The Hidden Costs of Becoming an S Corp

Welcome to the Creative Mind Smart Money Podcast where we turn financial confusion into creative confidence. I'm Samantha Eck, the keeper and fractional CFO for creative entrepreneurs. Each week I'm sharing my financial expertise and actionable strategies to help you build a thriving creative business. Plus, you'll hear from industry experts who bring fresh perspectives on growing your business beyond the numbers. And building a successful creative business starts with strong financial foundations. Your next chapter starts now. Your listening to the Creative Mind 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 the NPSC 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're 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 glove like, oh, 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. It can cause you a lot of heart against dressing 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 provider. 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. OK, so it sounds amazing until you realize what comes with it. The dangers of electing to 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. OK, so when you become an S Corp, you're a payroll provider. You have to run payroll for yourself. There's no more casual owners draws and being like, OK, I'm just going to 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 now have to pay yourself consistently. And you have to pay yourself a reasonable salary. You can't just be like, I'm going to pay myself $500. No, it has to be reasonable. So if you're a social media manager, usually that requires you doing some research into what a reasonable amount of social media manager might be paid. If you are underpaying yourself, the IRS is going to 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, OK, I'm just going to pay myself $500 because you can't. That's not how this works. OK, so you also have an increased administrative burden. So you do need to file a corporate tax return, which is a form 1120S. It is very different from your 1040 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 are you are adding to. So we've already talked about that, but we're talking about how, you know, payroll is a cost. We're talking about how payroll software is a cost. We're talking about how, you know, 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, 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 that 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 can that profit and that does mean that your savings may get eaten up by payroll processing fees, CPA costs, annual S Corp compliance, what you could save in taxes could actually cost you more and admin and stress because you want to make sure that you're staying compliant as a S Corp. So again, that's something that you want to think about. The final thing that I want to 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 want to make sure that you're actually ready. Because once you elect, you're in a whole set of rules, 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 going to 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 is 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. 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 consistency, 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. 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 at Hawk, 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. It'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'll have someone on your team who's able to do that. Because there's a lot more complex city that comes with S Corp bookkeeping than just LLC bookkeeping. You're looking for some plus to the MP's, not complex city 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 you willize 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 percent, it's too soon. So don't even think about it. Your net profit is consistently 60K plus. If you've hit 60K plus a 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 8 to 10K a year, then yes, you have real taxes exposure and the cash flow 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, you, if you already have a system in place for owners 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're well, you already have that regularity. You know when the money's coming in. So you can just kind of like put your payroll around that that regularity. If you're ready to run payroll and do it right, you set up a tool 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 super business account, clean categorization and you're already doing monthly financial reviews. Then again, you are ready. You have a to someone to file your taxes with as a CPA and EA or you are willing to hire one because without a tax pro, it's just a liability. Like you do not, you do not want to use turbo tax 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. Of course, if you're thinking like someone who is ready for retirement, saving for taxes, building sustainable income, not really fine by the city or your pants anymore, then it's probably time to switch. And if not, stay LLC and focus on profit. So if you're ready to go, you're ready. If you haven't checked at least six out of those seven boxes, stay in L.C. 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 escort. Stick with the single member LLC. You know, stick with that for the time being. Obviously, you can also be sole prop, but stick with being a single member LLC that is taxed as a sole proprietor. Because as a single member LLC, you are a disregard identity. So you are technically a sole proprietor that just has an LLC, if that makes sense. It's a weird thing. But anyways, stick with it if it's too early. Focus on raising your prices, checking 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, but keep your CFO will help you build that financial foundation so that you can finally see when it is fully time to switch to an escort. And sometimes switching to an escort comes with a new EIN, which means doing away with your current set of books and having a new set of books. Because again, escort taxes, escort, but keeping ads a lot of complexity, then not a lot of people are familiar with. Okay. I just want you to understand that an escort 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, oh, 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 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 brushing. 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 to 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, below 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 going to have as many guests anymore that if we do have guests, they're 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. And I'm so 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.