By Jason Watson, CPA
Posted Sunday, December 29, 2024

We broached this little devil in a the previous section, but we want to expand on it. If you buy Google stock for $100 and later sell it for $150, you have a $50 gain. Easy. The first $100 represents a return of your capital and the next $50 represents your gain. Done. How does this to relate to S corporations?

If you inject $5,000 into your business, your business earns $100,000 and your business checking account has $105,000, you have $105,000 in shareholder basis. You can take all $105,000 out without trouble.

There are at least four scenarios where this breaks down, and we’ll review each one.

Depreciation

Please forgive us for reiterating this little issue, and to make matters worse we use a different data set for the example.

Depreciation bites people all the time, and bites hard! Same situation as above. $100,000 in net business income (profit) but you also financed a brand-new Ford F150 pickup truck for $60,000, and used 60% bonus depreciation to deduct it (for the 2024 tax year). Therefore, you have $105,000 in the business checking account and $64,000 in net ordinary business income after expenses and deductions (you had $100,000 in initial profit but deducted $36,000 in truck depreciation). Yes, we are not considering Section 179 expensing in this example yet it remains a good illustration.

Your shareholder basis is $5,000 (original injection of cash) plus $64,000 in net business income, or $69,000. If you take out $100,000 as a shareholder distribution, you have $31,000 of the $100,000 exceeding your shareholder basis and that portion will be taxed as a capital gain on your individual tax return. Yuck!

How do you fix this? Easy. You can either not take the cash out in the form of a shareholder distribution, or don’t use bonus depreciation on the new truck and pay more immediate income taxes. Wow. Not desirable at all!

You could use another depreciation method that spreads the deduction across several tax years. Sure, you will pay more income taxes in the year of purchase, but you won’t have the capital gain on the excess distributions. Moreover, you have a nice depreciation deduction in the future to offset hopefully increasing incomes (and associated tax rates).

Loans

This one can bite too! WCG has a client who is a very successful Amazon reseller. To add to the excitement, Amazon offered a low-cost $250,000 loan to the business presumably with the hopes that the business would buy more stuff to sell on Amazon. The business didn’t. The sole shareholder took the loan proceeds plus some extra cash out of the business as a shareholder distribution. Let’s breakdown what happened using our basic example above.

You inject $5,000 into your business and the business earned $100,000 in net ordinary business income after expenses and deductions. The business also took on a $250,000 Amazon loan and received cash. Therefore, your business checking account reads $355,000 but your shareholder basis is only $105,000. You can only take a $105,000 distribution leaving $250,000 behind without triggering a distribution in excess of shareholder basis. Another yuck!

When cash loans like above happen and the shareholder has a distribution in excess of his or her basis, we advise the client to return the cash to the business.

Recall that a business loan made directly to an S corporation from an external lender does not create shareholder basis even if the shareholder personally guarantees the loan. This is contrary to a partnership where each partner personally guarantees the loan, and adds to his or her partner basis. However, a shareholder who lends money directly to the S corporation does add to his or her basis (we typically suggest not making this is a loan, but rather a capital injection from the shareholder).

Business debt and capitalization must be handled carefully.

Payables

Along the same lines of loans are payables. Let’s say you record a $25,000 employer 401k match expense on December 31, but you haven’t sent the check yet. This would be recorded as a debit to 401k Company Contribution as an expense and a credit to a 401k Payable liability account. Additionally, this payable isn’t due until March 15 the following year, so you have some extra cash in your business checking account that is earmarked for the 401k payment. But it’s Christmas, and baby needs new shoes, so you pull this $25,000 as a shareholder distribution knowing that you’ll earn enough between January 1 and March 15 to make the 401k payment.

This distribution could exceed your shareholder basis as well. How? You reduced the amount of business profits by recording the 401k Company Contribution expense, but didn’t use cash to do so. You used a payable or an IOU if you will, freeing up some cash albeit temporarily. This cash-less reduction of business profits combined with a distribution can be bad.

Credit cards can create this little fiasco too and are very similar to the 401k example above. The IRS allows you to recognize the expenses as soon as you are liable for the payment (swipe the credit card, and boom you are liable). This is true even in a cash-based accounting system. Therefore, if you rack up a bunch of deductible business expenses in December with your credit card, you will have a gaggle of debits (expenses) and a Credit Card Payable as the corresponding liability (credit) on your balance sheet.

This in turn reduces your net business income (profits) but creates an artificial sense in available cash (since you haven’t paid the credit card bill yet). Here is what we mean-

If you take $90,000 out as a shareholder distribution on December 31, you will have exceeded your shareholder basis by $10,000.

What can be done here? Wait until January 1 to take the money out rather than December 31. Show the cash on the books for the ending cash number which is a part of your business entity tax return, wait 24 hours, and then do the money-grab.

Bad Basis Data

Most tax software will maintain shareholder basis using worksheets and other supporting documentation within the tax return. This information is typically not filed with the IRS or state, but it is a part of the tax return documents. Cool, right? If you switch tax professionals, your new person can easily take this data and enter it into the tax software to preserve your shareholder basis data. More cool.

This sounds great until it isn’t. Let’s say you’ve been in business for 20 years, and for some reason or another you’ve had four different tax professionals over the years. What if in year 4, a tax professional messed something up which caused your shareholder basis to get slightly out of whack; nothing huge, but certainly wrong. Your next tax professional simply took last year’s worksheets… did a quick sanity check… and plopped a number in as your shareholder basis that was too low. Ten years later, you are pulling some money out as a distribution and get hit with long-term capital gains.

Everyone is scratching their chin asking What happened here?

What makes matters worse is that a lazy tax professional who doesn’t want to dig into the numbers or have an awkward conversation with the business owner might create a shareholder loan to avoid the capital gain conundrum. In other words, he or she will take the portion of the shareholder distribution that exceeds the basis and call it a loan to the shareholder. Great, now we’ve taken a dumpster fire and threw a 55-gallon drum of gas on it. The IRS cannot stand shareholder loans since they are usually disguised distributions.

Lazy might be a strong word. And why are dumpster fires considered bad? They are safely contained in a thick metal box, no? We should say that someone is a camp fire in high winds. We digress…

What can be done? We usually advise pumping the brakes on the current year’s tax return and re-building the shareholder basis data from business inception. WCG just recently did this for a client who owned a bunch of Arby’s over several years; the shareholder basis on the worksheet from the previous CPA was understated by over $240,000. Yeah, a big number.

The lesson here is to be careful on seeing a bunch of cash and thinking you can do a money-grab without pain. Better yet! The lesson is to engage a team of wonderful Certified Public Accountants and business consultants to keep you out of trouble. We can fix things during the year. After the year is over, it might be hard to put toothpaste back in the tube.

Tax Planning Opportunity

But wait! There’s more. There might be a tax planning trick to welcome this capital gain on distributions in excess of shareholder basis. Huh? Well, the capital gain is considered long-term and as such has favorable tax rates versus ordinary income tax rates. In other words, if you are going to pay taxes on the income your business earns anyway, do you want to do it at ordinary income tax rates or capital gain tax rates?

You might have long-term capital losses that are quite large and might take a long time to recoup. For example, and for whatever reason, you have $100,000 in capital losses that are being carried forward. In addition, you don’t see yourself using these losses anytime soon. Under current tax law, you can only deduct $3,000 per year so quick math suggests needing 34 years to fully deduct these capital losses. Sounds like a long time, right? As such, having a shareholder distribution in excess of your basis which in turn causes a capital gain just to be absorbed by these losses doesn’t seem so bad.

We are saying this in the abstract, but there could also be tax planning opportunities when allowing this capital gain to occur.

By Jason Watson, CPA
Posted Sunday, December 29, 2024

With an S corporation or partnership you need sufficient shareholder / partnership basis in your business to deduct losses. For example, if you invested $10,000 into your business but the business lost $30,000, as an S Corp shareholder you can only deduct losses up to the amount of your shareholder basis (in this example, $10,000).

Think of Google. You invested $10,000 into Google stock and they go out of business, you only lose $10,000. Remember that with an S corporation you wear two hats- one as an employee, and one as an investor (shareholder).

Section 179 Expensing Losses

How does a loss in a small S corporation happen? A lot of small businesses are cash based and don’t have a lot of equipment (dentists are a common exception). However, for the sake of argument we will assume you bought a piece of equipment for $100,000 and borrowed $100,000 to pay for it. The equipment also qualified for Section 179 expensing deduction allowing you to deduct (or attempt to deduct) the full amount against business income. Great! The benevolent IRS king is alive and well.

Let’s assume that the business income prior to depreciation was $60,000 (and Section 179 expensing was $100,000). The S corporation tax return would still show a $60,000 net business income amount, but your K-1 would show a $70,000 amount for Section 179 deduction. Why $70,000? You had $10,000 in basis (using the example above) plus the $60,000 net business income. 10k + 60k = 70k, even in Canada. Sorry Canada… just too easy to pick on.

You would be able to deduct $70,000 as a loss. The $30,000 remainder of the Section 179 deduction that was not taken or used would be carried forward to future years. Yuck! Sorry, the once-benevolent IRS king is now asking you to be patient and wait.

Here is a table to demonstrate the depreciation conundrum more clearly. We love tables.

Bonus Depreciation Losses

Here is another example, that is just slightly different and shows a small difference between Section 179 and bonus depreciation. Similar example to above, but you used bonus depreciation.

Bonus depreciation is 40% for the 2025 tax year barring changes in tax legislation. The table above uses 80% bonus depreciation as an illustration.

What we are showing here are two things- first, your losses created by the bonus depreciation will be limited because of your shareholder basis. You started with $10,000 but didn’t have any net business income (profits). Rather, you had a $20,000 loss. $10,000 of this $20,000 was allowed and the remainder will be carried forward to future years.

The second thing we are showing is how your cash is trapped. You had profits before bonus depreciation of $60,000 and for the sake of argument this also is your ending cash balance in your checking account. This cash is trapped since you cannot distribute it without creating a distribution in excess of basis.

We will expand on this some more in a bit. The big takeaway is that business losses created by depreciation created by a financed equipment purchase can be painfully and unknowingly limited.

Wait! Looks like we talk about shareholder distributions and basis next. Yay!

By Jason Watson, CPA
Posted Sunday, December 29, 2024

State tax laws might not treat S Corp income and subsequent K-1 income in the same benevolent manner as the IRS. Recall that S corporations do not pay a federal income tax directly. Rather the income is passed onto the shareholders who are then taxed on that income at their individual tax rates. However, some states impose an additional tax. For example, California imposes a 1.5% franchise tax on S Corp net ordinary business income (profit) after expenses and deductions with a minimum of $800. Yuck. So, your 8% savings in federal tax turns into 6.5% after you pay California.

Other income tax free states, such as Texas, have similar taxations and various exemptions too. Franchise tax is another buzzword you might come across. Why do they call it a franchise tax, or a business and operating tax as they do in Washington State? They can’t call it an income tax because of the Interstate Income Act of 1959. Yup. Way back when, and it is battled every year in court, in various representations. Consider that in 1959, interstate commerce was quite small compared to what we have today with Amazon and all the interwebs. States are tired of businesses skirting local income taxes.

Before we get into that, there are two issues at play here and we’ll pick on California to illustrate some points. One, if you are an S corporation headquartered in California you will be subjected to the franchise tax. Period. End of story.

But the other side of the coin is state nexus (which was broached earlier) where you are not physically headquartered in California but have a nexus either physically or economically in California. This too would subject your income sourced from California to the franchise tax.

In some cases, you might have nexus in California but not have any California sourced income, and you will unfortunately be subjected to the minimum franchise tax of $800 (for the 2025 tax year). Nutty. You have nexus, but no taxable income, and you still pay the minimum franchise tax? Yes. This happens when you create an LLC, but all your income sources are outside California and they exceed certain thresholds. There are other situations where this can happen.

Conversely, if you are a sole proprietor in California (and not an LLC or corporation), you do not pay a franchise tax. Yes, you will be subjected to federal self-employment taxes which is why you want to consider an S Corp election. So therein lies the rub. Franchise tax versus self-employment tax.

About half of the states have some sort of franchise, business or excise tax. Back to the Interstate Income Act of 1959- it is against Federal Public Law 86-272 for states to charge an income tax on foreign businesses in certain circumstances. Remember, foreign does not mean domestic and international. Foreign is a business registered in Nevada doing business in California, as an example.

Here is a snippet of Federal Public Law 86-272–

States are therefore prevented under Public Law 86-272

• from taxing out-of-state businesses on income derived from activities within the state

• if the activities are limited to mere solicitations of tangible personal property, and

• the orders are processed from outside the state.

Note how this focuses on tangible property and not services. Huge distinction! Is internet hosting a service or tangible personal property? How about an eBook? This is discussed more in a later chapter, and the current news is not great. The future isn’t good either.

Let’s have California’s Franchise Tax Board offer a few words on Public Law 86-272-

Public Law 86-272 (15 USC Section 381) prevents States from asserting their right to impose a tax based on net income, such as the corporate income tax or franchise tax. Public Law 86-272 protection is available to out-of-state business entities that:

Sell tangible personal property in this state

Who’s in-state activities are limited to the solicitation of orders for their goods

As a result, if a taxpayer is protected by Public Law 86-272, they will not be required to pay the franchise tax or the corporate income tax, as both are measured by net income. However, even if protected by Public Law 86-272, an out-of-state entity that is doing business (R&TC Section 23101) in California is still obligated to file a tax return and pay taxes that are not measured upon net income, unless certain exceptions apply, such as:

The minimum franchise tax

Annual limited liability company tax

The limited liability company fee

You are probably asking, “What does this mean, how does this work?” First of all, protection under Public Law 86-272 does not apply to businesses that derive in-state income from the solicitation or sale of:

Intangible property

Services

Any combination of goods and services

Technical Advice Memorandum: 2018-03 addresses the application and interpretation of Public Law 86-272 in the context of delivering goods by company owned delivery vehicles. This memorandum concluded the delivery via a private delivery truck is protected activity under Public Law 86-272. However, any activity that goes beyond the scope of delivery, such as backhauling, is not protected activity.

For example: Corporation C, an out-of-state corporation that does not file a combined return, sells tangible goods over the internet and qualifies for protection under Public Law 86-272. For the 2019 taxable year, Corporation C has $1,000,000 of California sales but no property or payroll in California. Corporation C, though considered doing business in California because it has $1,000,000 in California sales, will not be subject to California’s franchise tax as it is protected under Public Law 86-272. This is true even if the tangible goods are delivered using Corporation C’s vehicles. However, Corporation C must still file a California return and pay the minimum franchise tax of $800. If Corporation C’s vehicles are used for any other business activity along with the delivery, such as backhaul of goods (like hauling off the customer’s old items), this activity would go beyond the solicitation of orders and would no longer be protected.

California has a lot to say!

So the wizards at various states came up with a tax that is not based on income or at least not called an income tax. Some states tax your gross receipts, no matter what your expenses are! Amazing. It is also noteworthy that Public Law 86-272 does not protect businesses located in and doing business in the respective state (only interstate activities, not intrastate activities). But it appears that states keep things consistent, and impose a franchise tax, a business tax or an excise tax on local businesses just the same. Genius.

Here are some sample state links-

New York City S Corp tax rate is 8.85%. Tennessee is 6.5%. Texas is about 1% on gross receipts exceeding $1 million. Washington DC has a tax it imposes on S corporations, but tax is exempt if over 80% of the revenue is from personal service. All kinds of rules!

Do you want more wrinkles? Here you go- California (we just love to pick on them) has a unique rule to their franchise tax. As a garden-variety LLC, you are taxed on gross receipts in addition to the $800 franchise tax. For example, you could have $1,000,000 in gross receipts and $1,000,000 in expenses. Your franchise tax would be $800 + $6,000 (for the 2025 tax year) although you do not have any net income. Yuck.

However, if this LLC is taxed as an S corporation, then it would pay 1.5% of the net income (profits) or $800, whichever is higher. Using the example above California’s franchise tax would be $800 versus $6,800. Therefore, the lesson is that you might be forced into electing S corporation status in California just to avoid its silly gross receipts tax.

To complicate things even more, you must apply nexus rules to all this. You might not be subjected to another state’s franchise or business tax if you don’t have an economic or physical presence in that state.

The issue of state business taxes and nexus is discussed in nauseating detail later in a chapter dedicated to state nexus. More buzzwords such as economic presence, throwback rules, tangible personal property, commerce and due process clauses, etc. Bottom line- talk to your nexus experts at WCG CPAs & Advisors to nail this down. It is extremely tricky, and states are extremely aggressive.

Before that, here are some big takeaways with this section-

• Income tax nexus and sales tax nexus are woefully different, and one doesn’t invite the other to the nexus party. Income tax cannot just show up with a plus 1.

• Each state is unique and different, like snowflakes, but without the innocence and the ability to be shoveled away.

• Tripping nexus wires can unwittingly expose your business to additional taxes beyond income taxes.

By Jason Watson, CPA
Posted Sunday, December 29, 2024

You might not reap all the benefits of an S Corp election and subsequent self-employment tax savings if you have other W-2 income. But there is a lot to unpack here-

• You have Medicare savings versus forfeited Social Security taxes.

• You have the pass-through entity tax (PTET) deduction that is only available in an S Corp or partnership environment.

• You have the qualified business income deduction (QBID) that might be wage limited once you hit the 32% marginal tax bracket.

These all interplay. We’ll start with forfeited Social Security taxes first.

Medicare Tax Savings

You might not reap all the benefits of an S Corp election and subsequent self-employment tax savings if you have other W-2 income. Let’s say you are an IT consultant for ABC Company, and you also do some outside consulting. If ABC Company pays you $170,000 in wages, you are already max’ing out your Social Security contributions, and therefore any supplementary income regardless of your entity will automatically avoid additional Social Security taxes.

You still obtain a small savings in Medicare taxes, which is generally immaterial at 2.9% or 3.8% of the side gig income. Then again, a tiny number multiplied by a big number can be a big number. We’ll talk more about when forfeited taxes exceed the reduction in Medicare taxes in a bit.

We find this very common among medical professions. Many times, a surgeon or anesthesiologist will be full-time for a hospital or medical group, but also moonlight on the side for smaller towns with smaller hospitals with even smaller budgets.

The problem with piling extra W-2 salary from your S corporation onto W-2 salary from your main job is the S Corp’s portion of payroll taxes. While both salaries might exceed your individual Social Security cap ($176,100 for the 2025 tax year), any salary in excess will unnecessarily increase the tax burden of your S Corp by 6.2% (the employer portion of Social Security taxes). Huh?

In other words, your main job will stop collecting and paying Social Security taxes once you reach the annual limit. However, since Social Security taxes are paid by both the employee (you) and the business, when you run payroll with your S corporation, the business will collect and pay Social Security taxes just like your main job.

On your individual tax return, you will get your portion of excess Social Security taxes refunded to you on Line 11 on Schedule 3 of Form 1040. That’s the good news. The bad news is that the S Corp’s portion will not be refunded. This is lost forever, and we call this a forfeited tax.

Here is yet another table to explain this further-

Ok… here we go. Let’s say you had a main job that earned $200,000 and you also run an online retailer business where you plan to make $200,000 net income after expenses (profit). You eclipsed your Social Security maximum with your main job salary, so the $200,000 is only subject to Medicare taxes plus the surtax, or $7,600 ($200,000 x 3.8%).

Now we elect S Corp for your business and pay a salary of $66,000. The total taxes paid not considering your portion of Social Security which will be refunded is $6,600. ER is shorthand for “employer” and EE refers to “employee.” The initial savings is $1,000. However, now you must run payroll and file a corporate tax return. Therefore, the savings are gobbled up by normal professional fees.

Therefore, in this situation perhaps a garden-variety LLC is more prudent from a cost-benefit and headache analysis. Having other W-2 income, however, could actually work in your favor- more on that later.

Sidebar: Having multiple sources of income can mess up your withholdings. Each source of income on its own might withhold correctly, but when combined, the total income will be in a higher tax bracket and unfortunately will have under-withheld as a household. Again, payroll tables don’t know about other jobs or sources of income and can only make assumptions. Some tax planning is a must. More about tax planning within your S corporation payroll in a later chapter.

Here is an internal table that we use during business consultations-

Tilt. OMG. We have four scenarios; salaries of 28% and 33%, and business incomes of $200,000 and $275,000. Let’s take one and quickly dissect it.

• The forfeited tax is your S Corp’s portion of Social Security taxes that must be paid but cannot be refunded. This is 28% x 6.2% or 1.7%. This 28% will be meaningful once we get into the Section 199A deduction.
• The Medicare savings is the remaining S Corp income that will now avoid this tax. This is 72% x 3.8% or 2.7%. The 72% is in the inverse of the salary percentage.
• The first delta is simply the forfeited tax less the Medicare savings, or 1.0%. The second delta is the calculated savings, and it ties out to the first delta since $200,000 x 1.0% is $2,000.

Wait! There’s more to consider when your main W-2 exceeds the SSA wage base.

Pass-Through Entity Tax (PTET) Deduction

We touched on this in an earlier chapter, but we need to bring it up again here. As you recall, with the Tax Cuts and Jobs Act, Congress wanted to limit state and local taxes (SALT) to $10,000. This means either state income taxes or real estate taxes, or both, were severely muted on their deductions.

States got creative and created a state tax that was deducted on partnerships and S corporations tax returns (otherwise called pass-through entities… or PTE if you are a cool kid) resulting in lower federal taxable income. This tax, paid by the PTE, is then credited on the business owner’s state income tax return (or in some cases the taxable state income is reduced by the PTE’s income). This is also called the great SALT work-around.

Cash is cash to a business owner whether it is spent by the business or the human, right? There are all kinds of rules, and not every business owner will benefit from the PTET deduction. Shocker, we know.

Bottomline is this- does it feel better to pay your state income tax with personal dollars or business dollars? It’s a bit rhetorical… no need to say it out loud or call us. However, you need to have a pass-through entity, which is either a partnership or an S Corp. A single-member LLC disregarded for tax purposes or a sole proprietorship does not qualify! Read more here-

wcginc.com/ptet

Qualified Business Income Deduction (QBID)

You are likely getting tired of this section, but there is one more consideration. As mentioned elsewhere, once your household taxable income reaches the 32% marginal tax rate, your QBID has a second test. If you are a specified service trade or business (SSTB) such as attorney, accountant, physician, consultant, etc. you are mostly hosed. But if you are not an SSTB such as a retailer or an architect or realtor or the zillion other business owners, then read on.

The qualified business income deduction is 20% of your business income. Easy. Once you hit the 32% marginal tax rate, then your QBI deduction is 20% of your business income or 50% of wages whichever is lower. Lower. As such, if you do not pay wages (complete with payroll filings and W-2s), you might be limited on your QBI deduction. Keep in mind that you cannot pay wages to yourself in a sole proprietorship or a single-member LLC that has not elected an S corporation election. You also cannot pay partners a wage in a partnership.

As such, you might have regular W-2 wages that exceed the Social Security wage base and you might still need to S Corp elect your business entity just to capture the full effect of the qualified business income deduction.

Net Net

What do we do with all this data? We compare all the possible savings to the additional fees associated with an S Corp which are specifically business entity tax return preparation (Form 1120S) and payroll processing. From there, a simple cost-benefit analysis is done. It is not all dollars and cents, however. Please recall from another chapter that S corporations enjoy a significantly lower audit rate risk than plopping all this side gig income and expenses on Schedule C of your 1040 tax return.

Make $200,000 with your W-2, and $150,000 with your used copier sales gig, and you live in California? S Corp is not shabby with about $7,500 in savings (factoring in franchise tax too by the way).

It is not all dollars and cents, however. Please recall from another chapter that S corporations enjoy a significantly lower audit rate risk than plopping all this side gig income and expenses on Schedule C of your 1040 tax return.

Ok, enough of that nonsense. Please contact us if you want your unique situation projected and analyzed.

By Jason Watson, CPA
Posted Sunday, December 29, 2024

If you earned $100,000 in your garden-variety LLC, your SEP IRA deduction is $18,587. How do we get there?

It is a two-step process. First, we need to calculate the deduction for half of the self-employment tax ($7,065). Second, we take the net business income and subtract half of the SE tax. This difference ($92,935) is then multiplied by 20%.

The 7,065 number should mean something. If you recall in a previous chapter, the self-employment (SE) tax rate is 15.3% but the effective rate is 14.13%. This is because of the reduction of the business income subject to the SE tax by the “employer” portion of SE tax. 7,065 x 2 is 14,130 or 14.13%. In other words, if you made $100,000 you would pay $14,130 in self-employment taxes.

Therefore, the SEP IRA calculation in our example is reduced to $100,000 x (1- half of 14.13%) x 20% = $18,587. Or simply $100,000 x 0.9294 x 20%.

Wow, did we belabor the heck out of that? Admit it; you’re better for it… you can wow your friends at the next cocktail party… or… proudly announce on Jeopardy, “I’ll take self-employment retirement calculations for $200 please Aaron.” We certainly miss you, Alex. Sorry, Aaron, not many miss you.

Do you want another way to calculate self-employment taxes? Business income x 92.35% x 15.3%. The 92.35 is simply the inverse of 7.65 which is half of the self-employment tax rate.

Back to the issue at hand- if you elect S corporation taxation, your SEP IRA is now 25% of your W-2. Let’s say you paid yourself $40,000 in wages, your SEP IRA contribution would be $10,000 versus $18,587. That is a huge difference!

However, if you leveraged a solo 401k plan instead, your total contribution is now $23,500 (for the 2025 tax year) plus 25% of your W-2 or $33,500. Another way to look at the SEP IRA versus 401k calculation is 401k = SEP IRA + $23,500+ $7,500 (if 50 or older).

The reduction in what you can save in your SEP IRA or solo 401k cannot be viewed in isolation. In the $100,000 example above, your S Corp savings might exceed $9,000. Also recall that tax deferrals are merely little IOU’s to the IRS. As such, the small reduction in contribution limits and the small tax deferrals and even smaller ultimate tax savings (provided your retirement marginal tax rate is less than your current tax rate) are shadowed by the savings of an S corporation.

Sidebar: While WCG CPAs & Advisors defers to your financial planner, we usually recommend Roth (post-tax) deferrals into your solo 401k plan. Yes, pay taxes now, but then your growth and distributions are tax-free later in life. Tax savings is a lifelong perspective. Also, keep in mind that the discretionary employer (your business) contribution are usually pre-tax. Therefore, you are achieving some immediate tax savings and hedging your tax bets at the same time. If you are going to have a tax bill, would you prefer it today during your working years or when you are watching Matlock reruns? More about this in our retirement chapter.

Note To The Sidebar: The SECURE Act of 2022 allowed for employer contributions to be post-tax (Roth). Many 401k plans are outdated and don’t allow for this, and need to be restated.

By Jason Watson, CPA
Posted Sunday, December 29, 2024

The IRS will expect unemployment taxes (FUTA) on all W-2 wages paid, including corporate officers. According to IRS Topic Number 759, for the 2025 tax year the first $7,000 will be taxed at 6% with a credit of up to 5.4% for unemployment taxes paid to your state (SUTA). This $7,000 has not changed since 1983. Crazy!

Some states such as Alaska, Kansas, Minnesota, Nebraska, Oregon, Washington state and Washington D.C. will allow you to opt out of state unemployment.

Before you opt out of your state unemployment taxes, consider two things. First, you get a credit for the state unemployment taxes paid when you file your federal unemployment taxes on Form 940. This is a big deal. Here is how it works-

Minnesota (for example) has a wage base of $40,000 (for the 2023 tax year). Let’s say the average SUTA rate is 2.6% and your salary is $42,000. You would pay $910 to Minnesota for unemployment. Then, because you paid into Minnesota’s unemployment system, the IRS only charges you 0.6% of the first $7,000 or $42. So… $910 + $42 = $952. If you opted out, you would only pay 6% of the first $7,000 or $420. Opting out in Minnesota at this wage base makes sense.

In Colorado, where you cannot opt-out but provides a good illustration, the wage base is $20,400 (for the 2023 tax year). If your SUTA rate was 2.1% then you would pay $428 to Colorado and $42 to the IRS for a total of $470. If you could opt out and did opt out, the IRS would charge you 6% of the first $7,000 or $420. A tiny savings, but a savings nonetheless (you just covered 10% of your wine pairing dinner at Ski Tip Lodge in Keystone).

Some states, such as California, were in arrears with the federal government on unemployment debt payments and as such the credit the IRS provides was reduced. For example, the FUTA rate is 0.6% if you pay SUTA, but for California businesses the FUTA rate is 2.7% in addition to the SUTA rate. California caught up on its federal unemployment debt in 2018 thanks to the backs of resident taxpayers, and the FUTA rate will revert to 0.6%.

Note the subtle difference- full FUTA rate is 6% and the reduced rate is 0.6%. The simple decimal move is sneaky.

The COVID unemployment craziness will certainly put more states into arrears with the federal government. It will be interesting to see how this plays out. There could be debt payments made on the backs of small businesses as they see a higher unemployment tax. Remember, unemployment is a payroll tax that is wholly paid by the employer.

Second… and this one you might laugh at… second, if you shut down your S corporation you might be eligible for unemployment benefits. Remember, unemployment benefits are administered by the state and if you opt out because of your corporate officer exemption, you could be limiting yourself unintentionally. Yeah, this is crazy but beware just the same.

Pre-COVID and from direct experience with some of our clients, Colorado fights the heck out of a former business owner collecting unemployment benefits; the business owner must show that his or her business suffered a catastrophic event; one that prevented future business income. Many other states are similar. During 2020 and 2021, all kinds of nutty things were happening with small business owners and unemployment benefits being paid to them. It’ll take some time to unravel and settle back into a predictable future.

COVID also shined a light on sick pay and disability, including medical leaves. Therefore, many states recently passed legislation to fund various state-ran programs to address these issues.

For example, California, Hawaii, New Jersey, New York and Rhode Island impose a state disability insurance (SDI) payroll tax when you run payroll on the shareholders (as of 2022). Colorado has the FAMLI program which stands for Family and Medical Leave Insurance. As of October 2023, over 20 states have some sort of paid family leave.

Critical Note: Specifically, California charges 0.9% with a maximum of $1,378 (0.9% x $153,164). Starting in 2024, however, California’s SB 951 eliminated the wage limit but lowered the tax to 0.9%. Yuck.

You can opt-out of California’s SDI if your underlying entity is a corporation or if you obtain voluntary disability insurance from an approved insurance provider. Read that again. This is for corporations. An LLC taxed as an S Corp remains an LLC with the Secretary of State and as such cannot opt-out of SDI. A C or professional corporation taxed as an S Corp may. Subtle difference, but one that bites people all the time.

But there is an interesting situation with California (and perhaps other SDI states). In California, employees pay into the insurance fund and not the employer. So, if you were paid a W-2 salary of $100,000 and then was converted to a 1099 contractor, you are suddenly saving $1,000 in state disability insurance taxes. Then again, if you create a corporation and also elect S Corp status, you suddenly pay at least $800 in franchise taxes. They get you… always… eventually.

To summarize some of these various terms that you might hear-

• FUTA and SUTA- unemployment tax. Unavoidable. You might be able to opt out, and as the Minnesota example above illustrates, there is a tax savings by doing so.

• SDI- state disability insurance. Might be able to opt out for single-owner corporate officers in California or with supplemental insurance.

• Workers Compensation Insurance-has nothing to do with unemployment or state disability insurance, and is not interchangeable with those terms. This is purely insurance coverage for on-the-job injuries and is provided by private insurance such as State Farm, All State, Farmers, etc.Washington state runs their own program but allows business owners to opt-out. Ask your local insurance agent if you can opt out. Typically, you can since you don’t plan on suing yourself for a paper cut or a rogue paperclip stabbing.

Be aware that additional payroll taxes can nibble at the S Corp savings, but frankly it is relatively small at approximately $500. We are not trying to value-assess your money since $500 is still a big number. However, it is dwarfed by the savings.

By Jason Watson, CPA
Posted Sunday, December 29, 2024

Paying shareholders through payroll and filing a corporate tax return costs money- but with a potential 8% to 10% savings of net income, the benefits will exceed the costs especially if the net ordinary business income (profit) after expenses and deductions exceeds $48,000. This is net income after expenses (profit)- not gross revenue. So many business owners think in terms of gross income- we don’t care about gross income necessarily when contemplating an S corporation election, and the IRS doesn’t care about gross income when it comes to taxable income.

Since the cost of payroll services and corporate tax return preparation is relatively fixed, the more profit you earn the more you’ll save. Something to discuss and consider.

Quick Numbers: Let’s say $100,000 in net income saves you $9,000. WCG charges $4,500 ($375 per month) for business entity and individual tax returns, payroll and estimated taxes, income tax modeling and planning, and business consultation under our Vail Business Advisory Services plan. Therefore, a $100,000 S corporation saves you close to $4,500 after our fee, and we do all the work (and give you wonderful tax planning, the forgotten art of most accountants).

Here is a link to our transparent fee structure including our Business Advisory Service plans (a CPA firm who publishes fees?!)-

wcginc.com/fee

If you already have a partnership or multi-member LLC, and you file a partnership tax return (Form 1065) your break-even point is about half, or $20,000 based on the sunk cost of the business entity tax return preparation.

Sidebar: The savings illustrated here and throughout our book is per person. If you have a multi-member LLC with three partners, and the business has profits of $300,000 (as an example), an S Corp election could easily save the group $27,000 as a whole.

If you also run payroll within your business because you have a staff, then the annual cost of having an S Corp could be zero. So, now your $100,000 actually puts $8,000ish in your pocket (there are some other expenses like unemployment taxes, keep reading).

In other words, a large chunk of the $4,500 is business tax return preparation and payroll (about $3,500). Therefore, if you already pay for these services within your business then they are considered sunk costs when contemplating the S Corp election.

Sidebar: Consideration of sunk costs should be removed from decision making. One and done costs, like business formation and set up fees should be amortized over the projected life of the business. Yes, it is real money. Yes, it hurts especially all at once. Yes, the pain goes away with time. Just ask a Jets or Browns fan.

If you break-even on the fees as compared to your savings, keep in mind the additional benefits. With our business advisory service packages you are getting individual tax return preparation plus routine tax planning and consultation. There is value there, so if you break-even in terms of cost-benefit analysis, you might actually be ahead.

We are not considering the huge benefits from pass-through qualified business income tax deductions as outlined in Section 199A of the Tax Cuts & Jobs Act of 2017. At this point, in this chapter, one of our primary focuses is the delta between a non-S Corp and an S Corp. Real numbers and real examples used to be contained in this book, but are now parsed out to be a separate addendum.

By Jason Watson, CPA
Posted Sunday, December 29, 2024

Not everything that glitters is gold so there are a handful of downsides, some manageable, to the S Corp election or having an LLC. A lot of these examples stand alone, and some of these depend on the net income of the business and other external factors. WCG can help guide you through the decision-making process.

And No, there are not 185 reasons- it was just a self-proclaimed catchy number. Most of these reasons in the beginning of this chapter focus on S corporations. However, there are some general pains with having any type of formalized entity, and those are near the end.

Specifically, in this chapter we will review these disadvantages to having an S corporation-

• Increased cost (tax preparation, payroll taxes)

• 401k or SEP IRA limitations

• Trapped assets

• Disparate distributions not allowed (but we have a work-around)

• Other W-2 income

• Deducting losses, trapped cash

• Expanding ownership

• State taxes

• Among other smaller issues

Specific to S corporations, we ask these general questions of each business owner before diving into the nitty-gritty-

• Does your business earn over $50,000 net income after expenses (profit)? Say Yes.

• Are you located in New York City or Tennessee where S corporation tax rates are egregious and suck up all the federal tax savings? New Hampshire? Say No (unless you are being limited by Section 199A for lack of wages).

• Do you have other W-2 income that exceeds or comes close to exceeding the Social Security limits of $176,100 (for the 2025 tax year)? Say No.. If you say Yes, we need net ordinary business income after expenses and deductions to exceed $250,000 in #1 above.

• Are your state and local taxes limited on Schedule A of your individual tax return? If so, an S corporation might create what has been deemed the SALT work-around where state income taxes are paid and deducted by the business. Say Maybe.

• Is this a going concern? In other words, is the business going to continue to earn the same income or more each year? Say Yes.

• Do you have an LLC or some other entity in place that can be elected to be taxed as an S Corp? Say Yes. If you say No, we have options just not elegant ones.

Are you still here? Excellent news… then read on!

By Jason Watson, CPA
Posted Sunday, December 29, 2024

There are several potential problems when electing a C corporation to be taxed as an S corporation. First is called the built-in gains tax, or BIG tax for short. If the C corporation has net unrealized gains on appreciated assets, you must track these assets for a certain period of time. This also means your assets need to be appraised as of the conversion date.

For example, if an S Corp that was recently converted from a C Corp sells some real estate that increased in value when owned by the C Corp, the S Corp will probably pay taxes on the appreciation even though the corporation is now an S Corp. The BIG tax is for any asset sold within 5 years of S Corp election (it was a 10-year look back period, then whittled down to 7 due to the American Recovery and Reinvestment Act of 2009 and then 5 thanks to the Small Business Jobs Act of 2010). Here is an example-

MyCorp was a C corporation for several years until it recently made an S Corp election following some good advice. The only asset had a value of $100,000 at the time of election and its basis was $20,000. Two years later the asset was sold for $140,000 without consulting with MyCorp’s accountant.

Because there was a net built-in gain at the time of the S Corp, it will be subject to corporate income tax on $80,000 of its gain. The remaining $40,000 of its gain is not subject to corporate tax.

However, the entire $120,000 gain ($140,000 less the basis of $20,000) is taxed to the shareholders of the S corporation (but it is reduced by the amount of tax that MyCorp had to pay on the gain).

See IRC Sections 1366(f)(2) and 1374 if you find yourself in the unique position of not having enough information on the BIG tax.

More bad news- Normally, Net Operating Losses (NOLs) can be carried forward and used in future years for C Corps. On the other hand, unused NOLs will be lost forever with an S corporation election unless the C Corp can use it for previous years through amended tax returns. Otherwise the NOL cannot be used by the S Corp nor its shareholders.

Other issues arise from accounts receivable, inventory, and rents, royalties and investment income. More discussion is always required when dreaming of converting your C Corp to an S Corp. And don’t worry, we won’t judge you on the reasons you were a C corporation from the beginning (there aren’t many legitimate reasons short of funding the startup or seed money with a self-directed 401k or paring down debt with excess cash).

By Jason Watson, CPA
Posted Sunday, December 29, 2024

As the only shareholder of an S Corp, you might think that everything the business owns you also personally own. Not true. The relationship you have with your S Corp is not a marriage where mine is mine and yours is mine too.

Part 1

If you want to move assets out of an S corporation or convert them to personal use, you will trigger a taxable event. A potentially big one. When assets are distributed to the S Corp shareholders, they are distributed at fair market value. Cash is easy. An automobile is generally not a big deal. But real estate can kick your butt.

We recently had a consultation with an S Corp owner whose business owned a hotel building. On the advice of an inexperienced CPA he revoked his S corporation election. This triggered a distribution of business assets at fair market value. The basis in the hotel building was $400,000 and the fair market value was $2,000,000. This sparked a $320,000 capital gain tax event reported on his K-1. Capital gains is a success tax, right? But when you don’t actually get the cash from the transaction, this tax could be impossible to pay. Keep appreciating assets out of an S corporation people (or at least have eyes wide open on the risk)!

Sole proprietors and garden-variety LLCs enjoy a bit more flexibility under certain circumstances when distributing property or assets out of the business.

Part 2

Assets within your S Corp can also be problematic upon death. If you own an asset at the time of death, the asset is re-valued and your heirs get a step-up in basis (cost). So when they sell the asset their gain is lower. For example, you buy a painting for $5,000 and when you die, the painting is valued at $20,000. If your heirs sell the painting for $22,000, they will only realize a $2,000 taxable gain.

If the asset is sitting in the S Corp upon your death, the S corporation’s stock value might get a step-up in basis through an appraisal. However, it might prove harder to demonstrate than the increased value of one particular asset. Look at it another way. S Corps don’t die, and therefore assets within the business don’t get a step-up in basis upon a shareholder’s death.

We’ll acquiesce. This trapped asset problem is super rare yet so many owners love to have personal stuff owned by the S Corp.

By Jason Watson, CPA
Posted Sunday, October 29, 2023

S Corp shareholders are allocated net ordinary business income (profits) as a percentage of ownership whereas multi-member LLC’s use an Operating Agreement. Electing S Corp status in certain situations can create headaches for silent partner or angel investor situations, and other non-traditional ownership structures.

Fluctuating Income Splitting

Recall in a previous chapter, an S Corp election can be problematic for partnerships or multi-member LLCs who have an Eat What You Kill revenue and profit arrangement. For example, WCG has a client where the entity was comprised of two insurance sales agents. They created a multi-member limited liability company to share in some of the costs and to gain some economies of scale by working together. After common expenses were paid, the Operating Agreement allocated remaining profits as a percentage of revenue generated by each of the partners. So, one year could be 60-40 and the next year could be 45-55. This worked fine with no problems.

However, if this multi-member LLC elected to be taxed as an S corporation the arrangement blows up since shareholder allocations and eventual distributions must be made on a pro-rata basis of ownership. In using the above example, an insurance agent might be a 50% shareholder but should only receive 40% of the distributions according to the income split agreement. This is no bueno which is Spanish for no bueno.

Here is why this is a problem-

In this example, Batman is receiving 60% of the distributions as a 50% shareholder. The negative ending basis cannot happen without ugly consequences in S Corps (we call this a shareholder distribution in excess of shareholder basis which causes a capital gains tax event).

You could solve this by changing salaries- however this usually creates unnecessary additional payroll tax burdens in the attempt to equalize the income. Let’s say you must pay Batman $15,000 more in salary to “equalize” the eat what you kill income split. This would cause about $2,000 in additional payroll taxes to be paid unnecessarily. Furthermore, the equalization calculation is circular since as you increase wages for one shareholder it reduces the remaining income for both shareholders. Yuck.

A more elegant way to solve this problem, as mentioned in our chapter dedicated to customized entity structures, is to simply create two more S corporations who are 50-50 members of the multi-member LLC (MMLLC). The Operating Agreement will still dictate the pro-rata share of distributions on a fluctuating basis yet the ultimate income is sheltered by the taxation of an S Corp. We did this in the insurance agency example, and each insurance sales agent was 100% owner of his or her respective S Corp.

Also, in that chapter on customized entity structures, and specifically the mothership baby S Corp construct, we recommended a fee for service or management fee arrangement in contrast to the S Corps being members of the MMLLC.

Here is that schematic again from a previous chapter (there are all kinds of good stuff in there).

Minority Shareholders

Similar problems occur with minority shareholders or silent investors. The author, Jason Watson, served on a jury trial in 2003 when 50 Cent was singing In Da Club. An S corporation was formed with three people. One owner was a 10% shareholder, while the other two were split evenly as a husband-and-wife team. Not looking good from the start.

The minority shareholder, the 10% guy, was constructively ousted from the daily operations of the business. He was not paid a salary. He did not receive any money from the business. Distributions were not made to any shareholder, but the husband-and-wife team paid themselves a salary and used expense reimbursements as a way to funnel money out.

The business began earning money, lots of money, and the minority shareholder was getting K-1s showing taxable income of several thousands of dollars. Good right? No. Not good. He had to report taxable income, but never saw any money in the form of a shareholder distribution. The husband-and-wife team were upset too since they could not take distributions without having to pay the minority shareholder. No one was willing to budge.

Sidebar: Had this entity had a strong Operating Agreement which forced distributions, minority problems can be avoided. One of the provisions we advocate for when working with attorneys is to establish a cash reserve (working capital) for operations and then distribute 40% of the remaining amount periodically throughout the year. This forces the entity to at least cover the shareholders’ typical tax obligation associated with the K-1 income.

By Jason Watson, CPA
Posted Sunday, October 29, 2023

Another problem a business entity might face, regardless of S Corp status, is debt service.

In a perfect world, if you had a $10,000 K-1, hopefully you received close to $10,000 in cash. But growing businesses might be re-investing all their cash back into the business and if a business has high debt service, taxable income might be present without cash. For example, your business made a $65,000 loan payment. Perhaps $60,000 of this was principal payment since the loan is near the end of its term, and the remainder was interest.

If the business has $100,000 in net ordinary business income after expenses and deductions but before accounting for debt service, it will only have $35,000 in cash but have $95,000 in taxable income. This in itself is not bad, but the business might not be throwing off enough discretionary cash flow for the owners. Huh? Example time.

The tax rate above of 30% is high and is artificially inflated to illustrate the point. In this example you have $35,000 in cash available for a shareholder distribution, and $28,500 will be eaten up on your individual tax return for taxes leaving $6,500 for happy meals and taco Tuesdays.

Loans are one thing. Buying a bunch of inventory can also cash-strap your business. Remember inventory is not deducted until it is sold or depleted, or deemed shrunk or obsolete. There are some newer accounting methods thanks to recent tax code changes to might allow for inventory purchases to be treated as cost of goods sold immediately.

Another concept to point out is that depreciation of an asset is supposed to alleviate some of this problem. Let’s say you purchased some equipment for $100,000. Similar to the example above, you had a high portion of your debt payment being applied to the principal amount of the loan. This reduces your cash yet taxable income is left unchanged.

However, depreciation steps in and saves the day by being a non-cash reduction in taxable income, and helps alleviate the principal loan payment problem. Here is an example using the same table above.

The depreciation amounts and effective tax rates were made up numbers to illustrate this point. As you can see, depreciation can alleviate some of the cash crunch. Then again, if you elected to depreciate it instantly with a Section 179 deduction, then you are back to square one. This is one of the examples where the bird in the hand is not worth two in the bush- the pleasure of an instant tax deduction via Section 179 which lacks the stamina to help you in future years (which presumably are at a higher income).

Note: This really isn’t a reason not to elect S corporation status- it is a problem for any business entity.

Cash is king. Plan ahead before paring down debt.

By Jason Watson, CPA
Posted Sunday, October 29, 2023

There are several issues where an S Corporation election does not make sense. Be wary of all the accountants and other business owners who automatically check the Yes box when asked about making the election. Attorneys screw this up was too often as well. As you can see in this chapter, it is not for everyone or every situation.

As always, WCG CPAs & Advisors charges $250 for 40 minutes of consultation where A Tax Manager or Partner will ask questions to ensure the fit is correct and that it makes sense. If you decide to engage us for future services, we credit back the $250. So… not no risk, but certainly low risk in terms of how you spend your money.

Three options exist from the consult-

• A solid Yes, or

• A solid No, or

• Another appointment to dig deeper into the facts and your objectives to ensure the fit is right.

Business Advisory Service plans is our core competency. We suggest taking advantage of it (Yes, more shameless self-promotion but in our heart of hearts we just want to help you avoid a mistake or a series of mistakes). We see too many costly decisions, and even worse, decisions that cannot be retroactively fixed. Buy yourself some information… buy yourself some peace of mind; if not with us, then with another competent small business consultant.

By Jason Watson, CPA
Posted Sunday, October 29, 2023

Is your S Corp going to be needed next year, or the year after that? While an S Corp might make sense in the immediate future, the costs and hassles of startup and shutdown need to be amortized or spread out over a handful of years at the minimum. In other words, if your consulting gig might turn into a W-2 job next year, perhaps wait or defer the S Corp election.

Marriage in itself is not a reason to elect S corporation status. But an S Corp is like a marriage- easy to get into, hard to get out. The S Corp election needs to be revoked, the business needs to reclassify itself as an LLC, a final tax return needs to be filed, payroll accounts need to be closed, etc. At times it is easier to shut down the entity and re-light another one.

We are not trying to alarm you or dissuade you, but at the same time many people forget about the back-end issues. Yes, WCG can take care of all this.

By Jason Watson, CPA
Posted Sunday, October 29, 2023

Children do not pay any Social Security or Medicare taxes until they reach 18 years of age if he or she-

• works for a parent who owns a sole proprietorship or partnership (recall that a multi-member LLC is taxed as a partnership),

• works in domestic service (babysitting, chauffeurs, etc.), or

• delivers newspapers (the law really lists newspapers.. who does this anymore?)

However, with an S Corp election this blows up because the child is now working for a corporation, and not the parent. In other words, when you run your business as a sole proprietor, you and the business are one in the same. Same thing with a single-member LLC and a partnership. But an LLC with an S corporation election now becomes a corporation for taxation purposes, and your child loses this exception.

For example, your sole proprietorship or LLC could pay your child $13,000. He or she would not pay payroll taxes (Social Security and Medicare), and neither would you as the employer. Your child could then gift the take-home money back to you and your spouse. It is presumed that his or her tax rate would be lower than yours, and therefore you created some tax arbitrage. There is not a kiddie-tax issue since this is earned income. Furthermore, depending on how fruitful you are or your religion, you might have a hefty amount of salaries being paid to your gaggle of children bypassing a lot of payroll taxes.

Yes, he or she would have to file a tax return. But you would still claim the exemption as a dependent. No, having babies is not good tax advice. Kids are expensive. Really expensive.

There are creative types out there who will set up a single-member LLC which is solely owned by the Mom or Dad. Then, this LLC charges a consulting fee to the S Corp and then pays out the proceeds as salary to the children. In theory this bypasses payroll taxes (Social Security and Medicare) since it is an LLC that is paying the salary rather than the S corporation. This is sometimes referred to as a Family Management LLC.

We do not know how this would play out in Tax Court. Oftentimes we see theory making sense on paper just to have it be viewed as an end-around by the court. However, if we can document the business purpose of the Family Management LLC as it pertains to its business-to-business relationship with the S corporation, then let’s document the heck out of it and deploy immediately. But please understand the risk. Even Forbes says Go for it, but then again, they aren’t going to pay your penalties and interest.

Conversely, there might be several situations where paying your children a salary from your S corporation continues to make a lot of sense. More in this and other fringe benefits in our chapter on tax deductions.

By Jason Watson, CPA
Posted Sunday, October 29, 2023

If your loan is not in writing or does not have a firm schedule for repayment, it might be labeled as a second class of stock which will nullify your S Corporation. We know it’s a pain but please go through the hassles of creating a proper instrument when lending money to your business. See IRC Section 1361(c)(5)(B). More amazing information! Or is it spellbinding?

As with most things in the IRS world, there are exceptions and many exceptions are called Safe Harbor provisions. In this situation, there is a straight debt safe harbor which allows for a loan by a person who is eligible to hold stock in an S Corp or is a business engaged in lending. The loan must not be convertible into stock, and there are some other rules. Let’s not muddy the waters quite yet since this is rare.

As mentioned earlier in this chapter, shareholder loans are generally a bad idea and might not be as elegant as basic cash injection.

By Jason Watson, CPA
Posted Sunday, October 29, 2023

You, or someone you know, might have had a job where the company-match to your 401k was vested over time or the business had a restricted stock grant that only triggered after so many years of service. For most of our readers this concern is moot since the idea of expanding ownership is not on the radar. However, life is funny, and you never know how your path might change directions with left turns at right angles.

If the transfer of stock and subsequent ownership is not handled correctly within your S corporation, this could be considered a second class of voting stock which nullifies the S Corp election. Therefore, if you are contemplating bringing in other owners or partners please read on. If you are not considering it, please read anyway so you have some basic knowledge of the problems.

Basis Problems

If you have a successful S Corp and you sell 10% of your stock to a key employee, you suddenly create a zillion headaches. First, what is the valuation of the stock? A valuation too low might be considered compensatory triggering an income tax obligation for the employee buyer.

What is the cost basis of the shares? This is arguably easier since we would just look at your shareholder basis to determine the capital gain (if any). However, many business owners freak out when they are faced with a capital gain when selling a minority interest in the business.

For example, WCG has a client who established a value of his business based on a long calculus. His basic argument was that he injected intellectual property into the business and therefore his shareholder basis was $250,000. Look at the big brain on Brad! No doubt, this guy was smart and his business was probably worth $250,000 from the beginning. However, he neglected some accounting basics and IRS law.

In its simplest form, you cannot create basis in a business without paying income taxes on the money used to establish the basis. Huh? Let’s say you have $1,000 in your pocket. You paid income taxes on that $1,000. You buy stock for $1,000 and sell it for $1,500. Your basis is $1,000 and your gain is $500. Piece of cake.

Same with a business. You wrote a check for $250,000 and you paid income taxes on that money. When you sell your business for $400,000 you will have a $150,000 gain because the $250,000 was already taxed.

Therefore, you cannot create basis out of thin air. In the case of intellectual property, the owner would have had to pick up $250,000 worth of income on his individual tax return somewhere in the past in order to have $250,000 of basis in his business. Same with a loan. If the bank gives you a loan, either through the business or through you personally, the principal payments are not tax deductible since it is essentially a return of capital. As such, if the personal loan is your injection to create basis in your business, it too is done with after-tax dollars.

Another way to look at this is your personal home. You borrow $300,000 to buy a $300,000 house. Over the course of 30 years, you paid over $500,000 in total payments but when you sell the house, your basis remains at $300,000 (and hopefully the $200,000 in interest was tax deductible).

Does this make sense? No? Crud. Perhaps have a nice Dale’s Pale Ale and give us a call. We can try walking through it another way. We might need a Dale’s too! Yum.

Back to the headaches of selling 10% of your business to someone else. This 10% owner now gets a K-1 with 10% of the S Corp’s net business income as taxable income. All shareholder distributions must be allocated among all shareholders. So, if you want to pull out $9,000 to pay for your family vacation, you also need to write a $1,000 check to your new 10% shareholder buddy. Cancel the flights. You might have to drive to vacation.

Death, divorce and incapacitation. Does your Operating Agreement (LLC) or Shareholder Agreement (C Corp or Professional Corp) deal with death, divorce or incapacitation? You need to. What is incapacitation? Do you need two doctors to sign off? If the remaining shareholders have first right of refusal on the re-purchase of the crazy man’s stock, how is that valued? It will be hard to negotiate in good faith with someone who is incapacitated.

We touch on various other traps and pitfalls in an earlier chapter when expanding ownership.

Speaking of value, 10% of the shares issued to the new shareholder have very little value. Since the S corporation is closely held, there is not a market to establish the value of the shares. A bank would probably not use the shares as collateral. The majority shareholder (you, in this string of examples) could run the business into the ground or simply shut the business down. The 10% shareholder has very little recourse outside of dissenting shareholder lawsuits (unless there is some contractual obligation governing these possibilities).

Lastly, the 10% shareholder might want to be involved with daily decisions or long-term decisions. Sure, the majority doesn’t technically have to listen or even care, but that isn’t the most professional way to foster the new relationship. Office politics suddenly become a reality in a business in which you never had to consider it. Want to buy a business car? Might have to get permission. Yuck.

So, what can you do? You have several options to bring in new owners without creating immediate problems, and you can get creative.

Employee Stock Ownership Plan (ESOP)

We mentioned this in an earlier chapter but we expand a bit to illustrate the challenges of expanding ownership and offer ESOPs as a solution for your S corporation. ESOPs are a great way to reward and incentivize employees. They also create a market for the shares of a departing owner or an owner who wants to expand ownership to the employees. Remember, if you have a growing business and you want to start working on an exit strategy or transition plan, using your own staff as future suitors might be the best idea. They have been vetted over time and know the business very well.

Here are the basics of an ESOP. A business creates a trust where shares or cash to buy shares are contributed to the trust account. Each share is allocated to individual employee accounts. You can discriminate based on years of service, full-time versus part-time and age. There are rules on this of course. The default is 1,000 hours of service in a plan year and 21 years old.

You can also create vesting schedules. For cliff vesting where the employee has either 0% or 100%, the maximum vesting schedule is three years. And for graded vesting schedules, the maximum is six years. This is because an ESOP is a qualified defined contribution plan and must follow the rules.

Here is a sample schedule-

You can find vesting rules in IRC Section 411(a)(2)(B).

Here are some other takeaways on ESOPs. The percentage of ownership held by the ESOP of an S corporation is tax-deferred. For example, the S Corp earns $500,000 and the ESOP owns 40%. $200,000 of the taxable income should be added to the ESOP and allocated to each employee participant. This is a tax deferral not a tax deduction. When the employee sells or withdraws the shares (such as retirement) there will be a taxable event based on the individual’s tax rate.

This makes sense since an S corporation is a pass-through entity. So if an ESOP trust owns a portion of the stock, the beneficiaries of the trust (employees) will have a deferred tax obligation.

As an aside, a common theme in income taxation is one person’s deduction is another person’s taxable income (mortgage interest is a great example). A great exception is charitable donations- your deduction is not a taxable gain to the charity. Back to the ESOP- if a business may deduct the cash or stock contribution into an ESOP, the taxable income is later picked up by the ESOP participants when the money is taken out.

Here are some more takeaways. The law currently does not allow ESOPs for partnerships or professional corporations. Departing employees’ shares must be re-purchased. Costs of these plans can be substantial (as much as $40,000 depending on complexity, according to the National Center of Employee Ownership).

If you are seriously considering this please review Section 401(a) of the Internal Revenue Code in between P90X reps at the gym, contact the NCEO (www.nceo.org) or contact us.

Here is quick link to NCEO’s article-

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Hybrid Purchase Schemes

If the ESOP doesn’t suit your needs and if you are afraid of introducing additional ownership through a simple stock sale, the sky is the limit on creating your own scheme. Time to put your thinking cap on.

Again, this is under the auspice of the problems of having an S corporation and wanting to expand ownership. Expanding ownership in a multi-member LLC does not have the same problems with distributions and allocations as an S Corp.

WCG recently consulted on a buy-in scheme involving several millions of dollars. A trust was created and funded with profit incentives. In approximately ten years, if profit goals were achieved, the trust would be fully funded, and a partnership would come to life. The funds would be directed by the trust and trustee to purchase a large chunk of the business for the benefit of the new LLC.

Initially the attorneys involved had an arrangement set up where three key employees would eventually be the members of the LLC (in other words, partners in a partnership). However, it was suggested to us that even key employees might come and go. Instead, each employee invited to participate would be granted units from a pool depending on years of service. Units could also be re-deposited back into the pool upon departure of a key employee.

This allowed seniority and longevity to become valuable, but the owner could also assign additional units as he saw fit depending on an employee’s individual contribution. The owner was also able to grant some units to his children to ensure their long-term legacy and wealth transfer.

In addition, the funding was augmented by cash value whole life insurance to protect the current owner’s interests and to help fund the transfer of ownership.

Recap of Expanding Ownership Issues

Creating ESOPs, buy-in schemes, Buy-Sell Agreements, and the like, for an S corporation requires a talented business law attorney in concert with business consultants who can draft the corporate governance documents correctly. This stuff is state-specific but also must follow national guidelines within the IRS, ERISA, DOL, etc.

Moreover, and we will expand on this in a bit, you need to be aware of ineffective S Corp elections because of side pot deals and extraneous contracts / promises made to others.

Let us know if you need help in selecting a proper attorney, and adding some creativity and protection to your scheme.

By Jason Watson, CPA
Posted Sunday, October 29, 2023

One of the rules of an S Corp is to only have one class of voting stock, and this can be a problem at times if you are trying to bring in a new partner or create a vesting schedule for future owners. You can have two classes of stock as long as the only difference is the voting rights between the stocks. See IRC Section 1361(c)(4). Quite the page turner.

So, if you want to provide distributions to a person but not give them control, assign him or her nonvoting stock (such as a retired parent who needs some money and enjoys a lower tax bracket than you).

Truly stock classes don’t trip up many S corporations. What can prove to be tricky and expensive to solve is expanding the ownership of the S Corp through key employees or other graduated buy-in situations. Keep reading.

By Jason Watson, CPA
Posted Sunday, October 29, 2023

If you believe Social Security will remain funded by the time you retire, you might be short-changing yourself since your salary will be used to gauge future retirement benefits. Remember, K-1 income from your S Corp is not subjected to self-employment taxes and therefore will not count towards your Social Security benefits basis.

Conversely the tax money you save today can make excellent retirement investments which can counteract the loss in Social Security benefits. In other words, the savings in Social Security taxes today might exceed the loss in future Social Security benefits if those savings are invested correctly.

The maximum Social Security benefit for 2021 is $3,957 per month for those who delay until age 70, or $3,135 for those who start benefits at full retirement age (FRA). Our apologies for not updating this data in a while, yet it remains relevant.

Using SSA.gov’s calculator, at $60,000 in salary with an age of 50 your benefit would be $1,955 at age 67 in today’s dollars. A $100,000 salary would have a benefit of $2,675.

Whoa! Look at those deltas between salary and benefits right around $90,000 to $100,000 in salary. This would suggest that salaries above $90,000 have a steep diminishing return on increasing SSA benefits. Or, said differently, salaries below $90,000 have a good retirement benefit for your salary buck. Additionally, consider that paying $140,000 costs about $7,500 in additional taxes without a corresponding strong future benefit ($50,000 x 15.3%). We’ll explore this more in our chapter on reasonable shareholder salaries.

Of course, there are a ton of assumptions in terms of age and consistency of earnings, but the table above illustrates some interesting points. You can probably imagine that this gets tricky right quick. Can I parlay my self-employment tax savings into better retirement benefits than the Social Security Administration? Probably. Are SSA benefits going away? Probably not, but they might become means tested and restricted in other ways.

Here is a link to SSA’s online calculator-

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