S-Corps Explained by Jasmine at UT Law Conference

Today what I’m going to be talking about at this conference is – I’m actually speaking to business attorneys – and what’s really important about today is that, as a tax attorney and CPA, my focus is making sure that these business attorneys have a foundation in tax.

There are a lot of things that we see, as CPAs and tax attorneys, when certificate of formations are filed and operating agreements are created by your business attorney, even though they say okay talk to your CPA and have your CPA choose the entity. So for example, a lot of times the CPA will say, “okay let’s choose an S-Corp” but there are things that your business attorney can actually do in the operating agreement that can terminate your S-Corp. So that’s one area I’ll be focusing on today. There are a lot of different ways you can terminate your S-Corp where it’s actually not a good entity to choose.

How to Elect an S-Corp?

Dan: How do you make a state corporation an S-Corporation for federal tax purposes? Jasmine, since you’re the practicing CPA in the group, why don’t you help us out with this.

Jasmine: Yes, so for S-Corps it’s a pretty simple process which is good and bad. I think that’s why maybe part of why they’re elected so often, but you know usually just by the taxpayer doing it themselves often not even knowing what they’re getting themselves into, but it’s just Form 2553, you fill it out, submit it to the IRS, and if you’ve submitted it within the required time period. So if you’re doing a timely submission, then it’s two and a half months right after the start of your tax year. So if you just form the entity it’s within two and a half months of that, you’ll be in a short year. And if you’re doing a late S-Corp election, then you have 3 years and 75 days but you just have to meet some of those additional requirements labeling that you’re submitting under the rev proc. So otherwise, it’s literally a one or two-page form, submit it and unfortunately, the IRS processing times are very long right now. So maybe like a year or six months until the IRS responds and lets you know that it was approved, but as long as you’ve done it right it almost always gets approved.

Late S-Corp Elections

Dan: What’s this Rev. Proc. thing that you’re talking about?

Jasmine: So rev proc, I can’t even remember the name 2013-. So it essentially allows you, it outlines as long as you meet certain criteria you’re allowed to file a late S-Corp election, and that’s what a lot of people use. So your timely S-Corp elections you pretty much have to be on top of it day one. So if you are creating your LLC, like Mackey said if you’re the next day deciding okay what do we want to be, that’s great then you can just do a regular timely S-Corp election. But what most what I usually see most taxpayers do is, and even as CPAs sometimes we’ll kind of use it as a planning tool where you know we don’t necessarily know how much what exactly that business is doing yet, they may have just gotten started, how big is it going to be, so we may wait a little bit to see. Okay, do we want to file an S-Corp? Are they operating as an S-Corp? So then if you’re outside that two and a half month period, then you need to follow all of the specific rules to be able to elect for a late election.

S-Corp Requirements

Dan: Are there eligibility requirements as well?

Jasmine: Yes, there are so many requirements for S-Corps, it’s crazy. So S-Corps have been branded as this you know simple just for small businesses that type of thing, and I think they do often work well for closely held businesses, which is maybe why they’ve been given that brand, but there are probably more requirements for S-Corps than for any other entity. There’s just so many things that can disqualify you, and that is a huge issue a lot of CPAs either don’t keep up with it or just don’t inform their client about it. But there’s so many different things that can terminate an S-Corp or revert you to a C-Corp, so you have to just make sure you qualify and not only have eligible shareholders. But that you don’t do any there are certain types of events you can do like disproportionate contributions and distributions those types of acts that can terminate your S-Corp.

S-Corp Eligibility

Dan: If you didn’t qualify to become an S-Corporation because you had a non-resident individual, or you had a corporation as a shareholder or an LLC that’s taxed as a partnership as a shareholder, what would happen then? Would you become an S-corporation?

Jasmine: So the argument I believe would be no. So if from day one you were never qualified, you never became an S-Corp. Now there’s practical considerations on the actual IRS side right. Because even though you never qualified, so for example if you’re in a community property state, you were required to have your spouse sign the election they never did. The IRS is usually almost certainly going to still approve your election. That being said, you never actually qualified to be an S-Corp, so you’ve got two different pieces here. The first piece is I think if you looked at the code you would say we were never an S-Corp and you’ve got a really great argument on that side, but then you’ve got this practical piece with the IRS which is the IRS thinks you’re an S-Corp. And so that’s going to be really difficult to you know go back and forth with them because that division is not necessarily one you can just pick up the phone and call and fix it directly with the entity formation section. So they think you’re an S-Corp they’re going to be expecting an S-Corp tax return and if you want to terminate it with the easiest way to get rid of it is usually a revocation, even though you know legally you were never an S-Corp.

Tax Pros and Cons of S-Corps

Dan: Why would you have a tax advantage as an S-Corporation? And it revolves around the employment taxes, and Jasmine can you handle that?

Jasmine: Yeah, so I mean it’s pretty much, it’s fully, the employment tax piece. So clients show up and they say I’m going to save so much tax as an S-Corp and a lot of times they don’t even have a concept that the income tax is exactly the same, but it’s really fully that self-employment tax piece so that’s social security that’s medicare tax and as we know or covered earlier, there’s most of that phases out once you get to around $150,000 the social security piece phases out and medicare will continue, so it’s on the difference. So if you can say ok I have reasonable compensation for my day-to-day work as only a hundred thousand dollars employed on my own business and the threshold is approximately $150,000 for the 15.3%, then it’s going to be the difference. So it’s that 15.3% on the on the $50,000 difference between the hundred thousand of reasonable comp and the $150,000 phase out which does keep going up every year. So that is essentially your savings, that’s the full savings that that number is often very big it’ll be $15,000, $20,000. So, to a lot of smaller business owners, they’re like well of course I’ll do anything to save you know $20,000 not realizing that there’s so much exposure, there’s so many risks, there’s so many requirements, there’s so many things you have to follow when it comes to being an S-Corp that you can very easily end up in a much worse situation, if you exceed your tax basis which essentially is a nice way of saying you’ve introduced an extra layer of tax that shouldn’t have been there based off of poor tax planning, that’s really common I see that a lot with clients so certain types of businesses just should probably never be an S-Corp. And then certainly, like we’ve discussed today, if you’re not even eligible to be an S-Corp, you put yourself in a much worse position potentially reverting to a C-Corp inadvertently.

Popularity of S-Corps

Dan: So let’s talk about where does this whole rage, I mean there’s a lot of LLCs out there right? So Jasmine as our CPA, who is driving this and there is a trend for LLCs to elect S-Corp status? Who is driving this in your estimation?

Jasmine: I mean I think there’s a lot of different reasons it’s so popular. I definitely think one the main reasons is clients a lot of times are driving it, so they’re showing up saying, you know I heard from my friend who’s not licensed, not a tax professional but they said that you know they paid so much less tax because they were an S-Corp. I want to do the same thing. I also think you know honestly there’s a lot of ads and that type that’s very popular on like if you’re on social media seeing all these ads. A lot of them are LLC S-Corp today. It’s one of those things that’s just very a quick sell because of the very short-term employment tax benefit. I think it’s a very quantifiable thing to sell to say I’m going to save you $30 000 today and so I think that’s been used a lot that convinces a lot of people to show up and say I really need an S-Corp.

Dan: Well, hold on, did you just say that on social media there’s ads saying?

Jasmine: It’s one of the most popular things to be advertised absolutely like directly to business owners right because you have to realize all of the people in this industry, they’re targeting business owners on social media is probably the most common place. Sure google ads, all that type of thing but it pops up a lot, so business owners are showing up feeling like they’re already educated a lot of times in an S-Corp in LLCs before they’ve talked to legal or tax help.

Dan: Well okay. that’s so.

Jasmine: That’s my experience.

So in today’s conference, we talked a lot about S-Corps. So LLC S-Corps that was the most popular topic for us, and that’s because a lot of things can go wrong if you don’t plan it out right. You really want to be tax planning if you’re creating an LLC, and then electing for an S-Corp because there are a ton of ways where you can then revert to a C-Corp, so if you want to learn more and book a call with us then go ahead and schedule a time at the following link: https://calendly.com/dilucci/dilucci.