I was reading an article this morning, and I had to share. I wake up around 4 - 4:30 AM. I am a morning person. From the hours of about 5 AM to 7 AM I read up on Tax Court cases, changes in tax law, and do research. This morning I read the article on the benefits of an S Corporation over a C Corporation. Early in my career, I would always give a blanket answer to a question. What that means is I would give the same advice to everybody. So, if you were my client, I gave you the same advice that I would give to everybody. Most accountants do that. They just give the same answer to every client that asks the same question. I no longer do this. I consider it malpractice. I have learned to ask so many questions that people to meet with me are probably wondering why I am asking. There is no blanket answer to a situation. That is what I’m about to write about.
Some background, people to go into business, typically start off as sole proprietorships until they meet with an accountant, and file their first tax return. They realize how much they have to pay in tax, and if the accountant is doing their job, or if they even care, they will suggest that the person form a corporation or an LLC. They will tell the client to have the corporation where the LLC taxed as a subchapter S Corporation. The reason for this is that sole proprietors pay something called self-employment tax. Self-employment tax is 15.3%. This is on top of any income tax at a rate of 10% all the way up to 39.5%. So conceivably a sole proprietorship can pay roughly around 40% to 60% in taxes. As an S Corporation, you avoid self-employment tax. An S Corporation does not pay tax, the profits and losses flow to the shareholder to be claimed on the shareholder’s personal tax return. The benefits of this is that you only pay tax on this money one time, and when the profits flow over to you, you avoid self-employment tax. This is typically in accountant’s blanket answer. It was mine for many years.
When I am faced with this question of a sole proprietorship, owing tremendous amount in taxes, I will typically recommend forming an LLC. I don’t like corporations for most clients. The reason for that is that corporations are very rigid and structured. An LLC, on the other hand is very flexible. You can write an operating agreement within an LLC that can say anything you want it to say. When it comes to taxation, LLCs are not a taxable entity. You need to make an election on the way you want it to pay tax. You can have an LLC taxed as sole proprietorship, partnership, S Corporation, or C Corporation. Your tax election does not change the fact that you are an LLC. It is a pretty neat concept.
Something we haven’t discussed yet are C Corporations. C Corporations pay corporate income tax. Corporate income tax, starts at 15% and on a graduated rate can pay up to 35% in tax. If you take money out of the Corporation, you pay tax again on your personal tax. So you pay tax twice on the same amount of money. This is known as double taxation. This is always the argument against C Corporations. However, something interesting happened this year. There was the creation of the 39.5% tax bracket for individuals. So, C Corporations have become a lot more attractive, depending on your particular situation.
As an S Corporation, you have to follow certain rules. Some things are not deductible like they are with C Corporations. For instance, health insurance, is not deductible to an S Corporation. In fact, you have to pay Social Security and Medicare on your health insurance premiums. In a C Corporation, you don’t have to do that. It is a little rules like that, that make the choice between an S Corporation and a C Corporation, something that has to be weighed. Most accountants don’t weigh the positives of a C Corporation and just give the advice of client to be taxed as an S Corporation.
In the article that I read, they were discussing the argument of an S Corporation being better than a C Corporation. The problem with the article was that they were giving a blanket answer to a question. You should never choose accountant that doesn’t get to know you, and your situation.
I spend a lot of time with my clients, getting to know them and their business. That’s what makes our company different. Most accountants, just fill out forms. Obviously, I do tax returns. But that’s not where I add value to your company or yourself. I spend the time to get to know you. Perhaps you should demand that of your professional.
On the topic of an S Corporation, or C Corporation, there are numerous arguments against C Corporations. The double taxation aspect, is just one of them. I like to use both corporations with companies that are making more income. For instance, let’s say you have an S Corporation, that’s net income is $200,000. S Corporations year end is typically a calendar year. Around the end of the year, your accountant should start making decisions on how to save you money in taxes. Going back to the example, you could start a fiscal year C Corporation, ending in September, for instance, and pay a management fee of $150,000 over to this C Corporation. This would leave you with, taxable income of $50,000. The additional $150,000, over in the C Corporation, you have until September to expense out. Typically this is done, by taking a salary, and deferring your income into a safe harbor 401(k), or something similar. The goal, would be to get the income of the new C Corporation, to $50,000 or less and pay 15% in corporate taxes. It is a little trick that corporations can do.
This is just one way that I like to use C Corporations.
Craig Smalley is the managing partner of CWSEAPA®, LLP. CWSEAPA®, LLP is a nationally recognized brand of accounting and financial services. CWSEAPA®, LLP is headquartered in Wilmington, DE with offices in Florida and Nevada. You can visit them on their website at www.cwseapa.com
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