S Corp Transition Pains
Posted September 7, 2019
Having your LLC elect S corporation taxation is fairly easy. But like King George in Hamilton, “What comes next?” The S Corp transition frankly speaking can be painful. Let’s run thought some of the transition concerns that we’ve experienced having done over a thousand S corporation elections in the past decade.
Oftentimes a client will call us in March or April freakin’ out about his or her huge tax bill. They dig a little deeper into their preliminary tax return to determine that the huge tax bill was in part due to self-employment taxes. Like you were down the count and drowning in ‘em. They try to find ways to reduce self-employment taxes, and they find the Watson CPA Group, S Corp experts. We explain that we can reduce a large chunk of self-employment taxes through an S Corp election. They say, “Awesome. Wow!” and we say, “Wait for it…” there’s more. Alright, enough Hamilton references.
Another part of the huge tax bill was just basic poor tax planning. So often we hear, “my friend who is in the same business I am, doesn’t pay any taxes.” Ok… sure… maybe your friend doesn’t have any taxable income. But what is more probable is that your friend has an excellent CPA who did proper tax planning; so while there was a tax obligation associated with the tax return, the “friend” made estimated tax payments along the way to land at tax neutrality during tax season.
Don’t confuse not owing taxes due to no taxable income with matching estimated tax payments correctly with tax obligations. If you have a tax obligation of $50,000 and paid in $55,000 leaving a $5,000 refund, you still owed taxes! You simply overpaid them during the year.
So paying for past sins is boiled down to improper tax planning but it still takes cash to unbury yourself. Problem #1 with the S Corp transition is paying last year’s tax obligation.
Proper Tax Planning
Going back to our client on the ledge, we demonstrate that an S corporation election is in his or her best tax interest, and we further show the benefits of our S Corp package for tax preparation, reasonable shareholder payroll and unlimited business consultation. The client says I Do, we say I Do, and off to the honeymoon we go.
Shortly after sorting out the mess, filing a late S Corp election, preparing tax returns and paying for past sins, we start tax planning right away for the current tax year. Tax planning starts with estimated net business income after expenses and before reasonable shareholder salaries. It ends with a mock tax return including all household income sources (spouse income, rental income, pension income, etc.) and a calculated tax obligation. We then process shareholder payroll and adjust income tax withholdings using the calculated tax obligations.
We define tax neutrality as a $1,000 refund from the IRS and a $500 refund for the state.
As such, Problem #2 with the S Corp transition is we are now increasing cash needs for payroll because income tax withholdings are increased to serve as estimated tax payments. In other words, we are leveraging payroll as a way to pre-pay your income tax as determined by proper tax planning.
Here is Joseph Bassett, an expert in tax planning and staff accountant for the Watson CPA Group, explaining how he helps small business owners plan for taxes.
S Corp Transition Cash Crunch
If we combine these two problems plus a shortened year, it can be super painful. This causes many people to wonder if the S Corp election is really worth it. We hear “it seems like I am giving up a lot of cash with this darn S corporation thing” often. Let’s recap the cash crunch.
In April, you paid a bunch of cash for last year’s sins. In May, we take the remaining 8 months (tax and cash compression) and compute the cash needed for the current year’s sins. So, yes, it appears a lot of cash is leaving your body because it truly is. Does it get better? Yes!
January of the following year we are dealing with 12 months so, we don’t have the cash compression. April rolls around, and you don’t owe any additional taxes. And life is good. But it takes almost a year to get there, and lot of cash.
We also hear, “I don’t think this S Corp election is really saving me taxes.” Foolish. This statement is theoretically impossible. Ok, not totally impossible. You could consider a reasonable shareholder salary to be equal to your net business income; but that would be equally as foolish as the previous statement.
So there you have it. The S Corp transition and the associated problems. Not everyone goes down this path of course, but many clients do. Hang in there! Together we will get through it.
Jason Watson, CPA is the Managing Partner of the Watson CPA Group, a business consultation and tax preparation firm, and is the author of Taxpayer’s Comprehensive Guide on LLC’s and S Corps which is available online.