You started a new business, congratulations!
Everyone around you is now an expert advisor telling you that you need to do this that or the other. For some reason, we value this person’s opinion and take it whole heartedly. If we do question what he says we turn to another friend or acquaintance for their opinion. Usually these opinions are from people that we trust but are usually from those who have always been an employee and have never owned a business.
These “trusted advisors” cause all sorts of issues and problems that for some take years to untangle, make right and cost thousands of dollars. The biggest one that I am hearing about these days is the pressure and necessity to incorporate their newly formed business. Sometimes they can’t even tell you why, but their brother-in-law’s cousin’s roommate was told to incorporate, and it saved them huge money. So obviously, you need to incorporate to also save yourself huge money. Regardless of their reasoning the truth of the matter is maybe, but not usually, and almost never for the reason that you were told.
Most of this misconception comes from people or stories of businesses prior to the recent tax law changes that were effective beginning in 2018. As a general rule if you are going off of advice given to anyone prior to 2018, ignore it and seek current advice. In regard to S Corps, the old advice was to form a corporation, take money as a distribution and not have to pay social security taxes on your profit. Boom! save 15% in taxes right off the bat!
If you have used a corporation for that simplistic reason, I hope your accountant was imploring you to use those savings to invest into a retirement plan. If not, you were done a disservice, sacrificing retirement for a nominal increase in annual cash.
The question of incorporation really needs to start with an attorney. If for legal reasons the corporate structure protects you the best there should be few additional questions. Consider the cost of forming and operating a corporation a worthwhile insurance policy. If however, you get the same legal protection from an LLC as you do a Corporation then the question should go to the CPA.
That analysis is different for each business and each person but what really changed the analysis is what is commonly referred to as the 20% pass through deduction. In its simplest form, this is a deduction from your taxable income of 20% of your company’s profit. Although the computation is complex, if you make less than $150k as single or $300k as married then regardless of your company structure, you qualify for this benefit.
There are three problems with your buddy telling you to incorporate.
The first is now your company gets a 20% deduction of your company’s profit. If your company is a sole proprietor or an LLC, you are not allowed to be on payroll hence your business profit is higher and therefore the larger pass through deduction you get. If you incorporate, you have to be on salary which will lower your passthrough deduction. Assume your reasonable salary is $60k. That salary results in an additional $12k of taxable income on your personal tax return ($60k X 20% = $12k in lost passthrough deduction).
If you didn’t catch it already you can see that the aggressive play here is to still incorporate and pay yourself a minimum wage; saving on social security taxes and still having a high profit to get a high pass through deduction. The IRS knows it and now you do.
That leads us to the second problem. The IRS is getting aggressive about what your reasonable compensation is. An owner of a Corporation must be paid on salary, a reasonable wage. This is vaguely defined by the IRS but can be in one method, what would you be paid to do what you are doing by someone else. If you are spending all your time as a bookkeeper in your business, what are the bookkeepers being paid in your area? If you are an attorney, what would an attorney be making in your area? What the IRS is saying here is that if you are an attorney that started your own firm, you cannot pay yourself a bookkeeper’s salary, automatically saving on social security taxes.
The third problem is administration. It is no secret to you, me, or the IRS that small businesses have a hard time with administration. Keeping receipts and documenting business mileage to name a few. A corporation is more administration. With annual shareholders meetings, approvals needed for most business decisions (like shareholder salaries) and the need to keep corporate vs personal spending completely separate, it is very easy to miss one or more of the requirements needed to be in good corporate standing. On the other hand, an LLC or sole proprietor has very few of those requirements if any.
So what do you do? Well if you have a corporation, you need to ensure you are paying yourself a reasonable wage. This needs to be supported, documented and approved by your shareholders. If you are just starting your business and have no idea on what to do; start with an attorney. You need to assess your potential legal liabilities. Then before you do any formations give us a call we’d love to help make sure it’s right for you.
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