Formation of an LLC or S Corp
By Jason Watson, CPA
Posted Tuesday, July 6, 2021
It is very easy to form an LLC and have it taxed as an S corporation. However, an S Corp is not formed by itself; another entity is created and then taxed as an S Corp.
While LLC formation is easy, it is also very easy to screw it up. WCG can assist with all the filings with the Secretary of State (for any state), and our fee is $425 plus the state filing fees ($50 to $200ish, some states are even $500). Some states such as Nevada require an initial report, and that will typically add $100 to our fee plus the initial report fee. As an aside, Nevada might have good corporate laws but it is an expensive state to form a business entity in. More on the Nevada hype in a bit.
Sure, you can do it on your own or through LegalZoom, but we will provide consultation and advice during the startup process. You can also use an attorney but be careful since not all attorneys are the same. If you were an idiot before law school, getting a law degree doesn’t suddenly make you smart. We have seen many things messed up by attorneys who didn’t understand their client’s needs, didn’t understand the tax code, unnecessarily complicated the heck out of an otherwise simple entity structure, so on and so forth.
Accountants and doctors are not immune. How many quack doctors are there? Plenty. Accountants? Just a bunch of nerdy, socially awkward types. Thanks to Ben Affleck, us accountants are also secret assassins. Thanks Ben, the secret is out. Way to go, wizard.
Some of the kidding aside, we have seen some attorneys do some ingenious things as well. We work with business law and corporate attorneys all the time. It is a great relationship since they know corporate governance and contract law, and we know taxation and businesses. Do not think you only need an attorney- you need both an attorney and sharp consultants.
WCG will do the following-
- Create Articles of Formation or Incorporation, and file with the Secretary of State,
- File an initial report if required,
- Check on local taxing jurisdictions for registrations (for example, San Francisco which has its own registration form and fee in addition to the State of California),
- Obtain your Employer Identification Number (EIN) from the IRS and,
- Create an Operating Agreement (for single-member LLCs only since rights are not being represented) or provide a MS-Word template set of Bylaws for corporations.
LLC, Professional Corporation or Corporation
Typically, we will want to form an LLC and later elect S corporation status. However, certain states require certain professions such as accountants, attorneys and doctors to be professional corporations. These entities can also elect S Corp taxation.
Side Note: California allows corporate officers to opt-out of the State Disability Insurance (SDI) tax, which can easily exceed $1,000 annually depending on your salary. However, if you create an LLC and have it taxed as an S corporation, California says No since the underlying entity remains an LLC.
If you create a corporation and elect S Corp taxation, then you can opt-out. Subtle difference, and the fees are virtually the same. Several states have nuances like this that LegalZoom and others might not be aware of since they don’t process payroll and prepare tax returns.
Multi-member LLCs and Partnerships need agreements between the members and partners respectively. As mentioned through this chapter, there are issues such as death, divorce, incapacitation, spending limits, required distributions (so you have cash to pay taxes), valuation techniques, etc. that need to be addressed. These agreements are legal in nature and represent rights, therefore WCG cannot assist in drafting these. However, we act in a consulting capacity with attorneys all the time to ensure a quality agreement is drafted that meets the client’s needs and objectives from all aspects.
We have more details on Operating Agreements later in this chapter. Please review yours for probable missing things.
If your underlying entity is a corporation then we also draft Corporate Minutes for your Book of Record to adopt an Accountable Plan which is used for employee reimbursements (see our fun-filled chapter on operating your S Corp).
The days of deducting out of pocket expenses such as mileage, cell phone and home office were not a good idea with S corporations prior to the Tax Cuts and Jobs Act of 2017, but today they are essentially gone. The Accountable Plan allows you to reimburse yourself as an employee, and as such the deduction is taken on the business tax return (which in turn reduces the amount net ordinary income being passed through to the shareholders). We will show you how this is a slick way of pulling money out of your business in the form of employee expense reimbursements.
Corporate Minutes and Books of Record
This is a bit old school. Back in the day, you needed an attorney and a $5,000 check to create a corporation since we didn’t have the use of an LLC. The process was very formalized since only large businesses did it, and the states used the process to track the comings and goings of businesses operating in their jurisdiction. Plus these documents were public and used by shareholders.
However, if your underlying entity is a corporation, WCG (formerly Watson CPA Group) recommends maintaining your Book of Record for three reasons- helps to maintains the integrity of the corporate veil, some banks and other institutions might ask for it to allow you, the controlling shareholder, to act on behalf of the corporation (such as buying an automobile in the business’ name), and the IRS from time to time will ask for it during an audit.
Corporate Minutes are generally not required for LLCs; again, because LLCs are not corporations.
The three typical formation documents (Articles of Organization / Formation, EIN and Operating Agreement) are required by most banks for a business checking account. An Operating Agreement is not always required. The Patriot Act, Bank Secrecy Act and Homeland Security want to clamp down on illegitimate business accounts and financial holdings. While it might throw off the Feds, Guido’s Money Laundering LLC is a no-go for your business checking account name unless you have an EIN, which defeats the purpose if you are Guido.
So, all banks will want either an EIN or a SSN to open a checking account regardless of it is a personal or business checking account. And an EIN is tied to your SSN. Follow the money, find the bad guys.
Note: You can also just get another personal checking account (typically for free from your current bank). However, if you plan on taking checks written in your business name, you’ll need a business checking account or a personal checking account with a DBA (doing business as). Then again, most people are utilizing direct deposit or some sort of ACH / EFT deposit which bypasses account names issues.
Remember, you can also create a DBA for your entity name. So, if your business is a franchise but you want a different LLC name on the checking account, you can be Big Bucks LLC dba Starbucks or Bad Coffee dba Starbucks. Remember, friends don’t let friends drink Starbucks. Please, find a decent coffee for yourself unless it is wintertime, and Starbuck’s chestnut and praline latte is in season. Yum!
We pick on Starbucks, but you have to admit while they might not have the best coffee, they are prolific and consistent throughout the world. You always know what you are going to get. Oh, and they made drinking $6 lattes fashionable and helped launch hundreds of thousands of small coffee shops. Wow, we really went off there.
S Corp Election
The S Corp election can wait. As mentioned throughout this book, $38,000 net income after expenses is the break-even point for an S Corp. Not sure? Not to worry, we can elect S Corp as far back as three and a half (3 ½) years using special IRS Revenue Procedure 2013-30 (as opposed to the 75 days provided in the Form 2553 instructions). WCG files about 150-175 late S Corp elections each year, and we are batting 100% on getting them pushed through.
Therefore, if net income is unknown or unpredictable, our advice is to wait until November or December to decide if the election makes sense, and then make it retroactive to the start of the LLC formation or January 1. So, get the LLC in place now and wait on the S Corp trigger until it makes sense- and Yes, we provide this consultation for you. Then again, if you are converting from W-2 to an independent contractor and your revenue is known, then we can file the S Corp election right away.
Note that the last paragraph spoke of possibly delaying the S Corp election for an LLC. What if you are required to form a Professional Corporation (PC) because of your business activity (doctor, attorney, accountant, etc.)? Since a PC must file a separate tax return and incur a tax preparation fee, which is large chunk of the break-even analysis, an immediate S corporation election upon PC creation might be prudent.
More on the late election later but here is a spoiler-
- You could be in the middle of March 2022,
- Elect S Corp status back to January 2021 and
- Run a late 2021 payroll event dated 12/31/21 (or simulate Officer Compensation with a one-time 1099-MISC). Boom! You just save 8-10% of your net business income in taxes.
This is all legit, pain in the butt for us, but all legit and successful. Sure, there are some devils in the details in terms of your reasonable cause of the late election, and we will review those with you. WCG did this about 160 times last year, and we’ve been doing this for more than a decade without major hiccups. Not the ideal way in the eyes of the IRS- but then again, hate the game not the player. We are just playing within the parameters of their game.
Not sure if you want to have a full-blown S corporation? As stated earlier, the break-even point where an S Corp makes sense is about $38,000 in net business income after expenses. Why? Simple cost benefit analysis. The expense of running an S Corporation such as payroll and tax preparation equals the savings at $38,000.
How did we calculate that? Our Vail business advisory service package is $3,420 per year. Take this number and divide it by an average savings of 9%, and that equals $38,000. Our business advisory service packages are discussed further, but it is basically your corporate tax return (Form 1120S), individual tax return (Form 1040 and state), payroll events, and unlimited tax planning and consultation.
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 individual tax return (Schedule C on Form 1040) as a sole proprietor, and take the small self-employment tax hit. Then simply file a No Activity tax return for your S Corp. Legal. Legit. All good in the IRS hood.
If you expect to lose money the first two or three years, the S Corp election becomes a bit more complicated and more discussion is required- it is generally better to delay the S Corp election so you can avoid the costs and hassles of filing a corporate tax return. More importantly, a single-member LLC or sole proprietor can theoretically have unlimited losses (assuming the money is all at-risk) where a partnership or S Corp cannot because of partner and shareholder basis rules. Briefly, as an S corporation you are both an investor and an employee. As an investor in any business, you cannot lose more than your investment (basis). Same thing here.
Here are some more gee-whiz stats (IRS is slow to release this stuff)-
|Professional, Scientific & Technical Services||702,282||16.7%|
|Wholesale & Retail||652,750||15.5%|
|Health Care & Social Assistance||354,625||8.4%|
|Accommodation & Food Service||234,534||5.6%|
|Waste Management & Remediation||209,690||5.0%|
|Finance & Insurance||162,832||3.9%|
|Transportation & Warehousing||152,086||3.6%|
Taxpayer's Comprehensive Guide to LLCs and S Corps 2021-2022 Edition
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