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

Yes, you are able to engage in revisionist history and retro activate your S corporation election to January 1, 2025, and have your income avoid a large chunk of self-employment taxes. First things first. You must be eligible to become an S Corp for taxation purposes-

• you must have an LLC, partnership or C Corp already in place (basically an entity that is recognized by your state’s Secretary of State),

• your entity must be domestic,

• have 100 or fewer shareholders,

• have shareholders who are individuals, estates or exempt organizations, and not have any non-resident alien shareholders, and

• have only one class of stock (you are allowed to have voting and non-voting as one class).

There some other devils in the details, but 99% of the LLCs, partnerships and C Corps out there qualify for an S Corp election.

If you do not have an entity already in place, there are organizations that sell shelf businesses. Note the word shelf- not shell. These shelf businesses, with an f, have EINs and file tax returns, and all their history sits on a shelf hence the name shelf company. How this works is beyond our book and usually requires a conversation. In other words, it gets a bit hairy.

Late S Corp Election, Oops

Form 2553 (the S Corp election form) must be filed with the IRS. It is typically due within 75 days of forming your business entity (right around March 15 of the following year). However, in typical IRS fashion there are 185 exceptions to the rule and the late S corporation election is another example. The IRS provides relief for the late filing of Form 2553. Historically, IRS Revenue Procedures 2003-43 and 2004-48 were the governing rules but the IRS has simplified it (imagine that!).

IRS Revenue Procedure 2013-30, effective September 3, 2013, allows an entity to get relief and elect S Corp status within 3 years and 75 days from the date the election was originally intended to be effective. Holy cow. Three years!

The IRS is basically saying that if you walk and smell like an S Corp, then you are an S Corp.

So, if it is November 2025, and you want to go back to January 1, 2025, no problem. If it is March 2026 (tax season) and you are freakin’ out because you forgot to make the election earlier, you can still go back to January 1, 2025. No that is not a typo… we are talking about going back to the previous year’s January 1!

With the preparation and filing of a late Form 2553 for your S corporation election, a reasonable cause letter must be attached. We have a template that we’ve used successfully at least 1,500 times, and we can guide you through it. Additionally, your reasonable cause cannot be “hey IRS, I just learned of this S Corp thing, and man, it sounds amazing. I would like to do this retroactively so I can save a bunch of taxes.”

Beyond the reasonable stuff, there might be other hiccups. Isn’t hiccups such a friendly word? Sort of like bumps in the road. Bruises is another word that is about as hollow as hiccups and bumps. No one says pitfalls or disasters anymore, just hiccups. The bottom line is that we can engage in some revisionist history on March 1, 2026 to take effect for all of 2025. Boom!

If your current CPA or tax professional says No, we kindly and very politely suggest you find a new accountant. WCG CPAs & Advisors has been doing this for over a decade (there was relief provisions prior to the 2013 IRS Rev Proc as well) without major problems. Given the timeline as it compares to the filing deadlines, you might incur some late filing penalties. However, these are usually abated under the First Time Abatement statutory relief program. Aside from that, the late S corporation election is straightforward.

Once the facts and circumstances are reviewed, and everyone thinks the S Corp election is the way to go, there are three things that happen simultaneously (assuming we are beyond December 1, 2025)-

• Fax Late S Corp Election Form 2553 to the IRS, Fee: $600 or $1,200 after Jan 1, 2026 which includes late filing abatement efforts since your tax return will unlikely be extended electronically. A timely filed S Corp election is $450.
  

• Open Payroll Accounts for 2026 (to be compliant in the future), Fee: $550 to $650 (depending on state, CA, CO, TX easier… NY and PA, rough, like a stucco bathtub)

• Issue a 1099-MISC as Officer Compensation for 2025 (in lieu of a late payroll), Fee: $650 (this includes tax planning and estimated tax calculations)

• Prepare 2025 (due Spring 2026) S Corporation Tax Return on Form 1120S, Fee: $1,500 (typically, most are $1,500)
  

So, you will spend about $3,200 however you will be saving anywhere from 8% to 10% of your net ordinary business income after expenses and deductions depending in your situation. Also remember that the late S Corp election and payroll account setup are sunk costs. In other words, you would need these things done regardless of late S Corp election for the previous year or waiting until next year. Bite the bullet now. Get it done.

Said differently; if we isolate 2025 only, your costs are about $2,150. If you have $50,000 in net business operating income after expenses, you will still save well over $2,000 after our fee.

In the past, to obtain relief with a late S Corp election during the tax season, we would prepare and paper-file Form 1120S (corporate tax return) and physically attach Form 2553 (S Corp election) to it. Today, there are three paths-

• If we are chillin’ around Thanksgiving, then we can likely submit the S Corp election via fax and have it processed by the IRS in time for the March 15 filing. Normal ops.

• If we are after December 1, then we prepare the S Corp tax return (Form 1120S) by March 15 and we electronically attach Form 2553. Clean. Nice. Having said that, we still fax the S election to the IRS as quickly as we can long before tax return preparation.

• If we are after December 1 and you want to extend the S Corp tax return, then we have some problems since we cannot electronically file a tax return extension. Rather, we attempt to file the extension which will be met with a likely rejection. Next, we deal with the late filing penalty with the First Time Abatement program with a massively high 99% success rate. Messy, but common.

Every once in a while the IRS loses its mind and rejects the late S Corp election. We always get it pushed through. Always. Unfortunately, the rejection or some other nasty gram of a notice arrives on your doorstep at 5:01PM on a Friday. Briefly freak out, send the documents to us, and then have a Coke and a smile- it’ll be OK.

At the very worst we have to obtain a Power of Attorney from you, call the IRS and give them a “see… how it works is…” spiel. We have a 100% success rate in getting these late S Corp elections pushed through. While your mileage might vary, we are also very successful with getting late payment penalties abated with the IRS. Each state is different, and some are unsympathetic. Again, the savings will outweigh the costs (or we wouldn’t let you do it).

Are you a bit confused? Yeah, we threw a lot of dates and bullet points and gibberish your way. The various bags of tricks and workarounds all depend on how quickly a decision can be made relative to the calendar. Regardless of the time between January 2025 all the way through the summer of 2026, we have solutions. Some elegant. Some less than elegant.

Note: This section and all its crazy dates has been updated for the 2025 tax year. Therefore, some of this seems futuristic. However, the concept remains the same for 2024 tax year. Let’s say it is March 2025, and you are wanting a late S Corp election back to January of 2024, that is totally doable with some of the hassles explained above.

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

Here is a summary of the life cycle of an S Corporation in terms of startup and shutdown-

• LLC Formed

• S Corp Election Made, Form 2553

• Payroll Accounts Opened

• S Corp Revoked, Letter to IRS

• Reverts to C Corp for Taxation

• Revert to LLC for Taxation, Form 8832 (Entity Classification Election)

• Distributions and Tax Consequences Dealt With

• Payroll Accounts Closed

• Final S Corp Tax Return Filed, Form 1120S

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

S Corps that lose their “S” status must typically wait five years before being able to re-elect it. As mentioned, deliberately violating one of the rules, such as transferring stock to an ineligible shareholder, is not a good thing. What happens if it was unintentional? The IRS in private ruling letters has on a case-by-case basis allow S Corps to remain as such if the event causing termination was not reasonably within the control of the owners. This is hard to demonstrate, and by the way, private letter rulings (PLRs) can cost thousands of dollars to submit.

In other cases, the IRS has relented and allowed an S Corp to continue when there is a more than 50% change in ownership. Details. Details. So, a business becomes an S Corporation. Revokes the election. Then has a greater than 50% change in ownership within five years. Begs to the IRS. Perhaps is granted an early S Corp election.

Another option is to relight with another entity. You have LLC A, and tax it as an S corporation. You bounce along, and then decide to revoke the S Corp election. A few years later, you want to re-elect S Corp status. Not good. One solution we see is a small business owner starting LLC B, taxing it as an S Corp, and then moving operations over to this new entity. More discussion is required of course; one of the problems is if LLC A had a government contract (such as defense or transportation) or an approval (such as Medicare), these cannot be easily transferred.

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

When you revoke S corporation status, you will trigger a taxable event. A potentially big one. Upon revocation, assets are distributed to the S Corp shareholders at fair market value. Cash is easy. An automobile is generally not a big deal. But real estate can kick your butt. Therefore, before we put out the flame, a review of the assets and fair market values must be done. To pay capital gains on appreciated assets when you have cash from a transaction is easy. To pay capital gains on appreciated assets when a cashless revocation occurs is brutal.

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

S Corps have relished being the class favorite for all kinds of reasons as stated in this book. However, the original C Corp could be making a comeback based on flawed logic from the Tax Cuts and Jobs Act of 2017.

The primary motivation is the seemingly attractive 21% tax rate for C corporations and while this might be lower than some taxpayer’s marginal rate, this is a sucker hole for business owners for two painfully obvious reasons. First, your marginal rate might be 22% or 24%, but your effective tax rate (or blended tax rate) is much lower. We’ll show you… not to worry.

Second, there is a little thing called double taxation where the C corporation pays a tax and then the shareholders pay a dividend tax on the money that is distributed. And… if you think you’re a smarty pants and say, “Yeah, but, I’ll just keep all my money in the C corporation for a rainy day and lower tax rates,” there is another little thing called accumulated earnings tax.

Buckle up buttercup ‘cause here we go-

As you can see, a C Corp does not make sense after you add in capital gains tax on the dividends. Also note the effective tax rate (or labeled as tax “pain”) for the S corporation owner. At $100,000 in net business income, the total tax pain including payroll taxes is 13.1%, and at $200,000 it is only 18.2%. This is still well below the C corporation tax rate of 21%.

One more thing that is not computed above; C corporations do not get the Section 199A deduction which is 20%. 20% times the marginal tax bracket of 15% is another 3% savings; 20% times the marginal tax bracket of 37% is another 7% savings. So, please pump the brakes on the “I wanna dump my S Corp for the magical tax arbitrage offered by a C Corp” nonsense. Wow, that was harsh. We did tell you to buckle up but then we offended you by calling you buttercup. Safety with an insult.

Sidebar: In a previous chapter we highlighted several reasons why a C corporation makes sense. Paring down debt, employee stock plans, funding with a 401k, keep income off your individual tax return, among many ideas.

Let’s say there are other reason to revoke S Corp election. Yes, you can change back and the present-day solution is accomplished by either liquidating, or terminating the S Corp election.

Liquidation is the more complicated of the two. In a nutshell, the process begins with a unanimous vote to close the business. Once that decision is made, it’s a complicated process of contacting creditors, assessing receivables, distributing or selling property and closing up the books.

Termination, moderately more elegant. Terminating the S Corp election can happen one of two ways. Preferably by revocation, or the next best alternative, violating one of the S Corp rules. Violating one of the S corporation rules is not an elegant option, however.

Therefore, revocation is the preferred direct route and is as simple as writing a statement to the IRS revoking your S Corp election. In this manner, obtaining written consent from more than 50% of your shareholders is required. Simple for one or two owner S Corps, but community property states, tenants in common, and majority shareholders could complicate that. Again, if the underlying entity is an LLC then the members will be bound by the Operating Agreement in terms of voting and other requirements.

When your S corporation election is revoked, either intentionally or not, your business will more than likely revert to a C Corp for taxation. We can then file a Form 8832 which will reclassify your business back to an LLC or partnership, again for taxation. Remember, the underlying entity does not change with the Secretary of State. There might be some accounting headache and subsequent tax consequences with capital accounts or other assets, but we can advise you on those concerns once all the details are vetted out.

Why would you want to revoke your S Corp election? There are many reasons- business closed or is shrinking to a point where it doesn’t make sense, lost the contract gig, got converted from 1099 to W-2, foreign investors, etc. are among the most frequent. We can help guide you as these situations arise.

Notice how making too much income wasn’t on the list of possible reasons. Of course, there are exceptions, but generally speaking if you make $30,000 or $300,000 or even $3,000,000, the S Corp election is going to be your friend.

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

Massaging of the equity section of your balance sheet is required when being taxed as an S corporation. But what if the underlying entity is an LLC? Good question. We believe, for elegance sake, that an LLC being taxed as an S corporation should walk, talk and smell like a corporation on the tax return. Ultimately this does not alter the ownership; the IRS calls you a shareholder since that is what the K-1 reads, but if you are an LLC you truly remain a member and your ownership is called an interest (not a share or a stock).

So, you are living two worlds. You have the governance of your entity (LLC – Operating Agreement versus Corporation – Bylaws / Shareholder Agreement) in one world, and the tax election in another.

A lot of people will tell us, “I have an LLC S Corp,” or “I have an LLC taxed as an S Corp” or something similar. This is great since it helps us understand the business acumen of the owner in terms of their understanding of the S corporation mechanics. Ok, upward and onward…

Here is some nauseating accountant jargon. On January 1st, or the effective date of the S corporation election, the equity section would have five accounts-

• Capital Stock

• Additional Paid-In Capital (for each shareholder)

• Shareholder Distributions (for each shareholder)

• Retained Earnings, and

• Net Income

Unlike a C corporation, an entity being taxed as an S corporation can only have one class of stock, so preferred stock is not allowed, yet common stock within an S corporation structure can still have voting and non-voting rights. This section of our book is regarding an LLC but if a C corporation elected to be taxed as an S corporation (for example), Dividends Paid would still be tracked within the equity section purely for legacy purposes. However, S corporations do not pay dividends. Rather shareholders receive distributions.

The challenge becomes how to “fund” the Capital Stock and Additional Paid-In Capital accounts. Typically, an LLC will be initially funded with the owner injecting cash and perhaps some equipment to start the business. This would have been a debit to Cash and Equipment separately, and a Credit to the owner’s Capital account. Upon S corporation election, the Capital account would be closed out to Capital Stock using a pre-determined par value such as $10 per stock and a nominal number of shares such as 100, or $1,000 in Capital Stock.

We recommend keeping the Capital Stock account as small as possible because it provides the most flexibility in taking future Shareholder Distributions without affecting Capital Stock. The remainder would be a credit to the Additional Paid-In Capital account(s). Yup we are geeking out.

Generally, when taking a C corporation and electing S Corp status, existing Retained Earnings needs to be recorded separately. Why? Theoretically these earnings would have been subjected to dividends taxes paid by the shareholders if distributed. Therefore, the IRS is wise and doesn’t want you to enjoy a 21% corporate tax rate as a C Corp, elect S Corp status and then distribute the prior earnings tax-free. There are some devils in the details and there are some things like Built-In Gains taxes, ordering rules and stuff, but that is rare for most small businesses converting to an S corporation. A ton more discussion is required for each person’s unique situation and is beyond the scope of this book.

Since it is common for small businesses to operate as LLCs for several years and to have incomplete records (shocking), the “funding” of the equity accounts might have to wait until the end of the first year of S corporation election to maintain sanity. For example, on December 31st Capital Stock and Additional Paid-In Capital are zero, including Retained Earnings.

The following three journal entries would be made-

• Net Income would be closed out with a credit to Retained Earnings, and

• Shareholder Distributions throughout the year would be closed out with a debit to Retained Earnings, and

• A correcting entry would be made with credits to both Capital Stock and Additional Paid-In Capital using the same guidelines of keeping Capital Stock a nominal value such as $1,000, and a debit to Retained Earnings.

You really don’t care about this, do you? No worries, we provide these journal entries during tax preparation.

Another technique where historical records are incomplete would be using the amount of cash in the business checking account on January 1 of the first year of S corporation election as the initial capital injection. The entry would be a debit to Cash, and credit to Capital Stock and Additional Paid-In Capital. The adjusted cost basis of injected assets would be handled similarly.

For example, you have a piece of equipment that you purchased for $28,000 and $20,000 was already depreciated on previous tax returns. The adjusted cost basis is $8,000. The journal entry would be a debit to equipment for $28,000, a credit to accumulated depreciation for $20,000 and a credit of $8,000 to Additional Paid-In Capital. If you were already carrying this information on an LLC’s balance sheet, then there might be some other entries to true things up.

Sidebar: If you are an LLC and have assets, they are probably detailed on your fixed asset listing as part of your Schedule C and Form 1040. Holding periods and future depreciation schedules do not change when electing S Corp status. Keep in mind that the underlying entity does not change; just the tax election. This section highlights how we would set up the equity section to simulate a corporation when the underlying entity was an LLC (especially since we now have to represent all this on your S Corp tax return).

While these techniques are not as elegant as tracing the capital structure from the beginning, it does create efficiencies and simplicity within a small business. Shareholder basis would also be the beginning cash, unless there are some other issues at hand (like transfer of depreciated assets, shareholder loans to the S corporation, etc.).

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

Let’s take a step back and talk about some of the underpinnings of the S corporation election. Some of this is boring legalese and some of this is nerdy accountant-ese, but you’ll be better for it. Perhaps.

Business Entities

Treasury Regulations Section 301.7701 discusses all sorts of things about business entities and the default tax classification. The IRS website has a nice summary-

A Limited Liability Company (LLC) is an entity created by state statute.

Depending on elections made by the LLC and the number of members, the IRS will treat an LLC either as a corporation, partnership, or as part of the owner’s tax return (a disregarded entity).

A domestic LLC with at least two members is classified as a partnership for federal income tax purposes unless it files Form 8832 and elects to be treated as a corporation.

For income tax purposes, an LLC with only one member is treated as an entity disregarded as separate from its owner, unless it files Form 8832 and elects to be treated as a corporation. However, for purposes of employment tax and certain excise taxes, an LLC with only one member is still considered a separate entity.

This simply means that unless you do something extra (which the IRS refers to as Check the Box elections), you will default to the tax classification above. Therefore, and as summarized by the IRS above, three possible tax classifications exist for business entities- corporation, partnership or disregarded entity. As we’ve discussed elsewhere, community property states usually follow the single member LLC disregarded entity rules above.

Treasury Regulations Section 301.7701-2 expands this a bit and defines business entities separately from corporations. We’ll move along unless you are starting a bank or insurance company.

Form 8832

Form 8832 allows you to change the tax classification of an entity. Treasury Regulations Section 301.7701-3(g)(1) outlines the various re-classifications, and we’ve summarized them here-

1. Partnership to an association (corporation). The partnership contributes all of its assets and liabilities to the association in exchange for stock in the association, and immediately thereafter, the partnership liquidates by distributing the stock of the association to its partners. Woohoo!
2. Association (corporation) to partnership. The association distributes all of its assets and liabilities to its shareholders in liquidation of the association, and immediately thereafter, the shareholders contribute all of the distributed assets and liabilities to a newly formed partnership. Exiting!
3. Association (corporation) to disregarded entity. The association distributes all of its assets and liabilities to its single owner in liquidation of the association. Riveting! This would be the aftermath of revoking an S Corp election and electing the association to now be taxed as a single-member LLC.
4. Disregarded entity to an association (corporation). The owner of the eligible entity contributes all of the assets and liabilities of the entity to the association in exchange for stock of the association. Neat! This would be part of the process of electing S corporation tax status (more on this in a bit).

Is Form 8832 necessary when electing S Corp tax status? No. In fact, you should avoid filing Form 8832 if your true intent is to be taxed as an S corporation. Why? If you file Form 8832 and the IRS accepts that, you are now going to be taxed as a corporation. If you then file Form 2553 and that is rejected for whatever reason, you are stuck with being taxed as a corporation. This is not the worst thing on the planet; the Bears winning a Superbowl naturally is. However, this “8832 no man’s land” is certainly an avoidable annoyance.

Rather, if you only file Form 2553 and that is rejected for whatever reason, your tax classification remains as-is. Want to know more? Of course!

Treasury Regulations Section 301.7701-3(c)(1)(v)(C)… yeah… way deep into the indentation… states in part (we saved you from some of the extra verbiage)-

An eligible entity that timely elects to be an S corporation under section 1362(a)(1) is treated as having made an election under this section to be classified as an association.

Ah! This basically says that if you have an eligible entity and you timely file Form 2553, you will be treated as making the election to be classified as an association (corporation) alongside being taxed as an S Corp (a two-fer if you will). Don’t get freaked out about the “timely elects” part. As discussed, IRS Revenue Procedures 2013-30 allows for late S corporation elections and as such considers them timely if certain rules are followed.

Tax Free Transfer

The transfer between LLC and association (corporation) is tax free of course unless the LLC’s liabilities exceed its assets. Additionally, IRC Section 351(a) applies which generally states, “No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control (as defined in IRC Section 368(c)) of the corporation.”

Don’t get too hung up on the control piece. For most small business owners, this is not a big deal. However, the liabilities exceeding assets part can be a trap especially if you fully depreciated an asset while having a loan (think automobile). If this applies to you, please consult with us.

Timely Election

An election is considered timely if filed within 15 days and two months of January 1 or the entity’s activation. Activation is the earliest date of an entity having shareholders / members (owners), acquiring assets or begins conducting business.

Form 2553

Completing Form 2553 for the S corporation election is straightforward. The form asks for basic business information such as name, EIN, date of incorporation (activation date) and date of election. Keep in mind that this form was built for a C Corp electing to be taxed as an S Corp, so some of the form boxes use words like “incorporation.” LLCs are not incorporated; rather they are usually formed or organized depending on your state’s nomenclature.

It also requires signatures from all owners. Again, the form references shareholders, but an LLC has members. Don’t get too hung up on this, but please understand some of the subtleties. For sanity, members = shareholders = owners. Additionally, use ownership percentages rather than shares.

Another way to view the references to incorporation and shareholders is to recall that as Form 2553 is being processed and approved by the IRS, the entity’s classification is changing to association (corporation) as it is also being taxed as an S Corp (Treasury Regulations Section 301.7701-3(c)(1)(v)(C)).

Housekeeping

If your LLC has an existing Operating Agreement, it might need to be amended or restated so it aligns with your entity being taxed as an S corporation. We can help guide you on this. We will also explore ineffective S corporation elections because of problems generated by Operating Agreements.

If you are using a corporation (C Corp or Professional Corp), a corporate resolution might need to be drafted and signed allowing for this tax election. However, Form 2553 references this implicitly within the signature blocks of each shareholder.

States

Five states require a separate S corporation election form to be filed- Arkansas (really?!), New York, New Jersey, Ohio and sometimes Wisconsin. Generally nothing needs to be done with your state’s Secretary of State in terms of notification or housekeeping stuff.

If you live in a community property state such as Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin your spouse might need to sign the Form 2553 even if he or she is not an owner.

Side bar: Community property laws originate from Spanish property laws which is why most of our bordering states are community property states (red does not mean Republican). Wisconsin has no excuse, and Idaho was just caught in some peer pressure from Washington and Nevada.

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

It’s July and your golf game is just as crummy as it was in May so you start focusing on your business. You talk to us, and we decide that the S corporation election is the way to go. We don’t go back to Q1 and Q2, and process late payroll events for those quarters. That is an unnecessary can of worms. We simply open payroll accounts for Q3, determine your reasonable salary for the year, compute your tax obligation through mock tax returns and planning, and chop it up for the remaining months.

For example, let’s say shareholder payroll is set to start on August 1 and continue each month. There are five payroll events left (August, September, October, November and December). As such, if your salary is $60,000 for the entire year, we will set up payroll to be $12,000 per month for the remaining months, and then $5,000 starting January of next year.

No, the IRS does not get alarmed when you start payroll in the middle of the year. No, they are not concerned about the lopsidedness of your payroll events. Yes, there might be some underpayment penalties if you haven’t made any estimated tax payments. But wait! The super cool thing about payroll is that a singular event on December 31 is considered to have been paid evenly throughout the year, including income taxes. Therefore, you should not incur underpayment penalties if your withholdings encompass your tax liabilities. Nice!

More on withholdings and tax liabilities in another chapter. Also, more on why a singular payroll event on December 31 is strongly discouraged (spoiler alert: humans are humans and spend money they don’t truly have… shocker, we know).

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

There is a near certainty that we can make the S Corp election retroactive to January 1 of 2025. As mentioned earlier, one of the pillars of S Corps is to pay a salary to the materially participating shareholders. If you are reading this after Thanksgiving dinner and yet another tragic Cowboys loss, it is time to step on the gas and get payroll setup so a payroll event can be processed before the end of the year.

But if it’s 2026, and 2025 is all over, there are three options (in descending order of elegance)-

Issue a 1099 to Yourself

Really?! For real? Hang in there on this one (in all fairness we did allude to this earlier). What we can do is issue a 1099-NEC for a portion of the business net income to yourself which will be reported on Schedule C of your individual tax return (Form 1040). In turn, this income will be subjected to self-employment taxes. Remember self-employment taxes and Social Security and Medicare taxes are the same thing.

The amount of the 1099-NEC is entered into Line 7 of Form 1120S as Officer Compensation. Therefore, from an Officer Compensation to net business / K-1 income comparison, this technique still satisfies the reasonable salary sniff.

While the IRS might frown upon this option, at the end of the day they are typically satisfied since employment taxes are essentially being paid. Again, this is not as elegant as the W-2 option, but it certainly works for the first year.

Additionally, if you were to lose an IRS challenge on reasonable salary determination the IRS would impute income on Schedule C. We are simply following what they would eventually do anyway. Again, this is a first-year mulligan. A one and done. Payroll must be set up for the following year, and normal W-2 and other filings must be done. Said differently, the 1099 workaround is not a long-term solution.

Who should lose their mind with this solution is the state since unemployment and other insidious taxes such as state disability insurance (SDI) is not being paid. Then again, we’ve never heard of a state challenging this either.

Manual Late Payroll Event

WCG used to do late payrolls since we processed payroll manually, in-house. Currently, we are partnered with ADP to handle all our payroll processing (we still consult with you on a reasonable shareholder wage and make the payroll entries into ADP). ADP is wonderful, but they are rigid. As a result, no late payrolls.

We list this option is case you or someone else wants to run a late payroll event after December 31, but we advise against it. If you want to see a flurry of IRS and state notices, and waste time wading through it all, then go for it.

Having said all this, at times we must process a manual payroll if there is a Section 199A qualified business income deduction (QBID) situation. Keep in mind that once your household is at the 32% marginal tax bracket or higher, there is a secondary test on the QBID calculation- 20% of business income or 50% of W-2 wages paid, whichever is lower. As such, there are times where we must process a manual payroll versus issuing a 1099-NEC for QBID optimization.

Roll the Dice

As paid tax professionals, WCG cannot advise this course of action. Having said that, we have observed several taxpayers labeling the first year as a mulligan, not creating a W-2 or a 1099, and taking his or her chances. Audit rates are about 0.4% for S Corps, and currently the Treasury Inspector General of Tax Administration (TIGTA) is charging the IRS with the task of auditing S Corps that do not pay a salary and who report losses for three or more years. As a result, profitable S Corps appear to be flying under the radar especially if you only miss one year of paying a salary (your first year).

What could happen? The IRS could simply impute wages, create payroll liabilities and send you a bill. We’ve seen S Corporations get these types of notices. This is not ideal since the state is not getting its share of things such as unemployment and disability, and the IRS is sharing data with states.

Again, rolling the dice is not our professional advice, even if it rhymes. We do not want some stray bullet from the IRS hitting us while trying to hit you- we will decline the engagement if you want to roll the dice. We don’t want your problems to become our problems (sorry).

Conversely, let us do it right. You sleep well at night. More rhymes. Everyone wins.

Of course, we can take care of all this paperwork for you!

Huge Emphasis: We cannot stress enough that having an LLC in place is cheap insurance even if you don’t ever elect to be an S Corp. While IRS guidance is hazy, it is our recommendation plus the recommendations of tax attorneys and other consultants that the effective date of the S Corp election should not occur before the earliest date that the LLC has members, acquires assets or begins conducting business.

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

Not sure if you want to have a full-blown S Corporation? Break-even analysis is based on our annual fee of $4,500. If an S corporation saves you 8% to 10% (on average) in taxes over the garden-variety LLC, then $4,500 divided by 9% equals $48,000 of net ordinary business income after expenses and deductions.

Let’s say you are teetering on that income figure, and not sure about running payroll and all that jazz. You could still run your business income and expenses through your tax return as a sole proprietor or another single-member LLC, and take the small self-employment tax hit. Then simply file a No Activity tax return for your S Corp (this assumes you already filed an S corporation election, and now regret the cost of running payroll or some other expense).

Conversely, 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 with the value received. We’d like to think so (of course we would, right, we’re the one collecting the check).

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

Limited Liability Companies (LLCs) are amazingly flexible in structuring a deal. As mentioned elsewhere, you can build an LLC with all kinds of deal structures such as-

• Special allocation of income and losses (including qualified income offsets to maintain compliance),

• Liquidating distributions made in accordance with positive capital account balances,

• Employment agreements,

• Buy-sell and redemption agreements, and

• Options and warrants, including convertible debt.

This list isn’t exhaustive, but what this is telling us is that certain agreements inside and outside the Operating Agreement might make the S Corp election ineffective. Why? Special allocations are simply not allowed in a S Corp. That’s easy. However, the outside agreements such as employment, buy-sell, redemption, options, warrants, debt instruments, etc., can create a second class of stock. As you might recall, an S corporation can only have one class of stock (voting and non-voting is allowed, however) according to Treasury Regulations Section 1.1361-1.

Let’s use buy-sell or redemption agreements as an example. It is common for business owners to enter into agreements where shares or interest may be redeemed upon a certain event such as a change in ownership or change in control. This in itself does not create a second class of stock. However, if the purchase price is significantly above or below the fair market value of the shares or interest, it might invalidate the S Corp election.

In continuing with our example, there is a safe harbor where book value may be used. In other words, if the purchase price is somewhere between fair market value and book value, this would be a strong argument that the buy-sell or redemption agreement does not create a second class of stock.

The big lesson is that having an entity taxed as an S Corp suddenly truncates some of the flexibility offered by various deal structures and Operating Agreements (and the like). The determination of a second class of stock is largely based on the governing documents. However, whether all shares have equal rights to distribution and liquidation proceeds is ultimately the deciding factor.

Please don’t get too hung up on this. It doesn’t affect 99% of the businesses out there who are exploring an S Corp election.

What happens if you made an S Corp election but perhaps shouldn’t have? There are several Private Letter Rulings from the IRS that are littered with all kinds of examples. Here are some recent ones-

PLR 202053005 (Oct 6, 2020)
PLR 202110002 (Nov 2, 2020)
PLR 202111011 (Dec 22, 2020)
PLR 202124002 (Mar 19, 2021)

A lot of these are after-the-fact “oopsies” where the entity is now asking for relief from the IRS for electing S Corp status when in fact their Operating Agreement or other agreements made the S election ineffective. As a side note, the user fee charged by the IRS can range from $3,000 to $12,600 (and sometimes as high as $38,000). This does not include your attorney’s fee. So, Yes, these PLRs had some big reasons to ask for forgiveness.

What can be done if your entity has “some hair” on its agreements and overall governance? First, you can amend or re-state your agreements to become compliant prior to electing S corporation tax status. But more importantly, the question should be asked, “Why do you need an S corporation election here?”

We don’t want to get too far into the weeds with discussions of Q Sub elections where two S corporations are combined (parent is an S corporation and an eligible subsidiary wants to be taxed as an S corporation as well). That’s another book, or at least a thick pamphlet for sure, discussing all the reasons why.

Small Spoiler: Most small business acquisitions are an asset sale versus a stock sale, but if the entity you are acquiring cannot transfer its assets easily, then you might have to purchase the stock and file a Qualified Subchapter S Subsidiary election for the combination. An example would be an entity who has a lucrative long-term government contract that cannot be re-assigned. In this case you would buy the entity as a whole, warts and all, versus just the assets (e.g., government contract).

However, if the objective is pass-through taxation and the avoidance of self-employment taxes associated with the entity’s income, a multi-entity arrangement as discussed in Chapter 2 might be your best bet.

By Jason Watson, CPA
Posted Tuesday, October 31, 2023 (boo!)

There is a misconception floating around out there that an S Corp is a standalone entity. Not true. There are several entity types, and the three most common are-

• Limited Liability Companies (LLCs), either as a single-member or multi-member

• Partnerships, including all the variants (LP, LLP, LLLP, etc.), and

• Corporations (C Corps), including Professional Corporations (PCs).

Each can elect to be treated as an S Corp for taxation purposes under subchapter S of the revenue code.

So, while we might talk about your “S Corp”, we are truly talking about your LLC, partnership or C Corp being treated as an S Corp for taxation. Also, the words member and shareholder are synonymous as well from a conversational perspective- for an LLC, the state considers owners to be members, but the IRS considers the owners to be shareholders when issues like distributions, basis, etc. are discussed. Same is true for equity accounts on the balance sheet.