In this week's episode, Steve and Cliff discuss the benefits of choosing an S Corporation as your business entity. S Corporations provide a myriad of benefits as a business entity, but there are some formalities that must be maintained. Learn more about S Corporations in this episode.
Episode Transcript
Intro:
You're listening to the Practical Tax podcast with tax attorney Steve Moskowitz. The Practical Tax podcast is brought to you by Moskowitz LLP, a tax law firm.
Steve Moskowitz:
Welcome to our podcast, and today we're going to be talking about business entities, corporations, certain types of corporations, like S-corporations, partnerships, LLCs. And, I'd like to introduce my friend and colleague the manager of our tax department at Moscowitz LLP, Cliff Capdevielle. Cliff is both the tax attorney with many years experience, and also an accountant. Cliff, tell us about these different business entities.
Cliff Capdevielle:
Sure, Steve, so one of the first questions that we need to answer for any new client, and oftentimes for returning clients, is what's the best way to structure your business? Is that gonna be as a sole proprietorship, a C-corp, an S-corp, or a partnership structure, like an LLC or limited partnership? And there are different answers depending on the type of business. So, the simplest form of structure is what's called a sole proprietorship, and that's when you're essentially doing business in your own name or as a DBA. It's the easiest business structure to set up, but it's not a separate legal entity. And for that reason, we usually don't recommend it. As you know Steve, a lot of what we do is asset protection. We want to, we wanna the business owners assets and the sole proprietorship does not separate personal assets from the business assets. And as a result, we usually don't recommend the S-corporation or sorry, the sole proprietorship. Instead, we usually recommend an S-corporation or an LLC, depending on the type of business.
Steve Moskowitz:
Somebody has a sole proprietorship and something goes wrong in the business, they could sue and take away the person's personal assets.
Cliff Capdevielle:
That's the problem with it, Steve. And I know you've seen this in your practice, comes up all the time, and we've also seen businesses survive and owners keep substantial assets, if they've properly separated their assets from the business assets.
Steve Moskowitz:
You know, you told us about different forms of assets and corporations is one of them, but sometimes a business owner and say, "But Cliff, you know if I form a corporation, it's great for asset protection." which I'll ask you to explain to us. But people say, "Well, wait a minute, I don't wanna be paying taxes twice." First, the corporate taxes and then the personal taxes. How do we handle that?
Cliff Capdevielle:
Yeah, so today we're gonna talk about S-corporations. And S-corporations are considered pass-through entities for tax purposes. So, what does that mean? That means that there's no tax, typically at the corporate level. The tax attributes pass to the individual owners. So, you're only paying tax at one level with an S-corporation, or an LLC. Just like you would with a sole proprietorship. But the advantage, the huge advantage of the pass-through entity is that asset protection that we mentioned.
Steve Moskowitz:
So, does that mean that if the business gets in trouble that the assets of the owner are safe?
Cliff Capdevielle:
If they run the business properly, and they mind their Ps and Qs, they can potentially protect their personal assets from the assets of the business.
Steve Moskowitz:
And Cliff, what happens if the business makes a loss?
Cliff Capdevielle:
Well, in that case, in many instances the business can pass through those losses to the individual owner, who can deduct those losses against other income.
Steve Moskowitz:
So, if the owner made a loss and his or her spouse had a profitable business, or wages you could offset one against the other?
Cliff Capdevielle:
That's right, and we often will use that strategy to save clients a lot of money.
Steve Moskowitz:
And Cliff, tell us this, suppose we're looking at two neighbors, John and Mary, and they make identical amounts. And Mary's in business and she's made a profit of 100, and her next door neighbor John, gets wages of 100. If Mary went ahead and did an S-corp, could she go ahead and only pay a lesser amount, like 80% of her income? How would that work?
Cliff Capdevielle:
Yeah, we're gonna talk about the qualified business income deduction in just a minute. That is one of the advantages of the S-corporation, and the other pass-through entities, is that with the Tax Cut and Jobs Act, Congress attempted to level the playing field tax wise with C-corporations. So, as you remember, C-corporations are now taxed at a 21% tax rate generally for federal taxes. And, in an attempt to give a tax break to S-corps and LLCs, that would mimic that tax structure, the Congress introduce what's called the qualified business income deduction. And that's something that has been very important in terms of planning in the last few years. And it does provide a substantial deduction for many businesses.
Steve Moskowitz:
So Cliff, taking that forward, does that mean if Mary walked in the door and Mary was a sole proprietor and she made a profit of 100, does that mean if you turned her into an S-corp, she'd only have to pay taxes on 80% of her income instead of 100%? Just by changing her business entity from a sole proprietor to an S-corp.
Cliff Capdevielle:
In many cases, that's correct Steve. So, the net income of an S-corp or pass-through, other pass-through entity, like an LLC, is often entitled to that qualified business income deduction. Which can be as much as 20% off the top, which is a huge advantage.
Steve Moskowitz:
I think anybody in their right mind given a choice between paying tax on 100% of their income, or 80% of their income, I'm gonna bet that they're gonna go with the 80%.
Cliff Capdevielle:
Well, you would think so.
Steve Moskowitz:
I would think so. So, this is great. How do you become an S-corp?
Cliff Capdevielle:
So, that's a filing that we do, combination with the state and the federal government. So, with the state, we set up the corporation and then we notify the IRS that you're choosing to be treated as an S-corporation, as a pass-through entity for tax purposes.
Steve Moskowitz:
So, we know that when somebody incorporates, if they don't do anything, they start off as a C-corp, where they pay the double taxation. Suppose Mary walks into the door and says, "Oh no, I started this company 10 years ago, it's been a C-corp." "I don't wanna go out of business, what can I do?"
Cliff Capdevielle:
Well, you can make an election to become an S-corp at any time. We're gonna talk about the planning around that in a little bit. But in general, that's allowed. So, even if you've been operating as a C-corp for many years you can convert to an S-corp and take advantage of some of these benefits of the pass-through entities.
Steve Moskowitz:
And Cliff, could you update us? Because, I know in past years, the ability to be an S-corp was so much more limited than it is now. Can you tell us now what we do to be an S-corp? All the people that are included.
Cliff Capdevielle:
Yeah, so now you can have up to 100 shareholders, and that's a huge advantage, Steve. So, the, one of the issues that prevented many entities from using the S-corp form was a restriction on the number of shareholders, for example. And that's been expanded over the years. There are still restrictions, and you have to be mindful of those. And you really, if you run a foul of the S-corp rules the IRS can treat you as a C-corp. And what does that mean? That means double taxation. Taxation at the corporate level, and then taxation again as you distribute money at the individual level as dividends. So, that's one thing that we're very careful about when we're talking to clients, is make sure that they they understand the rules for an S-corp and make sure that they follow those.
Steve Moskowitz:
Excellent, and tell us Cliff, with an S-corp, what are the other, some of the advantages of having an S-corp over some other form of business?
Cliff Capdevielle:
Sure, so let me tell you how we analyze a client's business as they come in the door, what we look for, and what to be cautious about when that client is trying to decide on the choice of entity.
So, one thing we wanna be careful about is separating those personal and business expenses. And this can cause real headache, not only for tax purposes, when you're trying to prepare tax return, separating the business from the individual expenses. But also, in terms of liability, because an S-corp that is not mindful of those corporate formalities can run into trouble. If they ever have a problem with a vendor, or any kind of judgment or lawsuit, that can be a real problem. Another issue that we we run into all the time in the IRS is now carefully scrutinizing this, is owner compensation. So, an advantage of the S-corp is that the net income of the business after wages, is not subject to self-employment tax. Some business owners make the mistake then of not paying themselves any compensation. And, that is something that at the IRS is looking at carefully now. So, we're gonna meet with the client and explain the reasonable compensation issues. Make sure that the business owners of an S-corporation are paying themselves appropriate salaries. And, to your question about conversion we also look at what's called the built-in gains tax. And this is a corporate level tax that can apply when a C-corporation has assets with built-in capital gains and on conversion, the IRS could be looking for a check to pay those taxes, as if those assets had been disposed of.
