There may be errors in spelling, grammar, and accuracy in this machine-generated transcript.
Jeremy Wells: Hey there, I'm Jeremy Wells, CPA. Back with another episode. Today we are talking about reasons not to make an S election. Now, this is a little bit of a controversial topic, and it's one that I see a lot of tax advisors and tax professionals talking about online. There is [00:00:30] discussion over when should we be making these selections? When does an LLC need to be an S corporation to the point at which there's a cottage industry developing around this concept, and there has been for several years now. We're kind of in this perfect storm now to where we've got a lot of work from home. Uh, a lot of the gig economy going on. So a lot of people are in these situations where independently, they're making a relatively [00:01:00] substantial amount of money as self-employed people. At the same time, we have just frankly, a shortage of good, qualified tax advisers that can offer help to them. Uh, this is a topic that's been covered a lot elsewhere, so I don't want to get into a discussion of the future of the of the accounting and tax profession. But really, uh, there's been this need, honestly, for, uh, whether we call [00:01:30] them accounting firms or whether there's something else that are helping these independent, self-employed micro businesses, uh, get the right kinds of tax and accounting, uh, and sometimes even legal and just business advice that they need, um, and working directly with a, uh, tax professional or an accounting firm, sometimes that's not necessarily what a lot of this next generation of self-employed folks and independent contractors, [00:02:00] small business owners.
Jeremy Wells: It's not what they need. And so they're looking for alternatives to that traditional accounting firm model. And so we have companies. We have startups that are actually defining themselves around this concept of helping these individuals and these small businesses get up and running with an S corporation. And in general, it makes sense if you're self-employed and you're relatively successful at that, you're pretty quickly going to [00:02:30] run into a tax burden. That's it's nine times out of ten. It's unexpected the first year, probably more often than that even. I've worked with a lot of self-employed people who came to me 2 or 3 years after they started down the path of being self-employed, and they thought they could just handle it themselves. Everything was fine. But after a year or two of big tax bills whenever they prepare their returns. They just kind of say, I need help [00:03:00] with this. One of my biggest successes early on when I became an accountant was a client of mine, a brand new client. I was brand new to the profession. He came to me. He had, uh, been converted, let's say, uh, from an employee to an independent contractor. Of course, he only had one client, his former employer. And so obviously there was an issue there. But in general, he was fine with the idea of self-employment.
Jeremy Wells: He wanted to dig into that. So I helped him, uh, very early [00:03:30] on. I knew and I had been mentored, uh, on the basics and the applications of S Corporation. So I helped him get his S Corporation set up. He got in control of his tax situation. We started planning out the taxes, doing some bookkeeping, doing some tax planning, recommending some estimated payments, which he made. And within a couple years he went from having debt to both IRS and his state tax agency, to he was starting [00:04:00] to get small refunds year after year. Of course we were planning on that. We were trying to get him a little bit of a refund back. Um, not a big refund. Uh, you know, not thousands, thousands of dollars, but just enough to where it felt like he wasn't, uh, completely out of control of his tax and financial life anymore. And the S Corporation was definitely part of that set of strategies. So there is a time and place for the S Corporation. Unfortunately, that's been taken to the extreme. And now there is [00:04:30] an entire industry built up around that. And so we as tax advisors, we really need to be discerning when we're talking to clients. And honestly, when we're putting information out there in public, whether that's on social media or whether we're talking to friends and neighbors. And every account knows that as soon as a friend or neighbor or, uh, you know, somebody at your church or temple knows that you are an accountant.
Jeremy Wells: All of a sudden they start asking you tax questions, and inevitably, if they're [00:05:00] self-employed, they're going to ask you whether they should be an S corporation. We've all been there. So how do you respond to that question? You know, should my business be an S corporation? Should I be an S corporation? In general, we need to get better at the way we respond to that question, because there's really two camps. There's the one camp that says, you know. Yeah, I mean, why not do it? Uh, and again, there's this cottage industry kind of built up around that. And it's and unfortunately, that's kind of become the norm. On the other hand, [00:05:30] uh, the reaction to that has been, uh, you know, very, very critical of s corporations, almost to the point at which, uh, you know, there's probably always going to be a better option than an S corporation. I'm not necessarily in that camp either. I'm somewhere in between, again, in the right context for the right reasons. It's a good decision. So what are some of the red flags that are going to tell us that this business probably isn't right for an S corporation? [00:06:00] And how do we then explain that to the client and and get them to understand that, yes, social media might be telling you that the S Corporation is going to save you a whole bunch of taxes, but not necessarily in your case.
Jeremy Wells: What are some of those red flags? What are some of those things we need to be looking for? So I've got a list here that I want to run through. And these are some of the red flags that we're looking for when we're advising clients. These are some of the things that we're asking them about. Some [00:06:30] of these are going to particularly pertain to sole proprietorships, to individuals, uh, operating, uh, whether they have an LLC or not. The process of getting from a sole proprietorship where there's no entity to an S corporation is not that difficult. Um, Usually we just tell them in order to make that selection, there needs to be something registered at the state level. So normally what people do is they register an LLC. We're not going to advise you to do that in our firm. [00:07:00] We do consider that some limited practice of law. We won't go as far to say that it's actually practicing law, but there is an aspect of that to it. So we do usually refer them to an attorney or at least some sort of legal service that's going to help them register the LLC and hopefully get an operating agreement. We're definitely going to recommend that they do that. But that trip from sole proprietorship with no registered entity to an S corporation is relatively quick and easy. And unfortunately, that's part of why we have [00:07:30] so many S corporations and so many businesses that, looking back, probably really should have never made that election.
Jeremy Wells: Why do we say that? Why do we look at a new client coming to us that already has an S corporation or clients coming to us begging, sometimes even demanding that we help them become an S corporation, and we're really hesitant to do so. There are a few different things. Um, and so if they're an S corporation, we usually have one set of questions. We ask if it's a partnership, if it's, uh, [00:08:00] multiple individuals, uh, collaborating or if they've registered an LLC and there are multiple members in either case that's going to default to a partnership. There's another set of questions we'll ask them. There's a lot of overlap between those two sets of questions though. But the there might be some you might have the same answers to a lot of those questions. And we might come up with a different recommendation, whether that's a sole proprietorship or a partnership. And I'll get into some of why that might be the case. [00:08:30] So what is the first set of questions we're going to ask about the first, uh, you know, kind of characteristic of this business we're going to be concerned about when it comes to whether an s lesson makes sense. The very first thing we're going to do is if this business has been operational for more than a year or two. We want to see the balance sheet. And in particular we want to see two different things about this balance sheet.
Jeremy Wells: And so these are the first two criteria. But the first one is debt. We want to see if there's a lot of debt on the balance sheet a lot of debt on the balance sheet [00:09:00] relative to assets with an selection can be a deal breaker. First of all, shareholders do not get basis for debt, unlike sole proprietorships and partnerships. This is something that is surprising to a lot of business owners. It can also be surprising to tax preparers. Unfortunately, I've seen several where they weren't aware of [00:09:30] the implications of having debt on the balance sheet at the time of making the selection, or even after the election when that business is operating as an S corporation. So shareholders don't get basis for debt. Now, unfortunately, a lot of tax preparers and tax professionals that are unadvisedly recommending s corporations seem to not understand that there is a difference between partnerships and s corporations when it comes to how debt [00:10:00] affects shareholders basis. It doesn't for S Corp shareholders, it does for partnerships. If the partnership has debt, then each partner gets their allocable portion of that debt added to their basis. Now when does this matter? It matters when the business has losses. If those losses don't exceed the partner's basis, then they can take those losses on their personal returns and offset other kinds of income with those losses. [00:10:30] Now, for an S corporation, that is going to be, uh, more difficult because now debt is no longer part of that calculation.
Jeremy Wells: So even if the business has a substantial amount of debt as a partnership, partners will get credit for that on their basis calculations. If that same partnership elected s, all of a sudden that part goes away that's no longer considered part of their basis as shareholders. Now then you'll see [00:11:00] the term debt basis thrown out there for shareholders, for S Corporation shareholders. And there is this concept of debt basis. However, the only way a shareholder gets debt basis is by actually making a bona fide loan to the corporation. That is what debt basis is. In fact, the Tax Court has consistently interpreted the particular the particular Treasury regulation and circuit courts [00:11:30] have a forum have affirmed this, that debt basis does not come from personally guaranteed debt. What do I mean by that? I cannot go get a loan and intend to use the funds in my S corporation, but if I'm personally guaranteeing that debt, that is not me generating debt basis, I am not loaning money to my corporation. Yes, if the corporation [00:12:00] fails, I'm on the hook with my creditor for repaying that loan. But that is not a source of debt basis. Instead, if I take cash out of my own pocket, regardless of whether where that cash comes from, and then I can and then I loan that cash to my S corporation, that is debt basis.
Jeremy Wells: I have generated debt basis in that way. In fact, there is a concept now of what's called back to back debt basis. This is essentially I go out [00:12:30] and borrow the money, and then I lend the money to my S corporation rather than the S corporation taking on the debt and I just countersign or cosign for it. Right. That is not going to generate debt basis. However, if I borrow the cash and then loan it to my s corporation, that in fact will generate debt basis. This is going to this is particularly prevalent for s corporations that and sole proprietorships as well that existed during the [00:13:00] Covid years. And those sole proprietorships that then elected s and then took those economic injury disaster loans or idols from the SBA during Covid, those loans were virtually all to the corporations, the s corporations, and they were virtually all personally guaranteed. I saw a lot in the tax and accounting community discussing whether or not this helped those shareholders in terms of their basis, because the entire point [00:13:30] was that the business was not able to fund distributions and fund its operations. And so were those idle funds able to offset those losses and those distributions in excess of basis in any way. And they're not, because even though they're personally guaranteed, they don't increase those shareholders debt basis. Now, at the time of an election, the entity is deemed to [00:14:00] have made a section 351 exchange.
Jeremy Wells: This is a two step process with an S election. If it's an LLC and this is something that isn't really well understood among a lot of the tax professionals that I see talking about s corporations, that's election even though it's one form form 2553. There's actually a two step process that happens there with an LLC. First of all, that LLC is electing to be treated as an association, [00:14:30] which is the term used in the Treasury regulations and as an association it defaults to being treated as a C corporation. Then, instantaneously, that association elects to be treated as an S corporation. When that first step happens, we actually have a section 351 exchange. The entity, the LLC, is exchanging its assets and liabilities with this new corporation [00:15:00] in exchange for stock. So what happens is the assets and liabilities effectively transfer from whether it was a sole proprietorship or a partnership before the election into this new association or C corporation in exchange for stock. So if you think about it and this business has assets in excess of liabilities, that's fine. Whatever the net basis there is is going to be the entity's [00:15:30] basis in that stock. The second step is the entity is then going to distribute that stock to its owner or owners. But if those liabilities exceed the assets now we have a situation. Because what's effectively happened is that the entity has some sort of gain. It has a relief of those liabilities that's in excess of the assets it contributed.
Jeremy Wells: Now, we can't have negative bases in really anything under tax law, but [00:16:00] we definitely can't have negative basis in stock. So what happens then. Well essentially that gets treated as taxable gain to the entity. And if that entity is a sole proprietorship then its taxable gain to the owner. If it's a partnership it's taxable gain. That then is going to get allocated to all of the partners. So we need to be careful looking at the entity in terms of its debt to asset ratio before we make that election, [00:16:30] because we might be creating a taxable event through that selection. Generally, an selection shouldn't be a taxable event. A section 351 exchange should not be a taxable event. However, if we have liabilities in excess of assets, we might be inadvertently generating a taxable event for that owner or those partners when they make that selection. So it's for a couple reasons here that we really want to analyze the balance sheet. We want to be aware of the debts and liabilities, [00:17:00] especially relative to the assets. If we're looking at a lot of service businesses where there's not much in the way of assets, some cash in the bank, but the debts could be credit cards, could be loans that have been made to the entity. It could very easily run into a situation where maybe not a lot. But, you know, we do have situation where there's liabilities in excess of the assets.
Jeremy Wells: And so now we've created a taxable situation that no one expected. Unexpected. So [00:17:30] thinking about this, we're going to want to be clear on the assets and liabilities, which means we're going to need a balance sheet. A lot of times I will see clients, taxpayers, entities that want to make an selection and they haven't actually set up bookkeeping yet. This is a broader concern because not only do we not have a clear idea of what the balance sheet looks like, but do we even have a clear idea of what profitability looks like? And so do we [00:18:00] know do we have the information available to start estimating what the tax savings from that selection are? And I'm getting a little ahead of myself. But at this point, we need to be clear on what the financial situation of the business looks like, especially when it comes to the balance sheet. Now, the other part of the balance sheet that we're concerned with, and this is the second set of of questions we're asking in red flags we're looking for is when it comes to equity because an S corporation gives us a lot [00:18:30] less flexibility with equity, especially compared to a partnership with a sole proprietorship. We're not worried about equity that much because it's just 100% equity in one person. But with a partnership, we might have a situation where we have partners that have different allocable shares, they have different capital percentages.
Jeremy Wells: Maybe they even also have different profit and loss percentages. That's a situation that is not going to work with an S corporation. In an S corporation, all [00:19:00] items of income, loss, deduction, gain and credits are going to be allocated to the shareholders pro rata with their percentages of ownership in the corporation stock, and there are no exceptions to that. Whereas with a partnership we have much more flexibility. Now there are some limitations on that. You know, we have to look at, uh, the substantial economic effect of those allocations, of course, under IRC section 704. [00:19:30] But in general, partnerships give us a lot more flexibility over how we're allocating different items than we have with an S corporation. As corporations also require a single class of stock now, voting rights don't create separate classes of stock. But unlike a partnership where you can have differential rights to distributions, the same thing with a C corporation, for example, but with an S corporation, we can't do that. Again, [00:20:00] distributions are also required to be pro-rata. So this gets really important when we look at the operating agreement, which is going to be another set of questions that I'm going to talk about in a minute. But when we're looking at how distributions are structured, and especially if they're ordered among the different partners, then that's going to be a pretty significant red flag. And a lot of times operating agreements will include certain rules about who's going to get paid [00:20:30] first when the partnership starts making distributions.
Jeremy Wells: That right there is probably going to be a deal breaker. Um, because either we're going to need a change to the operating agreement, or this entity just isn't going to be eligible to make an election. As I said, pro rata distributions are required with an S corporation. So if the entity wants to make differential distributions to different partners based on different criteria, that's fine. It just won't be able to do that as an S corporation. [00:21:00] There are no special allocations with S corporations. Again all items of income deduction, gain and loss have to be allocated according to their ownership in the stock. With a partnership, you can get very creative again within the rules of section 704. But you can get very creative as far as how those different items will be allocated among the partners. And oftentimes that's necessary from a business perspective [00:21:30] because you might have people invest into that activity or you might have people be involved. And in order to convince them to invest or work in that partnership, they want some guarantees or they want some special treatment in the way distributions and income are going to be allocated. That's all fine and good in a partnership. Can't happen with an S corporation. And then finally, you know we always have to plan with the [00:22:00] end in mind, especially when it comes to equity. We ask a lot of questions with our business clients about what their goals are, what their long term goals are, what the what the end result looks like.
Jeremy Wells: There has to be some reason that they're doing this, that they're running this business. Running a business is incredibly difficult. Nobody does it just because they want to. People do it because they have some sort of goal, some sort of financial goal, life goal that they're trying to achieve. [00:22:30] And the business is a tool toward doing that. A lot of times they're building this business with the hopes of eventually it being acquired. And it's not just Silicon Valley startups that are doing that. You can have small local businesses being started with the intention of, within some time frame, 3 to 5 years, 8 to 10 years of being acquired. And that's the owner's plan. They want to build a business that is attractive to buyers, [00:23:00] get it acquired, make a profit, reinvest that in the next project. At some point, acquisitions with an S corporation can be much more complicated than they would be with either a partnership or a sole proprietorship. Ship, especially if you have a non qualified acquirer. So when you're dealing with an S corporation you have to think about who are the eligible shareholders [00:23:30] in an S corporation. It's US based individuals partnerships C corporations uh non us uh people. They are not eligible uh to be owners in S corporation's generally uh there are some, some uh some very specific uh exceptions to that rule.
Jeremy Wells: But in general, if you're looking at the kinds of uh, legal entities that are created [00:24:00] to do mergers and acquisitions, they're generally not going to be eligible s Corporation shareholders. So if you have an acquisition involving one of those non-qualified acquirers, then you have to be really concerned about terminating. That's election, which could cause a lot of problems. Now there are ways around that. You could do an asset sale instead of a stock sale, for example. Or you could do what's called an F reorganization. Every organizations are beyond the scope of this episode, and really [00:24:30] they're beyond the scope of my practice. They're an interesting topic, one that I definitely recommend looking into. But in general, they're just not something that we want to have happening every day in my firm. We'd rather work with the S corporations and their owners than try to figure out how to make them able to be acquired. But the the gist of an F reorganization from the perspective of someone advising a business owner on whether to make [00:25:00] an S election or not, is that they're they're going to be complicated and they're going to be expensive. And so if we want to avoid that, we want to keep that business eligible to be acquired as easily and honestly as cheaply as possible. Right. And so we're definitely going to avoid an S corporation if we can, if that's going to cause a problem for an acquisition down the road.
Jeremy Wells: Now I mentioned operating agreements earlier and [00:25:30] that is the next set of red flags. We're looking for questions we're going to ask. It's very easy to just sort of forget to ask for an operating agreement. It's very easy to just sort of slip right past that step. When we're looking at onboarding small business clients. We set up some rules in our firm to ensure [00:26:00] that we always have the operating agreement, especially for multi-member LLCs. Now we're a little less stringent on that rule with single member LLCs. And even then Sometimes we run into problems. A single member, LLC might. The owner might decide to bring on a partner. Now, in that case, we're going to advise them, of course, to work with an attorney to draw up the agreement to bring on the new partner and whether that's [00:26:30] part of the operating agreement or whether that's a separate agreement. We're definitely going to recommend and advise them to go get a go work with an attorney to get that operating agreement written up or a partnership agreement. I use those two interchangeably. They are technically different. A partnership agreement would be an agreement for an actual state legal partnership or a non-registered entity, an operating agreement. That concept is usually specific to a [00:27:00] limited liability company or an LLC. However, most businesses that we work with, uh, have been registered as an LLC. And so we just have gotten in the habit of using that term operating agreement interchangeably with partnership agreement.
Jeremy Wells: And really, just as a catch all for any sort of agreement that explains how a non-corporate entity, basically meaning [00:27:30] an LLC, is supposed to function. What are the rules as far as the ownership? Who owns what? Who contributed? What? When did they join this, uh, activity? Uh, what is the decision making process look like? What kind of, uh, tax elections are available to this entity? That question is particularly important. We have taken on clients that [00:28:00] had LLCs registered, and they came to us with operating agreements that had language that expressly prohibited selections, Actions. Sometimes that language will say just that, that the business cannot do any sort of corporate election. Sometimes it will have language that looks like this LLC will always be a partnership for tax purposes, and therefore will be governed under subchapter K of the Internal Revenue Code. [00:28:30] However, that language reads we as the tax advisor, we need to be familiar with that. We need to understand if those restrictions exist in the operating agreement and what they mean for that entity. Obviously, we don't want to start making recommendations if they run counter to what is plainly there in the operating agreement. Now, there's always the opportunity for the owners to go back [00:29:00] to their attorney and revise the operating agreement. That's fine. You know, we can talk to them if it's two 5050 partners and and they're, they're just really, uh, demanding to be an s corporation, uh, to have their LLC elected an S corporation.
Jeremy Wells: That's fine. We're going to tell them they need to go talk with their attorney first, uh, to get a either a new operating agreement drafted or, uh, have the current operating agreement amended so that [00:29:30] it allows for that. Now, not all operating agreements have that language. Some operating agreements are written from templates that don't include that language. Uh, some operating agreements just completely leave that language out. In general, I will see, uh, even even templated, even bare bones operating agreements refer to subchapter K, other than an explicit prohibition against making a corporate election, I have never seen an operating [00:30:00] agreement. And granted, I haven't seen that many, um, maybe a couple hundred total over the years. Few hundred total. But I've never seen one that explicitly took the possibility of an selection into account. In other words, I never saw an operating agreement in an original draft of an operating agreement that listed out. Here's what's going to happen if an election ever happens. I think in general, uh, operating [00:30:30] agreement templates that attorneys and legal services use, they they just don't consider the possibility of an election. They are all written from the perspective of subchapter K, which is the part of the Internal Revenue Code that gives us the rules for how partnerships operate. And that's fine. The default for a multi-member LLC is a partnership is subchapter K, uh, for tax purposes, that's absolutely [00:31:00] fine.
Jeremy Wells: However, if we're reading through an operating agreement and that's all we get And there are provisions in that operating agreement that specifically reference subchapter K, then we either are going to recommend that they discuss with their attorney what the implications of an selection would have on the terms of this operating agreement, or that they just have a new one written that allows that explicitly allows for an selection. If we [00:31:30] see language in there that might have that might contradict or conflict with the rules of subchapter S for S corporations. So what are some of those issues that might conflict with subchapter S or actually contradict subchapter S? Again, many operating agreements are written with subchapter K in mind. And S corporations are not partnerships. S [00:32:00] corporations have a lot of aspects in common with partnerships. They're both pass through entities. They both allocate items of income and expense gain and loss and credit to their, uh, to their partners or shareholders. You know, they they both have separately stated items. There are a lot of similarities, but there are a lot of differences too. And not understanding those differences and taking them into account is what can lead to some pretty serious problems with S corporations. There [00:32:30] can even be provisions in the operating agreement that directly contradict subchapter S, and in that case, we actually have situations where the IRS or even the Tax court has gotten involved and had to interpret those conflicts and contradictions, uh, in, in terms of terminating the s election.
Jeremy Wells: Now, there are ways to get around what's called an inadvertent termination [00:33:00] of an s election. However, those ways usually involve something along the lines of private letter ruling or dealing with the tax court. And again, that can be complicated and costly for the taxpayer. And we really want to avoid that if possible. It might be annoying to have to go spend a couple of days, maybe a few hundred dollars, a couple thousand dollars working with an attorney to rework an operating agreement to make sure that everything is okay with the selection. That's going to [00:33:30] be a lot less annoying and a lot cheaper in the long run than having to go through the process of getting a PLR from the IRS, or dealing with the Tax court in order to save a an inadvertent termination of an S corporation. So some of these issues and operating agreements that can blow an s election, one is looking at subchapter K, IRC section 704 [00:34:00] B, which I've already referenced, requires partnership agreements to ensure that allocations have what's called substantial economic effect. The special the the substantial Economic effect regulations require that liquidating distributions from a partnership go according to positive capital accounts. What do I mean by all that? Let's assume that you have a partnership and it decides to liquidate. When a [00:34:30] partnership liquidates, it distributes all of its assets out to the partners.
Jeremy Wells: Now, how it distributes those assets is going to be based on their capital accounts. And their capital accounts is essentially the measure of their book equity in the partnership. Now, I'm oversimplifying that a bit, but let's just think of it that way for now. What happens in a partnership when it liquidates? Eight. If you have partners with negative [00:35:00] capital accounts, in other words, they're not getting a liquidating distribution out of the partnership. They depending on how the operating agreement is written, they might actually owe money back to the partnership because their negative accounts, negative capital accounts means that other partners with positive capital accounts aren't getting the full liquidating distributions that they deserve out of the partnership. Something caused their capital accounts to go negative, and that [00:35:30] means there's not enough assets, usually cash, left in the partnership, to cover the positive capital accounts of the other partner or partners. So there needs to be some way of accounting for that. Now we can either, uh, differentiate the way we're taking distributions. We can differentiate the way we're allocating, uh, deductions and losses throughout the years that the partnership is active. The 704 B regulations are incredibly [00:36:00] complex and give several different methods for how we account for this. One of those methods is to force the entity to make non pro-rata distributions. In other words, to effectively cancel out those negative capital accounts. The partnership is going to make distributions that are going to balance them back out by either either giving more to [00:36:30] the partners with positive capital accounts, or essentially affecting the way those distributions are calculated in in prior years before the liquidation.
Jeremy Wells: Even if the operating agreement is silent on liquidating distributions, then usually state law will still require them. Remember, state law is what creates LLCs and partnerships to begin with, and state law will [00:37:00] usually include some provisions of what partnership liquidations will look like. So even if we have an operating agreement that doesn't really cover these topics, that's when state law intervenes. And really, from the perspective of the partners and the business owners, we would rather have them determining what a liquidation is going to look like than letting state law do that for them. Now, because we're talking about liquidating distributions and situations with negative capital accounts, we can very easily run into a situation where we have non pro-rata distributions [00:37:30] that might be required by the operating agreement or by state law. And notice that non pro-rata distributions is one of those things that can lead to the termination the inadvertent termination of an selection. So if the operating agreement or even the state law in which that partnership or that LLC was registered uh With those non pro rata distributions, we might have an inadvertent termination of the s election before [00:38:00] it's even made. We just didn't know about it. So those can be situations that can cause any of those sorts of 704 B provisions that are going to account for, uh, negative capital accounts when the partnership liquidates those can cause and it's not just when the partnership Liquidates we can have those non pro rata distributions in years prior to the liquidation to prevent negative capital accounts at a liquidation. [00:38:30]
Jeremy Wells: We can just in order to prepare to plan ahead for the possibility of liquidation, the partnership may be required to take actions that could contradict the rules of subchapter S, and therefore lead to an inadvertent termination of the s election. Some operating agreements also will include what's called waterfall distributions, which are essentially a set of rules that will prioritize some members over [00:39:00] others in terms of getting their distributions or calculating how much distributions they should get. Again, that is going to violate S corporation rules as far as pro-rata distributions go. So we have to very carefully read operating agreements. Now we're not attorneys. We're not trained in reading the legalese that would go into an operating agreement. However, we are going to read through it and try to pick out these terms and concepts and potential red flags. If we see [00:39:30] these things, we're going to go back to the client and or the taxpayer or the partner or whoever we're talking to and tell them, look, we're seeing this. This indicates to us a potential problem. Please go back to your attorney and have them clarify this. If it's in an existing operating agreement, then tell that attorney that you may want to consider revising that along with the other partners or LLC members, if you want to go through with the selection.
Jeremy Wells: Otherwise, we're going to have to come up with a different plan. So [00:40:00] those are just some of the ways that the operating agreement can be involved. Now, I started this section off talking about how we require getting operating agreements from our clients, especially the multi-member LLCs. And we're pretty strict about that with multi-member LLCs. We're actually getting more strict about that with single member LLCs, to the point at which we've let a lot of Ex-mlc clients get by without one. We're actually coming back and recommending now that they go [00:40:30] ahead and get one, even if they don't have any intentions of bringing on a partner or anything like that. It's it's just better to have one just in case. Um, and of course, we're proactively recommending that they discuss with their attorneys some of these issues that can come up. For example, make sure if you're going to talk about subchapter K that you talk about it in a way that it's either reversible or [00:41:00] that if an election ever is made, that the provisions of subchapter S override those of subchapter K, for example. In other words, we just want to make sure that the operating agreement is written in a flexible way so that if the owner or owners want to make some sort of tax election down the road, that the operating agreement at least permits it.
Jeremy Wells: Another set of questions we're going to ask about now. And this this gets [00:41:30] back to the balance sheet, is now we're looking at the asset section of the balance sheet. So is there the possibility of significant transactions involving fixed assets. And could those transactions cause any issues. So I already mentioned that when you elect S, we have the section 351 transfer that is going to exchange the assets and liabilities with this new corporation for stock. Now, [00:42:00] if we have assets in the business and the business is expecting those assets to appreciate in value, then we might want to look into that more. Typically, the only assets that a business would hold that we would expect to appreciate are real estate for a variety of reasons. We generally recommend not holding real estate in an S corporation, and this is essentially why distributions [00:42:30] of appreciated property to a shareholder result in reportable gain. So if you have an S corporation that has appreciated property, whether that is stock or real estate or some sort of, uh, you know, rare, valuable thing that it has on the balance sheet for some reason. If that's corporation distributes that to a shareholder, then that will lead to reportable gain for the, uh, for [00:43:00] the shareholder in a partnership. That gain from a distribution of a of an appreciated asset would generally be deferred, as long as the property is not a section 751 hot asset.
Jeremy Wells: So that's that's an asset that's going to generate ordinary income such as inventory or accounts receivable. We're not we're not worried about that right now. We're talking about appreciated uh more fixed assets, long term assets. And those sorts of things [00:43:30] are going to create taxable gain for shareholders if they're distributed. Not so much for partners, at least not when they take possession of that distributed property. Now they might turn around and sell it later. When they sell it, they're going to sell it at the original adjusted basis of the partnership or what it was contributed to the partnership at. And so there's going to be a lot more gain when they sell it. They're not going to have any kind of step up or anything, but they're also [00:44:00] not going to have taxable gain when they receive that asset that's been distributed from the partnership. So that's something to keep in mind if there's the possibility of the entity distributed distributing an appreciated asset, then we're probably going to avoid or recommend against an election. Now the other side of that is that there's no step up of inside basis whenever shareholders change [00:44:30] or exit in an S corporation. This is an important planning tool with partnerships under section 754 of the URC. A partnership can step up the basis of its assets, what's commonly known as its inside basis. With respect to a partner, when it acquires a partner's interest in a partnership, or when it inherits a partner's interest [00:45:00] after death, this helps mitigate the reported gain on the sale or distribution of those assets after the partnership ownership changes.
Jeremy Wells: This is actually a really important planning tool for partnerships, but there's no such election available for S corporations. There is nothing in subchapter S that pulls in the possibility of a 754 election to step up the basis of inside assets [00:45:30] for the the inside basis of assets for an s corporation. It's possible with a partnership and it might be advisable in a partnership that's not going to be possible in an S corporation. So again, if we're looking at holding assets that we expect to appreciate over time, we're probably not going to look at an S corporation for an selection for that entity. It's just not going to make sense, at least not in [00:46:00] terms of how we're going to think about and plan around those fixed assets. There might be other reasons, uh, compelling reasons, that we would want to elect s for that entity. In that case, we might look at some strategies where we could either go ahead and distribute out those assets of the partnership before we make the selection, or we might look at splitting it into two entities. Now, this is a common structure where you have a business that operates as an S corporation, [00:46:30] and you have a related owner, usually the same owner as the shareholder of the S Corporation that in a separate entity owns the real estate.
Jeremy Wells: So maybe you've got a business that operates out of a storefront, and the storefront is also owned by the same person that is the shareholder of the S Corporation. That's perfectly fine. In fact, you see that structure a lot because we don't want the appreciating asset, [00:47:00] the real estate also being held in the S Corporation. Now, there are some self rental rules that we need to be aware of and take into account with those situations. But it avoids the weird issue of having appreciated assets locked inside of that's corporation. And then the last set of issues that we're going to look for really just have to do with the mechanics of s corporations and how they operate from year to year, especially from a tax perspective. [00:47:30] We really want to make sure that there is a clear projection of the tax savings from electing s. A lot of times when I see the benefits discussed of an S corporation, that analysis begins and ends with savings of self-employment tax. And yes, in general, that's the virtue of an S corporation is compared to a sole proprietorship or a partnership for [00:48:00] a general partner who their share of the income is going to be entirely subject to self-employment tax. In general, the benefit of an S corporation is you can use reasonable compensation as a way to limit the amount of self-employment tax or under an S corporation to becomes payroll tax that that shareholder is going to be subject to.
Jeremy Wells: That's fine. I've helped a lot of my clients, uh, do that use an S corporation to do [00:48:30] that. The problem with that comes when we're not taking into account all of the other aspects of that individual's tax situation that are going to be affected by that selection, and that issue is amplified and multiplied when we have multiple owners in the same entity. So I might have the exact same activity, [00:49:00] exact same PNL, even exact same balance sheet. But I have one activity that has a single owner and another activity that has 3 or 4 partners running it. I might come up to it with a very different recommendation just based on that fact alone. So what are some of the things that we're looking at that could factor into the, uh, the tax savings decision to make an s election, besides the self-employment tax savings? The [00:49:30] first one is reasonable compensation itself. A lot of the estimates of tax savings with an S election are they're just estimating reasonable compensation way too low. Those tax savings are not the result of making the s election. Those tax savings are unreasonably low salaries being paid through those S corporations. Of course [00:50:00] I can save you on self-employment tax if I make an S election. And then just don't run any payroll to you. I'm going to save 100% of your self-employment tax doing that. However, we know that's not how an S corporation works.
Jeremy Wells: We know that that's not the right way to run an S corporation, and it's definitely not the right way to advise the owners of an S corporation who are active in that business. So we need to make sure that the reasonable compensation analysis that goes into [00:50:30] that decision to make an S election makes sense. We need to make sure that the wages paid that we're projecting is reasonable. We also need to look at the section 1099 a qualified business income deduction. That's going to be calculated based on the pass through net income. So if we do run reasonable compensation that's going to reduce the net income that's going to pass through. And that's going to reduce the qualified business income [00:51:00] deduction. So in essence we're saving a little bit of self-employment tax. But we're also costing ourselves a pretty significant deduction for a lot of small business owners. Now we are not sure at this point while I'm talking what section 1099 a cap A is going to look like in the near to long term future. However, when we're advising for right now, we have to assume that tax law [00:51:30] is going to stay the way it is at this point, as I'm speaking. Section 199 cap A will sunset. So that's changing the way we're advising our small business owners as far as making an selection in the future. That could change. And if it does, we'll have to revise the way we're making those recommendations.
Jeremy Wells: But the point is, you have to be aware of how that pass through income and any potential deductions or effects on the [00:52:00] shareholders personal tax situation is going to play out. And then finally, we got to look at state and local taxes on s corporations. I have recommended or not s elections in some places based on what the state and local tax situation will look like for that entity. So again, a lot of the analyzes of whether to make an S election or not look at self-employment Employment tax. But then they ignore the state and local [00:52:30] tax effect. Tennessee imposes the state of Tennessee imposes a 6.5% tax on s corporations. New York City imposes an 8.85% tax on S corporations. Those taxes can wipe out any projected tax savings from an S election. And so we have to be very careful about where we're actually recommending this now. A lot of tax professionals as well as taxpayers, [00:53:00] uh, worry about California. California has an $800 minimum tax on LLCs. But for S corporations it's actually the greater of that or 1.5% of that's corporations net income. Now, if I had to choose, I would much rather pay 1.5% tax than a 6.5% or an 8.85%, but still 1.5% of net income is a pretty could be a significant [00:53:30] effect on the owner's tax situation. And it's something we need to take into account when we're advising an election. Now, a lot of states now with the salt cap on individual tax returns in their schedule, A's, a lot of states have enacted what's called a pass through entity tax or a tat.
Jeremy Wells: And that subject is beyond the scope of this episode. But it can be a way to offset some of the cost of operating an S [00:54:00] corporation or a partnership, but that therein lies an issue. And really, it's the theme of this episode. There are things that differentiate s corporations and partnerships, and then there are things that are also similar as well. So it's not quite an apples to apples comparison, but it's also not an apples to oranges comparison either. There's just enough similar frame of reference between a partnership and an S corporation that we need to be aware of what the important differences are, and we also need to look at what the similarities [00:54:30] are and if we can achieve similar results without the significant administrative burden, additional taxes, uh, important issues that could affect the the validity of the election itself, then we don't want to make our default position to just be make the selection and then save on SC tax. We need to seriously look at what that entity election will mean for the business today, in the future, and [00:55:00] for the shareholders or partners themselves. So that is some reasons not to make an selection or really to think a little bit more critically about whether or not to make that selection.