In this webinar we’ll discuss the benefits of choosing S Corporation status for tax purposes compared to filing as a sole proprietor using Schedule C. Explore the advantages of forming a partnership or operating as a sole proprietor, along with the nuances of a single member LLC. Gain valuable insights into the tax implications and potential savings associated with each entity classification. Don’t miss our expert panelist, Joshua “JJ the CPA” Jenson, a renowned national speaker, author, and practicing CPA, as he shares his expertise in tax planning strategies. Register now to optimize your entity classification and maximize your tax advantages.
Entity classification, the tax advantages of filing as an S-corp instead of filing a Schedule C. Hi, I’m Mike Vannoy, vice President of Marketing at Asure Software. This is a really I, I think, wonky topic that a lot of entrepreneurs don’t necessarily think about, but it’s one of the easiest ways to add money to the bottom line by cutting out expense from their business. You’re gonna have to, you hear it from a CPA to really unpack this information, but there’s some, most companies, most entrepreneurs, you know, they, they hang a shingle up for themselves. They are a great carpenter. They’re great at doing hair, they’re great at artists, they’re great at whatever they do. And as they add employees, they’re unaware of the tax ramifications of some of these decisions, or may I say, non-decision. So I have the perfect guest for this topic today.
Jj the CPA Joshua Jensen JJ is a national speaker, author practicing c p a with 30 years of public accounting experience. His YouTube channel, jj, the CPA, has over 79,000 subscribers, more than 6.6 million views. JJ has authored two books. He’s traveled over 50 cities presenting tax courses to thousands of fellow CPAs covering the latest tax laws and strategies. He’s founded his own c p a firm at the age of 25, and still serves and advises his own private clients today. JJ also manages his life and disability income insurance practice. Jason Jensen Insurance, j jj, welcome back to the show.
Hey, thanks, Mike. I appreciate that. You’re right. It’s such an in important topic, and what I love about Asure and what you all provide not only to your customers, but the business community at large is just basically putting a spotlight, spotlight on really important issues just like this.
Yeah. And so a lot of what we talk about on this show, you know, it’s really payroll centric, it’s HR stuff, how to build greater, better teams be more productive, stay compliant in the process. But this one is, this one’s kind of tax CPA wonky that I think a lot of entrepreneurs miss because as they go from zero employees, they hang on the shingle for themselves, all of a sudden they start to grow and they become a 10, a 20, or 50 person company. They’re unaware of some of those tax advantages for a different type of entity classification. So maybe, maybe before we start getting into specifics about why you should classify yourself as an S-corp, can you even just explain what, what does entity classification even mean? And then let’s kind of walk through the, the, the, the most common types.
You bet. So the biggest thing for most small business owners, and I’ll be honest with you, even still today, I’m surprised at fellow tax pros, bankers other type of professionals that work with small businesses that really can’t get this very beginning part straight, which is this, when you’re talking about your legal formation. So what kind of legal entity are you that is strictly with the state that you’re in with the Secretary of State to be specific, and you’re either an L L C or you’re an Inc or you’re a limited liability partnership. There’s not that many really to pick from, but really think of it as that is then your start point, and that’s how your business comes alive. Then when you say entity classification, that is only then determined with how you plan to tax yourself or your business with the I R S, and there’s really not that many to pick from.
Really starts with if you’re just basically a very, very small entity with very little net profit, and maybe you’re unsure if this is gonna be something long term. You can be a sole proprietor filing a Schedule C if you’re a farmer, it’d be Schedule F. If you are then a have at least two owners. You can be a partnership. Or if you’ve got one or more owners, you can be an S-Corp or a C-Corp. So those are the entity classifications that you pick from after you determine how you wanna be taxed really at the entity level. In terms of your legal designation, and I’ll just say this, if you’re in Inc, well then you can only be an S-Corp or a C-corp. If you’re a L L P or some kind of LP limited partnership, well then you can only be a partnership.
What we recommend, and it works really in most states, and it definitely works in mine, is that you just simply be an L L C, which is a limited liability company. And the reasoning for that is that the i r s allows an L L C to be then taxed as anything from the standpoint of you fill out a form 88 32, and you literally check a box of how you want to be taxed, whether it’s a disregarded, which just means it doesn’t file a separate return or an S-corp. That then requires you to take an extra step, which we’ll talk about or to be a corporation, and then you start filing the tax return based on how you’ve selected your entity classification with the I R S. And then here’s what’s key. Whatever you elect to be taxed as with the i s, then that’s how you’re going to follow the tax laws.
So there’s not laws specific to L L C or inks or LPs, because what the IRS looks at is, well, how are you taxed? So that’s the biggest thing that I think people miss, is they get caught up in getting confused on these two issues. But really, when you understand it, like we are talking now, yeah, hopefully it kind of clears the smoke and lets, you know, kind of what you wanna be focusing in on, which in my opinion is yeah, having legal protection, that’s why you have the entity set up with the Secretary of State, but then what’s going to yield the most tax favorable circumstances for the kind of business that you’re in?
And I think a lot of entrepreneurs, if you’re the kind of person who’s willing to take the risk of putting a shingle up for yourself, and you start your own business and you’re the, you’re the only employee, maybe sole proprietorship, just that kind of resonates with your head. And so you think, okay, that’s what I’m gonna do. Oh, but you’ve also heard of that you wanna limit your liability. So I should probably set up an llc, a limited liability corporation. And it’s more about, I, I think most entrepreneurs understand the limitation of liability. We don’t have to spend a ton, ton of time there. But no thought is ever given to the taxation. So I, I, we’re gonna spend the meat of our conversation on S-corps and, and the taxation aspect, but I don’t want to Asureme with too broad of a brush that this is automatically the right decision for everybody. Can you maybe unpack what would be some of the reasons why someone might, you know, you alluded to one, but why, why would someone be a sole proprietor? Is there a good reason to ever stay as sole proprietor, partnership, et cetera?
Yeah, and the, the one thing I always tell people with even my own clients, if they’re starting a new business, is day one, step one, set up an L L C. Because you’ve separated that business from you personally. You’ve taken that first step to the liability protection, and as we just indicated, you can be taxed as anything. And so the next step is if somebody’s just really starting the business, they’re maybe not sure that they’re going to continue it. They wanna kind of dip their foot into the deep end and see is there really a business here? Then I say, you know what? Just be a sole proprietor, file a schedule C and really remain that maybe until you are netting regularly, maybe more than 20, 30,000. And then you should start considering your other options. And the reasoning for that is that when you’re a sole proprietor, that’s filing a Schedule C, that would be an llc, single member filing a Schedule C.
There’s lots of terminology that people come up with. But at the end of the day, if you are filing a separate return and you become an S-corp or a C-corp, there’s gonna be a separate bank account required financials are gonna be needed. There’s gonna be more sophisticated, basically tracking of your income and expenses expected, not only by the I R S, but the banks and third parties that you may be relying on. And that all then equates to cost, right? And so what it really comes down to with my clients is I say, Hey, listen, until you hit about 20 or 30,000 net, you’re probably gonna then basically pay self-employment taxes to the same amount that you would probably have expenses to take your business to the next level with the sophistication of doing something else. And so, like I said, many clients, their first year, we got ’em as an L L C, we filed a Schedule C.
Also, if you have a loss, you don’t have to really get concerned with what’s called tax basis to allow the loss, which we’ll talk about. But the biggest downfall, and I’ll just put it that way to a Schedule C, is that you have zero control to the net income being subject to an additional tax in addition. And that, that’s exactly what I mean to your regular income taxes. So if you’re not a sole proprietor, you’re not a business owner, you get your wage interest, dividends, et cetera, you figure out what that income is, minus standard deduction or itemized deductions, it arrives at taxable income and you pay regular income taxes on it. And then if you’re a sole proprietor, you’re gonna pay all that same tax. So whatever your business nets, you’re gonna add that to it, you’re gonna pay regular income taxes, but specific to a Schedule C, then whatever that net income is, there’s gonna be a separate line item under other taxes, it’s self-employment tax, and you’re gonna pay 15.3% additional tax on that net as a sole proprietor.
And that’s gonna then add to or be on top of your regular income taxes. So if you were to net a hundred thousand dollars, let’s just say for grins with a dual income, let’s just say all knowledge, your income tax might be, I’m gonna low ball it, just call it maybe it’s 10 grand, maybe 10 12 grand. But if you net it a hundred thousand also as a sole proprietor, in addition to that, you’re gonna pay another $15,300. Now it does cap out in 2022. It caps out at 147,000. And in 2023 it goes up and it’s somewhere around 160,000 self-employment taxes, social security and Medicare taxes. And I want us to remember that 15.3% cuz it’s gonna come in key when we talk about S-Corps here shortly. But when we talk about that additional tax, the the downside, as I was indicating, is not just that it’s an additional tax, but you have no control, meaning whatever the net is that’s subject to that additional tax.
So let’s just go back to my example. Let’s say somebody $20,000, well, at 15.3%, that’s gonna be an additional $3,000, right? In these self-employment taxes. But if somebody then goes to the next step to make a entity classification with the IRS to either be a C-Corp, S-corp or partnership, there’s gonna be these additional costs with private parties, not with the irs. And at best it might save you then this $3,000 in self-employment taxes. So what I tell people is, well, don’t go over here and spend three grand if all it’s gonna do is save you three grand in taxes, let’s wait until the business is off and running. And then when would you wanna remain an as a, a, a soap proprietor is you kind of have a side gig that you’re gonna net 20,000 or less. It probably just would make sense to continue to be a Schedule C.
Yeah. Yeah. This might sound like a stupid question, but I I I I, I’m certain there are some people in our audience, what is a Schedule C, right? So and and difference between what, so I guess what I want you to talk through is not just what is a Schedule C, but what is it about a Schedule C versus having a a, like an S or C corp that is a separate entity that gets taxed, has different tax returns, what flows to your personal, what doesn’t in the, in the different scenarios?
Yeah. So really simply a Schedule C is then just a schedule that’s attached to your Form 10 40. So it gets filed with your individual return, which more also is that you’re not filing a separate and distinct tax return for your business from your individual return. And so the other attracted part to that is just that it’s like, well, I just put my income in my expenses, I put it on this form, schedule C goes with my form 10 40, I don’t have to file something separate. So when you’re a C-Corp or an S-corp or a partnership, then the business income and expenses are gonna go on a separate and distinct business tax return that gets filed separately from your individual return from partnership and an S-corp, whatever the net income is, then you will pay tax on that down at the individual level. Stated another way, there is no tax at the partnership or s-corp level in terms of federal taxes.
So the thing that I always point out to everybody is that, in that example I told you that if you were to net a hundred thousand, well, if you have two or more owners and you are electing to be a partnership, and that partnership nets a hundred thousand dollars and what’s common is you would have two spouses that might own that partnership 50 50, well, down at the individual level, they’re gonna show a hundred thousand in that net income and they’re gonna pay income taxes on it, just the same as Schedule C works just the same with an S corp. If that were to net a hundred grand, well, because that S corp has what’s called a Schedule K one that then gets reflected and that owner, the individual, they’re gonna then pick up the a hundred grand. So as you can tell, no matter where you have your business and how you elect for it to be taxed, someone’s paying tax on that a hundred thousand on the net.
But the difference is with the Schedule C, meaning you haven’t filed a separate and distinct return, well then no matter what, whatever that net income is, is gonna be subject to the self-employment tax just really quickly with a C-corp, many get easily kind of in a daze because the C-corp does pay tax on its net income, and that net income tax rate is 21%. So immediately anybody looking at this will go, wow, that seems like a much lower tax rate than my personal rate, so I wanna be a C-corp. The the problem there is that the only way to get money out of a C-corp is to pay yourself a dividend or wages. Well, if you pay yourself wages, you’re paying regular income taxes on it, as well as then payroll tax, which employee or employee com combined is 15.3%. So that’s not a reason to be a C-corp.
The other is, if you pull money out as a dividend, well it can be taxed as a capital gain rate, but typically that’s gonna be at least around 15%. And that’s kind of a flat rate, unless you don’t really make any money, it could be lower as a 0%, but most people that are business owners are gonna be up in the 20% capital gain rate. So all of a sudden the money that you pull out, you’re paying tax at 20% at the individual level net investment income tax. If you make over two 50, the individual level hits. So you’re paying 23.8%, and then for the C corp it paid 21%. So all of a sudden you’re looking at this and you’re like, whoa, I’ve paid, you know, almost 45% in taxes. So for somebody that’s less than typically in, in our opinion really less than maybe 10 million in net, really would never see a reason to consider being a a a C corp. But of course, there’s people that can listen right now and have a whole bunch of reasons why you should be a C corp. I’m just saying in general, one to two owner, 10 or less owners, your net and less than 10 million not really a great option there for you. So really at the end of the day, then that’s where
With a C corp is there an advantage over S corp for retained earnings. Like, so it’s, it’s, it’s more expensive to pull the money out, but if, if you got, you know, you got a great business on your hands, maybe it’s still under 10 million, but you’re trying to build something big, you’re trying to build a 10 million, a 20 million, a 50, a hundred million company, this, this is a, it’s, it’s tax beneficial to leave the money in the business and not be taxed. Am I saying that right?
Yeah. So really the thank you for that clarification on that. So yeah, if somebody’s coming to me and they’re building something that they wanna have a ton of owners and investors and they’re really just gonna pull a salary out, they’re trying to put something together to your extent of income, maybe they’re gonna go public, they really wanna get this up and running and then merge or sell it. Meaning if they’re not interested as in the owners of getting to that net income, then yeah, a C corp can make sense. But most small business owners, you know, they’re wanting to get a salary and then they’re hopefully adding to their lifestyle by pulling out the net. But you’re, you’re great point there. So here’s why I just say you’re gonna have a lot of owners, investors and you and or you wanna grow this to then sell it and you’re not interested in pulling out a lot of profits, then yeah, the C corp can start making a lot of sense.
Yeah. Okay. Let’s kind of, so I, I think we’ve covered it, covered the, the periphery. Let’s, let’s narrow in here on, on S-corp. Why, and, and, and, and, and you, and you’ve given a couple use cases, but let’s really break it down what, why entrepreneurs should do it if you’ve kind of said that, but then what do they need to do and what is the specific impact of filing a a changing entity classification? So I’m rambling here, but what do they first need to do to, to change classification? And then what do they need to do from a tax filing perspective? Then let’s talk through some use cases about, you know, before or after impact.
Yeah, so with the S-corporation, typically if the client is gonna be actively involved in their business, then the S-corporation is really just a no-brainer. And the reasoning for that is that the net income from the S-corporation is not subject to this self-employment tax by law. But if for whatever reason, let’s just go with at the beginning, you are a Schedule C, so you’re not filing a separate return, but you are an L L C, then there’s a form 88 32, again, it’s a check the box, it’s actually says at the top entity classification. And you would follow the instructions literature pretty straightforward and check the box that you now want to be taxed as a corporation. And then you would then file a form 25 53. That’s a separate form with the irs. Again, pretty straightforward, but the form 25 53 says, well, I want my corporation to be taxed as an S corporation.
Now I’ll just tell you this, if initially at the very beginning you’re just gonna out the shoot b an S corp, then the IRS does allow you to just skip the step of the form 88, 32 and just file a form 25 53. But I’m gonna give a caveat to that, Mike, because about 50% of the time, if we follow the steps that the IRS tells us, we may get a letter back from the IRS that says, oh, you gotta file form 88 32 as well. So I’m just telling you what the IRS instructions say to do. And with that once you become an S-corporation, then you do have to remain an S-corp for five years. That’s where you’re tied into that, and then you’re off to the races. Now you will need to file this separate return, which is a form 1120 s, and that is then where you report the income and the expenses of the business.
Okay? So the average entrepreneur, they start as some L L C, but not esco sole proprietor partnership, some LLC not classified as S corp. They file the appropriate paperwork either on their own or presumably through the cpa. Like, like yourself, I, I think we should probably note folks listening. Don’t, don’t be scared. JJ amazes me the way he rattles these <laugh>, not just forms, but which specific questions and IRS FAQs off the top of his head you don’t have to know all this stuff. Your CPA is gonna know this stuff for, for you, right? So but the point is here, hey, get re fellow the, the, the proper paperwork to, to reclassify as an S-corp, okay? Now I’m classified, what do I, what are the requirements that I need to go through that are beyond just, okay, now I have a corporate tax return and my personal tax return. There’s some other things that involve payroll to make this a a, a tax advantage for you.
Yes. And what I would say is, you know, when you’re a sole proprietor the IRS really just sees you and your business as no separation. Now, from a legal standpoint, you’re separate. But the reason I say that is the IRS doesn’t care if you have a separate bank account. They’re not gonna be worried where your assets titled in the business or not. But when you become an S-corp, and this would be the same if you’re a partnership or a C-corp, but when you become an S-corp, then you need to have a, a separate and distinct bank account that all income that you’re planning to be taxed as the S-corp is gonna go into that bank account. And then all expenses are paid out of that. If you get a credit card, then you would have a credit card that the s corp, that bank account would pay whatever the credit card charges are.
And then I, this is where we get into a lot of opinions amongst tax pros and CPAs and EAs in terms of now the next topic, which is having payroll to yourself as an owner. So what the i r s looks at, and this is where it gets into opinion, is that technically the I r S doesn’t require a wage to be paid to an owner. And when I’m talking about require, I’m not talking about our emotions about it or what we think or folklore or if the iris were to audit, they would say, where’s the wages? I’m just saying when you go to form 1120 s and when you look at the rules and the law, there is, there’s actually no requirement. And that’s where then the S corp can get a little dangerous because people look at it and they either come up with an opinion of, well, I don’t have to pay myself anything.
So what comes into play is that the IRS does indicate that a reasonable wage, a reasonable compensation, does mill still need to be paid to the owner. And so with that being said, I’ll just go right to, that’s usually the biggest hurdle for someone deciding to be an S-corp is, well, now do I have enough money to pay myself and do I have enough going through my bank account to pay myself regularly as a wage? I’m not talking about writing yourself a check and then the memo calling it payroll, I’m talking about through what we’re getting ready to talk about. But then there’s a cost to it. And really it’s almost like no matter what you’re having to pay, you can search it. So like whatever you guys are charging, extremely reasonable. I know you also do some other services but online services where you’re going through QuickBook or third party, but Mike on this issue that it’s just some expense to it a monthly and quarterly and annual expense because of all the things that have to be filed.
So what’s then a reasonable wage? Well, that’s where the crux comes in. And so I really tell my clients this, A reasonable wage is first based on your cash flow. Second, it’s based on availability of your cash flow. Third, it’s based on, well, how much money you’re actually pulling out for yourself. Cuz really what the IRS looks at is if you’re pulling money out for yourself, well, they’re gonna expect some of that to be then a W2 wage. Why? Because a W2 wage is subject to social social security and Medicare taxes, which magically when we take the amount withheld and the employer match, it’s 15.3% as we talked about earlier. It really puts you in the same position where, ah, so the S corp, the net income is not subject to self-employment tax, but the i r s is expecting, let’s be clear about that.
They’re expecting a reasonable wage to be paid based on cashflow, based on need. And then that’s the amount that is subject to that 15.3%. But the key is, as I tell clients, we have control over that. So let me give you some quick, and, and this is where there will be opinions all over the place, Mike, when I travel around the country, I always enjoy kind of as I’m trying to break up the day, I always ask my fellow CPAs, EAs, and tax pros, I say, Hey raise the hands, you know, what net income level do you think in an S-corp someone needs to start paying themselves wages? So here’s what I just say. If you’re showing a loss and you’re borrowing money, the IRS cannot compel you to then borrow more money to pay yourself a wage. The second is, is that, you know, if you’re netting 10 or $20,000, to be honest with you the IRS might look at that and go, well, I mean you’re still kind of getting off the ground.
I don’t know that you really need to pay your yourself a wage. Maybe something six grand a year, 10 grand a year. So let’s just go now to real life situations, though we’re past the losses, we’re past that low income. I just pretty much say up to a hundred thousand of you pulling money out. Okay, not necessarily a hundred thousand net. Cuz what the IRS looks at is the money that you’re pulling out. It’s either a distribution or it’s payroll. It’s the only two ways that you really can pull money out of an S-corp. And with that distributions represent the net income, which is to say it’s not taxed. Again, unlike the C-corp, when you pull money out, it’s not a dividend, it’s a distribution, which by law is not subject to an additional tax because whatever that business nets, that individual is gonna pay tax on it regardless if they pulled money out, right?
So again, the IRS then looks at, if you netted a hundred grand but you pulled out, let’s just call it 90,000 for yourself, I tell people reasonable would be 60% wages and maybe 40% would be distributions. Someone could go 30% distribution, 70%. What the IRS is looking at is that there’s an effort being made and there’s something reasonable. And the reason I say reasonable is I have clients, they have an S corp, they’re involved, but they grow the business that they don’t do anything with the S corp. I mean they have people running it, they’re expanding it. So they’re really now just an officer. So we may say, well, I mean a reasonable compensation is also based on what’s your effort in the business. So we may go down and not pay all that much. It might be more like an officer. However, most small businesses, they’re in there by the sweat of their own brow, they’re helping to generate and manage.
So then you have to look at, well what would you expect to be paid if you were working for this business a wage? And that might be really kind of a best indicator. Now most small business owners, all of a sudden they go to a mindset of like, well, I should be paid a million dollars <laugh>, great, I probably don’t disagree. But it’s then based on what cashflow. So here, let me just give you an example. So if I have a client and they’re netting a hundred grand, they’re gonna pay tax on that a hundred grand. But if they paid themselves a wage of 60,000, well then they’re gonna be able to deduct that wage to the scorp. So if somebody were to jot down, now we look at the net income after the wage to the owner of 60,000, and I understand that you could have some tax pros listening, they’re gonna know there’s some other caveats, but we’re really gonna try and keep this simple.
Yeah. So down at the individual level, they’re gonna pay tax on that $60,000 wage. And then now the business has a net income of 40,000 because the wage got deducted from that net income. But with an s s-corporation, it doesn’t pay its own income tax. That owner of the S-corp, we’re Asureming a hundred percent is gonna now pick up that net income, which is reported on what’s called a Schedule K one. But that’s gets reported down at the individual level. This is regardless if the owner pulled out any money representing that 40 grand, right? Right. But as you can tell down at the individual level, they still paid income taxes on a hundred grand. But compared to if they were a sole proprietor, what they paid that social security Medicare tax on or the 15.3% was only on the $60,000. If they later pull out distributions or during the year, it’s irrelevant cuz it represents the net income that they’re gonna pay tax on.
But on that 40,000, they did not by law, by statute pay self-employment tax or pay the 15.3 or pay the social security, Medicare, all the same thing. So what did they save there? Well, I’m just kind of rounding. Well, they just saved $6,000 in this tax. Then what the IRS would look at, and this is what I tell my clients, Mike, is that if you’re gonna pay yourself a wage of 60 grand, it needs to be regular and routine. Yeah, at least once a month, you know? But most likely if you’re paying other employees in the same timeframe in a very regular amount. The other part is if you’re gonna pull out distributions of 40 grand, I’d be telling a client, well that represents net income and leftover dollars if you will. So that probably needs to be quarterly. So if I have a client, it’s like, oh, I can’t wait that long.
It’s like, well then you probably need to pay yourself more wages. And see, this is where the devil’s in the details, Mike. So all the clients I work with, what they do is maybe four, maybe five if not three. I’ve got some clients that only do two and I’ve got a few clients that only do one distribution a year. And the reasoning for that is we don’t want it to look like this is a wage. So if the IRS were to come and look, which be be the only way for them to, to be in your details this way, and they see that you’re paying yourself a wage once a month, but then anytime you want, you pull money out of your business, you’re paying personal expenses, the IRS goes, that’s payroll. I mean that’s, that’s regular compensation. So we’re gonna reclass that and we’re gonna say that that’s payroll.
And or they come in and they go, well gosh, you’re pulling out money all the time and you’re just paying yourself a $24,000 wage. So where does a slippery slope come in? Well, this is where I make it simple for clients. This is how you’re going to, this is how you’re gonna need to approach this. So that distributions represent net income, wages represent that dollar amount where a lot of, and I’m just gonna be honest, I think a lot of people don’t then maybe spend the time with their client to talk through these things. And so the client’s kind of to their own mindset of like, well, I’m paying myself a wage, I don’t wanna pay myself any more than I have to cause I gotta pay this tax and then I’ll just take distributions as as much as I need it.
But the, the, the other thing I’m just gonna point out, Mike, and, and, and you’ll let me know how much more we wanna go into this, but then what we hear from the other side, which is a very good point, well, but if you’re only paying 60,000 in wages, then you’re only paying into a source of security and Medicare based on that because that’s all you’ve paid in towards. So what you have to look at, and you can go to ss.gov, log in, run your own numbers. Typically if someone pays themselves 60 grand a year, they’re gonna have probably hit the full max. So people have to make their own decision. But just because you pay yourself more wage doesn’t always lead to more and more and more from social security in retirement cuz there’s a max that people can qualify for sure. But most small business owners, what we have to remember is this is what are we doing in the beginning and the next step and the next step and the next step.
So if somebody’s now able to pull out more than a hundred thousand to themselves, well then we’re kind of looking at, okay, we have more money to work with. What would then be a reasonable wage? That’s really look at what you’re doing here. But Mike, I’m gonna be honest with you, the client that does one distribution a year, okay, they pay themselves 244,000 a year to max out the retirement. They have about 10 employees, they work every day and they pull one distribution a year and it’s about 1.5 million. So the 244,000, well we’ve paid the max social security into the IRS on those wages. That’s very reasonable based on what this person does. And them pulling out that huge amount once a year as a distribution, pretty clear that’s not payroll. Pretty clear that’s based on distributions, right? So I don’t know how the IRS could combat.
So it’s not just always laid down as well. The money I pull out, I gotta do a certain percentage of payroll, at least in my mind. Okay? So what that requires, Mike, is that you have a relationship with your tax professional to talk it through and vice versa, a tax professional take time to talk with their client to kind of figure out what they’re doing. Cuz I’m telling you the client that we do an annual wage of 6,000, well he has four s corporations and one of his s-corps, he pays him to have 244,002 of S-corps. He doesn’t pay any wages out of it cuz there are no wages out him. It’s completely, pretty much a, a conduit in between several companies. And then the one, he’s got all these employees running and he pays himself 6,000. So with this, I, I know we’re kind of getting beyond the step of sophistication, but I’m more kind of pointing out that you have to really look at the facts and circumstances, but hopefully I’ve kind of laid out enough to give some ideas of, well, when do these things come about?
So, so I want to, I’m gonna attempt <laugh>, I’m gonna attempt to kind of recap a super simplified version. You tell me if I’m understanding it right. So I’m an entrepreneur, I’ve got a nice business on my hands. I’m, I’m generating $500,000 a year in revenue. I’ve got $400,000 a year in expenses. So I got a 20% margin business. So I, I have a hundred thousand dollars left over regardless of how I think about classifications. I’ve got a hundred thousand dollars left in my pocket if I, if I’m operating as a sole proprietor, I gotta list all these details on the Schedule C for my normal individual tax return. And so I’m paying full tax on that entire a hundred grand if I reclassify to an s escort and give myself a reasonable wage. And you, you, you took us through a bunch of nuance about what reasonable may or may not be, but Asureming I’m a daily operator of that a hundred thousand dollars if I put myself on payroll.
And so I am now a W2 employee and I’m getting paid biweekly like the rest of my staff for $60,000, now I’m paying, you know, state, federal, normal employment taxes on that 60. But I, and I’ve got another 40 that I is still income to the business. It’s still taxable whether I pull it out or, or not. But that’s 60,000 so I’m paying tax on it, but now it is a business expense, therefore reducing my adding to my $400,000 expenses. It’s now 460,000 expenses. The business only had profit of 40,000. So what falls to my personal tax return is a smaller dollar amount. The punchline is by simply putting myself on payroll, I’m literally reducing my tax burden. I’m gonna incur some additional expense cuz I’ve gotta pay for payroll, I’ve gotta have the separate bank accounts. I’m gonna have a little more money flown to my cpa. But in general in that scenario, we’re talking about a roughly $3,000 versus $6,000. If you got a hundred thousand profit in your business, you could be putting three grand in your pocket just from an entity classification and just simply changing the way you do your, your business as is without a heck of a lot of extra effort. Am I oversimplifying that?
Not at all. It was so well stated, Mike. I wish I could, I wish I could say it that simple cuz you said it so perfectly. The only thing I’ll add is on that 40,000, actually you’d save six grand because it’s 15.3% savings on that 40 grand. So you were running a lot of detail. I’m not gonna hold you to the math cuz I tell my own clients, listen, I’m using a calculator, all right <laugh>, I’m using a calculator, but I’ll I’ll just say you’re, you’re saving that 15.3% on the 40 grand so it save you six grand. That’s the punchline. But Mike, really with that what it comes down to is then does the client want the hassle of all that? And many go, you know what? I don’t want the hassle. And there’s a lot of tax pros that actually say, I mean I’d probably say 30 to 40% of tax pros would say don’t become an S corp until you’re netting a hundred grand.
And that’s where I look and I go, boy, if we could save six grand a year, even if you netted a hundred grand forever, if you could save six grand a year for the next 10 years, 20 years, I mean this starts to be a real dollar amount. Yeah. And maybe not dollars to just go out to eat more often, but maybe you’re now using that because before, if you’re, and I’m just gonna use the term cuz I do it on my YouTube channel, if you’re gonna be lazy, you’re gonna be a lazy tax preparer. And don’t, don’t use that on a thumbnail <laugh>. If you’re gonna be a lazy tax preparer or a lazy business owner then what you’re gonna say is, well, I don’t want all that hubbub, so I wanna pay the full amount. I’m fine overpaying by six grand if you will.
And I’m not sophisticated enough, I don’t think my client’s sophisticated enough to take the 6,000 a year and put it in their own retirement account. Get the deduction for it. Because at 60 grand you’re gonna be putting a lot towards your own social security. Number one. Number two, that six grand over a 30 year career, cuz that’s what the s the Social Security Administration looks at, is what were your wages over a 30 year period, you get the 30 highest. So let’s just go now, apples to apples, if people are gonna really argue the point other than just getting emotional about it. So six grand a year for 10 years, what’s that? 60,000? What’s that? Over a 30 year period. $180,000. As many as people think that social security is wonderful, I do, I think it’ll be around. I’m not any, I’m just not cynical about it.
I think it’ll be around for my kids. Yeah. But at the same time, most of us are not going to live much beyond maybe 10 years. I mean for just doing national average on social security, meaning the average for a man is mid seventies and a woman a little more than that. So where’s that 180,000 gonna be more valuable to you upfront in retirement. Whereas social security, which is great, it’s wonderful, everybody has different opinions on when you should take it. The end of the day you’re gonna get it at some point. But my whole thing is, is that I work with clients that by educating them, they’re not lazy cuz they don’t wanna be because they wanna save tax, they wanna have control. In most small business owners, they wanna have control. Why? Because they don’t wanna work for somebody else. Why? Cause they don’t want someone else telling ’em what to do. They want to have control of their destiny. Well, isn’t this another way to control your destiny on this? So it just always baffles me and I always have fun kind of sparring with those that say on the a hundred thousand that would be a good point. So really what it comes down to, I spent all that time just adding a bunch of flare. But again, you, you really nailed it on the head there, Mike. And it comes down to about 6,000
Just kinda how I think about it. And so why I appreciate dare I dare I call it your wonkiness. I mean you obviously know this stuff inside and out in, in a way that the average entrepreneur never will. In what I wanna make sure that we don’t do is that we make this sound so complex and all there, there’s all these caveats and nuances that we scare people. If you’re if you’re a manufacturer producing widgets and you had a chance to switch suppliers, which might be a little bit of a pain, but to save $6,000 a year, you, you would, you of course you would do it right? If you are a construct, they run a small construction company remodeling some kitchens and bathrooms and you found a supplier of granite that you could charge the same to clients, but you saved 6,000 on the backend, that’d be a little of a pain.
You got some new just things to switch, but of course you would do it. I think my coaching to small businesses would be form this, form that nuance here it is complex, but that’s why you have tax pros, right? That that’s why you have a financial advisors to, to walk you through this and take you through this. The punchline is if you have a profitable business, you’re being taxed on the profit whether you like it or not, right? So you, there are major tax advantages to the tunes of thousands of dollars that go straight in your pocket by simply reclassifying to scorp claiming the payroll expense in, in, in trusting your tax pro to to, to navigate you through the process. I think it is that simple in in why. Nailed it. Entrepreneurs nailed, should not be afraid of this.
Well, Mike, I’m gonna be taking notes after this because you’ve given me some good language to add to some of my videos. You know, as a cpa, our training, you know, same with EAs and tax pros, you know, we know that well, you gotta do these little things. You know, I get caught up in that a little bit cuz it’s like, well to actually do it, but, but let me, let me just add to what you said by saying it’s actually only complex the first day, meaning, right, you set up an L L C at the Secretary of State. Ooh, it’s scary. You got it done cuz you got it done in one day. What’d you immediately do after that? You went to irs.gov and in five minutes you have an e i n whew, got through it. Alright? Take a deep breath. What’s the next thing?
I’m gonna go find these forms that somebody told me 88 32 or 25 53 how irs.gov search the form. And I’m telling you, I get it, if you don’t know it, 25 53, maybe it takes you an hour even though I can complete it in five minutes. Cuz there’s only like 10 line items. You actually complete name of the business. When do I want the s corp sign it? You send it in. Then on that same exact day, you go to your bank and you say, okay, here’s my llc, here’s my e i n I wanna open a bank account. You put a hundred dollars in it, you’re off to the races. So thank you Mike, cuz really it’s only overwhelming, complicated the first day. And what the reason I even point that out is that I usually tell clients, you know, listen, just get off high center and so you can get off high center in one day.
Now maybe with your professionals, this takes a two week process, but I’m telling you, I’ve had clients where we’ve run into some circumstances related to opportunities and we’ve literally walked all this through in one day because it’s just that straightforward. Technically you can do it in a morning and then from there your only complication is, well I have a separate bank account. So just requires that your money go into that and your expenses come out of that. I never understand why that’s overwhelming. And then the reason payroll won’t be complicated in overwhelming is that you hire Asure or get a professional to help you. Michael just tell you this, starting at year five, so when I was 30 years old, so 20 years ago I just told clients, listen, we’re not doing payroll anymore. I want you to go do this payroll company. And if you won’t, then I don’t want you as a client, no offense, but I need you with a professional that I know trust that’s gonna be able to get it done.
And if you are penny pinching and you wanna do your own payroll and keep up with it, the second something gets awry on that, well then you’re gonna expect me to fix it and I’m not doing any of that stuff. So only reason I’m saying this is that the next complicated thing is the payroll, right? And, and it is complicated, but you hire the pro and it’s very inexpensive compared to your time and effort. And if you screw it up just a little, the penalties where payroll companies gonna stand by it and they’re, they’re, they’re not gonna screw it up. All I’m saying is that the payroll company can be also set up one day. So I’m just telling you over the years, literally everything I just told you we walked through in one day. Well I’ve had it to where then they’re signed up with the payroll company day one, they got their loan day one and, and literally all of this walks through then after that, and thank you Mike, because you’re, you’re helping me keep in mind that I do need to even simplify it in some of my videos. After that, you’re doing what you were already doing. You’re out getting customers answering calls. That’s right. Bringing in money, paying, and it’s going through some bank account. Well, it’s just now this account that you set up and at the end of the day I I I’m being sincere, I appreciate the way you’ve, that you’ve put this because after that initial getting off high center, you’re just off to the races. Like you would always,
Yeah, you’re running your business like you otherwise normally would. And certainly there are CPA firms and, and and CPAs that do payroll. And if you wanna use your cpa, fine. Yeah. The, the goal of this show is to provide the very best information we can to entrepreneurs, small businesses, medium-sized companies to, to grow that, that that’s it, plain and simple. If it also results in Asure being able to serve you, that’s, that’s a win for us. We’d, we’d love it. But I think the punchline, whether you, whether you go with as Azure, whether you go with one of the big national brands, outsourcing payroll is not a new concept. They’re, you’re not on the bleeding edge here. This has been around for decades in calculating gross to net, you know, what time did someone punch in and punch out or, you know, writing a check for someone’s salary.
That’s not hard. The taxes of payroll is what’s hard and why you wanna outsource it, right? And so for the expense, there’s expense, but it’s not much for the little bit of expense. You’re gonna have an outsourcing payroll, just like the little bit of expense you’re gonna have in bank fees, just like the little bit of expense. You’re gonna have the year end paying your tax preparer to file a a a, a separate return for the business and your personal return. There’s some expense, but it’s a lot smaller than the, than the, than than the the gain you have from a lower tax burden. So jj, I think we, I think we nailed it. You nailed it. Love talking to you. I learned so much from you. Whenever I, whenever I do, is there anything you wanna I wanna add to put a bow on this topic?
Yeah, and I appreciate that. Two things. I don’t let my clients go to the national brands that everybody would probably know. I know with your company you’re somewhat sometimes behind the scenes if you will. I know you work with a lot of CPAs. I really like the way you approach it. It’s the customer service. And I think the difference is, is getting somebody that you’re able to communicate with, which is like Asure the other three brands. The only reason that I even say that is they’re good people, they mean well, but they really lack in the customer service. And that’s what’s key here. And I would also then just add this because anybody that then says, well, you told me all the reasons to be an S-corp. So let me just tell you simple. When you’re not an S-corp, you’re investing in real estate, okay?
Then you wanna be an LLC tax as a partnership. If you’re not gonna be active in the business, as in I’m just lo I’m just basically putting money into this restaurant, I don’t know anything about it, I’m never gonna be in it. I’m a passive owner. Do it through a partnership. Why? Because that net income is then not gonna be subject to self-employment tax, but more key, those kind of investments. There’s more requirement for flexibility with money in money out with loans, having losses and having basis. And with that being said, the other aspect is with a partnership, if you’re actively involved, and many tax pros unfortunately are still missing this, and I think it’s gonna be a top 10 easy audit target, which just means the IRS is just gonna go, well, we don’t need to even come and talk to you. But if you’re actively involved in a partnership that net income is subject to self-employment taxes, just the same as if you were a Schedule C. So let’s sum it up. You’re making more than 20 or 30 grand. You’re actively involved. You want the money that it’s netting. B an S corp, you’re netting more than 20, 30 grand and it’s passive. You’re just doing investment, you’re doing real estate, you wanna be a partnership, you wanna take this thing to the moon, you don’t want to pull money out cuz you just wanna sell this company. Then you’re C-corp. So hopefully that’s a bow related to kind of overall the theme here of kind of what we were talking about.
Really, really well said, jj. Enjoy talking to you. Thanks so much. And until next time, and to the audience hopefully thank you, hopefully really sound advice here. We’d love to talk to you about this. If not, go talk to your financial advisor, your tax preparer, your cpa and, and get moving on this topic if you haven’t already. Until next time, happy holidays everyone. Yep.
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