cases. So you got to file that form. It's got to be signed by all the shareholders. So if there's just you, it's just you. And you've got to mail it or fax it. Yes, they still have fax. You still can't submit it online. You can obtain— you can— no, you can't. You can, you can file your SS-4 to obtain your EIN, your Employer Identification Number, online, but you cannot file the Form 2553 online. So let me go back a second. Let's walk through it from the, from the inception. I'll just tell you what you have to do. So if you, if you go to the Secretary of State, form an LLC, then you have to go to the IRS website and obtain a federal, uh, identification number, an EIN. That is with Form SS-4. That can be done online. And part of the filing of that SS-4, completing it, is telling the IRS how you're going to be taxed. Now, that's where people get screwed up a lot because they, they go and they obtain their EIN and they don't know how they're going to be taxed— partnership, sole proprietor, S corp, whatever— and so they make the wrong selection. And that's actually a bad idea because what you're doing when you're filling out that form is the IRS puts in their computer, okay, this is how they're going to be taxed, these are the tax forms that I expect, and this is when I expect them. Them. So if you, for instance, go and, and do, um, uh, obtain an EIN and fill out SS-4 and you put partnership, they're going to be expecting a Form 1065, um, every March 15th. And, and if you don't file it, they're going to send you a letter and say, why didn't you file it? And then potentially they can say, well, you didn't file it, here's the penalty for not filing it, and start trying to collect it. So You, you can fill out the SS-4 yourself. I don't recommend it, um, but you know, if you're comfortable with that and you know that, you know, like, I want to be taxed as an S corporation, you can make that election on your SS-4 and, and file it and obtain a number. You'll receive a PDF letter online instantaneously. Keep it, absolutely keep it. You're going to need it. Your bank will want it. Um, you'll want it in case the IRS loses their other paperwork. So keep that letter that they give you with your EIN. It should be like permanent records, lockbox, safe deposit box, whatever you do. Okay, so then you get to Form 2553. You have to file that again timely. All the shareholders have to sign it. It has to be done manually, meaning fax or mail., and then you'll get back a letter after some time from the IRS saying we accepted or rejected your application to be an S corporation. Um, and assuming that they accept it, which they generally do, uh, because the, the only reason— well, the, the majority of the reasons that we see that it's rejected is because it wasn't timely filed. Okay. But assuming you get back that letter that says, yeah, we've accepted your S corp election, also put that in your permanent file because we have seen where they have approved the S corp election and then when they didn't change their little system in the back, and then when you file the return, they say, oh, we didn't show that you, uh, filed the Form 2553, uh, you can't file this tax return 1120-S. So when you get that letter, hold on to it as well. Okay. So now you've, you've done that. Congratulations. You're an S corporation. Now what? The first thing that is, is uber critical is something you should be doing anyway as a business is keeping your business records straight and separate, as in no personal. Um, but when you have an S corporation, if you don't, you also, you, you have the issue with the IRS. Like, if they come in and they see that you don't have things separated, they're going to hammer you on an audit, um, and disallow everything and say, well, this is all personal. But also you have the additional legal liability. Again, I'm not a lawyer, um, because what that does is that gives somebody the impression that you really don't have separate entities, and then, then that legal protection that the LLC had goes away. Um, so the first thing is you've got to keep good books, you got to keep good records. If you have an LLC, most states only have an annual filing requirement. There's not a requirement like there is with a corporation to keep a record of minutes and meetings. You don't have that with most LLCs. Again, I'm not a lawyer. You need to talk to a lawyer about those specific things in your state. But, uh, you, you, you want to have good separate bookkeeping. That's the first thing. The second thing you have to have is payroll. Um, now does the, does the IRS say just because you have an S corporation, you personally as the owner need to take payroll? No. What they do say is that if you have an S corporation and you work in that business, you must compensate yourself with a reasonable salary. What is a reasonable salary? Great question. It is not clearly defined in the code. It's reasonable. I can tell you that generally speaking, um, if you go real low, you're going to get hammered. Uh, they don't really care with an S corporation if you go high. Now I'm going to pause and tell you why the IRS doesn't care. It's completely irrelevant. It's a little bit of trivia. Hey listeners, are you ready to turn your passion into profit? Then grab a copy of Profit First for Creatives. Click the link in the show notes to purchase a copy. And if you're not ready to make that full commitment, you can download a free copy of the first chapter. Check it out right now. The reason why they don't care and why they've never litigated it is because the problem they have— the IRS has— is that in a regular corporation, not a small business corporation, in a regular, regular corporation, the tax planning angle is, is that the owner will zero out the company's profit by taking it all as, as wage so they don't pay double taxation. So they'll jack up their, their wage every year to, to eliminate however much profit they have. Well, the IRS on, on that, in that case, would be saying, well, the, the salary that you took out was too high, not too low. And so they can't really define it one way without screwing themselves on the other. So they just don't, they don't litigate it. They don't, generally speaking, they just don't litigate it and say, well, this is, this is absolutely the lowest, or this is absolutely the highest, because they don't want to cause themselves trouble. Back to, out of, out of trivia, back to your situation. So you have to start taking a payroll. How do you do that? Well, you can go to Gusto or any one of those payroll providers to, um, set it up and start drawing a salary. How much should it be? It should be reasonable. How much is reasonable? I can't answer that for you. Um, I think you can look at different job sites to see what salary ranges are for people in your industry and what you have to pay. The problem as the owner is that you don't have one job, right? You're bookkeeper, you're marketer, you're, you know, photographer, editor, all wrapped into one. So you can't just say, well, okay, I'd pay a bookkeeper $40,000 a year and that's what I'm going to pay myself because that doesn't necessarily reflect what you do in the business. So you have to take a reasonable salary and you have to take it as a payroll. You have to have somebody pay to, to process that payroll because once you start doing that, there are additional taxes and additional forms that have to be filed quarterly, annually— 940, 941. How frequently do you have to take the payroll? You could take payroll once, once a year. It doesn't— the IRS does not care, but you have to take a salary, and it has to be run through payroll like any other employee, and all of the applicable taxes and returns must be filed. Okay, so why would you even go through all of this headache? The example I have in the book lays out the numbers, and I'm not going to try and guess what I put in there, and I didn't read it before I started this podcast, so I'm just going to give you simple numbers. Let's say your business makes nets after expenses $100,000 in income. That's an easy number for me to work. I don't even have to take off my shoes to do the math. Um, and you're a sole proprietor, okay? You're, you're filing as a sole proprietor even if you have an LLC. Doesn't mean you made the S corp election. You're, you're filing as a sole proprietor. It goes on your Schedule C of Form 1040. You're going to pay what is called self-employment tax on that $100,000. That self-employment tax is essentially 15%. It's not exactly— I'm not going to go into why— it's 15% for our purposes, which means that your business has generated a tax liability of $15,000 being taxed as a sole proprietor. That's not income taxes. Income taxes are on top of that. So you got a $15,000 hickey Right off the bat, why do they have self-employment tax? Well, self-employment tax is supposed to mirror the tax that you would pay as an employee if you were working for somebody else. They call that FICA. You pay half, the employer pays half. As a sole proprietor, you get the benefit of paying all of it, so it's 15%. Now, how does an S corporation Fix that. So that same $100,000 business taxed as a sole proprietor, let's move that into an S corporation. The S corporation does not pay self-employment tax. It flows through to you as the shareholder, as the owner, which means that if you took no salary, that $100,000 would show up on your 1040 Schedule E as through a K-1, and you would eliminate all of the self-employment tax. You would just owe income tax. Well, that sounds brilliant. Why wouldn't I do that? Because we go back to the payroll. The IRS says you have to take a reasonable salary. Okay, so the phrase I use is, is pigs get fat, hogs get slaughtered. If you don't— if you have an S corporation and you're generating any profit and you do not take payroll, you will be audited eventually. I can tell you that, guarantee it. It's a red flag with the IRS. There's a separate line item on the Form 1120-S that says officer's compensation. And, and if you have a zero amount on there, you're going to get audited. So don't do it. So what do you do? Well, you take a reasonable salary. And let's say in our case, that $50,000 is a reasonable salary. So you're going to pay yourself a W-2 wage, and you're going to pay the FICA and the match as the employer, that same 15% on $50,000, which means that you've got a tax liability of, uh, $7,500. Okay, the other $50,000 that you didn't take a salary Regardless of whether you take it out of the business or not, is going to flow through to you and be taxable on your 1040. Okay, but it doesn't get subject to payroll taxes or self-employment tax. So essentially what you've done is you've taken that $15,000 bill, tax bill from self-employment tax, being taxed as a sole proprietor, and you've cut it in half, $7,500. And that's in perpetuity. As long as you make money, you know, you know, again, variables of the business, profitable profitability of the business may change. You may have to change your salary. But what I'm saying is that's a permanent change in your tax structure. You no longer are going to pay self-employment tax on all of your profit in your business. And that is significant. And it's a big number for a lot of people. And that's why people go through the hassle of forming an S corporation. And doing all of those things because it's worth it. So to recap, you can do all of this yourself. There's absolutely nothing that is— that has to be done that needs to require a professional. I will tell you that I've seen none. I can tell you this, zero. I have seen zero people that come to us that already have an S corporation that are doing all the things right, or they think they have an S corporation. They either didn't file it, they didn't file it timely. They're not taking payroll. They're not taking enough payroll. They're not filing their payroll taxes right. They're not doing their bookkeeping right. That's zero. None. Nobody does it right. And I'm not saying that to sell professional services. I'm just telling you the reality is it's complex enough. It's kind of like rewiring your house. You might be able to change the light switch or maybe the ceiling fan, but do you want to go into the breaker box? No, you'd obviously call a professional because you don't want to fry yourself. It's the same principle. It's complicated enough that you, you can do it, but you're going to hurt yourself. So don't. I don't care if you hire CORE, but hire somebody, because if, if, if you try to do this yourself, you're going to do it wrong and it's going to cause you additional taxes. You're not going to save the taxes that you could, and you're going to cost yourself a lot of time and stress. So that's the recap of the S corporation. Love to hear your feedback. Drop your questions in the chat there and let me know. That's all I've got for today. Until next time, ta-ta for now.