Smart Income Tax Strategies and Considerations for Ecommerce Businesses - PART 1

Tanner is, if I'm not mistaken, the biggest CPA firm headquartered in Utah, where we are also headquartered. Is that correct?

0:27 Heather Allen

That's right.

0:28 Stephen Brown

They have a well-known reputation. As we were talking in our pre-webinar chat, they work with companies across the nation, and we've worked together over many years, so we have a lot of confidence in their capabilities.

Heather and Steve, do you guys want to introduce yourselves any further?

0:45 Heather Allen

I think that was great. You can see our bios up on the screen, not that you need to read through any of that. But at the end we'll also have our contact information, so we're always happy to answer questions.

0:58 Heather Allen

I guess just high level, Steve and I both work with a lot of growing companies in that middle market space, really from startup stage all the way to either public companies or an eventual exit. So that's exciting for us, to work with companies as you're really experiencing a lot of those growing pains. And we like to come in and be able to help in the areas of our expertise, knowing that you have a million other things that you're focusing on every day.

1:34 Heather Allen

So yeah, thank you, Stephen, for having us today, and we're excited to get to talk tax with all of you.

1:39 Stephen Brown

All right, let's go ahead and get rolling.

1:46 Heather Allen

Well, as Stephen mentioned, please bring up questions.

So our agenda today. We're going to talk about tax entity selection, really from the get go, what makes sense, and the legal structure and how to operate your business.

2:16 Heather Allen

State and local tax considerations, which I'm sure many of you have already been involved in and understand those issues, as you expand your customer base as well as internally with your workforce.

2:24 Heather Allen

Preparing for an exit and the due diligence that comes along with that. It's never too early to start thinking about that.

And then lastly, we're going to talk through just some favourable tax elections. Not all may be applicable, but just some items to think about and talk through with your tax preparer, just to make sure that you are taking advantage of the benefits that are out there.

2:56 Heather Allen

So this little cartoon is fun. It would be nice if you could just elect out or unsubscribe from the IRS, but knowing that we can't do that, the tax world is huge. And so we want to jump right in. We've got a lot of information to cover, and I'm happy to answer questions as they come up.

3:14 Heather Allen

So I'm going to turn it over to Steve to jump in on this first agenda item.

3:21 Partnerships and LLCs

Steve DeWitt

Alrighty, well thanks, Heather.

A lot of times the first thing that we're asked as tax professionals, by people who are starting businesses or business owners that have been going for a few years, is what kind of legal entity should I be? What should I be taxed as? Or am I in the best entity for the type of business I have, or for the different goals that I have?

3:45 Steve DeWitt

And so in our first section we're going to cover different types of legal entities, their tax impacts, and some of the pros and cons of each.

And first we'll start with what are called flow through entities, or pass-through entities, and the reason for that name will become apparent here in a minute.

4:01 Steve DeWitt

The most common type of pass-through entity that we see is an LLC that's taxed as a partnership. Partnerships can also be structured as a general partnership or limited partnership, but generally we see legal entities as an LLC, that's what we commonly see in practice.

4:18 Steve DeWitt

And then as a brief aside, you can also have an LLC that's owned by one person. Those are commonly referred to as single member LLCs, and that's where the owner just reports the income on their own individual income tax return. But if you have a multi-member LLC, then that's going to be generally taxed as a partnership.

4:43 Steve DeWitt

And partnerships have the benefit of the income only being subject to one layer of tax. The taxable income is calculated at the partnership level and then is allocated out to the partners via K-1, and then that information is just reported on the owner's tax return and they pay the tax on that income once.

5:01 Steve DeWitt

Any future distributions of cash or property is generally going to be tax-free, as either a return of their previously taxed income, or return of the capital that you contributed.

5:20 Steve DeWitt

The other benefit is that the losses, besides income being passed through, when losses are passed through those can also be used by the owner to offset any other income that they have, and help reduce their tax liability. While the business is getting started up you might be incurring a lot of losses, and so having those losses on your individual return can also help mitigate some of your other taxes that you have.

5:43 Steve DeWitt

For partnerships, allocation of income and loss can be very flexible, same with distributions. Those can be structured in different ways depending upon the operating agreements, as long as they conform with the Internal Revenue Code regulations.

6:01 Steve DeWitt

The downside is, income that's going to be flowing through to individual owners can be taxed at up to a 37% rate for federal. That's the highest federal marginal rate.

6:13 Steve DeWitt

And then additionally, for people who are active in the business, you're also going to be subject to self-employment tax on the income, which for the first 160,000 or so is going to be taxed at about 15.3%, and then anything after that's going to just be 2.9% for just the Medicare piece of self-employment tax. So there's quite a bit of large tax liability that can come from that income being passed through.

6:36 Steve DeWitt

But luckily, a few years ago in the Tax Cuts and Jobs Act of 2017, there was some relief that was brought in for business owners of pass-throughs.

The act instituted what we commonly call the qualified business income deduction, or the section 199A deduction. And what this allows is for business owners to exclude 20% of that income that's being passed through to them.

7:07 Steve DeWitt

So that's a permanent exclusion, and it essentially cuts the tax rate down on that pass-through income from 37% to 29.6%. So that gets them a little bit more on par with the corporate rate of 21%, and helps alleviate some of that tax bite that is there.

7:27 Stephen Brown

Let me see if I understand this right, Steve, because I do have one question from an attendee.

So basically with an LLC, you can allocate 20% of the taxable income and say, I get to carve that out separately and tax that separately. Is that what I'm hearing you say for the qualified business income deduction?

7:47 Steve DeWitt

That's right. So you're able to exclude 20% of that income from being taxed if you meet all the requirements.

7:54 Stephen Brown

Another question around LLCs, I don't think you have it spelled out right here. How do I pay myself as an LLC? Can I run payroll on myself as an LLC?

8:07 Steve DeWitt

When you're structured as an LLC, if you're taxed as a partnership, you can't be an employee of the partnership. And so generally you're supposed to give yourself a guaranteed payment, which is also reported on your K-1. So it's kind of like a salary, but it's just reported a little bit differently. Usually you would get a W-2 if you're an employee, but where you're the owner of the LLC and a partner, you would have a guaranteed payment, which would be picked up on your individual return as a salary that would be subject to self-employment tax as well.

8:41 Steve DeWitt

If you're operating an LLC as just a single member LLC, reporting on your Schedule C, you're not really an employee either. You can't be an employee of your own single member LLC, and so you just pay yourself through distributions from that LLC if you have residual income that's there.

9:06 Steve DeWitt

Like for example, my wife has a salon that she runs by herself. She doesn't have any employees, but when we need to take cash out of there we just take the cash out of that bank account and transfer it over to our personal bank account. And that's how she pays herself within the residual profit that's there.

9:16 Stephen Brown

And I think that's one of the biggest mistakes we see people doing, is putting themselves on payroll when they're only an LLC taxed as a partnership.

9:28 Steve DeWitt

Yeah, that's correct. And the IRS is very clear that owners of LLCs can't be employees. It's not a huge deal, but it does impact some benefit plans and there are other issues that can arise. The taxes kind of work out to the same, but the IRS is very clear that you need to be treated as a partner and receive a guaranteed payment if you're going to work for the LLC as well.

9:53 Heather Allen

So maybe I'll just add in there too, that means there's no withholding on that salary, not like there would be on a W-2.

So Stephen, that's probably what you were thinking about as well. When you're getting a guaranteed payment, that means you're responsible for making your own estimated tax payments and remitting all of that for yourself as an owner.

10:10 Heather Allen

As Steve mentioned, generally those are grossed up to make sure that that self-employment tax is covered, and you're not personally in a worse case than if you had been an employee. But the business is not withholding and remitting payroll taxes for you, or your federal income tax or state income tax withholding. So you need to be prepared to do that at the individual level instead.

10:36 Steve DeWitt

Yeah, exactly. And it's also important to note that that qualified business income deduction doesn't apply to your guaranteed payment. It's only going to be from the income that's actually passed through to you on the K-1. So it wouldn't apply to the guaranteed payment.

10:52 Stephen Brown

So I've got some follow-on questions that lead us to the next section. How does an S corp change this? Is there anything else you wanted to mention on the LLC taxed as a partnership before we move on to the S corp?

11:05 Steve DeWitt

No, I think we can move on to the S corp. I was going to talk about state income tax compliance, but we can tack that on to the S corps, because the same principles apply there.

11:19 S corporations

Steve DeWitt

And so S corps are a little bit different. These can either be a state law corporation that has made an election with the IRS to be taxed as an S corp, or what you'll sometimes see is a state LLC that also can make that same election to be taxed as an S corp.

11:45 Steve DeWitt

And so you'll see either Incs or LLCs, and either one of those has the ability to be taxed as an S corp.

So S corps have similar features as partnerships, like income flowing through to the owners, one level of tax.

12:05 Steve DeWitt

And then the state income tax compliance that I was going to mention with partnerships, that just has to do with, because you're getting allocated the income wherever your company is operating, not only does the entity have to file some state income tax returns, but any income that's passed through to you may give you a requirement to file state tax returns as an individual in that state and pay taxes there. So it can create quite a bit of compliance where you're filing multiple returns in multiple states. And so that's one of the downsides of being involved in a pass-through entity.

12:41 Steve DeWitt

So owners of S corporations can only be US individuals. So that excludes, an S corp can't own another S corp, a partnership can't own an S corp, or a C corporation. And then there are certain trusts that can also own S corporations. So it's very limited on the types of owners that can be involved with S corporations.

13:06 Stephen Brown

Let's pause on that point real quick, because I know we have a few people from outside the country here. We deal with this from time to time, their international sellers. They want to sell in the US, they go ahead and they set up their US entity so they can be compliant with sales tax. In that case they would have to be just an LLC, they could not be an S corp?

13:27 Steve DeWitt

Yeah, that's correct. And it could also be a C corporation too. They could set up a C corporation, they could be an LLC that they elect to be taxed as a C corporation, because LLCs can also be taxed as C corporations. Or just a straight LLC.

13:51 Steve DeWitt

Usually I think we'll see in that situation, Heather, tell me if I'm wrong, but we'll see just an LLC taxed as a C corp, or just a regular C corporation.

13:59 Heather Allen

Yeah, and that's what I was going to mention as well. If it's just an LLC that maintains that flow through status, that brings the entire foreign company into having permanent establishment or presence in the US. So that can create a lot of compliance and complexity, pulling the entire foreign entity in instead of just the US subsidiary.

14:24 Heather Allen

So many times we see that US subsidiary make a C corp election, just to draw the line, and then only the US entity operating here is what you are needing to file tax returns for, and deal with that separate income or loss, rather than pulling in the entire foreign operation.

14:43 Stephen Brown

So I've got questions pouring in fast and furious, let me get a couple of these.

Let me see if I can reiterate this. The big changes with S corp election are, I can be an employee of my company. And the primary benefit of the S corp election is I pay myself a salary, and that's taxed under normal employee and employer tax rates.

15:17 Stephen Brown

Just to summarise, an employee pays a certain amount of taxes, and then the employer also has to pay the FICA taxes. But other distributions to the owner with an S corp don't have to be taxed at that same rate. Is that correct?

15:38 Steve DeWitt

Yeah, that's right. So what happens with an S corp, like you said, Stephen, is if you are an employee, you can be an employee of your S corp if you're working for the S corp, and also an owner. So you can be an owner employee, which you can't be in a partnership.

15:54 Steve DeWitt

You need to pay yourself what's considered reasonable compensation. And that is essentially, what would it cost for you to go out to market and find somebody to do what you're doing, and what you would have to pay them? So the IRS is very strict about reasonable compensation, to make sure that the owners are being paid what they should be.

16:12 Steve DeWitt

And that is subject to just the normal W-2 withholdings, the payroll tax, Social Security, Medicare, all those federal and state withholdings. So that's all done like normal payroll.

16:23 Steve DeWitt

And then any residual profit after that is not subject to those payroll taxes, the self-employment tax. So that's where a big saving could come in. If you're paying yourself up to the FICA limit, which is about 160,000 in 2023, then you're paying all the FICA you need to pay anyway through payroll. But then you're saving about three percent of Medicare on any of that residual profit that's allocated to you. So there is a nice about three percent tax saving that you could have if you're operating as an S corp.

17:01 Stephen Brown

Let me clarify on that, because this is a big question I see out there. What is a reasonable salary? That's the hardest. I've looked at this before, because LedgerGurus is an S corp, and I'm like, what is a reasonable salary? And there's no clear answer there.

17:19 Stephen Brown

So you're saying, even if there are benefits to pay yourself under that limit, the self-employment tax cap is 160,000, but what you should be paying is what you feel like you'd need to pay for somebody to do your role. And that's where it gets a little bit arbitrary.

17:36 Stephen Brown

But even if you paid yourself over that limit, you're also saying there's still a benefit to the S corp, in that, which tax did you say that you don't have to pay? Medicare, the Medicare tax. So even if you pay beyond that, there's still a benefit, is what I'm hearing.

17:49 Steve DeWitt

Yeah, even if you pay over the Social Security limit, say you pay yourself two hundred thousand dollars, you're going to pay a little bit more Medicare tax on your own, because you're going to be responsible for the Medicare on that forty thousand dollar difference from 160 to 200,000.

18:08 Steve DeWitt

But let's say you still had a profit of a million dollars coming through that's allocated to you on your K-1. Then you save three percent on that million dollars, because that's just over and above what you're paying yourself as reasonable compensation.

18:19 Stephen Brown

All right, I'm going to hit some more questions fast and furious.

With a partnership, can you transfer from an LLC to a personal account as described for a single member? Can you move your money from the business as an S corp to your personal account?

18:45 Steve DeWitt

Yeah, so if you're in a partnership and you're operating as a partnership and you're an LLC, then you can get distributions from the company and those can go into your personal account. And like I mentioned before, those distributions are generally non-taxable. There are some calculations that go into there, but generally they're a return of capital or return of previously taxed income.

19:04 Steve DeWitt

And that money can be transferred out according to your operating agreement. Let's say you have in your operating agreement that everyone gets a 40% tax distribution, and then that money can just go into your personal account from there.

19:16 Steve DeWitt

For an S corporation it's similar, except distributions have to be pro rata. So if you want to distribute out to the owner, say you're in a 50-50 S corp and you want to distribute out a hundred thousand dollars to help the owners pay their taxes, then each owner needs to get fifty thousand dollars, because those distributions need to be pro rata according to ownership. While partnerships, there is a little bit more flexibility in how those operate.

19:44 Stephen Brown

Okay, next question. Any updates on when or if the 199A deduction will no longer be available? Is there a sunset on that particular part of the tax code?

19:52 Steve DeWitt

Yes, currently there is a sunset on that piece of the tax code. I think after 2025, Heather?

20:04 Heather Allen

Yes, it's 2026. I'm not sure if it's the beginning of that year or after that year, but it is set to sunset.

20:10 Steve DeWitt

Yeah, and it has been a pretty popular aspect of the Tax Cuts and Jobs Act, so I could see it be something that does get extended. But with the current climate in our government, it's not safe to say if it will or not. So we'll just have to wait and see once that time comes.

20:28 Stephen Brown

Okay. Can an S corp be a partner in a partnership?

20:36 Steve DeWitt

Yes, but not the other way around.

20:42 Stephen Brown

Okay. How should payment to an owner be categorised in the books for an S corp? Salary expense and an income?

20:54 Steve DeWitt

Yeah, if it's for their salary, then it should just be like your normal salaries expense with all your other employees. If it's a distribution of profits over and above the salary that they're making, then it would come out of equity as a distribution. So it's not an income or expense item, it'll hit the balance sheet.

21:12 Steve DeWitt

It hits the balance sheet. You take the cash out and then take it out of equity.

21:20 Heather Allen

And to clarify there, because distributions in an S corp have to be pro rata, the only way to get different amounts of cash to different owners is through salaries. So you can still have different salaries, different bonus structures for any S corp owners that are also employees. But when it comes to the distributions that hit equity, as Steve mentioned, they have to go according to ownership. If not, then you're putting your S election at risk.

21:55 Stephen Brown

Can you backtrack and become an S corp? Let me see if I can put a little colour on that. Can an LLC become an S corp?

22:07 Heather Allen

Yes. That could be a single member LLC, because an S corp can have one owner. So if you're operating just as a sole proprietor right now with an LLC and it's reporting on your Schedule C, you can make an election to be an S corp. And then same for a partnership, you can make an election. There are some nuances to it, but generally it's an eligible entity that can make that S corp election.

22:34 Heather Allen

You can make it up to 75 days after. So if you want to make an election effective 1/1/23, you can still do that up until March 15th. But that's really the only time frame that you have to go back. You can't go back to prior years and change that.

22:50 Heather Allen

If you're a brand new entity that's never filed a tax return, so say you just started in 2022 and you're working on your initial tax return now, there is some late election relief to say, hey, we know we missed the 75 days initially last year, but this is our first return and we just want to be an S corp from the beginning. So there's some late election relief there. But generally 75 days is all you've got to work with when you're trying to go back in time to make that election effective.

23:14 Steve DeWitt

Yeah, good point there, Heather.

And one thing with S corps, they're eligible for the 199A deduction. We talked about the one class of stock with the distributions.

23:33 Steve DeWitt

One thing that's tricky with them is if you have any kind of potential for an M&A transaction, they can be somewhat difficult to pull off, just because of the ownership requirements. Usually private equity is coming in, or buyers coming in, and they're structured differently. They might be a C corp or a partnership, and as we discussed, those aren't eligible owners of an S corporation.

23:51 Steve DeWitt

And so there are some reorganisation type things that need to happen before someone can buy into your S corp that's not an individual. So it does make things tricky down the road. Something to keep in mind when you're trying to decide if you want to be a partnership or an S corporation, just how soon that might come, and how there could be potential for a little bit more work to get a deal done.

24:23 Stephen Brown

The last question on S corps, and then I have a question on C corps. Thomas, we're going to get to that next.

I think you've already covered this, but this was a good way to summarise. In what case would it be beneficial to convert a sole proprietor LLC to an S corp?

24:41 Steve DeWitt

If you're very profitable and paying a lot of self-employment tax, then converting to an S corp is going to help you save on some of that self-employment tax. Heather, anything else?

24:53 Heather Allen

I mean, that's probably the biggest advantage of an S corp these days, is just that self-employment tax. A lot of the other stuff are more cons than anything.

25:07 Heather Allen

And just to throw out, in the environment, I won't say current environment, but a year ago when there was a lot more tax talk on the table in Congress, that was actually an issue that was being discussed, of removing that. Congress feeling like there shouldn't be this self-employment difference between the two.

25:21 Heather Allen

Again, nothing passed and that's kind of died down. But that's not to say that that discussion won't come up in the next couple of years if there's other tax reform on the table. So that is something that some people don't think there even should be that difference.

25:40 Stephen Brown

And my theory is it'll never happen, because Congress all take advantage of S corps. There are notorious cases in history of members of Congress who have made boatloads of money and taken advantage of the S corp election.

25:56 Heather Allen

Very, very true, Stephen. Very, very true.

25:58 Stephen Brown

Let's move on to C corps. I have a question, unless there's anything else.

26:09 Heather Allen

The only other thing I was going to say is, a lot of times when you think of stock based compensation you're thinking of a C corp with stock options and things like that. But there are ways to incentivise some of your key employees with equity-based compensation in both partnerships and S corporations. So that is available. It's a little trickier than stock options in a C corporation, which we'll talk about in a minute, but those avenues are available to you if you want to incentivise key employees sticking around for a future exit.

26:40 C corporations

Heather Allen

So with that though, yeah, we're kind of switching gears now. Steve was talking about flow through structures, types of entities that aren't taxable generally themselves, but the income or loss flows through to the owners.

26:54 Heather Allen

C corporations are taxable entities. So you get into this double layer of tax. We've probably all heard that before.

Before the tax rates changed in 2018, that was a much bigger difference than it is now. But with the corporate rate dropping to 21% the last few years, this differential, even when you layer in a double layer of tax, may not be as large as you think it is between the flow through entities and a C corp structure.

27:29 Heather Allen

So generally what we bring up first to clients when we're having this type of discussion is, what do you plan to do with this entity, and when do you think that will happen? Is it something you want to continue operating until you retire? Is it something that you're saying, nope, I'm starting this up, I want to build value and I plan to sell in three to five years? Those questions produce very different answers on what may be the right type of tax entity selection.

27:57 Heather Allen

So as I mentioned, the biggest difference is income or loss in a C corp is taxed at the corporate level, currently 21% federal rate plus any state rates. There's no flow through treatment. So if you have a loss that creates an NOL, that you carry forward at the corporate level to offset future income.

28:14 Heather Allen

The second layer of tax comes in when you pay dividends to your owners. So, same idea, where we're talking about net profit in the business after compensation, after all wages that you've paid yourself, because you can also be treated as an employee, you should be treated as an employee if you're working for the corporation. But any extra profit that you're not keeping in the business and you're distributing to owners, that creates a second layer of tax, and that's what you report on your individual returns.

28:47 Heather Allen

So it can keep your individual return actually a lot simpler than in a flow through structure. You're not dealing with a K-1, you don't have the potential additional state filing requirements that Steve was talking about. You basically have your W-2 for the wages you're getting, and then if there's a dividend paid you would pick up that dividend as well.

29:05 Heather Allen

C corporations are probably the most widely understood type of entity out there. There are no restrictions on who can own it. When you're going into an M&A transaction, private equity, venture capital, foreign individuals, they're all very familiar with the C corp structure, and so it may make that process a little simpler. But it still provides a lot of flexibility with the options that you have for equity or for debt investment.

29:42 Stephen Brown

Is it true, I mean, it would be fair to say 100% of publicly traded companies are C corps? When you're talking about buying stock off a stock exchange, you're buying C corp stock.

29:56 Heather Allen

That's right, yep.

29:58 Stephen Brown

The other thing I hear frequently is, if you're going to take investments from venture capitalists, they usually require a C corp.

30:12 Heather Allen

It's either an LLC or a C corp. Sometimes they're okay with an LLC structure, and they may actually prefer that flow through structure, depending on how they're looking at it from the investor's side.

30:24 Heather Allen

But yes, many times if you're not a C corp, they will either create a new C corp and transfer assets into there to hold the business going forward, or they will require you to convert before their investment comes in.

30:37 Heather Allen

And again, very high level, but LLCs are just generally the most flexible. You can get into any of these other structures from a legal LLC from that standpoint. Once you're in an S corp or once you're in a C corp, getting out is generally just not an option, because of the tax implications of doing that.

31:05 Heather Allen

So that's why the selection in the first year at the beginning does become very important, to make sure you've had these types of conversations on what we think may happen in the future, what we're trying to set up for. Because once you make that S election or that C election, you're probably going to be stuck with that entity structure until there's an ultimate full exit at the end.

31:27 Asset sales, stock sales, and equity grants

Stephen Brown

Okay, a couple of questions on stock, and you've mentioned this. If somebody was wanting to sell their business, would it make sense to convert to a C corp before trying to sell their business?

31:39 Heather Allen

It can.

31:51 Heather Allen

We've got a basic comparison between an asset sale and a stock sale. So if the buyer wants to come in and buy assets, then it probably doesn't make sense to make that conversion before. Because a C corp selling assets is going to pay tax at the C corp level first on the gain on the sale of those assets. Then when they distribute the cash to their owners, there's going to be a second layer of tax. Whereas in an LLC or an S corp, there's just one layer of capital gain that's just taxed at the individual level.

32:21 Heather Allen

If they're wanting to buy stock, then a seller always wants to sell stock. That is generally capital gain, you don't have any ordinary income issues, and one layer of tax in a C corp. So it can make sense to do that. I won't say always, because it's going to depend on what that M&A deal structure looks like.

32:49 Stephen Brown

What we've seen, it seems to be more common in ecommerce, is asset purchases. The buyers will want to purchase the business assets, not the business entity, which is considered a stock acquisition.

33:00 Stephen Brown

So that's the other thing you have to realise, is what is the buyer climate? Unless you're very large, my guess is most buyers for your businesses are going to buy your assets. So to Heather's point, you don't have a choice a lot of times. They'll be like, I'm buying the assets, not the business. So you're at the mercy of how they want to structure the deal, unless you can somehow leverage your position.

33:28 Heather Allen

Right. So you may be at their mercy for the structure, but you may have a negotiation point on what that purchase price is.

We've done many types of these analyses to say, that's fine, we're happy to sell assets, but if that's going to be the case, we want the purchase price grossed up so that we are in the same net position as a seller as if we sold stock.

33:52 Heather Allen

Generally a buyer is at least willing to entertain that conversation, because the depreciation and amortisation benefits that they're looking for by buying the assets are still worth it, even if they gross up the purchase price a bit.

34:02 Heather Allen

So that's not to say it always works, but at least it's worth the negotiation to say, okay, we'll go down the asset route, but we want to do some calculations to see what we're leaving on the table under that structure, and negotiate the purchase price from there.

34:20 Stephen Brown

On the topic of stock, this is probably very hard to answer in just a few seconds, but what would be the big differences in distributing stock as an S corp versus stock as a C corp?

Let's say you wanted to give stock to key employees in your S corp, and you want to give stock to key employees in your C corp. Are there any key differences that you'd have to be aware of in how granting stock would be different between those two entity types?

34:53 Heather Allen

You can really do stock option plans under each scenario, so it is fine to do that. Steve, you were going to jump in with something?

35:07 Steve DeWitt

Oh, I was just going to say, for an S corp, we just need to know that that employee is now going to get an allocation of income once he owns that stock, because now he or she's an owner.

35:18 Steve DeWitt

For a C corporation, they would only get income allocated to them if there's ever a distribution, a dividend, and they have rights to those dividends. So that's the big difference between the two of those. But yeah, there are opportunities for stock options and stock grants in either one.

35:36 Heather Allen

I don't think you're going to see incentive stock options or non-qualified options like you do in a C corp, you wouldn't see those necessarily in an S corp. But there are different ways that you can do stock options in an S corp. I think the main difference is how the individual is taxed, their ownership.

35:53 Steve DeWitt

Yeah, you need to understand that they'll get a K-1 and the complexity that comes with that.

And generally, in those situations, there is an income inclusion event to the person being granted the stock, if that stock has value. So they'll have to include the fair value of that stock that they're being granted in their income, and then that establishes their basis going forward if there's ever a sale.

36:17 Stephen Brown

And that's a big deal, let me just point that out. Basically, if you granted stock in your S corp company, your employee or partner or whatever now has a big tax burden that they have to pay in the year they've received that grant, correct?

36:35 Heather Allen

And the same applies in a C corp if you're actually just granting stock. If you are giving somebody equity that they did not purchase, that creates a taxable event. There are ways to structure stock option plans to make that not taxable until potentially they exercise the option.

36:53 Heather Allen

But yes, and I would say in any case, if you are granting equity that is worth something today that they are not paying for, that will create a taxable event, whether you're an LLC, S corp or a C corp.

37:05 Heather Allen

An LLC, this is honestly one of the reasons why many companies choose to stay an LLC taxed as a partnership, even given the self-employment impact and some of these negative consequences. Because it has a lot more flexibility on how you grant future equity to key employees.

37:25 Heather Allen

So if you've heard the term profits interests, that's something that is worth zero today. I don't have equity in the current value of the company, but then I get equity in future appreciation from this day forward. You can really only do that in an LLC.

37:45 Heather Allen

So those types of issues may be a larger benefit in specific cases than the tax consequences, and why many companies choose to operate an LLC just as a partnership, to retain that flexibility.

37:56 Stephen Brown

Two more questions. I want to clarify this. You can go from an S corp to a C corp, right? That was a question.

38:04 Heather Allen

That's right. And to also clarify, maybe one step past that, if you're an LLC that made an S corp election, if you withdraw that election you don't go back to being an LLC, you go back to being a C corp.

38:17 Heather Allen

So yes, an S corp can revoke their S election and go back to a C corp, which was their default status if they were a state law incorporation entity when they set up. Or if you're an LLC that made that election, you're going back to a C corp by revoking that.

38:38 Steve DeWitt

Yeah, that's because when you're an LLC and you make the S corp election, you're actually electing to be a C corp first, and then making an election to be an S corp. That's why you revert back to a C corp if you're an LLC coming from an S corp.

38:50 Stephen Brown

Final question on this. What environment would make it profitable to convert to a C corp from an S corp, and what would be involved?

39:02 Heather Allen

I guess we generally don't see that unless it's in an M&A transaction, where the buyer just is not a qualified S corp shareholder and you have to convert back to C.

39:14 Heather Allen

There can be reasons to choose to do that, but it's just a facts and circumstances type case. I don't know, Steve, I just don't generally see that unless it's a requirement. We brought in a private equity partner and so we have to revoke our election, because they want to buy a C corp rather than an S corp.

39:39 Steve DeWitt

There are other ways around that though. There are other tax strategies if the buyer is a C corp and they want to buy into an S corp, or they want to buy 100% of the S corp, where it's advantageous to both parties. There are certain elections that can be made and certain ways to structure it where you don't have to go back to a C corp first.

39:57 Steve DeWitt

The buyer could form a subsidiary and buy the assets of the S corp, or there are some other reorganisation things you can do beforehand if the old S corp owners want to stay owners in the new business going forward. There are ways that that can be structured as well.

40:15 Steve DeWitt

So I don't think we generally see people go from an S to a C just for an M&A transaction, since there are other ways to deal with that.

40:22 Heather Allen

And something on the next slide that we'll talk about is a reason why you may want to avoid that S election at all. Really planning to make an S election for self-employment savings now, if you think a C corp is what you ultimately want to be, can kind of shoot yourself in the foot by doing that.

40:42 Heather Allen

So I think that's why we generally don't see those elections revoked, unless it just has to be because of something that happens in the future.

40:55 Stephen Brown

One clarification. What you said, when you go from an LLC to an S corp, are you converting to a C corp with an S corp election for tax purposes?

41:02 Heather Allen

Yes.

41:12 Stephen Brown

So from a tax perspective, you're basically saying I am a C corp now.

41:17 Heather Allen

That's right. It's streamlined now, where it didn't used to be. It's all on one form. If you're an LLC and make that S election, you file the form with the IRS, you're deemed to have also made the election to be a C corp first, and then finally the election to be an S corp, on that one form.

41:36 Heather Allen

Back in the day, before they streamlined it, you would first make an election to be a C corp and then file another form to make the election to be an S corp. And so that's why, when you revoke your S election as an LLC, you default back to a C corp, because that's the first election that you're deemed to have made.

41:54 Qualified small business stock

Stephen Brown

So many great questions. All right, let's move on to the next section, because I have a question that relates to the 1202. So why don't we dive in and tell us what the 1202 is, and then I'll ask this question that came up.

42:07 Heather Allen

Perfect. So you may have heard this referred to as 1202 stock, qualified small business stock, QSBS. These are all words that are thrown around talking about the same thing.

This is something that's been around since the 90s, so it's not new, but we've seen a very much increased level of activity surrounding this.

42:32 Heather Allen

So first off, it only applies to C corp stock. What it does is give you the benefit, when you're selling section 1202 stock, to exclude the greater of 10 million dollars of gain, or 10 times your basis in that stock.

42:45 Heather Allen

So as a founder, generally your stock basis is very low, so you're looking at a sale, if you meet all the other requirements, getting to exclude 10 million dollars. And that's just permanent savings, that 10 million dollars never has to be recognised in taxable gains.

43:04 Heather Allen

If you've bought into a corporation later, say your basis is two million dollars, then your exclusion goes up to 10 times that amount. You can potentially exclude up to 20 million dollars of that gain. So the 10 million dollars gets thrown around, but the exclusion actually could be much higher than that.

43:23 Heather Allen

So the requirements are, first, as I mentioned, it has to be C corp stock, and it has to be C corp stock when you originally received it. So if you've made an S election in the past and so you've held S corp stock, then you revoke that S election, you're not converting that stock into qualifying 1202 stock.

43:42 Heather Allen

So that's one big issue, it needs to be C corp stock from the date it was issued to you. Or if you had LLC units and then made the election, that also qualifies. But the S corp in there can mess this up.

43:56 Stephen Brown

So let me clarify, because this is the question. Can you convert from S corp to C corp to start the qualified small business stock status?

44:03 Heather Allen

You can, for stock issued after that revocation of the S election. So for future stock grants that can qualify. But if you held the S corp stock, just revoking your S election does not convert your stock into qualifying stock.

44:20 Stephen Brown

If you're the sole owner, let's say you start out an LLC, you go to an S corp, and then you're like, hey, I'm going to go to a C corp. I can't do the qualified small business stock?

44:32 Heather Allen

That's right. You'll never be able to convert that previous S status stock to C corp stock.

If you're an LLC that makes a C corp election, you're the sole owner, on the day you make that C corp election, that's when your 1202 clock starts for the five-year holding requirement. So you can do that. But if you're an LLC that makes an S election, you are deemed to have been issued S corp stock on that date, and then that stock is always tainted as S corp stock.

45:04 Heather Allen

I mean, honestly, this is something we see a lot. The S election can be the right choice, but just making sure you have these conversations up front, so that there aren't any unpleasant surprises later, because some things just can't be undone.

45:16 Heather Allen

And many people do that for self-employment tax savings this year, which again can be the right choice, but you need to take a higher level view. If you're starting a company and you're saying, yeah, in five years I want to sell this, this 1202 benefit can be huge.

45:36 Heather Allen

And that's the second requirement, is you have to hold it for five years. So this is an individual shareholder opportunity. So you can have shareholders in the same corporation where some have qualifying stock and some don't. Either because of the S election, and when you got your stock, that we just talked about, or because somebody maybe just came in and they've only held for two years, you've held for seven. Yours may be qualified, and theirs, they just haven't met that time period yet.

46:06 Heather Allen

The other important thing is that it must be originally issued from a corporation. So you can't come in and buy someone else's stock. If you're coming in as a new investor, the money's got to stay in the corporation for newly issued stock to you. It can't be, I come in and just buy Steve's shares, he wants to get out of the company, I want to get in. That's not qualifying stock to me as the buyer. So it's got to be original issue.

46:33 Heather Allen

And skipping down to the end, on that redemption test, there are certain types of redemption transactions that will disqualify your stock, or potentially everybody's stock. These rules were put in place to avoid people being able to get around that original issue requirement, by saying, I want to invest money, Steve wants out, just by me putting the money in and then the corporation redeeming Steve's stock. That's essentially the same thing as me just buying the stock from Steve.

47:00 Heather Allen

So that redemption transaction can disqualify the stock. So it's really important to be tracking those, to make sure you're not tripping any tripwires that will disqualify stock.

47:13 Heather Allen

And if you think you have qualified stock, really you've got to go back throughout the history of the corporation and just confirm that none of these transactions in the past would mess things up. Because the thresholds are pretty low. Five percent of the value is a pretty low threshold that can disqualify that stock.

47:33 Heather Allen

And then the last piece is that it only applies to certain types of businesses. So again, ecommerce, probably most people on this call, totally fine, it applies in that arena. For Stephen, Steve and me, an accounting business, that's a disqualified business, so we couldn't convert our accounting businesses to C corps to try to take advantage of this.

47:56 Heather Allen

So you just need to double check that list of qualifying business activities, if, outside of ecommerce, you just want to make sure that you're participating in a qualifying activity in the first place.

48:03 Heather Allen

So I know that was a lot of information, but any 1202 questions?

48:16 Stephen Brown

We're good, let's keep cruising. We've got a lot more good stuff to cover. No questions, so let's keep moving.

48:22 Heather Allen

Okay, great. We knew this would be the biggest chunk of it, because it's just such a big deal and it sets the stage for the business going forward.

And then the next piece Steve's going to jump in on, but also a very big area that is constantly evolving.

48:32 State and local tax

Steve DeWitt

Yeah, so I'll try and get through this kind of quickly since we're getting a little low on time.

But back in 2018 there was a big Supreme Court case that many of you may be familiar with, it was Wayfair against South Dakota. Basically this case challenged a law that had been in place since the early 90s, that companies weren't subject to sales tax if they didn't have a physical presence within the state. And so if you didn't have boots on the ground or any kind of property in a state, the state couldn't charge sales tax on your sales to that state.

49:05 Steve DeWitt

But obviously a lot's changed in the last 30 years with regards to the economy and the types of products that are being sold now, with internet sales and digital sales. And states were getting a little dried up on some of their revenue, because they weren't able to collect as much sales tax as they wanted.

49:22 Steve DeWitt

And so some states started challenging this rule from the 90s about the physical presence, and they started assessing sales tax on out-of-state companies. One of them being Wayfair. South Dakota said, hey, you're doing business in our state, you have all these sales from your online store, we want to collect sales tax, and so we're going to assess sales tax on you.

49:46 Steve DeWitt

That got challenged and worked its way up to the Supreme Court. And that was kind of the intent of South Dakota, like, hey, we want to get this up to the Supreme Court so they look at it again and change the rule that had been there since the 90s.

49:58 Steve DeWitt

The Supreme Court agreed, and they said that the state does have the right to assess sales tax on a company even if they don't have physical presence within that state. And so this created a huge change in what we thought about sales tax.

50:15 Steve DeWitt

And lots of states jumped on board and they started assessing sales tax on remote sellers based upon the activity they have in their state. Usually it's based upon the amount of gross receipts that you're deriving from that state. Most of them are about a hundred thousand dollars.

50:35 Steve DeWitt

So if you have a hundred thousand dollars of sales to California, but you don't have employees there, and your product is taxable for sales tax purposes, then you need to be collecting sales tax in California.

50:46 Steve DeWitt

Some states have higher thresholds. I think some are half a million, I think New York might be a million. So it just varies state by state. Some states are in the number of transactions, so if you have 100 transactions in the state, even if they're really small, even the volume of transactions can trigger a sales tax reporting requirement.

51:11 Steve DeWitt

I know a lot of companies, a lot of selling platforms like Amazon and Walmart where you may be selling your products, have helped mitigate some of this impact. They help collect the sales tax and charge the sales tax to your customers.

51:22 Steve DeWitt

But it is something that needs to be looked at, and you need to keep an eye on. Because if you're not collecting the sales tax and the state comes after you, then it's going to be coming out of your own pocket, when it's something that you could have just collected from your customers and remitted to the state, where it wouldn't have been a direct cost to you. But if they do catch you and you haven't remitted your sales tax, then it comes right out of your pocket and it affects your bottom line.

51:50 Steve DeWitt

So just something to keep in mind since 2018, that there's a lot more sales tax exposure and potential to be assessed out there for you.

51:57 Steve DeWitt

Any questions come through on that?

52:00 Stephen Brown

Not on that. LedgerGurus does a lot of sales tax, so if they've been paying attention to any of our media or emails, or work with us, you're just reinforcing what we've already shared with them. We actually ask Tanner when we have questions on sales tax, so they kind of help consult us when we get stuck.

52:24 Steve DeWitt

Oh, that's perfect.

52:26 Stephen Brown

There are actually a couple of questions here.

Shopify is a marketplace, as they sell directly to Instagram, Facebook customers, and should be remitting taxes similar to Amazon.

I wish I had my sales tax expert. I'm not aware that Shopify is doing marketplace facilitation. Are either of you?

52:42 Heather Allen

I'm not aware.

52:44 Steve DeWitt

I'm not sure. Maybe that's what Taylor's saying, that they are doing that. I don't think they are at this point.

52:48 Stephen Brown

But you can reach out to us and we can put you in touch with our sales tax experts and get you an answer.

53:00 Stephen Brown

Another question. Logistics operations automatically create a nexus regardless of sales, correct? So if I had no sales in a state but I had a warehouse, that creates tax liability?

53:06 Steve DeWitt

Yeah, the physical presence rules still apply, but nexus has just gotten more broad, with sales also creating nexus as well. So you can get hit both ways.

53:18 Steve DeWitt

Even if you don't have sales to the state, but you have a warehouse full of inventory sitting in a state, that does create income tax or sales tax reporting requirements. But if you don't have sales in that state then you're not collecting anyway, but you might have to register and at least file zero returns.

53:42 Steve DeWitt

And moving on to our next point, that type of activity can also create income tax nexus in a state, where if you have physical presence with either employees or inventory that's sitting somewhere, or any other kind of property, you can create income tax nexus.

54:01 Steve DeWitt

The income tax nexus rules haven't quite caught up with sales tax, but more and more states are moving in that direction for income tax as well, where if you meet certain economic thresholds then you would have a filing requirement for income taxes in that state.

54:13 Steve DeWitt

So like California for example, they say I believe it's a half a million dollars of sales, or fifty thousand dollars of payroll, or fifty thousand dollars of property. If you exceed any one of those, then you need to file an income tax return in California.

54:33 Steve DeWitt

And so what that does is, a slice of your net income then is apportioned to California and it's taxed there. And so you're subject to whatever California's tax rates are.

54:46 Steve DeWitt

If you're operating as a pass-through, then what happens is you're taxed on all your income in your residence state. So say you're in Utah, you're taxed on all your income in Utah, then a piece of that also gets taxed in California, and you're probably going to say, hey, that's not fair, I'm getting double taxed.

54:59 Steve DeWitt

But what happens is you can claim a credit for those taxes paid, up to the amount of what you paid in Utah on that same income, and so that helps mitigate some of the double taxation. If you're taxed as a C corp, then you just get a deduction for those taxes that you're paying to all those different states, rather than any kind of credit.

55:19 Stephen Brown

I see, okay.

55:26 Steve DeWitt

And so those are the differences in state taxes, how those work between a C corporation versus a pass-through like a partnership or an S corporation.

55:33 Steve DeWitt

And then also remote employees and contractors obviously create nexus issues, because now you do have a physical presence there. Even if the contractors aren't your employees, they're agents of your business, and so they can create nexus issues where you may need to file income tax returns in those states where you have those contractors or remote employees.

55:56 Steve DeWitt

And that's becoming a bigger issue these days, just because businesses are hiring more people out of state, looking for talent wherever they can find it rather than just sticking to their home state.

56:08 Steve DeWitt

And so that's just something to keep an eye on as you expand and as you hire new employees. Not only will you have payroll tax considerations to worry about, but there's also a chance that you might need to start filing other types of returns like sales tax, income tax, et cetera. You might have one employee in Florida and that can create a filing obligation for those different taxes.

56:25 Stephen Brown

And the inventory location, one of the clarifying questions, that would include a third party logistics company?

56:36 Steve DeWitt

That's still, even though they're holding it, it's your product, it's still your inventory. And so if title hasn't transferred to them, then it's still your inventory, and so that's something that would need to be tracked.

56:48 Stephen Brown

And then is there any impact on the state tax liabilities based on entity type? Is there anything different between a C corp and an S corp?

56:59 Steve DeWitt

Yeah, so there's going to be different rates between the C corp and S corp and a partnership. So for an S corp and a partnership it's going to be the individual rates that are going to be assessed on that income, which generally are close to the C corporation rates.

57:16 Steve DeWitt

But there are some variances. Like for example California, the C corp rate which would be assessed on the income from the C corporation is 8.84%. But California for individuals has the highest marginal rate, I think they're up to 13% depending upon the amount of income. And so there is some difference in the tax rates between the states, and so that's where differences would arise there.

57:41 Stephen Brown

Well, if you have offshore employees, a lot of ecommerce sellers use people in the Philippines or India or wherever, does that, at that point you're dealing with foreign tax issues, not necessarily US tax issues. Am I correct?

58:01 Steve DeWitt

Yeah, that's right. If you're using contractors that are abroad, usually those services are being performed overseas, and if they're just contractors and not employees, that generally doesn't create any kind of issues where you would need to file returns in those foreign countries. And that doesn't create issues for those contractors as long as they're not performing services in the US. Once they're in the US performing services then they might have a US filing requirement, whereas if they're just staying abroad then usually it's just income to them in their home country.

58:30 Steve DeWitt

But if you have employees that are doing things in other countries, then that can create a problem for the company, where you're creating what's called permanent establishment. It's similar to the nexus rules, but that permanent establishment could suck you into that country, where you might have filing requirements in that country.

58:49 Steve DeWitt

And so that's usually where we'll see people open subsidiaries in the foreign country, just to provide a little bit of a barrier between them and the foreign country that they're operating in.

Heather, do you have any other thoughts on that?

59:01 Heather Allen

Nope, that was great.

59:06 Stephen Brown

I keep getting questions. Does direct marketing sales create a nexus?

I guess my question is, what is direct marketing? Is that like if somebody goes to another state and sells from that state, does that create a sales tax nexus?

59:29 Heather Allen

So for sales tax, yes. If you meet these other thresholds in that state based on the number of transactions or the level of sales, you likely have a sales tax collection and remittance obligation.

59:41 Heather Allen

For income tax, direct selling, in the general term I think of direct selling anyway, almost always creates nexus, because you have an agent on your behalf likely holding inventory, fulfilling for you. They're not just out there soliciting sales.

1:00:06 Heather Allen

So the traditional rule, if you're selling tangible personal property products and you just have a door-to-door salesman that's just out there with the catalog, they're just soliciting sales, all those sales come back to the headquarters to get approved and shipped from there, that by itself hasn't created nexus.

1:00:19 Heather Allen

But the direct selling environment that we're in now, those agents, or your partners, are generally doing a lot more than that. And so they're crossing that threshold and likely creating nexus wherever you have a direct selling partner located.

1:00:37 Stephen Brown

Here's a follow-up question on that. What if you're just going somewhere else for lead generation, so you're not actually doing any sales? You go somewhere else, you generate a bunch of leads in that state, you go back home. Does lead generation create any sort of sales tax or nexus issues?

1:01:00 Heather Allen

[unclear] days or something like that, then you may be exempt from that. But if it is just attending a trade show, conference, lead generation, really just in that soliciting the sale bucket, then you may be protecting yourself from the income tax nexus pieces.

1:01:12 Heather Allen

But as soon as you are offering a warranty on your product, or again, a direct seller is holding inventory in their home that they're selling on your behalf, those things are going beyond that.

1:01:25 Stephen Brown

And just as an anecdote, if you hear about professional athletes, this is a big problem for them, because they are playing around the country. Their tax issues are immense. If you dig down you'll find stories about that from time to time. And there's a reason why athletes sometimes like to play in Florida, because they don't have income tax in Florida, at least for half their games. They can reduce that.

1:01:48 Stephen Brown

We're at the top of the hour. We might have to do a follow-up, this has been fantastic. Let me just wrap up the questions and then we want to get your information out. I think we'll have to talk about doing a second part of this, because it's just been so great.

1:02:06 Stephen Brown

An ecommerce company based out of Tennessee with another physical presence in Arizona would also pay California and Texas franchise taxes. We pay sales taxes in over 40 states, and taxes in the EU and UK. Not sure what the question is there. I think my answer is yes, that is yes for online sellers. The multi-state sales tax, and you get international with that tax, it is the nightmare that we have all experienced since 2018, since the Wayfair ruling.

1:02:33 Stephen Brown

Final question. We are paying income tax for remote employees that sell lead generation based on their location, but was curious about the sales tax nexus for lead generation.

So this is coming back to that earlier question, where they're paying income tax for remote employees that sell lead generation based on their location. Is there a sales tax nexus?

1:03:02 Steve DeWitt

Potentially. But if the product that you're selling is just the lead generation, like you're getting compensated for the lead generation as a company, then that's most likely a service. And generally services aren't subject to sales tax, it's usually tangible property.

1:03:19 Steve DeWitt

Lots of states are trying to get services subject to sales tax as well, just to boost their revenues, but for the most part services aren't subject. However, it could create reporting requirements where you have to report in that state, but then all your sales aren't subject and they would just be excluded from collecting.

1:03:37 Steve DeWitt

So is that what you're getting from that, Heather?

1:03:39 Heather Allen

Yeah, that's interesting, to know what their question is. If it's the actual lead generation that you are out there performing, or if we're talking lead generation in the terms of soliciting sales for your ultimate product that you're trying to sell. Unless you're generating leads for other companies and they're paying you for that, that would generally be a service.

1:04:05 Stephen Brown

So for the sake of time, I suggest let's wrap up. Heather and Steve, we will have to look at maybe a part two, because I think the second part of this conversation was really around selling your business and tax implications. Fantastic questions.

1:04:19 Stephen Brown

Michael, we're going to look at doing a part two, just because we're out of time and we want to make sure that we're sensitive to everybody's time. Sorry, Michael, I know there's just so much to cover. At the pace of questions we're getting, we'd probably be here for another hour.

1:04:37 Stephen Brown

So what we're going to do is we'll sync up with Heather and Steve and see if we can find a time to do a second part of this conversation.

1:04:48 Stephen Brown

Do you guys want to just throw up the contact information you have? We love Tanner, hopefully you can see why they're really great to work with. And I will have Kelley, who's our content manager, coordinate with them, see if we can find a time to do a conversation specifically around the issues of selling. We kind of teased on, we talked about some of the initial parts, but I think when we get into this, that's another hour.

1:05:13 Stephen Brown

So thank you to everybody who attended. Thank you, Heather and Steve. Obviously you've got their contact information here, and we will look at doing part two of this conversation in the future, so that we can cover those other issues.

1:05:32 Heather Allen

Yeah, I just want to say thank you for having us, and thank you for making it so engaging. Because we could talk about these tax issues all day long, and it's always nice to get into specifics that are actually applicable to people listening. So again, thanks for taking an hour and talking taxes.