The most common way to create an S Corp is to first form a limited liability company (LLC) then elect to be taxed as an S Corporation.
But, the S Corp election can wait. And more importantly, should wait. Why? $40,000 net income after expenses is the break-even point for an S-Corp. Not sure what you’ll earn? Not to worry, we can elect S Corp as far back as 3 ½ years using special IRS Revenue Procedures (as opposed to the 75 days provided in the Form 2553 instructions). Stay tuned for our next blog article on the late — as in super late — election.
Therefore our advice is to wait until November or December to decide if the election make sense, and then make it retroactive to the start of the LLC or January 1. So, get the LLC in place today and wait on the S Corp trigger until it makes sense (spoiler alert, you could be in the middle of March 2016, elect S Corp status back to January 2015 and run a late 2015 payroll event- all legit, pain in the butt for everyone, but all legit and routinely successful).
How it Works
Let’s say you are teetering on that $40,000 net income figure, and not sure about running payroll and all that jazz. You could still run your business income and expenses through your tax return as a sole proprietor or another single-member LLC, and take the small self-employment tax hit. Then simply file a No Activity tax return for your S Corp.
If you expect to lose money the first two or three years, the S-Corp election should be avoided. A single-member LLC or sole proprietor can theoretically have unlimited losses where a partnership or S Corp cannot because of shareholder basis rules. Briefly, as an S Corp you are an investor and an employee. As an investor in any company, you cannot lose more than your investment. Same thing here.
Why Having the Right Business Partner Matters
If an S Corp is ultimately desired, and if you have a partner, remember: nothing lasts forever; even the Cubs will eventually win a pennant. If your business partner is not your spouse, understand that you could suddenly find yourself in business with his/her spouse or worse, his/her children.
Image you and your partner. Happy as a clam. Successful. Cement truck. Dead. She left everything she owned to her children including her portion of the partnership. Now you and her kids are partners. Wonderful. Do scenes from Horrible Bosses come to mind?
You need to design exit plans if a partner wants out, and you need to design first rights of refusals for divorces or deaths. There are all types of plans and strategies, such as Buy Sell Agreements, where the company has the option to buy back stock in the event of a divorce or death or some other unfortunate event. Incapacitation is another consideration- look at the recent LA Clippers situation where Donald Sterling who was found mentally unsound and could not run his company. If your partner is Donald Sterling, who is not dead nor divorced, much to Clipper fans’ chagrin, you might want a contractually obligated and legally enforceable plan to get rid of his partnership interest.
But valuation and funding are the biggest hurdles. For example, the company might be worth a zillion dollars, but has no cash. Or the value is all tied up in assets, such as houses or machinery. Exit plans or Buy Sell Agreements really make sense only when the partnership has value. In many cases, the remaining partner or partners can simply start up a new company in a different name, and carry on as usual.
Jason Watson is the Managing Partner for Watson CPA Group, located in Colorado Springs, Colorado. He is also the author of Taxpayer’s Comprehensive Guide to LLCs and S Corps. The Watson CPA Group specializes in S Corps being owned and operated by people all over the world. They exclusively use CorpNet for all company formations.