Author Topic: Starting a business, S Corp - questions, tax related  (Read 810 times)

frugalnacho

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Starting a business, S Corp - questions, tax related
« on: February 25, 2021, 01:34:16 PM »
I want to start a business with some former coworkers.   We are in the environmental field, I don't want to give too many specifics, because it's a small world and I've already had people contact me via PM from previous threads I've posted and they've been able to identify me right down to the 12 man office I worked at at the time.  I'd like to retain a bit of anonymity though. Never ran a business before, so I want to make sure I have a good understanding of some things before I get in over my head.

I think we want to go with an S Corp.  My understanding is that we have to file taxes as an S Corp.  All income the business receives is revenue, all expenses (payroll, FICA, rent, insurance, operating expenses, etc) get deducted, and anything left over within that tax year is claimed as profit for the S Corp.  The profits then get passed through to the owners in proportion to their ownership of the company, and that amount gets claimed on each of our personal tax returns.  Money put into the business (at startup, or interjected at any point), and distributions from the business to the owners is irrelevant because everything gets captured on the S Corp tax return and passed through and we each have to pay our own tax liability based on that regardless of whether we actually take that money as a distribution or reinvest in the business or whatever.  Is my understanding correct?

It's also my understanding that we have to pay ourselves a "reasonable salary" which will be based on industry norms.  The purpose of this is to prevent us from taking $0 salary and then a huge distribution at year end because we avoid all FICA tax by doing this.  The business can be insanely profitable and we can in theory take million dollar distributions without paying FICA or self employment taxes, so long as we have a "reasonable salary" in which we do pay those taxes.   Surely it would be unreasonable to begin paying ourselves any salary at all before we have any income, and even once we start having some income it would probably be wise to build up some reserves for the business before even considering salary, even though this will lead to "profits" on paper.  How long can we go without paying ourselves any salary?  Are there any special considerations given, for example if the business makes $100k "profit" in 2020, but all of it is rolled back into the business with no distributions taken, are we still required to draw a "reasonable salary"? How large can we build reserves in the checking account before we would be required to start taking a reasonable salary?

To elaborate on that we are likely going to need roughly $100k in equipment to begin.  We are also going to need to lease shop/office space, and have a commercial vehicle.  We probably will not be able to outright fund the purchase of a vehicle, set aside money for the entire term of a lease, buy $100k worth of equipment, and also have cash reserves to fund everything needed to float us until invoices start coming in.  We are obviously mostly concerned with getting things started and rolling, but we anticipate to grow, and will need to constantly purchase more equipment as we do.  I think a reasonable estimate of total equipment including vehicles would be somewhere in the $500k-$1M range

When it comes to vehicles I would prefer to finance one instead of dropping the $25k or so I anticipate we need, but I also anticipate that buying a $25k vehicle in the name of a brand new business with no revenue will not get approved, and if it does it won't be at near as good of a rate as I could get on my own.  Is it possible for one of us to purchase a vehicle in our own name using our own credit and our own W2 income, and then quitting our job and transferring the vehicle into the business name?  If necessary we have the cash to outright purchase the vehicle, but it would be really nice to have a $450/mo vehicle payment rather than buying it outright to start. 

frugalnacho

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Re: Starting a business, S Corp - questions, tax related
« Reply #1 on: February 25, 2021, 02:48:19 PM »
We also are likely to hire a couple of employees within the first year, and hopefully several more employees after that.  We will offer some kind of 401k plan.  I am interested in potentially being able to do a mega backdoor roth down the road.  With everything that needs to go into this, I feel like this might be putting the cart before the horse at this point, but I'd also like to educate myself so when the time comes we can make the best choices to suit our needs. 

Lamancha

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Re: Starting a business, S Corp - questions, tax related
« Reply #2 on: February 25, 2021, 10:37:29 PM »
Posting mostly to follow.  I am not an accountant, but I do own an S Corp with my boyfriend (50/50 ownership.)  It's been over 2 years and I am still learning as I go.  It seems like you have a pretty good understanding of how it works though.  Only advice that I have is to do it.  I've never once regretted becoming a business owner.

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Re: Starting a business, S Corp - questions, tax related
« Reply #3 on: February 26, 2021, 09:51:47 AM »
Also posting to follow. I wish you the best of luck - it can be exciting and overwhelming to start a new venture like this. You might want to remove your city, state from your profile if you hope to fly under the radar a little better -- when you list a suburb of 30,000 people, it makes it a lot easier to narrow down the searches. Best of luck on the new venture.

frugalnacho

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Re: Starting a business, S Corp - questions, tax related
« Reply #4 on: March 02, 2021, 10:37:17 AM »
Is this sub dead?

bwall

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Re: Starting a business, S Corp - questions, tax related
« Reply #5 on: March 02, 2021, 12:45:55 PM »

It's also my understanding that we have to pay ourselves a "reasonable salary" which will be based on industry norms.  The purpose of this is to prevent us from taking $0 salary and then a huge distribution at year end because we avoid all FICA tax by doing this.  The business can be insanely profitable and we can in theory take million dollar distributions without paying FICA or self employment taxes, so long as we have a "reasonable salary" in which we do pay those taxes.   Surely it would be unreasonable to begin paying ourselves any salary at all before we have any income, and even once we start having some income it would probably be wise to build up some reserves for the business before even considering salary, even though this will lead to "profits" on paper.  How long can we go without paying ourselves any salary?  Are there any special considerations given, for example if the business makes $100k "profit" in 2020, but all of it is rolled back into the business with no distributions taken, are we still required to draw a "reasonable salary"? How large can we build reserves in the checking account before we would be required to start taking a reasonable salary?

When it comes to vehicles I would prefer to finance one instead of dropping the $25k or so I anticipate we need, but I also anticipate that buying a $25k vehicle in the name of a brand new business with no revenue will not get approved, and if it does it won't be at near as good of a rate as I could get on my own.  Is it possible for one of us to purchase a vehicle in our own name using our own credit and our own W2 income, and then quitting our job and transferring the vehicle into the business name?  If necessary we have the cash to outright purchase the vehicle, but it would be really nice to have a $450/mo vehicle payment rather than buying it outright to start.

I'm not an accountant, but I've run an S-corp (or two), so I've encountered these same questions from your point of view. Here are my (non-professional) thoughts (not advice). If a CPA reads this, please correct any errors I make.

Salary: Since all profits are passed through (as you mention above), it negates just about all tax advantages to keeping the money in the business account (vs. say, a C-Corp). I guess it saves on the mechanics of taking salary/profits, etc. and then having to put it back into the business at a later date.

I think that the purpose of 'taking a reasonable salary' is to avoid someone starting up an S-corp, writing off their entire extravagant lifestyle as business expenses ("We took our clients to Vegas on the chartered private jet and paid for their hotel and entertainment b/c they're such great clients. Of course we had to stay in the same hotel as they did!") and then claiming you can't 'afford' to pay yourself any salary.

The only real difference between paying yourself a salary and letting it pass through to your personal account is payroll taxes. Uncle Sam doesn't like to see business owners using their business to avoid payroll taxes (FICA, SS, unemployment, etc). Thus, the 'reasonable salary' requirement. In my non-professional opinion, perhaps a CPA can correct me?

I think (but do not know) that if you just started a business that in the first year or two you might have leniency in the 'reasonable salary' dept. A tax professional could give better guidance.

Vehicle: If you have a company vehicle as a business owner, then I think there are requirements such as placing a logo on the car, what percentage is for business use and what percentage is for personal use, etc.? Maybe even keeping a log book? Again, they're looking to avoid a pizza delivery guy trying to write off his Ferrari as a business expense "b/c we can deliver quicker and get better tips when we drive it!" or some such BS. Perhaps writing off a $100k SUV by claiming to drive around clients who, unfortunately, only visit once a year.

Also: if the company owns a vehicle, all company owners will have to sign (notarize?) the title at the time of sale. Perhaps even include a corporate resolution authorizing the sale. It's not hard if everyone is at the office everyday and gets along, but if you're spread out a bit or there's a disagreement among the owners......... it can get tricky.

You've got some pretty detailed questions. I'd say it's worth investing a Benjamin or two for a meeting with an accountant.

frugalnacho

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Re: Starting a business, S Corp - questions, tax related
« Reply #6 on: March 02, 2021, 02:13:04 PM »
Some of the instruments/analyzers we need can run $20k, and if we grow the business to the size we want we will need several $100k more in total equipment.  So I guess the situation I'm looking at is if we make $300k profit over the next 2 years and pay taxes on that, but we don't draw any salary because we pump those profits right back into the business, is the IRS going to come knocking and saying we need to draw reasonable salaries since we are making profit, even though none of it is being distributed?  We could just pay ourselves salaries, then turn around and dump it back into the business, but we'd lose a shit ton to FICA and what not, so I'd rather cut out the taxman and just reinvest directly in additional equipment from the company bank account. 

I suppose we could deduct equipment purchases to wipe out our personal tax liabilities, but if I am going to be living out of my bank account with no salary I would much rather take the tax "hit" while my income is artificially low and carry over the deductions into future years when my income will be higher.   

Definitely plan to talk to an accountant before we make any moves, I'm just trying to do my homework ahead of time.  I don't want to pay accountant rates to have him explain to me what an S Corp is, and other information I could gather myself. 

bwall

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Re: Starting a business, S Corp - questions, tax related
« Reply #7 on: March 03, 2021, 06:11:03 AM »
I can't replace a tax professional, but I can provide food for thought and perhaps make a future conversation with a tax professional more productive. Anyone please feel free to correct the comments below if I made a mistake.

Thoughts:

If four people are working and not taking any salary, is the $300k left over at the end of the year really a profit, or merely diverted salaries? Is the answer the same if there are six people not taking a salary? Or just one person not taking a salary?

If four people are working without salary, is the $300k left over at the end of the year really worth it? Wouldn't you be replacing your currently paid job for another one, but with all the risks of ownership, without any job security or higher pay?

Could you achieve your objective 'reasonable salary' requirements by opening a C-corp? I believe there are no salary requirements there and it doesn't 'pass through', so would that be a reasonable alternative? I think it might be easier to carry over deductions with a C-corp  instead of an S-corp (not sure, though!). Have you considered a C-corp?

And on a final note; about business partners. A few years back, I called a guy who was selling his car. We got to talking and somehow the conversation veered off into business and taxes. Turns out, he owned 10% of a business and his 90% partner ran off with the money and didn't pay taxes on corporate profits. The tax due was a huge amount, too, like, well into the six figures. Who did the taxman call next? HIM! Turns out, as a business owner, you're jointly and severally liable for all taxes, NO MATTER WHAT PORTION OF THE BUSINESS YOU OWN!  Meaning, yeh, if you hold 1% of the company and the other 99% owners run off, then you are responsible for 100% of the taxes.

I didn't have any business partners back then, but just hearing that scared the living daylights out of me.

frugalnacho

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Re: Starting a business, S Corp - questions, tax related
« Reply #8 on: March 03, 2021, 08:01:27 AM »
If four people are working and not taking any salary, is the $300k left over at the end of the year really a profit, or merely diverted salaries? Is the answer the same if there are six people not taking a salary? Or just one person not taking a salary?

That's really the question, can we have $300k "profit" (on our S Corp tax filing) while having no salaries, and does it depend on what that $300k gets used for?

If four people are working without salary, is the $300k left over at the end of the year really worth it? Wouldn't you be replacing your currently paid job for another one, but with all the risks of ownership, without any job security or higher pay?

The $300k was just an example, I don't know what it will be.  Our focus isn't really on what the end of year profits are going to be for the first or second year.  I am imagining I would be in much better financial shape for the first 2 years if I just kept my job and didn't take a risk.  But I am mustachian and in a great position to be able to take a risk, and I expect to make more money from year 2-3 onward.

Could you achieve your objective 'reasonable salary' requirements by opening a C-corp? I believe there are no salary requirements there and it doesn't 'pass through', so would that be a reasonable alternative? I think it might be easier to carry over deductions with a C-corp  instead of an S-corp (not sure, though!). Have you considered a C-corp?

And on a final note; about business partners. A few years back, I called a guy who was selling his car. We got to talking and somehow the conversation veered off into business and taxes. Turns out, he owned 10% of a business and his 90% partner ran off with the money and didn't pay taxes on corporate profits. The tax due was a huge amount, too, like, well into the six figures. Who did the taxman call next? HIM! Turns out, as a business owner, you're jointly and severally liable for all taxes, NO MATTER WHAT PORTION OF THE BUSINESS YOU OWN!  Meaning, yeh, if you hold 1% of the company and the other 99% owners run off, then you are responsible for 100% of the taxes.

I didn't have any business partners back then, but just hearing that scared the living daylights out of me.

When I checked it seemed much more favorable to do S Corp status.  This is something I would have to discuss with an accountant before we move ahead to make sure it's the best option for us.

SeattleCPA

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Re: Starting a business, S Corp - questions, tax related
« Reply #9 on: March 03, 2021, 08:06:41 AM »
@frugalnacho you want to get a local CPA's help with your venture... but now is not time to do that. Form an LLC now... then after tax season, find someone local who can help you with the S corporation thing.

You can get quite a bit of data on S corporations and partnerships of S corporations at my blog. Link below...

Tip: You can make an S election really late. The 75 day timeclock doesn't really matter.

frugalnacho

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Re: Starting a business, S Corp - questions, tax related
« Reply #10 on: March 03, 2021, 12:16:16 PM »
Thanks.  I've already been getting some useful information from your blog.  I don't think we are ready to form an LLC just yet.  For starters we haven't been able to come up with a name.  On one hand the business will function the same regardless of the legal name, but on the other hand it's going to be our brand.  It's going to be on our equipment, in our email addresses, and all over our reports.  I want something that's going to be decent, and not just "Generic Services, Inc." or "F(rugal) N(acho) Company" or something that's a legal name but completely meaningless, forgettable, and doesn't roll off the tongue or have a nice ring to it.

Second, we are going to be in direct competition with the current employer of my business partners.  So I think they need to gracefully exit and sever ties with the company before we start doing anything in an official capacity.  I am also under the impression that when we form the company legally it should be done with all of us, rather than me forming it and then having them join in at a later date once they have left their employer.  I don't know the logistics of all that, but it seems like it would be easiest to just form the company with all of us at one time.

Tigerpine

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Re: Starting a business, S Corp - questions, tax related
« Reply #11 on: March 03, 2021, 12:45:28 PM »
I want something that's going to be decent, and not just "Generic Services, Inc." or "F(rugal) N(acho) Company" or something that's a legal name but completely meaningless, forgettable, and doesn't roll off the tongue or have a nice ring to it.
How about F'N Company...or Effing Company?  ;)

frugalnacho

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Re: Starting a business, S Corp - questions, tax related
« Reply #12 on: March 03, 2021, 01:26:35 PM »
For the mock website I made I used the placeholder name Deez Nuts.  I particularly like the section that tells you how to get in touch with Deez Nuts.  Unfortunately I don't think that business name will go over well in the industry, so we are trying to pick something more professional sounding. 

drcodes

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Re: Starting a business, S Corp - questions, tax related
« Reply #13 on: June 27, 2021, 05:34:29 PM »
I've been running my S corp since 1997, have started two others in that time, and can give my take. I file my own quarterlies, and the annual 1120S and K1s. I also do my own 1040. I'm not a CPA and this is not to be construed as tax advice.

Your understanding is good. S corp pays no (federal revenue) taxes on income/profits, profits get passed through to shareholders on their annual K1, according to their % ownership (which is determined when you create the company - total # of shares and # of shares each person owns). Note stock ownership determines % ownership, not officer titles. Distributions (profit) can be paid throughout the year to shareholders (again, according to their % ownership).

The key to understanding the salary issue is profit. The IRS requires a 'reasonable' (read: Market value) salary to be paid for the work BEFORE distributions would be expected. Distributions would only be expected to be paid if there was profit (which would be AFTER salaries. There is no profit if salaries are not being paid). Distributions are similar in concept to dividends in a C corp. So if the company will not have a profit on the 1120S, why would it have paid distributions? Therefore, before any distributions are considered, be sure all employees (including officers) have been paid market value for their work.

If you break even (by chance or by reinvesting within the tax year into supplies, etc), or if there is a loss (which would give you a nice deduction on your 1040 and would mean you put money IN, be sure to track your basis), then there is no profit and no distributions. THEN, whether you pay yourself a salary is a matter of whether you can afford to. If the business is operating at a loss, there may be no money to pay. Lots of business owners donate their time for free to get things going, sometimes for years. There is no requirement to pay yourself a salary when there is no money to do so, or if you would rather put the money back into the business. Salary only becomes an issue once profit starts getting handed out in the form of distributions.

You are free to execute your business plan as you see fit, including if that means reinvesting all the 'extra' money and working for free. The issue to consider here is if a business runs a loss for too many years, the IRS may come looking. I've heard this but don't have any concrete data about if or how many years. Generally speaking I wouldn't personally be worried about 2-3 years of losses after a start up.

Note that if you leave the money 'sitting' in the corp bank account, it will be counted as profit and passed through on the K-1. I like to leave a couple months payroll in the account just to be safe at all times. This money would have been taxed in whatever year it was received (I'm on a calendar fiscal year) and can float forevermore. Likewise, expenses are deducted in the year they occur, so if I have a big year, I sometimes in December pre-pay recurring expenses for a year or two, or order extra supplies in Dec etc.  Note that equipment purchases require depreciation, Quickbooks/Turbotax does that for me.

As a side note, I can say that S Corp has proven to be an amazing tax advantaged structure for me over the years and I highly recommend it. It's true what they say about corporations not paying taxes. Also, I used to pay $1500/yr for an accountant to do the 1120S and K1, now I do everything in Quickbooks including payroll, and I use turbotax business for taxes. My business has a fairly simple transactional footprint though, if it were much more complicated I might outsource.

Last thing that comes to mind- S corp requires annual meeting notes and no co-mingling of funds. I have a business attorney who keeps my 'binder' with my annual meeting minutes. And I'm very careful to keep business accounts/cards strictly business. If there is any co-mingling of funds the IRS can take away your S corp status retroactively. When I started out, I had a CPA who filed my quarterlies, 1120S and K-1 until I learned how things should be, and Business attorney who helped me establish best practices for a few years. Well worth it, esp in the early years when there is no time. Good luck.

« Last Edit: June 27, 2021, 06:01:47 PM by drcodes »

SeattleCPA

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Re: Starting a business, S Corp - questions, tax related
« Reply #14 on: June 30, 2021, 02:40:06 PM »
Salary only becomes an issue once profit starts getting handed out in the form of distributions.

I disagree with some of what @drcodes says here... and I'll point out the most significant disagreements below but the above point is really the main thing IMO. IRS can't force you to pay payroll. But if you don't pay reasonable compensation to shareholder-employees, they can reclassify distributions as wages.

...so if I have a big year, I sometimes in December pre-pay recurring expenses for a year or two, or order extra supplies in Dec etc.

That's not a valid approach. You can't prepay a year or two of expenses simply to gin up deductions. You're only getting away with this because IRS hasn't spotted it.

Note that equipment purchases require depreciation, Quickbooks/Turbotax does that for me.


You should probably be using the tangible property regulation rules to avoid depreciation...

That'll keep your balance sheet cleaner.

Last thing that comes to mind- S corp requires annual meeting notes and no co-mingling of funds. I have a business attorney who keeps my 'binder' with my annual meeting minutes. And I'm very careful to keep business accounts/cards strictly business. If there is any co-mingling of funds the IRS can take away your S corp status retroactively.

I don't think I would say this. First, the OP should use an LLC which massively simplifies overhead. Also, IRS isn't going to retroactively take away your S corp status for co-mingling.

What causes the IRS to terminate your status (an absolute worst case scenario) would be more than one class of stock or an ineligible shareholder or something like an alleged "sham" situation like Ryan Fleischer (see link below).

https://evergreensmallbusiness.com/s-corporation-paperwork-problems/

When I started out, I had a CPA who filed my quarterlies, 1120S and K-1 until I learned how things should be, and Business attorney who helped me establish best practices for a few years. Well worth it, esp in the early years when there is no time. Good luck.

I would question a non-accountant's ability to optimize the 199A deduction, do the QuickBooks right, and handle things like Paycheck Protection Program calculations and employee retention credit calculations.

Very frankly, regularly small practice CPAs don't do enough S corporations to handle them comfortably and in a way that maximizes benefits and dials down risks. It would be extremely unusual for a non-accountant to handle them well. Sorry...

trollwithamustache

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Re: Starting a business, S Corp - questions, tax related
« Reply #15 on: June 30, 2021, 03:54:28 PM »
so the first year and the second year of the company can be very different.

1. You do get to write off start up costs when you form the buisness. So potentially a lot of your analyzer costs could go in there.

2. Some of these bigger purchases, like the 100k analyzer, you need to talk to an accountant. If you have to depreciate them, you don't write off the cash cost in year 1 but over however many years they get depreciated.

3. the more years you go without a profit, the more likely an audit. No salary or profit in year one is not so unreasonable if you are profitable and paying salaries in year 2.

4. There needs to be some written agreement between partners as to who owns what share. this all sounds pretty up in the air. Like a business plan needs to get written up in the air.