06 May Electing S-Corp Status, Continued…

In our last blog, we discussed the pros and cons of electing S corp status with the IRS.  This week Edwards Law had the pleasure of talking with Heather Nydam, owner of Tiberian Consulting, a consulting firm dedicated to advising businesses on formation and organizational issues.  Edwards Law asked Ms. Nydam to expand on some of the information provided in last week’s blog, and the following dialogue ensued.  Please note that this blog, like our last blog on S-Corp elections, is based on a general understanding of S corp status, and is not meant to be taken as legal advice:

Ms. Edwards: In our last blog, Edwards Law referenced variations in how LLCs can be taxed, such as a corporation, or “C corp”, and S corp elections.  Are there other options available in addition to electing to be taxed as a C corp or an S corp?

Ms. Nydam: Yes. An LLC can be taxed as a sole proprietorship, partnership, S corporation, or C corporation. The default for the IRS is that the LLC will be taxed as a sole proprietorship if there is only one member, and will be taxed as a partnership if there are two or more members.  The IRS will assume your business does NOT want to be taxed as a C corp or an S corp, unless you specifically tell them otherwise, via Form 8832, a form Edwards Law discussed in last week’s blog.

Ms. Edwards: What do you see as the most beneficial reason for electing S corp status, vs. a sole proprietor election or partnership election?

Ms. Nydam: Similar to “sole proprietorship” or “partnership” taxation, S corporation tax status provides for the benefit of “pass-through tax status,” which means the S corp’s income and deductions are “passed through” to the personal income tax returns of its shareholders/owners based on their pro-rata ownership interest.  In plain English, this means you, as an owner, pay personal income tax instead of corporate tax.  But the biggest benefit to S corp status, as Edwards Law alludes to in its prior blog, is that as an S corp owner, you can both pay yourself a “reasonable” salary (subject to the same sort of payroll taxes deducted from all paychecks) and pay yourself a draw/distribution as a “profit,” which is not subject to the 15.3 percent self-employment tax.  If your business generates more than the salary you pay yourself, the resulting savings can be substantial.

Ms. Edwards: OK, so why wouldn’t a business elect to be treated as an S corporation by the IRS?

Ms. Nydam: Although S corps allow for pass-through taxation and potentially big savings on employment tax, which as Edwards Law mentions in its blog can together result in a huge tax benefit, S corp tax elections (as well as regular or C corp elections) are subject to the same very strict rules that entities classified as corporations by the state are subject to, including all of the topics Edwards Law stated and more, such as limitations of membership size and who can be a member of an S corp.  For example, an S corp cannot have more than 100 shareholders, and shareholders can consist of only natural persons, and must be citizens or resident aliens of the United States.  This means other LLCs and other corporations cannot own the S corp (banks and insurance companies are also barred from being shareholders).  Also, the S corp is allowed to issue only one class of stock.

And there is more.  An S corp must be careful to pay its owner/owners what the IRS would consider a “reasonable salary,” based on the standard for a professional in the owner’s industry with the same job title and responsibilities.  So, if you are a software developer paying yourself $15,000 a year and claiming $100,000 in profit, there is a good chance your software company will be audited, and that it may owe a hefty penny in back taxes when the S corp status is blown and it ends up owing past due corporate tax and employment tax.

Ms. Edwards: That is a lot to consider.  What would Tiberian Consulting recommend to the average small business owner not looking to expand–to S corp elect, or not?

Ms. Nydam: The answer to that question is wholly dependent on where you see your business going in 5 years, literally.  Although an entity may elect to change its classification with the IRS, it may do so only every 60 months (that is, 60 months after the entity change effective date). What this means is, once you elect S corp status with the IRS, you are stuck with it for 5 years.

So, if you are a single-member LLC, and plan to stay that way for several years while you generate income and map out the long term goals and marketing strategies of your company, the S corp election provides the most tax benefits for a fledgling single-owned company.

However, if your startup is in a hot industry like software development, and you are going into business with numerous people with the intent to sell the business to the highest bidder in two years, an S corp election is most likely not ideal for your business.

Ms. Edwards: It sounds like an S corp election should only be made with some good future planning.  Any final thoughts on S corp elections?

Ms. Nydam:  Yes, one final thought.  If you are an LLC looking for a tax election that is certain and not likely to change in the near future, put some thought into making an election other than an S corp election.  The IRS is constantly changing and/or threatening to change rules pertaining to LLCs that elect S-Corp tax status, some of which take previously conforming LLCs and make them nonconforming, as well as some that make it less of a tax benefit.  Your best bet is to sit down with a tax accountant before you make your election, so that you are certain of the tax environment and can plan accordingly.

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If you or your business are looking for help in forming and organizing a new company, Edwards Law welcomes your questions.  Call today for a free consultation with Edwards Law, and its strategic business partner, Tiberian Consulting.