Insights into Value Creation and Achieving Optimum Exits
This Edition's Topic
Becoming an S Corporation: Consider Your Exit at the Beginning
By Valerie Moseley, CPA, Guest Contributor
Valerie is a Founder Who Took Her Tax Business from Launch to Exit Over an 8 Year Span
Valerie Moseley is an entrepreneur, CPA, tax specialist, board member, and mentor. After spending many years as a contributor within tax accounting firms she bravely stepped out on her own and launched Moseley and Associates. The practice thrived over the next several years, grew a long list of clients, and employed a small group of talented experts. She sold the company after eight years and now operates as a solopreneur focusing on emerging and growth stage companies.
A Founder, His Buddy, and a Tax Accountant…
Your buddy at the cocktail party (a.k.a. virtual happy hour) tells you, ‘hey, you gotta become an S Corporation, cuz dude, it saved me tons!’ And then you call your accountant, ‘hey, my buddy says I’m a chump if I don’t make the S Corporation election.’
Well, yes, there can be some tax savings involved with an S Corporation election, but I see many folks jumping into an S Corporation without thinking past those tax savings. Let’s do a quick breakdown.
When Does an S Corporation Become Attractive?
In the eyes of the IRS, your sole proprietorship and you are the same thing. You don’t take a salary or a wage out of the sole proprietorship; instead you are just taxed on the profits of the company, no matter how much cash you leave in or take out. So, at what point does an S Corporation become attractive?
When the Business Becomes Bigger than You!
Imagine for a minute you had to hire someone to replace you at a reasonable wage, taking into consideration your duties, the current employment market in your area, and so on. Is there any profit left in the company after paying out the wage? If no, then there are no tax savings to be harvested. If yes, then it's time to talk to your CPA. The actual inflection point will change based on current tax law, but this is a good rule of thumb to keep in mind.
Consider the Additional Costs…
When doing the math on whether or not your business should become an S Corporation, don’t forget to add in the additional costs. An S Corporation tax return will cost you additional fees. You will also have to pay for payroll processing because you will become an employee of your company. And, if you were keeping okay books before, they need to become great books (the S Corporation tax return requires additional details). So, you may need to pay for more or better bookkeeping.
Once You Are In, It’s Hard To Get Out…
Getting into an S Corporation is easy; it only requires filling out a few boxes and signing the form. (The IRS is even pretty cool if you accidentally file it late!) But don’t let that ease fool you.
Revoking your S corporation election is a taxable event!
I hear lots of clients say, oh, that doesn’t matter, I’m going to sell before I would ever have to revoke the S election. If you’re reading this blog, selling is indeed likely your #1 plan. But #1 isn’t always how it goes; I’ve seen it. A trusted partner does something fishy and you have to split up the assets and go your separate ways. Your dream buyer never materializes, and you decide to downsize. Or, you may find an investor who wants your company to be a Partnership or C Corporation and accommodating them is important to your deal. So, before you sign at the bottom of that oh-so-easy form, run some scenarios. Your CPA can help you calculate what that tax hit might be and may be able to help you mitigate the worst of the hit.
The Fine Print…
If you are considering becoming an S Corporation, be sure to talk to your CPA about the details. For instance, S Corporation can’t have more than 100 shareholders. There are limitations on who can be an S Corporation shareholder. The timing of the election can be important. Only certain kinds of underlying companies can make an S Corporation election.
Should You Thank Your Buddy for The Advice?
Turns out your buddy at the virtual happy hour could be right, but he could be hasty. Be sure to think all the way through to the end before jumping in.