In this week’s episode, Steve and Cliff discuss the benefits of choosing an S Corporation as your business entity. S Corporations provide a myriad of benefits as a business entity, but there are some formalities that must be maintained. Learn more about S Corporations in this episode.

Episode Transcript

Intro:

You’re listening to the Practical Tax podcast with tax attorney Steve Moskowitz. The Practical Tax podcast is brought to you by Moskowitz LLP, a tax law firm.

Steve Moskowitz:

Welcome to our podcast, and today we’re going to be talking about business entities, corporations, certain types of corporations, like S-corporations, partnerships, LLCs. And, I’d like to introduce my friend and colleague the manager of our tax department at Moscowitz LLP, Cliff Capdevielle. Cliff is both the tax attorney with many years experience, and also an accountant. Cliff, tell us about these different business entities.

Cliff Capdevielle:

Sure, Steve, so one of the first questions that we need to answer for any new client, and oftentimes for returning clients, is what’s the best way to structure your business? Is that gonna be as a sole proprietorship, a C-corp, an S-corp, or a partnership structure, like an LLC or limited partnership? And there are different answers depending on the type of business. So, the simplest form of structure is what’s called a sole proprietorship, and that’s when you’re essentially doing business in your own name or as a DBA. It’s the easiest business structure to set up, but it’s not a separate legal entity. And for that reason, we usually don’t recommend it. As you know Steve, a lot of what we do is asset protection. We want to, we wanna the business owners assets and the sole proprietorship does not separate personal assets from the business assets. And as a result, we usually don’t recommend the S-corporation or sorry, the sole proprietorship. Instead, we usually recommend an S-corporation or an LLC, depending on the type of business.

Steve Moskowitz:

Somebody has a sole proprietorship and something goes wrong in the business, they could sue and take away the person’s personal assets.

Cliff Capdevielle:

That’s the problem with it, Steve. And I know you’ve seen this in your practice, comes up all the time, and we’ve also seen businesses survive and owners keep substantial assets, if they’ve properly separated their assets from the business assets.

Steve Moskowitz:

You know, you told us about different forms of assets and corporations is one of them, but sometimes a business owner and say, “But Cliff, you know if I form a corporation, it’s great for asset protection.” which I’ll ask you to explain to us. But people say, “Well, wait a minute, I don’t wanna be paying taxes twice.” First, the corporate taxes and then the personal taxes. How do we handle that?

Cliff Capdevielle:

Yeah, so today we’re gonna talk about S-corporations. And S-corporations are considered pass-through entities for tax purposes. So, what does that mean? That means that there’s no tax, typically at the corporate level. The tax attributes pass to the individual owners. So, you’re only paying tax at one level with an S-corporation, or an LLC. Just like you would with a sole proprietorship. But the advantage, the huge advantage of the pass-through entity is that asset protection that we mentioned.

Steve Moskowitz:

So, does that mean that if the business gets in trouble that the assets of the owner are safe?

Cliff Capdevielle:

If they run the business properly, and they mind their Ps and Qs, they can potentially protect their personal assets from the assets of the business.

Steve Moskowitz:

And Cliff, what happens if the business makes a loss?

Cliff Capdevielle:

Well, in that case, in many instances the business can pass through those losses to the individual owner, who can deduct those losses against other income.

Steve Moskowitz:

So, if the owner made a loss and his or her spouse had a profitable business, or wages you could offset one against the other?

Cliff Capdevielle:

That’s right, and we often will use that strategy to save clients a lot of money.

Steve Moskowitz:

And Cliff, tell us this, suppose we’re looking at two neighbors, John and Mary, and they make identical amounts. And Mary’s in business and she’s made a profit of 100, and her next door neighbor John, gets wages of 100. If Mary went ahead and did an S-corp, could she go ahead and only pay a lesser amount, like 80% of her income? How would that work?

Cliff Capdevielle:

Yeah, we’re gonna talk about the qualified business income deduction in just a minute. That is one of the advantages of the S-corporation, and the other pass-through entities, is that with the Tax Cut and Jobs Act, Congress attempted to level the playing field tax wise with C-corporations. So, as you remember, C-corporations are now taxed at a 21% tax rate generally for federal taxes. And, in an attempt to give a tax break to S-corps and LLCs, that would mimic that tax structure, the Congress introduce what’s called the qualified business income deduction. And that’s something that has been very important in terms of planning in the last few years. And it does provide a substantial deduction for many businesses.

Steve Moskowitz:

So Cliff, taking that forward, does that mean if Mary walked in the door and Mary was a sole proprietor and she made a profit of 100, does that mean if you turned her into an S-corp, she’d only have to pay taxes on 80% of her income instead of 100%? Just by changing her business entity from a sole proprietor to an S-corp.

Cliff Capdevielle:

In many cases, that’s correct Steve. So, the net income of an S-corp or pass-through, other pass-through entity, like an LLC, is often entitled to that qualified business income deduction. Which can be as much as 20% off the top, which is a huge advantage.

Steve Moskowitz:

I think anybody in their right mind given a choice between paying tax on 100% of their income, or 80% of their income, I’m gonna bet that they’re gonna go with the 80%.

Cliff Capdevielle:

Well, you would think so.

Steve Moskowitz:

I would think so. So, this is great. How do you become an S-corp?

Cliff Capdevielle:

So, that’s a filing that we do, combination with the state and the federal government. So, with the state, we set up the corporation and then we notify the IRS that you’re choosing to be treated as an S-corporation, as a pass-through entity for tax purposes.

Steve Moskowitz:

So, we know that when somebody incorporates, if they don’t do anything, they start off as a C-corp, where they pay the double taxation. Suppose Mary walks into the door and says, “Oh no, I started this company 10 years ago, it’s been a C-corp.” “I don’t wanna go out of business, what can I do?”

Cliff Capdevielle:

Well, you can make an election to become an S-corp at any time. We’re gonna talk about the planning around that in a little bit. But in general, that’s allowed. So, even if you’ve been operating as a C-corp for many years you can convert to an S-corp and take advantage of some of these benefits of the pass-through entities.

Steve Moskowitz:

And Cliff, could you update us? Because, I know in past years, the ability to be an S-corp was so much more limited than it is now. Can you tell us now what we do to be an S-corp? All the people that are included.

Cliff Capdevielle:

Yeah, so now you can have up to 100 shareholders, and that’s a huge advantage, Steve. So, the, one of the issues that prevented many entities from using the S-corp form was a restriction on the number of shareholders, for example. And that’s been expanded over the years. There are still restrictions, and you have to be mindful of those. And you really, if you run a foul of the S-corp rules the IRS can treat you as a C-corp. And what does that mean? That means double taxation. Taxation at the corporate level, and then taxation again as you distribute money at the individual level as dividends. So, that’s one thing that we’re very careful about when we’re talking to clients, is make sure that they they understand the rules for an S-corp and make sure that they follow those.

Steve Moskowitz:

Excellent, and tell us Cliff, with an S-corp, what are the other, some of the advantages of having an S-corp over some other form of business?

Cliff Capdevielle:

Sure, so let me tell you how we analyze a client’s business as they come in the door, what we look for, and what to be cautious about when that client is trying to decide on the choice of entity.

So, one thing we wanna be careful about is separating those personal and business expenses. And this can cause real headache, not only for tax purposes, when you’re trying to prepare tax return, separating the business from the individual expenses. But also, in terms of liability, because an S-corp that is not mindful of those corporate formalities can run into trouble. If they ever have a problem with a vendor, or any kind of judgment or lawsuit, that can be a real problem. Another issue that we we run into all the time in the IRS is now carefully scrutinizing this, is owner compensation. So, an advantage of the S-corp is that the net income of the business after wages, is not subject to self-employment tax. Some business owners make the mistake then of not paying themselves any compensation. And, that is something that at the IRS is looking at carefully now. So, we’re gonna meet with the client and explain the reasonable compensation issues. Make sure that the business owners of an S-corporation are paying themselves appropriate salaries. And, to your question about conversion we also look at what’s called the built-in gains tax. And this is a corporate level tax that can apply when a C-corporation has assets with built-in capital gains and on conversion, the IRS could be looking for a check to pay those taxes, as if those assets had been disposed of.

So, we have to be careful there. Other things we look at, we mentioned the qualified business income deduction. We’re gonna do careful planning there to make sure that the client is taking full advantage of that.

Steve Moskowitz:

Cliff, I had a question on that one. With doing that, that’s the one where you get to pay 80% of your profit instead of 100% which is really good. Explain to us how it’s important to plan with the wages to maximize our deduction on that one.

Cliff Capdevielle:

Sure, so what you wanna do, you wanna make sure that the net income of the business is below the threshold to qualify for the qualified business income deduction. That’s gonna depend on a number of factors, but we’re gonna help you plan around that, make sure that we claim enough expenses so that your business qualifies. Also, we wanna make sure that you are paying yourself reasonable compensation, for a number of reasons. But, the IRS is looking carefully at that issue. We can use that compensation to potentially reduce the net income from the business. And also importantly, Steve, we can use that owner compensation as a basis for a retirement plan contribution. And this is hugely helpful for many clients, we can dramatically reduce their income if they use an S-corporation, paying themselves a salary and then turning around and using that salary to fund a retirement plan, it’s very powerful tax savings tool.

Steve Moskowitz:

So Cliff, I think what I’m hearing here is this, suppose the owner of the S-corp has made a profit of a million, and the owner’s gonna take a million out of the S-corp into their account personally. But, you would help determining of the $1 million that’s coming out of the corporation, how much should be wages, and how much should be distribution. Because, by figuring the right amount of wages, it sounds like you’re getting a double benefit here. One, you’re qualifying to pay tax on only 80% of the profit instead of the other. And two, you’re maximizing your pension deduction, saving still more in taxes. Is that right?

Cliff Capdevielle:

That’s absolutely correct, Steve. So, these are very, very powerful planning tools. And we do this every single day, and we are saving our clients many hundreds, of thousands of dollars in some cases, in taxes.

Steve Moskowitz:

Now Cliff, sometimes people will say, “Oh, you know I can’t do all those corporate formalities.” “Oh, I’m just a simple business person.” You can go ahead and do all those formalities for the client and how does that work?

Cliff Capdevielle:

– Yeah, it’s much easier than it sometimes appears people are often intimidated by the idea of forming a corporation. It really, it can be done very quickly. You do have to mind those formalities, and make sure that you’re keeping up to date with the state’s reporting requirements. But it’s a, you know, it’s a tiny expense relative to the tremendous savings that’s possible.

Steve Moskowitz:

So basically Cliff, would it be fair to say that if a client came to you one day a year that you could do all the corporate formalities and they’d have all the benefits of the asset protection and all these tax savings?

Cliff Capdevielle:

Absolutely, it typically can be done over the phone or on Zoom. It’s pretty simple, relative to the tax savings. And that’s why we recommend it so often.

Steve Moskowitz:

So, maybe just a couple of few hours with you on the phone or the Zoom, and you get all these benefits. That sure seems worthwhile to me.

Cliff Capdevielle:

It’s absolutely worthwhile. Couple other things I want to talk about in our last few minutes, Steve.

One, is we get calls every day from clients, business owners who now have employees scattered through out the States. They’re doing business in many states, and may maybe, up until the pandemic two years ago, they had all of their employees in one office in California and now they’re scattered all over the world. How does that change the reporting requirements? And this is, you know, it’s a challenge. But, it’s certainly something that’s not insurmountable. We work with clients to make sure that they’re up to date with all their reporting and tax requirements, on all their, on all of their US filings, no matter where their employees, no matter what they’re doing business.

The other thing I wanna talk about is that, you know, probably one of the more confusing news items that we’ve seen this year is what’s called the SALT tax workaround, the state and local tax workaround. This is in reaction to the 2017 Tax Cut Jobs Act, where the Trump administration pushed for dramatic limitation and the ability of tax-payers to deduct their state and local taxes, limited to $10,000. In reaction to that, many governors and legislatures throughout the country in high tax jurisdictions have been attempting to work around that issue so that taxpayers are able to deduct those state and local taxes again. And in California, there is what’s called AB-150, AB-113. Those are two laws, which now allow the deduction on the tax return for those state and local taxes. The way that it works is a little complicated. Essentially, business owners of S-corps, other pass-through entities, can now pay that tax through the entity. There’s a special website, that we can let you know about, where you pay those taxes on, or before March 15th. And if you pay up to 9.3% of the net income of your business if it’s pass-through entity, you can claim a credit now on your individual return and get essentially a relief of up to 9.3% of the net income of the business.

So, it’s a huge, huge benefit for S-corp owners that, which is brand new this year. But, it’s important because now we have less than a month to do that calculation and make sure that tax is paid. But, be sure to call us if you’re in that situation.

Steve Moskowitz:

So Cliff, I think what I’m hearing is this, under the Tax Cuts and Jobs act, the law changed. So, we can only deduct a maximum of $10,000 of state and local tax on our federal return. With this workaround that has been approved in, oh, maybe approximately half of all different states, essentially when the dust clears this workaround, essentially, all gets back to what the old law was, where you can deduct an unlimited amount of state and local taxes on your federal returns. That would be… Is that correct?

Cliff Capdevielle:

Yeah, up to 9.3% of the net income of the business which is in many cases, a huge difference from prior years. So, it absolutely is something that business owners should take advantage of if you’re an S-corp or LLC, but you do need to act quickly because that tax, in order to be deductible on your 2021 return, has to be paid on, or before March 15th.

Steve Moskowitz:

And Cliff, in our waning moments here, is there anything else that you wanna tell us before we move on to another subject, partnerships in our next podcast?

Cliff Capdevielle:

Yeah, so before we talk about partnerships, just with regard to S-corporations, absolutely give us a call. If you’re considering converting from a sole proprietorship, or C-corp to an S-corp, we’re happy to offer free consultation. We can discuss all of these issues, the qualified business income deduction, built-in gains tax, the multi-state tax issues, all things to consider before you make that decision. But, in many cases Steve, we’re finding that clients can save a lot of money by making that conversion to an S-corporation.

Steve Moskowitz:

Absolutely, and folks, that’s one of the things we would do for you. You come in, we’ll chat with you and say, “Look, if you become an S-corp, here’s a list of advantages and here’s how much money it would save you.” As well as the asset protection, because if somebody sues you, you don’t wanna lose your personal assets as well. I like to thank our guest Cliff Capdeville, he’s the head of our tax department, tax attorney and accountant. Cliff, thanks ever so much.

Cliff Capdevielle:

Thanks Steve.

Steve Moskowitz:

You can call us toll free, at 1-888-TAX-DEAL. That’s 888-TAX-DEAL. 888-TAX-DEAL, or moskowitzllp.com. Moskowitzllp.com. Stay tuned for our next podcast, we’re gonna talk about partnerships and so many other areas, you’ll look forward to listening to this all the time. Thanks so much, bye for now folks.

Outro:

You’ve been listening to the Practical Tax podcast with tax attorney Steve Moskowitz. To hear more podcasts, go to moskowitzllp.com/practical-tax The information contained in this podcast is based on information available as obtained at the date of its release. Moskowitz LLP and its affiliates are under no obligation to update this information as changes occur. Applying this information to your specific situation requires careful consideration of all factors which may be applicable. And any information is not to be considered tax advice or legal advice. Further, this is attorney advertising, and the facts and circumstances displayed in this case are dependent entirely on the facts of that particular case. Please consult your tax advisor before acting on any matters discussed.