S Corporations - Spear of the Crypto Earner

Crypto Earners and Tax structures, Pt 3.

Disclaimer

None of the following is tax advice, it is just prompting the reader towards ideas, topics and questions for their own research or to bring up with a tax professional. Your own family situation, goals and residence have a tremendous impact on your specific tax plans so DYOR, and at least consult a tax pro if you can afford it.

Overview

Miniature disclaimer 2 – If you haven’t read parts 1 and 2 on Sole proprietors and C corporations, please do that before getting into this article.

The S corporation is weird. It is a structure that makes no sense besides the tax benefits. It smashes together elements of a partnership, a sole proprietor and corporation into one weird mutant tax Frankenstein that is tax efficient, but confusing. Just slapping an “S” on your business lets you avoid some self-employment tax without having to worry about double taxation, but the gotchas to running it are like a negotiated settlement instead of anything practical.

Formation

The formation of an S corporation is straightforward. Form your LLC or Corporation as you normally would, then file an IRS form numbered 2553. This form tells the IRS to “put an S on it” and you are set. Your Clark Kent Corporation has become a Super Corporation. This was simpler when the IRS was current on responding to things as part of the “put an S on it” form 2553 requirement is that you have to have an acknowledgement response back from the IRS and as of 2019, few to no one has been getting these responses. If this is your case, there is a way to reiterate the election when you file your return.

Tax Efficiency

Now that you’ve got your “S” we can cover tax efficiencies. First off, the tax breaks are great for an S corporation. It’s tax rates are essentially taking the sole proprietor’s ordinary income tax rates, knocking off some of the self employment tax and keeping the qualified small business deduction. It really doesn’t need to be buttered up any more than that. An S corporation’s tax burden is like being self employed, but with less taxes. The catch is that the benefit of lower taxes only works if you managed to clear all of the “as long as you do this” administrative hurdles. If you can’t clear them, you are just running a much more complicated sole proprietorship.

Administrative Burden

The first administrative burden is a term called Reasonable Compensation. This is part of what must have been the “negotiated settlement” for S corporations. That is to say, that if shareholders are taking distributions from the corporate profits, they have to also pay themselves regular payroll for the equivalent services they provide to the corporation. Determining that amount is a nebulous exercise, but it at least should involve you tracking how much of your time you spend working on the corporation.  This reasonable compensation will include payroll taxes, which is why the S corporation doesn’t let you entirely avoid self-employment taxes on your profits.

If you have passed the hurdle of figuring out what your “Reasonable Compensation” should be, paying it out as wages is also an administrative burden. You can’t just Venmo yourself the amount and call it a day, you have to run it as payroll. Payroll means you’re going to need to file quarterly and annual payroll tax remittances for the IRS, unemployment and withholding with your state and issue W2s. You now are exposed to the entire payroll and payroll tax system, which is a hassle if you are the only employee.

Reasonable compensation and payroll are also a bigger hassle if you are doing something that is a purely personal service business with your S corporation say, just giving speeches. In this case, it’s hard to argue that your ‘reasonable compensation’ isn’t just 100% of your income from the S corporation. You now have to run payroll for everything, through a payroll system, with a tax effect that is more burdensome and a little less tax efficient than just being self employed. Furthermore, if you fall into this trap after the fact, the penalties for not remitting payroll taxes are worse than if you just didn’t pay the self employment tax up front.

Administrative burden number two is that S corporations require their own separate tax return. This tax return has a different due date than your personal return and requires a lot more information that the 2 pager for Sole proprietors that goes with your personal tax return. This fun return is similar to a partnership tax return that it requires you to enter a lot of information that in the end has zero tax effect. It’s an information return that spits out a form called a K-1 which you then have to go and re-enter on your personal return and pay the tax there. Because there is no tax due with the return, it has it’s own special penalty for being filed late, or not at all. It’s penalty is $210 per month that the return is late, multiplied by the number of shareholders. So a husband and wife who missed the return date and filed 10 months late would have a $4200 penalty.

There is also an administrative perk of S corporations. S corporations do not receive 1099-NEC or MISC forms. They will still get 1099-k forms but have that advantage of you can prepare your taxes based on your books instead of getting submarined on April 30 when someone sends you a 1099-NEC form that they forgot to do, and is wrong after you have already filed your tax return as a sole proprietor.

State Taxes

State taxes can also be tricky with S corporations depending on the state. Most states with sane tax policy treat S corporations as pass through for taxes like the federal side does. However, California charges an extra 1.5 percent tax on S corporations presumably because they hate everyone that lives there, and Tennessee will get you with the full 6.5 percent franchise tax as a tradeoff for having zero personal income tax with your S corporation.

When to use

Given the reasonable compensation hurdle, and administrative burdens to operating an S corporation it is like choosing the “veteran difficulty” setting on your first play through a video game. You can do it, but you are going to have to learn a lot more. Second, there is an income efficiency that usually starts above $75,000 in net income. That efficiency is that if your reasonable compensation is $48,000 your self-employment tax avoidance is only going to be about $4000 on that amount and you are likely to spend much of that that $4000 on extra tax preparation, state filings and payroll tax compliance if you aren’t doing it yourself. The end result is that you do all of that extra work just to break even on tax savings.

Pig gets fat, Hog gets slaughtered

My last comment for S corporations is “The pig gets fat; the hog gets slaughtered” which is a saying I learned from a lawyer. The S corporation has the temptation to get into trouble this way in that so many people run zero reasonable compensation with their S corporations to avoid the payroll hassle and to maximize their tax avoidance. The problem is that no payroll with distributions is a layup win for a tax auditor so don’t be that guy who gets greedy as you become an easy fat tax target for trouble.

The second problem is that S corporations are something that I don’t feel like is going to persist forever. It’s such a strange setup and mishmash of tax features that doesn’t seem to have any purpose besides tax breaks that it seems like something that will get labelled as a “loophole” and eventually will be closed off. This is especially true as legislators and bureaucrats look for increased funding to shore up social security, which is the tax that you avoid with an S corporation. It just feels to me like something that is “too good to be true” to stick around forever, especially with the amount of people using it and using it aggressively with zero reasonable compensation.

That also brings me to the end of the tax structures of the Crypto Earner series. I hope you feel better equipped by reading it.