When, and how, you incorporate your business is key to growing Indestructible Wealth.
In this episode we’re talking about the pros and cons of LLCs, S-Corps, Sole Proprietorships and beyond… How to choose, how to do it, when to do it, and what to look out for.
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When, And How, To Incorporate Your Business To Save Money
I’m going to talk to you about incorporating. I took a poll in one of the groups I’m in with other entrepreneurs. I was curious about how many of them that are making good money are incorporated. I can’t say for sure that all of them that responded to the poll are six-figure earners, but I know that a lot of them are in different businesses. They have responded so far, and 23 out of 33 are not incorporated yet.
Kinds Of General Legal Entities
That gave me a little bit of pause or some concern that they do not understand all the benefits of incorporating, and don’t know what they should be incorporating, or how to go about doing it. I wanted to be able to teach you when is the right time to consider to start working on incorporating your business. I want to talk to you about the overall general legal entities. This isn’t the entire list, but these are the main ones that could make sense for us.
The first one is where almost all people or businesses start. It is a sole proprietorship. This simply means that you are running the business in your own name. You are the business. A sole proprietorship is great because there is no setup. You just say, “I’m starting a business.” You are a sole proprietorship. At this level, if you wanted to have a bank account set up in the name of your business instead of the name of you as an individual. You would need to go to the courthouse and get a DBA, or you didn’t have to go to the courthouse. You could do it online now. That is called Doing Business As. That allows you to set up a bank account in the name of a business and not yours. I suggest that you do that.
The second way is an LLC. This is called a Limited Liability Company. This is the most popular type of corporation because they are very quick and inexpensive to set up. You can do it on LegalZoom for $300. They give you protection for the business that you are running, legal protection, and taxes are simpler within LLC because taxes will be an extension of your personal return. In other words, you don’t have to go out, get in an accountant, and pay a CPA quite a bit of money to run a separate tax return because an LLC doesn’t require that.
The third is an S corp, commonly called Sub S. When the income justifies it, we will talk about when that happens, they have some downsides. They have a more expensive setup. You need to file a lot more documentation on a regular basis, and they require a separate tax return. They are more expensive to set up, but they can save you a lot of money. In an S corp situation, you become an employee of your corporation. Your business is no longer in your name. It also provides asset protection like an LLC.
The fourth type of entity is a C corp. This is for larger companies. It is not recommended for nearly all of us that are in the game right now. A C corp is generally done for bigger businesses because it allows for multiple shareholders. There is a limitation with an S corp that you could only have so many shareholders or owners of the company, whereas a C corp is unlimited.S-Corps are the only business entity that allows owners to save unemployment taxes, making them extremely popular among smart business owners. Click To Tweet
The fifth type of entity is a nonprofit 501(c). This is for a charitable operation where there is no intention to make a profit. Generally speaking, real estate properties will want to be held in an LLC or a Limited Liability Company instead of an S corp, whereas profitable businesses should generally be held in an S corp. Why is that?
There are multiple reasons. The main reason is that LLCs are easy and inexpensive to set up. They require little ongoing maintenance and costs. They don’t require a separate tax return. They allow for maximum tax deductions when you have real estate housed inside of them. I generally have multiple LLCs because I don’t want to have a huge number of properties held within one LLC.
If something were to happen to one of those properties where it creates a liability exposure for me, that could expose all the other assets inside of that LLC to that litigation. LLCs being simple, quick, and inexpensive to set up, they are more favorable for real estate investors. You can still take advantage of all of the great benefits of real estate investing, depreciation write-offs, and all of the other tax benefits that come along with investing in real estate property.
Why would you want to consider an S corp? Let me give you an example. Jennifer owns a business that generated $300,000 in sales. Her cost of goods sold or cost of products that generated that $300,000 in sales was $100,000. That means her gross profit was $200,000, and her total operating expenses were another $100,000. This is all of her advertising and marketing. Maybe she had one employee or two, all of her internet and her professional development. All of the things that go into running that business tallied up to $100,000. There is no business where the numbers come out this clean. This is for illustration.
Her business created $100,000 in net income, which is also her taxable income and also called profits. If she ran the business as a sole proprietor through her personal tax return, her taxes would look something like this. She has her federal income tax, whatever tax rate that is in. I didn’t look it up. She has her state income tax. There are certain states that don’t have a state income tax, but most do.
What I want you to focus on here is the FICA tax. It is social security and Medicare. FICA tax for self-employed business owners and sole proprietors is a whopping 15.3% total between the two. Social Security is a much higher number at around 12%. FICA tax alone on $100,000 in profits is $15,300. There is no way to get around this as a sole proprietor.
However, as an S corp, the game changes. Instead of paying that whopping $15,300, Jennifer forms an S corporation. I’m going to go through a little bit here. I’m going to go through how to get this done, but I want you to get the concept here. Her corporation pays her $60,000 in employee wages and bonuses.
Why does our corporation have to pay her a salary? With an S corp, per IRS guidelines, you have to pay yourself a reasonable salary. The golden metric rule is at least what other businesses pay for the same services. If it is not reasonable, the IRS could come at you and tax you additionally for having your salary set too low. The remaining profits, the other $40,000 in this example, pass through the S corp and are reported as a distribution on Jennifer’s personal income tax return. The $40,000 is not considered employee wages. She got the $60,000 in employee wages or salary. That $40,000 is considered distribution.
What is a distribution? It’s very simple. These are earnings and profits that pass through the corporation to you as the owner of the company. Let’s say you own an S corp and there is more than one owner. If a distribution comes out, and there are two owners in this situation, that $40,000 in distribution or earnings and profits would be split between the two of you. If you were the sole owner of that S corp, all of it passes through to you.
This is the important part and exciting part. This is how you accelerate your wealth. This is part of my make, keep, and grow your money and wealth. This is the key part because taxes are, by far and away, the biggest expense of your lifetime. Nothing comes even close. Because this $40,000 isn’t viewed as employee wages, neither Jennifer nor her corporation pays the employment tax on this amount. Jennifer and her business only pay a total of $9,100 in employment taxes instead of $15,300. What has that saved her? That is $60 to $200 in tax savings. That is a substantial amount of money that you don’t have to give to the government because you have been smart. You set up an S corp.
Here’s what happens after you form an S corporation. You won’t personally own your business anymore. Instead, it is going to be owned by your corporation or your limited liability company providing you with limited liability. With liability protection, you generally won’t be personally liable for your business’s debts or any lawsuits that arise. You do not get limited liability when you are working as a sole proprietor. Sole proprietors are personally liable for everything.
Another consideration beyond tax savings is asset protection. It’s the pass-through entity. What is pass through? Pass-through means that the income is flowing through the corporation and passing through onto you, the individual owner, where you ultimately will pay the taxes. Your S corp doesn’t pay taxes. You do, as the owner of the company.The taxable savings of an S-Corporation must outpace its costs to keep it active and running. You need to earn at least $40,000 to make this possible. Click To Tweet
Any business profits or losses are passed through to you, the owner, in proportion to your share of ownership. You will file everything on your personal tax return and your tax at your personal income tax rate. For example, if you are the only shareholder, all of the profits are losses of your business will go to you, and you pay income taxes on them, just like when you are working as a sole proprietor, but there is one major difference. You will become an employee of your S corporation, which means you will be the sole shareholder or owner, and also an employee.
The IRS rule states that if you have an S corp, you have to have an employee. You have to be an employee of that because otherwise, you are going to get a lot of taxes because you are only going to be paying taxes on the distribution or the profits and earnings. You will be paying payroll taxes. You are paying some taxes on that employee wage and that salary that you get.
Another consideration is there is no employment tax on S corporation distribution. The key thing to understand about these is that you don’t pay the employment tax on the distributions. The larger your distribution, the less employment tax that you are going to pay. No, the S corp is the only business entity that makes it possible for its owners to save on unemployment taxes. This is the main reason why S corps are extremely popular with smart business owners.
Here is the kicker. I want to urge you to say to yourself, “I need to earn at minimum $40,000 in profit tax, which is taxable income, for an S corporation to make sense.” Otherwise, the cost of forming and running it exceeds its benefits. What do you mean cost of forming and running it? There are both legal and accounting fees to not only set up, but you have to keep them active. If you don’t keep up with the paperwork, the filing of payroll, and paying yourself as a regular salary employee, your S corporation will be shut down. The operations will cease to exist in the eyes of the IRS, and you lose all of the advantages.
4 Main Costs Of An S-Corp
There are four main costs to running an S corporation. The number one thing is the accounting and namely, the tax returns. An S corporation requires a separate tax return from your personal return. That alone will be at least $1,000 or more per year, depending on the complexity of your corporation and how much there is for the accountant to get that tax return ready. I don’t know how much mine is. I spend an extra couple of thousand for my accountant to do my S corporation return.
You have accounting fees and payroll fees. Unless you want to run your payroll yourself, which I don’t want to mess with, I don’t know how to do it. I don’t want to mess around with the IRS and mess something up. I have my accountants do it. That is a cost that I have to pay my accountant to run my payroll for me. That is where I’m taking a monthly or a quarterly payment from the salary. They are pulling out all the payroll taxes that need to be paid from that salary to do all of that and keep up with all of that. That is an ongoing cost.
There is bookkeeping. Typically, you got to have accurate books and accurate reporting. You don’t want to mess around with your bookkeeping when you have an S Corp. I use QuickBooks online and then I have my accountants do a lot of the bookkeeping. They make sure that all my books are kept up to date. I have ten LLCs. I only have one corporation, but I have multiple LLCs. All that bookkeeping for all those entities adds up. It is an ongoing expense.
The filing is the paperwork that needs to be sent in to keep your corporation up to date and in good standing with the IRS. Those costs can be combined. All four of those can easily be a couple of thousand dollars per year or more. You want the taxable savings to outpace the cost of keeping the S corporation active and running. That is why you need to earn at least $40,000 in profit to be able to have it make sense.
Getting S-Corp Tax Status
How do you get S corporation tax status? Number one, you are going to form a corporation or an LLC in order to own and operate your business. You could go about this in a couple of different ways. You can go on LegalZoom and do it all right there. That is the cheaper of the options. For LLCs, that is generally what I do unless I’m setting up a more complex LLC.
When I set up the LLC this past year to form the self-storage investment with a total of 8 to 10 investors that invested in that fund, that was something I didn’t want to mess around with on LegalZoom. I had a lawyer. I paid the extra money and they set it up. If it is a simple LLC, more than likely, you can get this done and be confident in doing that through LegalZoom.
With an S corporation, I have only set it up once. It was twenty years ago. I had a lawyer do it. He files every year the minute that shows that the operation is active. That is something that I pay a lawyer to do to keep up with. I’m not telling you that you have to do that. There could be other cheaper options like LegalZoom, but I have not done it that way. Anybody who asks me how to set up an S corp, I tell them to go to a lawyer that specializes in setting up entities and corporations.
Step two, once you do this, you will own the corporation as the sole shareholder. You could be a shareholder with your spouse, which is the way Kara and I are both owners. We are 50/50 owners of our S corporation and we are both employees. Step three is you file an S corp election by filing IRS Form 2553 with the IRS. I have my accountants and lawyers. They keep up with all of that filing because I hate that type of stuff. I don’t like the paperwork. I’m too busy to try to keep track of that. I make sure the professionals take care of it, and the tax savings from them doing it more than offset the fees that I pay them.
This is all about setting S corps. If you have specific questions, you can reach out to me on Instagram. It is probably the quickest way to get any type of answer. Send me a DM and I will be happy to answer any other questions. It could give me great fuel to provide additional content on this subject in the future. Don’t hesitate to reach out with any questions. My Instagram handle is @IndestructibleWealth.
I hope this helps you. I would urge you, if you are over $40,000 in profits, especially if you are approaching $100,000, it is a total no-brainer. It is not even a question. You should be doing this and getting this process set up. This is the beginning of 2022. What better way to kick off the year than by having this setup and getting it out of the way and be done with it?
Here is my other suggestion in closing. Let’s say that the costs of setting up the S corp are about equal to the savings that you will get in taxes. I would urge you to get it done now so that as your business and income grow, you have positioned yourself with strength. You are ready to attract greater abundance. I always like to put myself in a position where I’m telling the universe, “I’m ready for more. I’m set up for more. I’m equipped for more. I’m ready to handle these greater amounts of profitability, income, and all of that.”
It is sending a message that you are setting yourself up for more success. You believe that success is coming. I wouldn’t wait. I would get it done. As the income starts to increase and flow in, you are not trying to backtrack. I know people had an incredible year, and they didn’t set up their S corp. They were stalled out or procrastinated. None of us enjoyed doing this process. I can’t say it is fun. What is fun is when you say, “I save $10,000 in taxes from setting this up and getting it in motion. I save $15,000 in taxes.” That is a lot of freaking bond.
Do it now, get it out of the way, and you are going to be happy when you have the big year that you got it done and you saved yourself a lot of money that you would have normally had to pay to the government. I’m leaving you with a quote from my accountant. She told me this when we met on Zoom. She said, “In classic Jack form, you made things more complicated.” In this case, she was referring to my books and things that we were doing in our accounting at my real estate company. I had to laugh for probably a solid minute when she said that. I hope I made this simple for you and didn’t overcomplicate it. I hope you clearly get the message of how important it is to go out and get this done. Have a great day. I’m signing off.
That is a wrap for this episode on the Indestructible Wealth. If you’d like to dive deeper into your own wealth-building strategy, check us out at MyIndestructibleWealth.com and follow along on LinkedIn, Facebook, Instagram, and even TikTok. Send me your questions and financial challenges, and I promise I will respond. Also, I will think you are awesome if you share and leave me a five-star rating and review on Apple Podcast. Until next time, remember our mission here is to help you make, keep and grow the wealth you can enjoy now and for years to come.