Episode 68: The Hidden Costs of Becoming an S Corp

Samantha Eck (00:33)
You’re listening to the Creative Minds Smart Money Podcast. And today is a topic that I have talked about before, but is one that I really want to dive into the cons of, because I think there are too many people who jump into S-Corp super early at the advice of people who don’t fully understand the breadth of an S-Corp and then end up getting

super, super, super overwhelmed and they can end up actually shutting down. So I really want to talk about today is the dangers of an S-Corp and why you should really consider all of the sides of things before switching to an S-Corp. And please, for the love of all that is good and holy, if you are not making money yet, please don’t, don’t become an S-Corp right off the bat. Unless you have some huge funding from someone, don’t just become an S-Corp, okay?

So I want to talk really, everyone online makes it sound like switching to an S corp is like the ultimate financial glow up. Like, you should just get an S corp and you’ll save on taxes. But I want to reiterate that it’s not always the right move. So yes, an S corp can save you money, but jumping in before you’re ready can also really backfire and backfire hard. can cause you a lot of heartache and stress that you don’t need. So we’re going to dive into the real dangers of becoming an S corp early.

what you need to have in place before you make this switch and a checklist to know exactly when the time is right. But I want to preface this by saying that regardless of what I say in this episode, yes, please follow it, but also please consult with a CPA or a lawyer who is someone who helps you transition to an S-Corp to fully understand if you are ready. Yes, use this, but also consult with someone additional, please.

First of all, quick refresher, what is an S-Corp? An S-Corp is a tax classification, not a business entity. So you can be an LLC or a C-Corp that chooses to be taxed as an S-Corp. You cannot be a sole proprietor, you have to be an LLC. So a lot of LLCs eventually will elect to be an S-Corp. I’ve considered it because I’m an LLC, I’m considering switching to an S-Corp.

The main appeal is that you pay yourself a reasonable salary and take the rest as distributions, which aren’t subject to self-employment tax. Okay. So it sounds amazing until you realize what comes with it. The dangers of electing too early is what we’re really focusing on today and what we want to really focus on. So first of all, you are now a payroll provider. Okay. So when you become an S corp, you’re a payroll provider. You have to run payroll for yourself.

There’s no more casual owner’s jaws and being like, oh, okay, I’m just gonna take $1,000 out right now. You need payroll software like Gusto, like Patriot Payroll, like QuickBooks, things like that. And if you miss a payroll tax deposit, the IRS isn’t playing around. you you now have to pay yourself consistently and you have to pay yourself a reasonable salary. You can’t just be like, I’m gonna pay myself $500. No, it has to be reasonable.

So if you’re social media manager, usually that requires you doing some research into what a reasonable amount a social media manager might be paid. And if you are underpaying yourself, the IRS is gonna have that be like a huge red flag. So you need to make sure that you have a reasonable salary and that it is actually reasonable. It’s not just like, okay, I’m just gonna pay myself $500 because you can’t. That’s not how this works. Okay?

So you also have an increased administrative burden. so you do need to file a corporate tax return, which is a form 1120 S it is very different from your 10 40 that has the schedule seat. It is very different, which is why a lot of CPAs, a lot of tax preparers will charge exorbitant amounts for it because it is a very complex tax return. It’s not as simple as a, as a schedule seat. A lot of them will say it is easier than a schedule seat, obviously because there’s no personal stuff on it, but it is not as simple as a schedule seat.

You’ll need very accurate books, proper payroll records, and someone to file your taxes. So of course there is that as well, considering all these costs that you are adding to. So we’ve already talked about that, we’re talking about how payroll is a cost, we’re talking about how payroll software is a cost, we’re talking about how the cost of a CPA, the cost of a bookkeeper, the cost of someone to keep all those records straight. It is extra work and extra costs every single year.

So that’s something you also want to consider. Reasonable salary is a legal gray zone. So the IRS does require you to pay yourself a reasonable salary, but it doesn’t define what it means. So again, this is one of those cases where we wish the IRS would just tell us something, but they don’t. So if you’re too low, you risk an audit. You risk them auditing you and saying, like, why are you paying yourself too low? But if it’s too high, you also risk losing the tax benefit.

that comes with paying yourself a reasonable salary. So you have to walk a fine line and document it, which is why I’m saying you need to talk to a CPA and actually understand what is a reasonable salary for you. I can’t tell you that, but it does have to be reasonable. That’s what I can tell you. Tax savings aren’t always worth it. So if you have a 30k net profit, and that does mean that your savings may get eaten up by payroll processing fees, CPA costs, annual escort compliance.

what you could save in taxes could actually cost you more in admin and stress because you wanna make sure that you’re staying compliant as an S-Corp. So again, that’s something that you wanna think about. The final thing that I wanna think, you to think of is that it’s not easy to undo. So you can’t just, you can revoke it, but it’s complicated and it’s not something to mess with casually. So if you’re getting into an S-Corp, you wanna make sure that you’re actually ready because once you elect,

you’re in a whole set of new rules, both legally and financially. So again, this isn’t something you want to do lightly and just be like, hey, I’m making enough money, I’m gonna switch to an S-Corp. I actually went through this. So I actually decided that I was going to do this last year. And shockingly, like very shockingly, I learned that there’s so much more to it than just switching to an S-Corp, okay? So there are…

times when an S-Corp doesn’t make sense, okay? So automatically these are red flags that you should be like, you know what, no, I’m not ready for an S-Corp. And if someone’s trying to push that on you, you kind of have to push back at this point because it just doesn’t make sense to you. You’re still building consistent revenue or having fluctuating months. So if your months are up, down, up, down, up, down, you are not ready for an S-Corp. Please do not sign up for an S-Corp. It’s going to hurt you.

don’t want to run payroll yet. If you’re someone who’s scared of payroll, maybe you don’t want to have that compliance issue, you don’t want to think about it. It doesn’t make sense. You pay yourself ad hoc, not consistently. So you’re taking money as needed from your business. It’s not very consistent. You don’t have a bookkeeper or somebody to keep track of your books. That’s obviously, again, something that’s… The audit risk for an S-Corp is much higher than the risk of an LLC. So you want to make sure that you have someone on your team who’s able to do that.

because there’s a lot more complexity that comes with S-Corp bookkeeping than just LLC bookkeeping. You’re looking for simplicity and peace, not complexity and compliance. So if you’re someone who just wants simple, there’s no reason you need to switch away from an LLC. Yes, are you going to pay a little bit more taxes? Yes. But you need to decide if the taxes are worth the additional stress or not. So now we want to talk about the exact checklist for when it’s time to become an S-Corp. And I want you to…

loosely keep these in mind. Again, please talk with someone else, but also utilize this again. So if you’re unsure, just run through this list. And if you can’t check most of these boxes, like I would say 90%, it’s too soon. So don’t even think about it. Your net profit is consistently 60k plus. If you’ve hit 60k plus in net profit after expenses for at least two quarters in a row, you’re probably ready and you’re probably okay to

become an S corp. Now, again, net profit is your bottom line number. So it’s after all the expenses for two quarters in a row. And that’s 60,000 per quarter. That’s not just 60,000 total. That’s 60,000 per quarter. You’re probably good to go. You’re already paying quarterly estimated taxes. If you’re cutting checks for eight to 10 K a year, then yes, you have real tax exposure and the cashflow to handle it. Because obviously, you know, that means that you do have a lot that you’re paying taxes. So

That’s something that you want to look at as well if you’re paying that much in taxes. If you already have a system in place for owner’s pay and you already have paid yourself regularly, either you’re already running payroll or you’re drawing income on a predictable schedule, you’re probably ready to switch to an S-Corp because you already have that regularity. You know when the money’s coming in. So you can just kind of put your payroll around that regularity. If you’re ready to run payroll and do it right, you’re set up with tools like Gusto.

or you’re willing to set up tools like Gusto and you understand how to set a reasonable salary and take distributions, then you’re probably ready again. Your books are clean and up to date. You have a separate business account, clean categorization, and you’re already doing monthly financial reviews, then again, you are ready. You have someone to file your taxes with that’s a CPA and EA or you’re willing to hire one because without a tax pro, it’s just a liability. Like you do not, you do not.

want to use TurboTax for an S-Corp. I swear to goodness, you need someone to help you. You need someone to help you. Please don’t do it yourself. You need someone who knows how to handle the compliance part of it. it’s so complicated. And I just want to make sure that you are staying protected. And of course, if you’re thinking like someone who is ready for retirement, saving for taxes, building sustainable income, not really flying by the seat of your pants anymore, then it’s probably time to switch. And if not,

Stay LLC and focus on profit. So if you haven’t checked at least six out of those seven boxes stay in LLC and focus on profit Especially the net profit one if you cannot check the net profit one You’re not ready period you’re just not you’re not ready to transition If it’s too early, this is what you should do instead to get yourself ready to become an S corp stick with a single member LLC

Um, you know, stick with that for the time being, obviously you can also be a sole prop, uh, but stick with being a single member LLC that is taxed as a sole proprietor because as a single member LLC, are a disregarded entity. So you are technically a sole proprietor that just has an LLC. If that makes sense. It’s a, it’s a weird thing, anyways, stick with it. If it’s too early, focus on raising your prices, tracking your time and your profitability, paying yourself regularly on a schedule and then saving for taxes quarterly.

And then of course getting support from that bookkeeper or CFO will help you build that financial foundation so that you can finally see when it is fully time to switch to an S-Corp. And sometimes switching to an S-Corp comes with a new EIN, which means doing away with your current set of books and having a new set of books. Because again, S-Corp taxes S-Corp, bookkeeping adds a lot of complexity that not a lot of people are familiar with. Okay.

I just want you to understand that an S-Corp is not a badge of legitimacy. It is a tool and using the right tool at the wrong time is still the wrong move. And I don’t want you to rush into something that someone has been pushing on you because they’re like, you’re ready, you’re ready, you’re ready. When really you’re not. And I don’t want you to end up getting into this, this tight spot where you can’t get out of really easily. And now you’re kind of stuck. You know what I mean?

So clarity is better than rushing. And of course your peace of mind is more valuable than any sort of tax loophole. So just make sure that you’re fully ready before you even consider transitioning and don’t transition too early because I would hate that for you. Okay. So if you found this episode really valuable, please like it, comment, subscribe, share it on social media so that other creatives can find this podcast. And if you found this valuable and you think, you know,

people need to know more about the dangers of escort, please show this online with other people who you think will enjoy it. Okay? If you want more topics like this or you have an idea for topics, fill out the form in the description box below and I’d be happy to review it and talk about different topics on the podcast. As you already know, we are not gonna have as many guests anymore. In fact, if we do have guests, there going to be more clients and we’re going to be doing client studies or key studies based on those clients and how…

their successes so that we can really see the benefits of having a good bookkeeper on your team. I am working with a podcast manager now, so a lot of things are shifting and changing with the podcast, but I’m still so excited to continue doing what I’m doing, and I’m so excited to just dive into it, okay? So, you know,

As always, I wish you the best week ever and we’ll see you next week. Farewell, fellow travelers.