You love your S-Corp. I know you do, because that's the way you set up your business. But did you make a mistake? We're going to get into that and so much more on this edition of the Inside B.S. Show.

Hey now, I'm Dave Lorenzo. I'm the Godfather of Growth. And today we're back with Harry Sendrowski, and he's going to give us the inside scoop on S-Corp, because before I met Harry, I thought S-Corps were the be-all, end-all.

I thought that's what I should do to set up my company. I might have been wrong. Harry, how are you? Welcome to the show.

Good afternoon. I'm doing great, Dave. It's spring, so spring's eternal.

It's a great time of the year. So everything's good. All right.

Fantastic. So I want to talk to you about S-Corp, because you and I have had personal conversations, private conversations about S-Corps in the past. And I know there are some things we need to be cautious of when we're setting up our businesses.

What is the deal? Why do we need to be cautious when we're setting up a business as an S-Corp? So, so when you're, when you're setting up a business as an S-Corp, what you should do, and what we always recommend is to a client is understand how the S-Corp works as compared to alternative forms. And what we try to get them to do, although it's speculation about what projections are and things of this nature, we'll ask them, you know, where do you think the business will be three, five, seven years from now, pick a time period, and then compare the benefits or the lack of benefits under an S-Corp as compared to an LLC taxed as a partnership, or as compared to a C-Corp. So I think what happens is the S-Corps have become the default go-to by people in our profession, which I'm a little befuddled about.

Their biggest issue, what they try to do is save on FICA tax, which I think is, it's okay in and of itself, but at the same time, you know, you're really not thinking about the long-term, you know, aspects of having that structure in place, and we'll go over some other things later on that, where I can highlight the complications with respect to that, but I just think it's pretty short-sighted. So the idea here is compare all three. What are you going to do with the company? You know, when you take a look at an S-Corp just compared to, let's say an LLC taxed as a partnership, if you went to the bank and you needed equipment for your business, and that equipment was allowed, a year or two ago, we were allowed to expense that equipment 100%, if you went to the bank and borrowed money, if you, in an S-Corp, you're going to be limited to your tax basis in your stock, which might be minimal as you got the, as you started the company.

However, if you went to the bank and borrowed the money in your LLC taxed as a partnership, you would get the full tax deduction allocated to you on your personal tax return as a flow-through. So that's just one simple way of explaining one of the big differences between an S-Corp and an LLC taxed as a partnership, because in an S-Corp, you do not get tax basis for the debts at the shareholder level, or, I mean, excuse me, at the S-Corp level. It doesn't go back to the shareholder level.

So it's one of the big detriments of an S-Corp. Okay. So I think what we need to do is we need to take a step back and define for our friends who are with us today what an S-Corp is.

An S-Corp is short for subchapter S corporation. What does that mean, Harry? That means is you have the benefits of having a corporation in place. So you have the legal protections of a corporation.

However, for tax purposes, it's treated as a flow-through entity. Now, S-Corps have, you're limited to a certain type of shareholder. So usually individuals, grant or trust, things of this nature.

So if you had a partnership that wanted to invest in your company, they couldn't because they would not be a qualified S-Corp shareholder, and then that would break your election. So, but an S-Corp is meant to have everything flow through to whoever owns the stock in their pro-rata share, you know, of the stock ownership. And when the government, the IRS or whoever set up subchapter S corporations to begin with, what do you think their intention was? If you were to read into what their intention was, what do you think they were intending to do by setting that up? Well, first of all, the S-Corps were set up prior to the LLC statutes.

So it was really to help individuals protect their personal assets, having a C-Corp, having an S-Corp in place so legally, and at the same time, getting the benefits flowing through to their personal tax returns because it's a flow-through entity. So who is an S-Corp a good idea for? Like when does it make sense to set up your company as an S-Corp? In certain cases, consulting businesses could be one. So maybe, you know, service type businesses or certain businesses, you have to be a licensed, you have to be a corporation in that state.

So you might not have the flexibility to be an LLC, but they're going to be very few, you know, circumstances that you're going to have that. Some people have actually put investment portfolio, you know, matters in there. I'm not sure what the real long-term benefit of that is, but they perceive a benefit.

I've just never been able to identify what that benefit is. Okay. So after you and I had a conversation about S-Corps versus LLCs, I mean, you had me convinced in the first five minutes.

So then I have to go back to my business partner and explain it, and I found myself speaking in tongues, basically. I have no idea what I'm trying to explain. So explain to the folks who are with us why setting up an LLC is, in your opinion or my interpretation of your opinion, just as good as what the S-Corp intends.

So LLC taxed as a partnership, you have to be careful because you can be an LLC taxed as a C-Corp or an LLC taxed as a partnership. So the idea with being taxed as a partnership, I'll just give you an analogy. So if you wanted to have a private equity firm invest in your company, they are not going to invest in an S-Corp because of the way that they're legally set up.

They would break your S-Corp election because they're not a qualified shareholder. They always want to have something, I shouldn't say always, a high percentage of the time. They want to invest in LLCs because two things.

One is the tax benefits flow through a little bit easier. Two is that the structure allows for, let's assume there are a series of financings over time, that you can have series A, B, C, and D. You can't do that with an S-Corp because you can only have one class of stock. So what it gives you is it gives you flexibility in the future for equity or for financings.

It actually gives you, I think, actually more flexibility because like in an S-Corp, I can't give you what's called a carried interest or I can't give you an interest in the S-Corp that way. You have to do it through the LLC. So there's a lot of different flexibility that affords the entity for the ongoing operations, executives, et cetera, et cetera.

So I can't give a profit's interest through an S-Corp. I can't do that through an LLC. So if I'm trying to attract Dave Lorenzo to work for me, he's not going to want to have the S-Corp set up that way.

Okay. Now, if we have this conversation and I need to make changes, when is the right time for me to make the change away from? So I've already selected the S-Corp. When is the right time for me to make the change away from the S-Corp? I just paid my taxes.

I just finished filing my tax returns a couple of days ago as we're recording this. Would this be the time or should I wait until I have an event where the structure of my entity is going to make a difference? So there are limited times when you can elect or change your structure. So usually it's going to be March 15th, but what you want to do from a long-term planning standpoint, you want to say, what do I want to accomplish in the next two to five years? And then what you do is then you take a look at how you want to be set up.

So what you could actually do is transfer the assets of the S-Corp to an wholly-owned LLC and then start planning along those lines. That's tax-free, generally speaking. And so what you're doing is you're setting up for the future.

Again, if you want to bring in private equity or you want to sell a piece of it. The other thing it allows you to do is, if you were going to sell your company in a couple of years, it's very typical now that you roll over part of your equity. So if you now transfer it now, then that rollover will be, for sure, it'll be tax-free to you.

And you don't have to go through a bunch of hoops to do it at that time. And to me, it also shows a little more business savvy by having the LLC when somebody's coming. Because S-Corps are just not flexible.

So people want people who are flexible in management, flexible in their thinking. And I think that if you had an S-Corp and then you were to change it, that's telling somebody that you're looking out for the future. And if I have a partner who's looking out for the future with me, our goals are probably more aligned than someone who's not.

So I think it tells a lot more about the entity and the individuals. Okay. I get a lot of questions, Harry, about reasonable salary.

And I don't know why it's... I guess I do know why it's the S-Corp owners that always ask about this. Because of the flow-through aspect. They're always asking about, you know, I'm supposed to pay myself a reasonable salary.

Let's first talk about the accounting definition. I guess it's the IRS definition of a reasonable salary, as interpreted by you, a CPA. So what is considered to be a reasonable salary? So a reasonable salary, what you would look at is the duties and obligations of that particular executive.

Remember, in a lot of these companies too, you have family members working. So there are compensation studies. You can also take a look at comparable data for companies that size.

And look at the average compensation for other executives. The reason the IRS wants you to have a salary that fits within that range is because then you have to pay your FICA tax and all the other taxes with it. What a lot of S-Corp owners do is they take a minimal amount out as salary.

Let's say $50,000 or $100,000. And the rest flows through without the imposition of the FICA tax. And that's where the IRS would take an exception, you know, to that type of setup.

So it's very easy for the IRS to get at that information. You can get at the information comparing. And then the other thing too, and a lot of people do, which I find kind of interesting.

In most organizations, you have other executives that you're paying whatever you're paying them. You know, if the CEO is getting paid $100,000 a year, but the CFO and the CIO are getting paid $500,000 a year, you know, it's kind of like, okay, guys, what's going on here? You know, you're kind of shooting yourself in the foot. So sometimes it has to pass the laugh test of what people are trying to do.

But it's very easy for the IRS to get at that information. You have the information. And, you know, when you really look at the interest and penalties associated with that and then fighting them, is it really worth it at the end of the day for all that time and aggravation? Well, and then in a business that's doing less than $10 million a year, let's say, or even slightly above $10 million a year, when you go to sell that business, if you've sandbagged a portion of your salary, if that business is purchased by an investor or an investment group, they're going to have to hire someone to fill your role.

And they're going to have to pay them the real salary eventually. So the value of your business is going to be discounted by all that money that you were taking and sandbagging to try and save on the tax. Right.

And what they'll do is that's what's called a normalizing adjustment. So if you're paying yourself $100,000 and it's really a $600,000 a year job, they're going to put that $600,000 a year in their projections. And that's based on a $600,000 salary, not a $100,000 salary.

So what that also does is raises other questions sometimes about tax due diligence. Sometimes when you do some things that are extreme, they're going to say, what else have you done? Have you filed in all the states that you should have? We had an acquisition. A client made an acquisition last year.

And when we took a look at everything, they made a very substantial investment. The gentleman was only paying taxes in his home state. We had to explain to him that he had nine states he was responsible for filing taxes and interest penalties, statutes.

So when people talk about tax due diligence and tax liabilities, the states are just as big as the Fed. So you've got to be very careful. In today's environment, the states are hungry for revenue.

So they'll try to save. If I'm selling my services in Illinois or California, they're going to say, wait a minute, your part of that income belongs to California or Illinois, whatever state it is, and they're going to want their fair share. So when you're looking at the entities, you've got to be careful of how you define tax due diligence, because that could be a big issue.

That is a really interesting subject. And I recall, and I want to make sure I get this right, so I'm not going to name the baseball player, but I recall a famous baseball player having a challenge, having an issue with a new contract because the governments of certain states were saying, well, he plays nine games a year here. And because that contract is so much, if we prorate that on a per-game basis, he should be paying tax on the income from those.

And it was because this guy made so much, it was substantial on a per-game basis. So is it where you actually do the transaction or where your customers are? So if you sell to someone in another state, but your customer takes delivery in your state, where do you pay the tax? So two different things. In your example, with respect to the professional player, so some of the leagues like the NFL, they have state tax agreements, how the players are going to pay the tax in each state.

So they do that at that level. And I know this because when the USFL was formed, we had to do things differently because we didn't have that type of tax pack with all the states. So we had to go into each one and then go through how much of this regular salary, how much of the bonus, things of this nature.

So getting back to your second question, if you're a customer of mine in California, and I'm shipping to you goods all the time and receiving the money, California is going to say, wait a second here. I need to tax you on part of those sales, especially if you have a salesperson in California or whatever the case may be or an office. So you got to be very careful about that.

But even on services, a lot of states have taken a position. If I'm performing services in California or Illinois or wherever the case may be or New York, those should be taxed there because I'm actually physically doing that. There are some de minimis rules on that, but the states have been very, very aggressive.

And what you got to be careful about is how you're treated in one state doesn't mean you're going to be treated the same by another state. So you got to be careful how you do your planning because you can get trapped about paying how the taxes are. So yeah, it's a very interesting time with the states because they're trying to be very aggressive on collecting the revenue.

So let me make sure we put a fine point on this. So if you're a therapist, let's say you're a physical therapist and you're based here in Florida where I am, there's no state income tax in Florida. So the patients come to me and go to my therapy place and I do what I do here.

I'm responsible for if there's state sales tax or whatever state tax there is here. But if the client comes from California, I have no issue with California because they're coming here. Right.

But if you had like a telemedicine or you had something else, or that's where the line starts to blur a little bit. Yeah, that's really an interesting thing that I hope we don't have to ever address. Well, I guess we're busy.

I mean, to give you an idea, in our firm now, we actually have, they call them SALT, S-A-L-T, you know, and so they specialize in this because the rules are so complex by state. You know, it's very interesting. The other thing too, when you have people coming and investing in your business or buying the business, state taxes come into play because a lot of times it'll happen is a seller will say, I only want to sell stock.

And then the buyer says, no, I don't want to buy stock. I want to buy assets. Yeah.

So when you do your analysis, then you got to factor in, you know, what the impact of the state taxes are. And we just closed on one transaction. The differential is $828,000, just a state tax portion, not anything else.

So it's, you know, it can be very, very expensive. That's crazy. That's a big number.

Okay, Harry. So let's wrap this up by talking about what people should do right now. So if they're in S-Corp right now and their time horizon for acquiring another business or selling their business or bringing in a partner or just taking in investor money for their business, if their time horizon is between six months and six years, what do they need to do? Let's say they're listening to this and it's June.

It's not March 15th. They're set up as an S-Corp. Somebody wants to invest in their company.

What do they do right now? So I'll break it down into a couple of your questions. So on the first question you asked, if they're going out and buying another company, they should not buy that company through the S-Corp. What I would suggest is they form a new LLC.

That LLC buys whatever company it is, whether you're buying stock or that. And then the S-Corp would actually transfer its assets down to the LLC. So we can actually start to take a look at what we want in the future.

Now, if the gross amount of those assets are less than $50 million, they might qualify for the Qualified Small Business Exception, even though they were an S-Corp before. If you're an S-Corp in and of itself, you can never qualify for that. So you can start doing that planning to say, hey, in five years, this is where I want to be, and still take advantage of that.

But you've got to do that now in talking to your lawyer and your accountant and looking at your projections. With respect to investments, as I mentioned a little earlier, people are not going to want to invest in an S-Corp. So you're better off now setting everything up so you make yourself attracted to them so they can actually do the investment in your company.

But in an LLC format. Now, in some cases, the LLC is a flow-through, but sometimes people elect C-Corp status, not only for QSBS purposes, but if you think about if you have a business that requires a lot of working capital, if you're only paying taxes at 21%, as compared to 37% on the individual, I don't need my calculator to tell me I can accumulate more cash and put it back into the business and invest and let the company grow. Sure, sure.

And you mentioned something there that I want to make sure we specify to the folks who are with us. And you said, and maybe this was my mistake from the beginning, I should have separated these two. So you can have an LLC and elect S-Corp status.

That's what I was referring to, an LLC selecting S-Corp status. That's what I've been talking about this whole time. Is there any difference between an LLC selecting S-Corp status and just a company setting up as a corporation set up as an S-Corp? Yeah, you're just subject to different governance rules, depending on the state.

So some states are more user-friendly in LLCs. So that's another distinction that you would make with legal counsel to say, what's important to you from a governance standpoint? The LLCs tend to be a little more flexible in general, but not always. And then sometimes there are certain provisions where you have to be, so like an ESOP, for example, that you actually have to be a corporation.

You cannot be an LLC taxed as a corporation. You actually have to be a regular corporation, let's say in Delaware or someplace else. So there are times when it is appropriate to have a, just a regular corporation set up as compared to an LLC taxed as a corporation.

So your changes pertain to the LLC, which elected S-Corp status. You have to then set up a new LLC, transfer the assets over. You can't just drop the S-Corp name.

Right, yeah. It's called an F-reorganization, but yes, you're going to drop the assets down into the new LLC in order to accomplish that. Okay.

All right, folks, listen, if you are baffled and bamboozled by what we talked about today, don't worry about it. Here's what you need to do. Just reach out to Harry.

You can call him at 866-717-1607, 866-717-1607. Call that number. That's Sandrowski Corporate Advisors.

They're part of Prosperity Partners. Ask for Harry. He will answer your questions.

And if you need help, connect you with the appropriate professional in the firm to make the right adjustments. I cannot stress this enough because I learned this from working with Harry that if you're going to have an event, whether it's somebody buying your business or somebody giving you money, loaning you money, any type of an event that is going to result in a capital infusion or a change in ownership, as soon as you think about doing this, that's the time to call Harry because you may have a look back period depending on what you're going to do. And you're going to want to get on top of this sooner rather than later.

If you just started making money and you're just starting to take distributions in your company, very good time to call Harry because he can make sure that you're taking advantage of the tax law as it's written to save as much money as possible. 866-717-1607. Thank you, Harry, for joining us today.

And thanks all of you for listening and watching. We'll be back with you again next week for another edition of, I guess we could call it tax time with Harry because we're teaching you how to save as much money on your taxes as is legally possible. Thanks and we'll see you soon.

Thank you, Dave.