The Section 1202 “qualified small business stock” exclusion, also called the QSBS exclusion, allows you to avoid taxes on the sale of your business.

Quite honestly? It doesn’t get better than this… But let’s go over the details.

The Section 1202 Exclusion in a Nutshell

The Section 1202 exclusion works simply. You avoid paying capital gains taxes on the sale of the stock you hold in your small corporation. (The corporation needs to be a regular “C” corporation. Not an “S” corporation.)

Example: You start your corporation by investing $10,000. Later you sell your stock in the corporation for $10,000,000. The $9,990,000 gain you enjoy? As long as you fulfill the Section 1202 requirements, you pay zero capital gains tax.

And it gets even better, if you can believe it. The QSBS stock exclusion also lets you avoid NIIT (net investment income tax) and AMT (alternative minimum tax.)

Amazing, right? Almost unbelievable…

So how do you qualify for this wonderful tax treatment? You need to meet six requirements.

Requirement #1: Five Year Holding Period

You need to hold your qualified small business stock (QSBS) for at least five years.

Another thing to note? Another section of tax law, Section 1045, says you can sell QSBS earlier than 5 years and “roll over” the gain of the disposition into the QSBS of a different issuer, provided you held the stock for at least 6 months.

So you have some flexibility.

Also, if you’re not a corporation? Not necessarily a problem. If you currently own and operate a sole proprietorship or partnership, you can incorporate your existing business to obtain your QSBS.

If you incorporate an existing sole proprietorship or partnership, however, the five year time clock starts at the point you incorporate.

Caution: Be careful if you’re not already a “C” corporation. You can probably incorporate an existing business without paying taxes using a Section 351 exchange.  (Your QSBS stock basis equals the market value of the assets on the day of the Section 351 transfer.) But switching to a “C” corporation after starting a venture may mean additional taxes on the unrealized “non-exclude-able” gain at the point of incorporation. Also, consider the possibility that an un-incorporated business selling assets may receive a higher price from a buyer as compared to a corporation selling stock. (The higher price would reflect the tax savings the buyer enjoys by depreciating purchased assets.)

Requirement #2 Originally Issued Stock

You can only use the Section 1202 exclusion if you acquire original issue stock. In other words, stock issued by the corporation.

If you buy stock from some other stockholder–so on the secondary market–you can’t use Section 1202 for that stock.

Requirement #3: 80% of Corporate Assets Actively Used

For stock to receive QSBS treatment, the corporation must use at least 80% of its assets in the active conduct of its trade or business. And if that doesn’t happen?

If 20% or more of the corporation’s assets are passive “income generating assets” like investment real estate, securities or excess cash (over and above what’s required for working capital), shareholders lose the QSBS opportunity.

Requirement #4: Assets Cannot Exceed $50 million

Section 1202 limits the size of a corporation whose shareholders can use the QSBS exclusion. Cash plus the adjusted tax basis of property held by the corporation cannot exceed $50 million.

Note: If your company’s assets grow over $50 million after the the stock is issued, initial shares of QSBS won’t be affected, but the corporation will never be allowed to issue QSBS again, even if the assets dip back below $50 million.

Requirement #5: Limit Exclusion to $10 million or 10 Times QSBS Basis

The Section 1202 tax law specifies a couple of limitations. First, the law limits the excluded gain to the greater of $10 million or 10 times the aggregate adjusted basis of the QSBS.

Example: The fair market value, or “QSBS” basis, of the assets you contribute to your corporation equal $5 million.  You sell your business in 10 years for $55 million.  You are able to exclude gain up to the greater of $10 million or 10 times your $5 million basis,  which is $50 million.  Your tax-free income exclusion in this case equals the full $50,000,000. Sounds pretty good, right?

Requirement #6: Eligible Industry

A second limitation: Not all industries qualify for the qualified small business stock benefit.

Trades involving the performance of services in health, law, engineering, architecture, accounting, performing arts, consulting, athletics, financial services, actuarial sciences, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees, for example, do not qualify for QSBS.

Note: Those familiar with our Section 199A, Qualified Business Income Deduction, blog post may notice the similarity to the definition of a “Specified Service Trade or Business.”

Tip: Check out the full list of ineligible industries in Section 1202(e)(3).

Final Thoughts

It’s not surprising if you have never heard of QSBS before.  Until recently, high corporate tax rates made C Corporations unattractive to small business owners.

Furthermore, it’s worth noting that the 100% gain exclusion on QSBS wasn’t always available. (The exclusion initially ran 50% when Section 1202 appeared in 1993.)

However, with corporate tax rates running at a flat 21% and the exclusion currently offering 100% tax avoidance, Section 1202’s exclusion may be worth a closer look.

Maybe it’s time to call your tax adviser?

The post Section 1202 Qualified Small Business Stock Exclusion appeared first on Evergreen Small Business.

The good news about timing a Subchapter S election? You’ve got lots of flexibility. The bad news? That flexibility creates complexity.

Fortunately, a handful of tips and tricks can make things easier…

S Election Timing Tip #1: Requires Eligible Entity

A first thing to know: You can’t make an S election unless you have an eligible entity—like a corporation or limited liability company—to make the election for.

This seems like an obvious point, but we do see people make Subchapter S elections for entities that don’t exist.

Even more commonly, we see people make a Subchapter S election with an effective date before the eligible entity exists. For example, someone sets up a limited liability company in April of some year, but the 2553 election form (which is how you elect Subchapter S status) sets the effective date as January 1^st of that same year.

Note: Our Preparing Form 2553 blog post explains how you make an S election for a Washington State entity, but you can use the same instructions for other states’ entities, too.

This premature election shouldn’t work, although the IRS seems not to catch this error. But you don’t want to do this. Electing Subchapter S status before your eligible entity even exists only works if the error isn’t caught.

S Election Timing Tip #2: Consider Early Election

You can make an early election. Specifically, if you have an eligible entity in place, you can make an election up to 12 months in advance (Source: Reg. Sec. 1.1362-6.)

For example, you could on January 1^st, 2021 make a Subchapter S election with an effective date of January 1^st, 2022.

Electing early sometimes makes sense when you know you want to operate as an S corporation… just not before next year.

S Election Timing Tip #3: Statute Says Elect Within 75 Days

You can go backwards with your Subchapter S election, too.

The law, in fact, says you can elect Subchapter S status as late as the 15^th day of the third month.

This means that if the tax year starts on January 1^st, you can elect S status as late as March 15^th.

March 15^th, for a corporation or LLC whose tax year starts on January 1^st, is the 15^th day of the third month.

A quick note: If you start the year at some point other than on January 1^st, you essentially add 75 days to that start date in order to calculate the statute’s required S election deadline. (Again, though, the actual statute requires the election by the 15^th day of the third month.)

S Election Timing Tip #4: Late Relief Usually Available

An exception to the statute’s rule… While the actual law says you’re supposed to make your election no later than the 15^th day of the third month, you can often make the election much later than this deadline.

Currently—and this has been the case for several years now—you can make very, very late elections.

In order to make a late election, you want to locate the most recent Revenue Procedure from the Internal Revenue Service that outlines the rules for late election relief. And then follow its instructions. (Right now, as I write this blog post, that Rev. Proc. is available here: Rev. Proc 2013-30.)

Tip: If you’re thinking about making an S election for a business, you might also be interested in getting some expert help with setting your S corporation shareholder salaries.

Set the salaries smartly, for example, and you should be able to save thousands per year per shareholder…

If this is an area where you want help, take a look at our downloadable ebook, “Setting Low Salaries for S Corporations“.

S Election Timing Tip #5: LLC Fiscal Years Start Whenever

You can use either a corporation or an LLC as the platform for a Subchapter S corporation. (I know, that seems weird… but you can.)

But the deadlines and timing of the S election effective date work differently with LLCs.

With a corporation, the Subchapter S election effective date is going to be either January 1^st or the incorporation date—whichever is later.

If the corporation exists on January 1^st, for example, that’s the date that you would make the S election effective. And if the corporation is formed after the year starts on April 8^th, that April 8^th date is going to be the effective date.

If you use an LLC as the platform for an S corporation, however, you can start the Subchapter S corporation’s first year whenever you want. For example, though the LLC may exist on January 1^st, you could choose to make the effective date any day of the year. Like April 8^th. Or May 23^rd. Or any other date.

The reason for this flexibility is a little convoluted, but the basic reason is your LLC will, for the period of time prior to the S election effective date, be treated as either a disregarded entity (probably a sole proprietorship) or a partnership. And that sole proprietorship or partnership status works just fine from the IRS’s point of view (and from your point of view).

S Election Timing Tip #6: Revoke Elections

You can revoke a Subchapter S election (Source: Reg. Sec.1.1362-2(a).) You just need a majority of shareholders to agree.

Some wrinkles exist, however, for revocations.

First, if you do revoke, you can’t re-elect S status for five years (Reg. Sec. 1.1362-5.)

Second, when you revoke a Subchapter S election, your S corporation becomes a C corporation. You need to be careful about revocation, therefore, and make sure you understand how a C corporation works. (Please, please consult your tax advisor before doing this.)

Third, just to be clear, if you used an LLC as the platform for your S corporation, note when you elected S status, the IRS on your behalf made a deemed entity classification (Source: Reg. Sec. 301.7701-3(c)) whereby it converted your LLC into a corporation so it could make an S election. This hidden tweak matters. Entity classification can’t be undone for at least 60 months. So that means, revoking an LLC’s S election may leave the business owners with a C corporation. At least for a while…

S Election Timing Tip #7: Rescind Revocations Within 75-Day Window

You can rescind, or undo, a Subchapter S revocation as long as you rescind either before the revocation becomes effective or by the 15^th day of the third month of the first year the revocation becomes effective (Source: Reg. Sec. 1.1362-6.)

An important point: If you rescind the Subchapter S revocation, the revocation never occurred.

S Election Timing Tip #8: Intentional Terminations of Subchapter S Status

If you want to terminate Subchapter S status but cannot do so with a regular revocation for some reason, you may want to look at the option of intentionally violating the eligibility rules for Subchapter S status.

• Add shareholders. Subchapter S corporations, for example, are limited in the number of shareholders they can have.)
• Add the the wrong sort of shareholder. Subchapter S corporations are restricted to having only, essentially, US individuals as shareholders.
• Create a second class of stock that treats some shareholders preferentially. (Subchapter S corporations can also have only a single class of stock.)

If you break any of these rules, you actually terminate the entity’s eligibility to operate as an S corporation—and you thereby end the Subchapter S status.

Intentional terminations due to losing your eligibility represent an in-eloquent way to terminate your Subchapter S status. But sometimes a business owner may want to discuss this option with his or her tax adviser.

S Election Timing Tip #9: Dissolution a “Nuclear Option” Revocation

A quick timing tip: If you dissolve the corporation or LLC, that dissolution effectively terminates not just the corporation’s or LLC’s life, but also the Subchapter S status.

S Election Timing Tip #10: Entity Classification Works as Backdoor Liquidation of LLC S Corps

One final tip related to Subchapter S election timing…

If you use a limited liability company as the platform for your S corporation, and if the LLC has operated as a Subchapter S corporation for at least 60 months, you can also use the 8832 entity classification form to “dissolve” for tax purposes the corporation.

This entity classification change causes your LLC to be taxed as a disregarded entity—so probably either a sole proprietorship or partnership.

Operating as an LLC formerly treated as a Subchapter S corporation is often a reasonable way to run a business the last year or two you operate. You get limited liability protection, but without the tax accounting complexity and cost of the corporation.

Again, make sure you talk with your tax advisor about this. Dissolving a corporation often triggers taxes.

Tip: Subchapter S corporations provide small businesses with one of the truly great tax loopholes.

But you should know that federal and state tax laws provide small businesses with dozens of other powerful loopholes for cutting taxes too.

If you want more information about these often “sanctioned by Congress” loopholes, consider our popular downloadable ebook “Small Businesses Tax Deduction Secrets“.

A Final Comment

The timing of your Subchapter S election matters. Both the benefits and the costs of your election start when you elect and end when you revoke your election.

But if you understand the rules, you’ll probably avoid the common mistakes and maximize your savings!

Other Posts You Might Find Interesting

How Much Tax Can an S Corporation Save Shareholders (an article at our S corporations explained website.)

The Million Dollar S Corporation Mistake

S Corporation Reasonable Compensation

The post Subchapter S Election Timing Tips & Tricks appeared first on Evergreen Small Business.

But you need to be careful. Getting a purchase like this to work right is tricky…

Accordingly, let me share some tips to help you find the right small business and then structure a solid deal.

Buying a Small Business Tip #1: Don’t Overpay

A first tip—and maybe one of the most important: Be sure you don’t overpay.

The rule of thumb for small business values, by the way, is roughly 2.5 times seller’s cash profits.

A business that makes $100,000 in cash profit for its owner is probably worth about $250,000.

But note that some variability occurs. Some firms sell at two times cash profits or less. And, sometimes, especially attractive small businesses sell for as much as four or five times the seller’s cash profits.

In all cases, however, small businesses sell at very low multiples. Way less than the multiples that get used to value large publicly traded companies. And so you should pay a very low multiple.

Tip: Your accountant can help you size up a seller’s price by first helping you calculate a good estimate of the owner’s cash profits and then looking at a database of comparable sales of small businesses (like the bizcomps database). You can also get a rough idea about fair market values and cash flow multiples by looking at one of the online businesses for sale websites, such as bizbuysell.com. Just keep in mind that listing prices regularly exceed the actual sales price paid in the end. And keep in mind that potential sellers are often more than a little starry-eyed…

Buying a Small Business Tip #2: Do “Do” Due Diligence

Sellers, I am sorry to report, sometimes sell their businesses at the high water mark. Right before they know they’ll lose a major customer or client. Or when they know a major vendor or product is going away.

You want explore these sorts of possibilities by doing as much free-form research as possible. And then with your attorney’s help, you want the seller to represent that none of this stuff is already happening.

Sorry I don’t have more to say about this issue. But don’t let my brevity suggest this issue isn’t big. It is big. HUGE, in fact.

Buying a Small Business Tip #3: Allocate the Purchase Price to Minimize Taxes

When you buy a small business, and maybe you know this, you typically don’t buy the business.

For example, if the business operates as a corporation, you don’t buy the corporation. Or buy all of its stock. At least not if you’re smart.

What you do is buy the assets of the business. Whatever you pay for these assets gets allocated to the specific assets you buy. If you buy a small business for (say) $300,000, you might end up allocating $100,000 of the purchase price to the inventory you bought, $100,000 to the equipment you bought, and $100,000 to the remaining intangible value of the business, which is usually referred to as goodwill.

The allocation matters because it makes all the difference as to how fast you deduct the amount you pay for the business. Inventory you purchase will be deducted on your new business’s tax return as soon as you sell the inventory. (That’s good.) Furniture and equipment can be deducted pretty quickly—maybe even immediately—via depreciation expenses. Goodwill you purchase gets deducted very slowly—over fifteen years typically—so you want to minimize this chunk if possible.

Accordingly, you want to “work” the purchase price allocation to your advantage if possible. Getting this part of the purchase right can reduce your tax bill by a ton—especially in those early years when cash flows may be tight.

Caution: If you buy a business by buying stock in a corporation, you probably don’t get to deduct much or any part of your purchase price. For example, if you paid $300,000 for the stock of a corporation and inside that corporation was $100,000 of inventory, $100,000 of fully depreciated equipment and implicitly $100,000 of goodwill, you would be able to deduct the $100,000 of inventory when you sell it… but not anything for the equipment or goodwill.

Buying a Small Business Tip #4: Verify the Financial Engineering Works

Let me share another subtle tip provided by a well-known broker who sells CPA firms, Mark Hause.

Mr. Hause has said something very wise concerning making the purchase of a small business work. He points out the buyer needs to get paid for their new job working in the business. He makes the obvious but important statement that there needs to money to pay any loan payments. And then he points out the deal needs to provide enough cushioning so some little bump in the road doesn’t cause you to drive into the ditch.

To illustrate, if you need to make $50,000 for your work, need to pay $50,000 annually in loan payments, and then ( just to keep the math simple) need $50,000 of cushioning, you need the business to generate $150,000 in profits.

You see the simple but critically important logic. If this business generates $200,000 in profits, things should work out great. (Fingers crossed.)

If this business instead generates $100,000 in profits, things will probably end poorly. With $100,000 in anticipated profits, the first time you experience a hiccup, you’ll either need to short yourself or default to the bank. That simply doesn’t work.

Hause’s advice sounds obvious. But you’d be surprised how many people structure deals that work only if everything—and I mean everything—goes perfectly.

The post Buying a Small Business: Tips and Tactics appeared first on Evergreen Small Business.

By the way, we aren’t going deep into the weeds in this blog post. There’s lots of complexity for small businesses related to the net investment income tax. But what you and I want to do here is have a discussion that gives you a good working handle on the issues you’ll face as a business owner.

Small Business Net Investment Income Tax Flows from Sec. 1411

Let’s start by pointing out that the net investment income tax flows from Internal Revenue Code section 1411.

This chunk of tax law says, essentially, that starting in 2013, some individuals, estates and trusts pay a 3.8% surtax on some or all of their net investment income.

Note: I’m not going to talk in this post about how the tax applies to estates and trusts. That’s a separate subject and probably not of much interest to small business owners and managers. However, if you use trusts, you’ll want to learn about this area of the law, too.

Investment income includes dividends, interest, royalties, rents not derived from a trade or business, trading, most capital gains, as well as net gains from disposition of passive activities (like an interest in a partnership) or disposition of a passive activity property (like investment real estate).

An important thing to note: The net investment income tax applies to your net investment income. If you have $100,000 of capital gains, $100,000 of capital losses, and $50,000 of interest, your net investment income equals $50,000.

You pay the taxes in this situation, potentially, on the $50,000.

Let me also tell you what income specifically is never hit with the net investment income taxes. The net investment income tax doesn’t hit income that’s already subject to self-employment taxes. The net investment income tax doesn’t apply to wages. The net investment income tax doesn’t apply to distributions from qualified retirement plans. And, important for business owners, the net investment income tax also doesn’t apply to gains you realize on the disposal of  property (like unneeded equipment) used in a trade or business in which you’ve been active and met material participation tests.

Small Businesses Don’t Get Hit Until Owners Cross Tripwire

Even if you have net investment income, you don’t necessarily pay the net investment income tax. You need to cross a threshold in order to be subjected to the tax.

That threshold is $200,000 for a single taxpayer, $250,000 for married taxpayers filing a joint return, and $125,000 for a married taxpayer filing a separate return.

And then there’s a little wrinkle to how this works. The actual amount taxed equals the lessor of your net investment income or the amount by which your modified adjusted income exceeds a threshold.

Modified adjusted gross income equals adjusted gross income for most taxpayers. (The modifications that Sec. 1411 requires relates to Sec. 911 foreign exclusion income. )

One final important note to keep in mind as a long-term planning issue: The threshold amounts don’t get indexed for inflation. What this means is that while the net investment income tax only hits a tiny percentage of taxpayers now, someday not that far into the future, the tax will hit many more people.

Workers and retirees who today might consider themselves “merely” successful middle-class folks will very likely pay the tax a couple of decades into the future.

Self-Employment Tax vs. Small Business Net Investment Income Tax

A slight detour concerning self-employment income…

As you may know, self-employment taxes run 15.3% up to the FICA limit ($118,500 in 2016 and $127,200 in 2017), then 2.9% on any income between the FICA limit and the net income investment income thresholds just mentioned, and then run 3.8% after that.

On the face of it, 3.8% self-employment taxes look like 3.8% net investment income taxes.

However, self-employment earnings probably represent a better “flavor” of income as compared to net investment income for a couple of reasons.

First, self-employment tax gives you a tax deduction whereas net investment income taxes don’t. (1.45% of your self-employment tax is deductible on your tax return.)

Second, self-employment earnings may create an opportunity to contribute additional amounts to a pension plan which reduces your modified adjusted gross income, and later on, as noted, draws from a pension plan are not subject to net investment income tax.

The upshot of this detour? Small business owners may want to look to re-categorize  income that would be subject to net investment income tax  as income subject to self-employment tax. (You probably want to confer with your tax adviser for help with this, but basically what you’d do is look at the self-employment tax law contained in Internal Revenue Code Section 1402.)

Taxation of Pass-through Entities Like S Corporations and Partnerships

Businesses operating as S corporations and partnerships get some special tax breaks related to the net investment income tax.

If you own an S corporation or a share of an S corporation and you actively participate in the business (meaning you pass a material participation test in Treasury Regulation Sec 1.469-5T), you aren’t subject to net investment income tax on the income and any gains on disposition of property that’s derived in the ordinary course of the trade or business. (This will be the sort of stuff that appears on the K-1 you get from the S corporation.)

Example: Your family’s income exceeds the threshold before your income from an S corporation. Even though the S corporation allocates $100,000 of income to you via the K-1, you don’t pay any net investment income tax on that $100,000.

If you own share in a limited partnership and you’re a limited partner, many people think the same rule applies to you: In other words, that if you pass a material participation test in the regulations referenced earlier, you don’t owe net investment income tax on the income and gains derived  in the ordinary course of business.

Example: Your family’s income exceeds the threshold before your income from a limited partnership interest in a partnership operating an active trade or business. You materially participate in the active trade or business. Even though the limited partnership allocates $100,000 of income to you via the K-1, you don’t pay any net investment income tax on that $100,000. Note that you probably also have a guaranteed payment from the limited partnership and this payment will be subject to self-employment tax.

Further, if you sell an interest in an S corporation or partnership and you’ve actively participated, you’re probably not going to owe much or any net investment income tax on the gain because much or all of the gain on the sale will be excluded from the net investment income tax. (This exclusion isn’t necessarily 100%, by the way. Some of the gain that occurs “inside” the S corporation or partnership may be subject to net investment income tax.)

Example: You sell an interest in a partnership or S corporation that generates $200,000 of gain and you’ve actively worked in the business. Even if the income shown on your tax return exceeds the threshold, you probably won’t pay net investment income tax or pay much tax on the $200,000 of gain.

A Final Bit of Clarification

If an S corporation or partnership invests in stocks or bonds or passive investments like real estate—the sort of stuff that would generate investment income if you owned it directly–that income and those gains will be subject to net investment income tax.

Whoever prepares the S corporation or partnership return, therefore, needs to do a good job of providing information about the net investment income earned by the entity and then passed through and allocated to the owners.

The post Small Business Net Investment Income Tax Primer appeared first on Evergreen Small Business.

In a nutshell, an S corporation allows a business owner to avoid payroll taxes on a chunk of the business profits as long as he or she pays the owner or owners reasonable compensation.

An S corporation, however, often also delivers other substantial tax savings to small business owners. And in this post, I want to identify three such benefits.

Quick Review of the Well-known S Corporation Benefit

Let me, though, before I get into the little known benefits of an S corporation quickly review the big, well-known benefit of an S corporation. This will put all of us on the same page.

If you run a sole proprietorship that makes a $100,000 a year in profits or you’re a partner in a partnership that generates a $100,000 distributive share, you pay two taxes on your income.

You pay income taxes. (This tax might often be between $10,000 and $20,000 depending on your other income and what deductions you take.)

And you also pay a 15.3% self-employment tax—the business owner’s version of Social Security and Medicare tax—on the $100,000.

The math is a little more complicated than this, but you can think about the 15.3% tax on the $100,000 as being roughly a $15,000 tax.

However, if you operate the exact same business as an S corporation and you split the $100,000 of sole proprietorship profits or the $100,000 of partnership profits into $50,000 of wages and $50,000 of distributive share, you only pay the 15.3% tax on the $50,000 of wages.

The savings of an S corporation in this example equals (roughly) 15% of whatever amount you call a distributive share. (People often describe the distributive share as a “dividend” but the technically precise term is distributive share.) And in this case, the accounting means you save roughly $7500 in payroll taxes annually.

Tip: You can use our free S Corporation Tax Savings Calculator to estimate S corporation tax savings for your specific situation.

The preceding paragraphs describe the well-known benefit of operating as an S corporation. But in addition to that benefit, S corporations potentially offer up three other big benefits to small business owners.

Selling the Business

For example, did you know that an S corporation supplies one of the easy ways for you to sidestep the net investment income tax if you sell your business? This is the tax that sometimes people refer to as the Obamacare tax. But let me explain.

If you someday have the good fortune to sell your business, the profits from that sale will be subject to either ordinary income taxes or capital gains taxes.

In addition, if the sale of the business pushes your income above $200,000 and you’re single or the sale pushes your income above $250,000 and you’re married and you file a joint return, profits on the sale may also get hit with the Sec. 1411 “Obamacare” 3.8% net investment income tax. (This would be case, for example, if you’ve operated your venture as a regular corporation.)

However, the net investment income tax doesn’t apply to sales of the assets of an S corporation or the stock in an S corporation if you’re actively involved in the business.

In other words, if you make 200,000 or $2,000,000 or $20,000,000 selling the assets of your S corporation or your S corporation’s stock and you’re actively involved in the business, you don’t have to pay the 3.8% net investment income tax. (Again though you will still pay ordinary income taxes or capital gains.)

Subchapter S corporation status can thus easily save a business owner thousands of dollars in taxes when the business owner sells out. And in a giant windfall situation, subchapter S status can save the business owner hundreds of thousands or even millions of dollars. Wow.

Tapping the DPAD Deduction

Here’s another little known benefit of Subchapter S corporation status that small one or two person businesses can sometimes use to save big.

If you run a sole proprietorship or a small partnership that makes stuff, grows stuff, or mines stuff, you’re eligible potentially for the Sec. 199 domestic production activities deduction, also known as the DPAD deduction.

The DPAD deduction—and this is an absolute loophole—lets eligible businesses deduct an amount equal to 9% of their business profits from their income. But there’s a requirement that commonly causes very small businesses to miss the deduction: The actual deduction can’t exceed fifty percent of your wages.

To show you how this works (or doesn’t work) suppose you run a small construction company or a digital goods company and you make $100,000 a year. You are potentially eligible to deduct $9,000 from your income… but not if you don’t have at least $18,000 of wages.

The rub is that if you’re really the only person working in the business and the business operates as a sole proprietorship, you don’t have wages. Or if the only people working in the business are two partners, again, the business doesn’t have wages.

The wage-based limitation evaporates if the sole proprietorship or partnership reforms as an S corporation, however. If the $100,000-in-profits sole proprietorship incorporates and makes an S corporation election, for example, the proprietor will need to pay out some of the $100,000 in profits as wages. But these wages will then let the business take the DPAD deduction.

For example, if the S corporation splits the $100,000 of profits into $50,000 of wages paid to the proprietor and $50,000 of distributive share, the business profit will equal the $50,000 of distributive share and this means the DPAD deduction will equal 9% of $50,000 or $4500. That $4500 deduction might save the taxpayer $1000 to $2000 in taxes depending on their other income and deductions.

Note: The DPAD deduction is regularly missed by small businesses, so if you run a manufacturing operation, a construction firm or a firm selling digital goods or digital services, you should look at line 35 of your federal 1040 return to verify you’re benefiting from this easy loophole. If the line shows no deduction value, talk with your tax adviser. You can also get some additional data on this deduction in another blog post here.

Double Deducting Pension and Health Insurance

One other little known benefit deserves mention, though it’s subtle in its effect.

If you operate as a sole proprietorship or partner in a partnership, the self-employed health insurance deduction and your pension contribution save you income taxes (assuming you’re eligible and follow the rules.) But these deductions don’t save you payroll taxes.

However, because electing Subchapter S status has the effect of moving these deductions onto your S corporation tax return, Subchapter S status often in effect lets you save not just income taxes but also payroll taxes on self-employed health insurance and pension deductions.

The accounting gets a little messy, I acknowledge that. To get what amounts to a double-deduction for the self-employed health insurance, you need to prepare the shareholder-employee’s W-2 in a very precise and proper manner. (Here’s more information about this.)

And the double deduction for a pension contribution doesn’t work for the elective deferral chunk of the deduction. This means that you can get a double deduction for SEP-IRA contributions, defined benefit plan contributions and the employer match on a 401(k) plan or Simple-IRA plan… but not on the elective deferral chunk of a 401(k) or Simple-IRA contribution.

Nevertheless, this double deduction business can make the difference as to when Subchapter S status makes sense. Sometimes one-person businesses or small partnerships that can’t otherwise justify the Subchapter S election should still elect S status due to the double-deductibility they’ll get from health insurance and pension deductions.

The post Little Known Benefits of an S Corporation appeared first on Evergreen Small Business.

We love helping small businesses. And we love S corporations. No, seriously.

But one unfortunate situation we commonly encounter is where someone with a regular, full-time job sets up an S corporation for a side-line, part-time business.

Usually, setting up an S corporation for a sideline or part-time business doesn’t work.

This post talks about why you usually don’t want to set up an S corporation for a sideline or part-time business if you’ve got a regular, full-time job.

And then, because the subject matter is so similar, this post also talks about the idea of using an S corporation for a very small, part-time venture. Usually S corporations make little to no sense for these ventures, too.

S Corporations Cost More Money

To start your thinking, you need to know that an S corporation increases your accounting and tax preparation costs.

Without getting into all the nitty-gritty details, you probably want to think about the decision as a $2,500 annual expense at a minimum. And you might end up paying closer to $4,000. But let me break this down.

For starters, you’ll pay probably $1,500 to $2,000 a year to a tax accountant to prepare the annual 1120S corporation tax return.

In most states, you will pay another $500 to $1000 a year in payroll taxes that you’ll owe even in the case where the only person working in the business is the shareholder.

Finally, an S corporation will require you to do a bunch of additional fiddling with payroll processing: quarterly returns, annual wage statements, regular paychecks and tax deposits. You will probably want to pay a service to “do” this payroll processing. That choice adds another $500 to $1,000 to the costs.

And now you’re at $2,500 to $4,000 in annual costs just to have an S corporation.

You Generally Must Pay Some Wages

Here’s the next thing to keep in mind: In order to make your S corporation tax return look reasonable, you’re going to have to pay some substantial chunk of the business profit out to yourself as wages.

The average one-owner S corporation pays its shareholder-employee about $40,000, by the way. So I think most S corporation owners probably want to get close to that number or have a good reason for not being there.

Now what’s weird about this is that in your real job, the full-time one you spend more of your time at, you may already earn a solid wage. But that wage won’t matter.

The comparison you’ll want to make (and it’s the same one I’ll guess the IRS computers likely make) is how your shareholder-employee wages compare to the leftover profits you distribute to the shareholders.

I think, for example, that even if you in your regular job earn $200,000 a year, you need to pay the first big chunk of your sideline or part-time business profit as wages.

And another thing—and probably more relevant to the typical small, sideline S corporation: If you make only a modest amount of profit in the venture (keeping in line with the sideline nature of the whole enterprise), I think you probably need to pay out most of the profit as wages.

For example, if you have a part-time business that makes, say, $10,000 or $20,000 a year, logically to me, most of that profit would likely stem from your labor and so should probably be treated as wages.

The bottom line here, then: While what you want to do with an S corporation is shield profits from employment taxes? You’ll find that hard to do with a sideline operation.

Tip: You can use our free S Corporation Tax Savings Calculator to estimate S corporation tax savings for your specific situation.

Marginal Employment Tax Rate Matters

Something else you want to know.

In the case where someone already earning the FICA limit operates a sideline business? Yes, that side business profit if earned in an unincorporated business is subject to self-employment taxes of roughly 2.9% to 3.8%.

But if that person instead operates a sideline business as an S corporation? The employment taxes run roughly 10% to 12% on the first chunk of the profits the S corporation labels as wages. And this means, in effect, you’re often going backwards at first, in terms of payroll tax savings, with a sideline or part-time S corporation.

This weirdness occurs because the FICA, Medicare, FUTA and equivalent state payroll tax limits get reset or partially reset to zero for the new employer.

Two Examples Illustrate the Problem

Let me give you a couple of examples so you understand what I mean.

The limits for Federal unemployment tax (FUTA) and state employment tax (SUTA) reset for the new corporation. Accordingly, even if you’ve fully satisfied your unemployment tax obligations in your first, primary job, you may end up paying these taxes again for the next job. FUTA, by the way, can run 6% on the first $7,000 of wages. And SUTA varies by state, but can easily run $1000 or more for an employee.

And here’s another example: While an individual who’s already broken through the FICA limit on one job ($168,600 in 2024) doesn’t need to pay 6.2% Social Security taxes on the wages from a second job, the employer providing the second job does.

The bottom line here? You will find it more difficult than you would expect to minimize payroll taxes using a S corporation when you’re talking about a sideline business.

And more to the point: In many cases, you can’t justify the $2,500 to $4,000 of out-of-pocket costs or the hassle factor of using an S corporation for a sideline business.

What about Part-time Businesses?

Let me throw out one related comment here, too.

Now, again, please understand: We love S corporations. They often work great. Someday, if you have a successful full-time small business, you’ll probably want to operate that venture as an S corporation. Absolutely.

However, all the stuff that causes problems with the S corporation choice for a sideline business probably also causes problems for a part-time business.

You have this relatively high cost you pay just to “play the game.” Again, maybe $2,500 to $4,000 a year.

Furthermore, you probably have to first pay the “reasonable wages” component out of the profit, which means your business needs to be making something quite a bit in excess of that “reasonable wages” amount in order to even break even on the costs.

An Alternative to the S Corporation Option

Can I make one related suggestion?

If you want to limit your liability, you may want to use a limited liability company instead of an S corporation. We’ve got do-it-yourself LLC formation kits which most people can use to quickly set up an LLC themselves. And note that an LLC can be easily converted to an S corporation at the start of any tax year. Here’s the list of links:

Alabama | Alaska | Arizona | Arkansas | California | Colorado | Connecticut | Delaware | Florida | Georgia | Hawaii | Idaho | Illinois | Indiana | Iowa | Kansas | Kentucky | Louisiana | Maine | Maryland | Massachusetts | Michigan | Minnesota | Mississippi | Missouri | Montana | Nebraska | Nevada | New Hampshire | New Jersey | New Mexico | New York | North Carolina | North Dakota | Ohio | Oklahoma | Oregon | Pennsylvania | Rhode Island | South Carolina | South Dakota | Tennessee | Texas | Utah | Vermont | Virginia | Washington | West Virginia | Wisconsin | Wyoming

The post Should You Use an S Corporation for a Sideline or Part-time Business? appeared first on Evergreen Small Business.

A client came into the office the other day and mentioned she had heard one can’t use an S corporation for a one person business or for a husband and wife business.

This is a great subject for a post—and the perfect time of the year to have a discussion. So I want to talk about whether one-person S corporations work.

Background: How S Corporations Save Tax

Just to first put us all on the same page, though, let’s make sure you know how an S corporation saves a business owner taxes. I’m going to use rough numbers.

If you operate a sole proprietorship or are a partner in a partnership and you make $100,000, you pay both income taxes and self-employment taxes (Social Security and Medicare) on the $100,000.

You might pay about $15,000 in income taxes on the $100,000 for example.

And then, in addition to that, you would also pay a 15.3% self-employment tax. The formula gets a little complicated, but this would work out to about $13,000 in the case with $100,000 in business profits.

Now that you know this, here’s the S corporation trick. If you incorporate the business, the S corporation tax return lets you split your $100,000 into two categories: wages and distributive share. And the thing is, only the wages are subject to the 15.3% employment tax.

If the $100,000 of profit, for example, gets split into $40,000 of wages and $60,000 of distributive share, the 15.3% employment tax (Social Security and Medicare) applies only to the $40,000 of wages. That equals roughly $6,000 obviously.

Compared to an unincorporated business, the S corporation option saves about $7,000 a year in payroll taxes.

Note, by the way, that because you pay income taxes on both the wages and the distributive share, your income tax bill should basically remain unchanged as a result of an S corporation election. If you paid, say, $15,000 income taxes before the S corporation, you’ll pay $15,000 after the S election.

Tip: Use our free calculator to estimate S corporation tax savings for your specific situation: S Corporation Tax Savings Calculator.

Some People Think One-person S Corporations Are Illegal

You can see pretty clearly how artificial the S corporation accounting gets, right?

And in a sense, you can understand why many people, including some CPAs and many people at the Internal Revenue Service, think this whole S corporation thing doesn’t work. Or at least shouldn’t work. Especially if someone has simply “incorporated” a job or a partnership interest.

Tip: If you’re unsure about how low you can set an S corporation shareholder’s salary, you need to do more research and analysis.

If you are still in the process of doing this research, consider acquiring our “Setting Low Salaries for S Corporations” e-book. The downloadable resource comes with a money-back guarantee…

Why One-person S Corporations Are Legal

But here’s the thing we all need to acknowledge about tax law: Congress makes the laws.

And that’s why I say the S corporation option works for small businesses—including the one-person S corporation. But let me explain my logic.

In the summer of 2010, the House of Representatives attempted to fix (sort of) the one-person or two-person S corporation loophole by passing the “American Jobs and Closing Tax Loopholes Act of 2010.”

In a nutshell, this piece of legislation disqualified most “white collar” and “professional” small businesses from saving employment taxes with S corporation.

If you want to get more details about the legislation, you can refer here. But the main thing to note is that the “American Jobs and Closing Tax Loopholes Act of 2010” would have meant that some S corporations with three or fewer shareholder-employees couldn’t play the S corporation accounting game.

In other words, the “Closing Loopholes” act was all about preventing some (again though, some and not all) one, two and three owner S corporations from saving employment taxes.

After the legislation passed in the house, the Senate attempted to pass its own version of the proposal, but Senate Republicans and centrist Democrats shut down the process.

I’m not sure that we know exactly why the Senate in effect killed the legislation. But, probably, the Senate at least partly killed the proposal because it was so patently unfair to close the loophole for some very small S corporations but not for others.

I’m not going to get into that debate here, however, because what I think we want to take away from this whole process is rather more basic.

Congress, the body that makes the rules, has had this debate. And the debate and legislative process incontrovertibly leads one to the conclusion that the loophole is still open for very small businesses.

This makes sense, right? If the loophole didn’t exist, the House of Representatives would have never spearheaded an effort to close the loophole. And again note that House legislation never eliminated the loophole for all one-shareholder, two-shareholder and three-shareholder S corporations. Only some.

The bottom line? Maybe this S corporation loophole shouldn’t exist for really small businesses. (That’s probably case for most loopholes.) But the loophole does exist.

And gosh, in a sense, the House of Representatives did a pretty big favor for one-person and other small S corporations because they explicitly acknowledged the loophole’s existence.

A Quick Caveat About Reasonable Compensation

Can I make a closing caveat here related to the really small S corporation? Everyone does agree that S corporations need to pay their shareholder-employees reasonable wages.

You can’t, in other words, use the Subchapter S gambit to completely avoid paying Social Security and Medicare wages. (You may also want to pay Social Security taxes so you someday enjoy Social Security benefits.)

Furthermore, paying reasonable wages in a single-shareholder, one-employee business may mean very little employment tax savings flow from the Subchapter S loophole. You need to check the numbers. And you may, if you have questions or are confused, want to get expert help from your tax advisor.

Tip: If you’re researching the Subchapter S election option, you should also know that tax laws provide small businesses with dozens of other powerful tactics for cutting taxes, too.

One useful resource that thousands of small business owners have found useful in this regard is our downloadable ebook “Small Businesses Tax Deduction Secrets“.

Final Comment: Still Time for New Year

A final comment: In order to use the S corporation gambit for the new year, you need to have either a corporation or a limited liability company in place at the very beginning of the year and then need to file Subchapter S election paperwork by March 15.

I mention this in case you want to do this for new year. There is still time.

Tip: I’ve got economical do-it-yourself S corporation kits for all fifty states. If you’re interested in quickly setting up an S corporation, therefore, click the state you operate in. And again, if you’re a client, you don’t need to buy a kit. Just e-mail me, Beth, or Matt for a free kit.

The post Are One-person S Corporations Illegal? appeared first on Evergreen Small Business.

Are you starting a new business? Beginning some new investment venture?

We’ve got a little gift for you. No seriously, we do. We’ll give you one of our do-it-yourself incorporation or limited liability company formation kits.

The kits include short ebooks that give you the “how-to” instructions for setting up a small business corporation or limited liability company in your state and for dealing with the Internal Revenue Service paperwork, including getting your employer identification number.

The kits also provide boilerplate corporate by laws (for the corporation kits) and LLC operating agreements (for the limited liability companies). These documents tell you how to operate your entity.

How the Giveaway Works

Ok, this is the easy part. Go to one of our websites that sell the do-it-yourself kits. For example, if you’re interested in setting up an S corporation, go to the scorporationsexplained.com website. If you’re interested in setting up an LLC, go to the llcsexplained.com website.

Note: Our main CPA firm website, stephenlnelson.com, also provides many of the kits, and someday we’ll probably provide all the kits from this blog, but hey, right now we’re doing this giveaway on a whim and shoestring.

After you get to the right website, use the list of states that appears on each page to find the appropriate state kit you want. For example, if you’re setting up a corporation in Texas, find the Texas incorporation kit page at the S corporations explained site. If you want to form a Florida LLC, you find the Florida LLC page at the LLCs explained site.

Once you find the right page, click the page’s “Purchase and Download” button.

Yes, I know. It looks like we charge for the kit (and in the past we have), but if you know the following discount code, which you enter into the popup shopping cart window, you can download a kit for free:

stephenlnelsoncpa

You will need to provide some contact info (including an email address we use to send you a backup link for downloading the .zip file with the kit). But that’s it.

The kit, by the way, should mean that you don’t need to pay some online incorporation service $500 or more or some attorney $1000 or more to form a limited liability company or incorporate. Good deal, right?

Some Suggestions for Background Research

If you need some help getting questions answered before you form an LLC or set up a new corporation, you probably want to review the FAQ pages at the two sites that provide the downloads. The FAQ page at the S Corporations Explained website, for example, answers dozens of questions that people often have when they go to set up an S corporation for the first time.

Ditto for the LLCs Explained website. It also provides a rich FAQ page you can use to get most beginner LLC questions answered.

Why We Do This

Well, first, we like providing entrepreneurs and small business owners with a truly low-cost way to set up a corporation or LLC.

Plus, the do-it-yourself kit giveaway lets us promote the three e-books we actually sell at our websites (including this blog) and also (hopefully in a classy way) the accounting services we provide to small businesses and their owners.

The post Download a free incorporation or LLC formation kit appeared first on Evergreen Small Business.

In earlier posts, I’ve described how to set up your own Washington corporation or limited liability company. And I’ve talked about the rules for and benefits of making a Subchapter S election.

In this post, I want to quickly describe the steps for making this election using the IRS Form 2553:

1. Download the election forms.

Download the IRS 2553 form from the Internet Revenue Service website. While you’re there, you may also want to grab the form instructions (though I’ll probably provide the step-by-step instructions you need in this post).

2. Provide the entity’s name, address, and EIN.

At the very top of the Form (see figure below), in the block labeled “Type Or Print,” you enter the name of the corporation or LLC, the street address, city and state, and the employer identification number. You also need to enter the date of incorporation, which is the actual incorporation date for a corporation and which should be the Subchapter S election date for an LLC.

And two quick notes: First, for an LLC, the 2553 election date is the “incorporation date” because prior to the S Election, the LLC is considered either a sole proprietorship (if it has one individual member) or a partnership (if it has multiple members) for tax purposes. Second, you do want to mark one of the applicable checkboxes in Box D if after receiving its EIN the LLC changed either its name or address.

3. Indicate the effective date.

Use Box E to indicate when you want the S election to become effective. Usually, you want to make the S election effective as of the start of the calendar year (if the entity has been in existence in previous years) or at the start of the entity’s existence (if the entity has just been created in the current year).

For example, if you’re turning an LLC that has existed for many years into an S corporation, you would probably want to make the S election effective as of January 1 of the current year. And if you’ve just created a new LLC as of, say, April 23 of the current year, you would probably want to make the S election effective as of that April 23 date.

4. Specify when the S corporation’s tax year ends.

S corporation fiscal years can end on December 31, or on the last day of September, October, or November. Having a non-calendar fiscal year—an accounting year that ends in September, October or November—only complicates your tax accounting and produces no real benefit for you, however. Accordingly, you almost certainly want to mark the Calendar Year option in box F.

Note: If you think you want a non-calendar fiscal year end, you shouldn’t make the S election yourself. You should confer with a knowledgeable tax practitioner.

5. Enter your name and telephone information into Box H.

This tells the IRS who to call if they have questions about the S election.

Note: In the area beneath box H, the IRS provides space for you to explain why you’re filing a late 2553 election. You shouldn’t need to use this space if you’re filing the election on time. People use this space when they miss the deadline and then need to file the 2553 form late with the actual S corporation return.

6. Sign the S election Form.

You’ll also need to sign and date the S election 2553 form at the bottom of page 1 (See earlier image) where the form asks for the signature and title of an officer. You may not have a “rea”” president or chief executive officer if you’re an LLC and not a corporation. However, you might as well identify yourself as the LLC “president,” “vice president,” or “treasurer.”

7. Name and get signatures from shareholders and spouses.

On page 2 of the 2553 form (see figure below), use columns J, K, L, M, and N to name each shareholder in the new S corporation. You need to provide each shareholder (or member) name and address in column J. You need to have each shareholder sign and date the S election in column K. You must use column L to identify the number of shares that each shareholder (or member) holds.

If members don’t hold shares but only percentage interests, you can enter those percentages into column L. You need to enter each shareholder’s social security number into column M. Finally, enter the month and day that each shareholder’s tax year years. (This should be December 31 in case of individuals.)

If any of your shareholders reside in a community property state (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, Wisconsin, and sometimes Alaska and Puerto Rico), the spouse of a shareholder must also sign the S election even if the spouse doesn’t own shares or an interest in the S corporation. Note that in the case of non-shareholder spouse, no stock is owned so a “NA” for “not applicable” can go into the Number Of Shares column and you can just put something like “spouse” into the Date column.

Note: You won’t need to worry about the third page of the 2553 form (see figure that follows). However, you should include the blank third page in the envelope or in the fax you send the IRS simply to show them the page is blank.

8. Fax or Mail the 2553 Form to make the federal S election.

I used to suggest that people mail the 2553 form using certified mail with a delivery receipt. I made this routine suggestion because if you mail the Form 2553 using certified mail with a delivery receipt and the IRS service center loses the 2553, you can often use a copy of the 2553 and your certified mail delivery receipt to prove a timely election—even if the March 15th deadline has past.

Certified mail with a delivery receipt isn’t a bad idea, but nowadays, the IRS is so forgiving about late S elections that it’s probably just as easy to fax the completed 2553, cross your fingers, and then make a late election via mail if there’s a deadline problem. Washington corporations and LLCs can fax the completed form to (801)-620-7116 or mail the form to:

Department of Treasury
Internal Revenue Service Center
Ogden, UT 84201
Fax: (801)-620-7116

Note: If your principal place of operation is not in Washington state, you may need to send the 2553 form to another location so check the 2553 form instructions for that address.

The post Steps for Electing Sub S Status for Washington LLC or Corp appeared first on Evergreen Small Business.

Both Washington state corporations and limited liability companies can elect to use the tax accounting rules described in Subchapter S of the Internal Revenue Code to save thousands in taxes each year. These corporations and LLCs, which are commonly called S corporations once they’ve made the election, become small business corporations in the eyes of the Internal Revenue Service.

Note: I’ve got a long page here that describes just what the S corporation tax accounting treatment does.

Which LLCs and Corporations Are Eligible?

In order to become an S corporation, a Washington corporation or LLC must meet several requirements.

• All shareholders (and shareholder spouses in community property states like Washington) must consent to the S election.
• The corporation or LLC electing S status must have only one “class” of stock ownership treating all members the same way.
• The corporation or LLC generally can’t have more than 100 shareholders (except that families of shareholders count as one shareholder for purposes of this test).
• Shareholders in the corporation or members in the LLC must generally be either U.S. citizens or permanent residents, estates of U.S. citizens or permanent residents, or certain trusts and charities.

Timing the Subchapter S Election

To make the election to be treated as an S corporation, you should file Form 2553 with the Internal Revenue Service by 15th day of the third month after the tax year for which the S election is to be effective starts.

For example, if a corporation or LLC exists on January 1, you should file the 2553 by March 15 of that year. If the corporation or LLC comes into existence on June 1, you should file the 2553 by August 15 of that year.

Two Timing Wrinkles

Let me mention two other wrinkles related to the Subchapter S election.

The first wrinkle? Currently, the IRS is very, very, almost pathetically lenient about late Subchapter S elections. If you want to make a late Subchapter S election, you need to locate the most up to date rules for making a late election and then follow them precisely. But if you do that, you should find yourself able to make very late elections. (At the time of this original post, the rules for late election relief appear in Rev. Proc 2007-62.)

The second wrinkle concerns LLCs. Even without the late election relief stuff, you can (for reasons too complicated to go into here) always make an S election for an LLC that becomes retroactively effective 75 days back. In other words, if you had a Washington LLC in place on January 1 but then near the end of the year (say November 15) you decided you wanted to make an election. You could go back 75 days from November 15 to September 1.

Again, note that this weirdness is something different that the late election relief you get by following the rules provided in Rev. Proc 2007-62.

You may want to ask your tax advisor for more information, but the “start date” for the 75-day count down starts on the effective date of your Sub S election.

The post How to Make S Elections for Washington Businesses appeared first on Evergreen Small Business.