Business Owner Edition: How to Unlock The True Benefits of an S-Corporation, with Mike Jesowshek, CPA
Learn how your business may be able to help you save more in taxes!
Having a better understanding of your business shouldn’t be complicated. Whether you’re new to the business world, or semi-retired with a thriving family business, this episode is packed with strategies presented “in crayon” just for you.
More specifically, we discuss:
- What is an S-Corporation, and how does it work?
- What are the main tax benefits of an S-Corporation election?
- Who should consider an S-Corp election, and who shouldn’t? What are possible disadvantages?
- What are the costs associated with being taxed as an S-Corporation?
- How should you run and manage your S-Corporation?
- What do business owners need to know before stepping away from their business?
- Tax strategies you can implement in your business:
- Maximizing everyday deductions
- Retirement plan
- Charitable giving
- Hiring your children
Resources From This Episode:
Mike’s Podcast: https://www.taxsavingspodcast.com/
The Key Moments In This Episode Are:
00:02:10 - Overview of S Corporations
00:04:21 - Basics of S Corporations
00:07:19 - Advantages of an LLC
00:09:59 - Disadvantages of S Corporations
00:13:34 - Disadvantages of an S Corporation for Small Profits
00:14:21 - State-Specific Disadvantages of S Corporations
00:15:00 - Additional Taxes for LLCs in California
00:16:29 - Importance of Proper Bookkeeping
00:21:23 - Cash Flow Management in an S Corporation
00:25:58 - Understanding Taxes for Business Owners
00:27:01 - Advantages of an S Corp Structure
00:29:45 - Stepping Away from the Business
00:30:16 - Tax Savings through Retirement Plans
00:38:52 - Maximizing Charitable Deductions
00:39:48 - Using Charitable Giving for Advertising
00:42:23 - Hiring Children in the Business
00:47:18 - Long-Term Benefits of Funding a Roth IRA
00:50:24 - The Power of Compound Savings
00:50:42 - Tax Strategies Made Easy
00:51:39 - Maximizing Deductions
00:52:32 - Taking Action on Tax Opportunities
LPL Financial and Planable Wealth are not affiliated with or endorsed by Mike Jesowshek or the Small Business Tax Savings Podcast.
This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
00:00:28 - Cameron Valadez
Hello, and welcome to the Retired-ish Podcast. This week we have a Retired-ish Business Owner edition for all you entrepreneurs out there and risk-takers alike. I'm your host, Cameron Valadez, and today we are fortunate to have on the show with me a special guest, Mike Jesowshek, who is a practicing CPA, fellow Business Owner, and Podcaster. He's the most fitting professional I could think of when it comes to discussing today's topic, which is S corporations and how to use them efficiently to help you generate and preserve wealth by holding on to more of those dollars you work so hard for.
Dynamic and ambitious, Mike is an accomplished professional dedicated to helping business owners achieve success, with both a bachelor's degree in Business Administration and a Master's in Accounting. Along with being a practicing CPA and Business owner and having been the CFO and co-founder of several companies throughout his career, he is well-equipped with the qualifications and expertise that are necessary to understand the complexities of tax planning.
Now, last certainly not least, Mike is the host of the Small Business Tax Savings Podcast, where he strives to empower business owners by providing them with the knowledge and strategies that are available to them to ensure that they are paying the least amount in taxes as legally possible year in and year out. I will tell you that it is a very educational podcast, one of the best I've heard, and that, my friends, is why he's here today. Mike was gracious enough to take some of his time today to share some ideas with our audience, and we thank him for that. That being said, how you doing, Mike? How's that for an intro?
00:02:12 - Mike Jesowshek
Yeah, Cameron, thanks for having me. Happy to be here. Doing good and kind of excited to bring this idea of an S corporation and some of the other tax-saving ideas behind being a business owner to your listeners.
00:02:24 - Cameron Valadez
Awesome. Thanks again, Mike. Glad to have you on the show! Before we dive into the meat of things, I want everyone to understand that building wealth includes controlling and managing multiple areas of what I would call your family balance sheet, which is essentially the same as a balance sheet for a business, which is basically the things you own, your assets, and the things you owe your liabilities. Looking at a balance sheet, there are several ways you can begin to understand how to increase your net worth, which is your assets minus your liabilities. However, some ways to do that aren't so direct. Rather than just hope, the value of some of your assets appreciates over time. And as time goes on, as you pay down your liabilities, you can utilize certain strategies with your business that are actually under your control so you can move that needle even faster. For example, if you are able to increase your earnings and also reduce expenses such as taxes, that, in turn, will allow you to increase your savings and investments, otherwise known as your assets, and therefore your net worth.
So reducing taxes is obviously going to be our favorite example because taxes are likely to be the largest expense you will incur over your lifetime. So the topic of today's show relates directly to increasing your net worth by taking advantage of the power of the S corporations. And again, that's for all of you business owners out there. Even if you are a business owner and you're not familiar with the term, don't worry. You're going to learn a lot about it today. No matter how big or small your company is, there can be many reasons why an S Corp may make sense as your entity structure. Whether you're new to the business world, own a successful generational family business, or are looking to step away from your business to enjoy the finer things in life or other hobbies and projects, I think we will have a few nuggets for you to take away from the episode. So let's get to it.
Okay, Mike, I think we should start with the basics. First, I think it would help those who are new to this. What is an S corporation, especially versus being a sole proprietor or maybe just having an LLC?
00:04:35 - Mike Jesowshek
Yeah, Cameron, that's a great question. I think just to kind of start and to go on kind of what you just mentioned, for those of you that are not business owners, we often say some of the easiest ways to save taxes is to become a business owner of some sort. And becoming a business owner doesn't mean that you have to quit your job and open up a business. You can easily have some sort of side hustle that can really produce income to you while also being able to reduce that income significantly through tax strategies around being a business owner. But when we talk about entity structures, an S corporation is simply a tax election.
An S corporation is not an entity structure. So you would be an LLC or a corporation at the state level, and then we're electing for that LLC or that corporation to be taxed as an S corporation. And I think when we look at this specifically is, some of you might be like, why would I be an LLC? Why would I be a corporation? And that's where this idea of a sole proprietor comes in. And basically, a sole proprietorship is a no entity. Basically, you're operating as if you maybe have a DBA, but there's no entity structure, and there's no protection that you have there from liability purposes. And so a lot of people start out as sole proprietors. And we often say if you just have a thought of a business, being a sole proprietorship is probably fine. Once you start to say, okay, I have a thought. I'm going to start opening some things. I'm going to start doing some ideas of getting this thought rolling, bringing some business in the door. We recommend that you always kind of start an entity of some sort. The reason being is before I said, in order to elect S Corp status, in order to elect to be taxed as an S corporation, you have to have an LLC or corporation set up. So if you're operating as a sole proprietor, you cannot elect S Corp status.
And so when we talk about S Corp versus a sole proprietorship, let's talk about how each is taxed. With a sole proprietorship or a single-member LLC, an LLC that's not taxed as an S corporation, you are taxed on the profits of your business. So let's say you have 100,000 in revenue, 20,000 in expenses. Your profit is $80,000. And as a single-member LLC, sole proprietorship, you pay your normal income tax rate on that $80,000 in profit that your business has. But you also pay self-employment taxes, which is roughly 15% on that entire profit amount. So on that $80,000 that you make, you're paying your normal income tax rate on that 80,000, plus an additional 15% in self-employment taxes. And if you're making $20,000 a year, $30,000 a year, no problem. We have no problem with you being set up as a sole proprietorship, single-member LLC. Once you start to hit a profit of, say, 40,000 or $50,000 or more, we're going to want to think about looking at the S corporation. And the sole reason to elect S Corp status is mainly to reduce the amount that you pay in self-employment taxes.
With an S corporation, you're still going to pay your normal, ordinary income tax rate on any income that you have. But with an S Corp, the goal is to how can we minimize that amount in self-employment taxes that we make. So that's kind of this thought. We're running a business. Are we making 40, $50,000 or more? That's when we're going to want to start to say, hey, we might want to look to change our entity to be taxed as an S corporation. And just one piece on that. If you're set up as a sole proprietorship, remember we said a sole proprietorship cannot elect to be taxed as an S corporation. And this is why we tell business owners to start an LLC traditionally. Get that entity set up even if you're not at that 40,000 or $50,000 mark because we don't know when you're going to hit that mark. And if we don't have at least that LLC set up, we can't elect S Corp status on that activity.
Sometimes I have business owners that come to me and say, Mike, my business blew up this year. I wasn't expecting it. Had a great year. We're in July, and I'm seeing $80,000 in profit already this year. I'm set up as a sole proprietorship. I want to do an S corporation. I say, unfortunately, we can't do that. We can't backdate an S corporation on a sole proprietorship. If you had an LLC, we could say, yeah, let's elect S Corp status. We can date it back to January 1, and you can take S Corp advantages all year long. But because your sub is a sole proprietorship, we can't do that. So what we can do is start an LLC today, and everything from today moving forward, we can look at an S corporation. I just say that for those business owners out there, one reason we'd say, hey, let's get into an LLC, even if we're not generating that type of income, is that you have that entity structure set up and ready for an S corporation when it makes sense, not to mention the tax or the legal benefits. An attorney can talk to you about why an LLC can help provide some protection to you while you're getting that business off the ground.
00:09:30 - Cameron Valadez
Right, I agree. Yeah. Those are all great advantages of the S Corp. You actually kind of answered that. I was going to ask you, what about the liability protections? But even though I know you're not an attorney, but just in general, that's one of those things that, again, like Mike said, the S Corp is not the entity itself. It's the way you're choosing to be taxed. The actual entity is the LLC, and the LLC is what can offer certain protections. So. Yeah, I love that. Now, we talked about some of the main advantages. Are there any real disadvantages to being taxed as an S Corp?
00:10:06 - Mike Jesowshek
Yeah. So when we look at the advantages, remember we said the purpose of doing an S corporation is to help minimize the amount that we pay in self-employment taxes. And how do we do that is we split our income into two pieces. So when we have an S corporation, if we use that same example as before, where you had $80,000 in profit, we're going to split that $80,000 into two pieces. With an S corporation, you're required by law to take a reasonable salary. So we're going to set some of that $80,000 in profit, and we're going to make it a salary. So you're going to pay W2 payroll to yourself as an owner of that business. That portion that you pay to yourself as a reasonable salary gets hit with self-employment taxes. Now, it's not called self-employment taxes. It's called FICA taxes, which are Social Security and Medicare. But when you add all that up, it's the same exact thing as self-employment taxes. So that amount we take as a reasonable salary would get hit with self-employment taxes. However, the amount of that profit over and above our reasonable salary, we avoid self-employment taxes on.
So let's use an example. Let's say you have that $80,000 in profit. Let's say a reasonable salary for the work you're doing, the amount of hours you're putting in, and the things that you're doing for your business is $36,000. We're going to pay self-employment taxes on $36,000, but that remaining $44,000 of that profit, we're going to avoid self-employment taxes on. And that's kind of the power behind an S corporation, why an S corporation can make sense. So again, with the sole proprietorship, single member LLC, we're paying self-employment taxes on 100% of the profit, and we're paying our normal ordinary income tax rate as well. With an S corporation, we're still going to pay our ordinary income tax rate on all of our profit, but we're going to only pay self-employment taxes on the amount that we take as a reasonable salary and avoid it on anything above that. So when we look at the disadvantages, one of the things is payroll. You have to pay yourself as the W2 employee of your business. And that's not as simple as just saying, hey, write a check to myself and write payroll in the memo. We need to set up with state agencies, I typically recommend using some sort of payroll software where they're withholding the taxes we're paying, filing payroll tax forms, and filing taxes on a quarterly basis. So disadvantages is you have to run payroll to yourself, which has some costs if you're going to use, which I'd recommend some type of payroll software.
Now, if you already have employees, that added cost of just adding you as another employee is very minor. But if you don't have any employees now, you have to pay that payroll subscription cost and go from there. The other thing with an S corporation, as compared to a sole proprietorship or a single-member LLC, is there's a separate business tax return that needs to be filed for an S corporation. Now, it's still going to flow through to your personal tax return the same exact way, but it's a separate business tax return. So we have a separate filing that we're doing with a sole proprietorship, single member LLC. We're just filing your business activity on your personal tax return via a Schedule C. With an S corporation, we have this 1120s, which is an S Corp tax return. We report all of our business activity on there, and then there's a K1 that you get from that tax return, which then gets reported on your personal side. And so, that separate business tax return is much more complex than a Schedule C. And as part of that usually has some added tax prep costs. So if you're working with an accountant or even doing it on your own, there's going to be some more time involved, some more costs involved to do that S Corp tax return.
And so those disadvantages, the payroll, and that more complex tax return are why we say let's wait till your profit is 40 or $50,000 or more. Because if you're making a profit of $20,000, that added cost of having to run payroll software, that added cost of this business tax return that you now have to file might outweigh your tax savings. So you might save some self-employment taxes, but now you have these added costs, which kind of maybe come to a break-even point. And so that's why we say, let's wait till we hit that 40 to $50,000 or more before we start to look at an S corporation because then we're going to outweigh our self-employment tax savings will far outweigh any additional costs.
Depending on which state you're in, there are some disadvantages to an S corporation. We might not want to look at it, or we might wait till you hit a certain amount of profit, which might be higher, or we might say if you hit X amount of higher amount of profit, we might want to then not be an S corporation. So there are a few states, but for 98% of the country, we don't run into those issues. Those states are Tennessee, we see some issues with an S corporation, again there are some workarounds we want to look at that analyze it, and New York City sometimes has some areas we want to kind of analyze that a little bit deeper but again, for the vast majority of business owners around the country, we're not facing any kind of additional state taxes by being an S corporation.
00:15:00 - Cameron Valadez
Like, I can definitely tell you that somewhere like California, you're going to pay an additional annual tax just for the LLC. So the entity itself actually has a minimum tax, not to the Fed, and it's not like your income tax. It's just a separate tax you have to pay to have that LLC. And then, once your revenue gets above a certain point, that tax actually increases, but there is a minimum.
00:15:26 - Mike Jesowshek
Another thing about that, you know, whether you're an S Corp or not, in California, as an example, if you have an LLC, you have that fee. The S Corp doesn't change that at all. I talked about it in the front. Like, we always encourage business owners to open up that LLC right away because you get that protection from a liability standpoint. And now you have an entity structure that's ready for an S corporation when it makes sense. But if you're in a state like California where there is that kind of higher annual fee that you have to pay to have that LLC, we might say, okay, let's hold off until we actually know we have a business going on here. If you're in a state like Wisconsin, where you have an annual fee of $100, $150, I'm going to say, hey, just get it started. If that business nothing takes off after two years, okay, it costs you $300 to take that venture or try out this business. I think that's worth the startup cost with some of the savings that you can provide from a liability standpoint and a tax savings standpoint if that business were to take off and be successful. So just something to think about when you talk about different state specifics on that LLC standpoint.
00:16:29 - Cameron Valadez
Yeah, absolutely. I would agree. And the other thing is, what about your books, your accounting? Because a lot of business owners that I run into that maybe are in the beginning stages of their business, or maybe they've had it for a while, and they just haven't transitioned to an S Corp for any particular reason, whether it's like a realtor or a commercial realtor or something like that, that maybe didn't know that they could do that. Sometimes they think their businesses are fairly basic and they don't have a lot of overhead. They don't have maybe a lot of employees, and maybe it's just them. And so they don't really keep very good books or very accurate books. Now if you decide to go, S Corp, that becomes a lot more important. Correct? Because now you have an LLC, and to keep some of those liability protections, you can't start commingling things. Typically, you got to keep things pretty clean. So you probably should get a bookkeeper as well, right? Or have somebody start to keep those for you.
00:17:28 - Mike Jesowshek
Yeah. So first off, any business owner, whether you are generating income or not, and whether you're an LLC, whatever it is, I would always recommend having a separate business bank account, have a separate account that all that business activity is running through. No matter how you're set-up, we want to have that separate activity because even if you're a sole proprietorship and you're commingling stuff, let's say the IRS comes knocking and says, hey, I'm a little concerned about your meal expenses here. I think your office expenses are a little bit high. Can you show me the bank statement for that? And you send them something that has business and personal and everything kind of wrapped into one. You're like, oh, here's the business items. The IRS is going to be like, I'm going to scrutinize this a lot heavier because I can see there's so many other things mixed into it. And how do I know for sure that this Walmart purchase was really business? Now I'm going to have to see receipts, and I'm going to have to analyze those receipts and go through it a lot deeper. Whereas if you're, say, just a sole proprietorship, but you provide a statement that's all business activity, all the income, all the expenses, all business activity, the IRS is going to say you're pretty organized. I'm probably not going to have to dive as deep into this. And this is just from a thought process because it looks like you have a clear separation. I'm not seeing items on here that would typically see on a personal statement. It seems to be pretty separate. So you just help create that protection, and it's a heck of a lot easier for you when it comes to tax time and providing those things.
But you're right. From a bookkeeping standpoint with an S corporation, we have that little bit more complex business tax return. And as part of that, we want to make sure that we have accurate financials. And when I say financials, I'm mainly saying, at least for tax purposes, an income statement or profit and loss and a balance sheet. Those two items are going to be what creates most of that business tax return. I'm just using an Excel file that you're just recording, incoming versus outgoing. You're not going to have a balance sheet, and you might not need a balance sheet for that tax prep of that S Corp based on your business size. But I always recommend, regardless of that size, just do your bookkeeping using software where you can create these financials and just have a solid set of information about how your business is doing. And there's a lot of software out there. I'm a big cloud-based software for accounting software. There's a lot of software out there. Some of it's free, some of it you have to pay a small monthly fee for. But this software makes this a lot easier for you too. You connect your bank accounts, it downloads the transactions in there, and basically, all you have to do is say, what was this for? Oh, this was a meal with a client that I had, or this was a new microphone that I bought for my office. So they make that part a lot easier. Not to mention it ensures that you don't miss things.
There are a lot of people that if you do your bookkeeping at the end of the year, there's probably expenses that you missed, there's probably things that you paid for that you're rushing together. You just want to get to your account, and you forgot about it. Or, on the flip side, there might be expenses that really weren't business, but you just flipped them in there because you were trying to rush through it and didn't know, which could come back to bite you in an audit so by doing that bookkeeping on a more regular basis, having an easy system, again, cloud-based accounting software, relatively cheap or free in some scenarios, having that system in place can make that job a whole lot easier. You're on top of it, and now regardless of where you are in there, you could be in June, and you know how your business is performing, which helps you in so many different ways.
00:20:47 - Cameron Valadez
Right, I couldn't agree more. And everything you just mentioned there, that's most business owners where things are kind of messy because you're busy running your business, and sometimes you can let that stuff get away, and then it catches up to you at the end of the year, and you're scrambling. So if you hire or delegate some of this stuff and let's say you hire a bookkeeper, hopefully, that bookkeeper keeps you on top of things and is regularly reminding you, hey, send me updated bank statements or credit card statements so they can keep those books up to date.
My next question is it kind of relates to some of the stuff we talked about. You already answered a part of it. But oftentimes, I find that people, even when they have S Corps, sometimes if the business is a lot smaller or maybe owner, only people get kind of confused on how the S Corp should be managed or run. So basically, I make this money, it comes into the account. I have these expenses that I pay, but then they don't understand, okay, if I have to pay another contractor or if I need to save for retirement or whatever the case is, pay taxes, do I pay those out of my personal account or my S Corp. How do I do that? How does the day-to-day cash flow work in the S Corp? How do we better understand that?
00:22:06 - Mike Jesowshek
Yeah, so I like to kind of just keep this simple because, especially when you're just a small one-man operation, whatever it might be, the business side is really simple. Again, the importance is having a separate business bank account and a credit card. If you're using one of those, once we have that, we know that there's separation. We have our business side. Anything business, whether it's income, whether it's expenses, anything business is going through this business bank account. And anything personal is happening on the other side, on your personal side. And so you're right when we talk about how does the flow of cash come. You're going to have income that comes into that business bank account. You're going to have expenses that go out of that business bank account. So whether it's paying contractors, whether that's paying for some advertising items, whether that's paying for a new desk, a new microphone, a new computer screen that you have, all that's going out of the business bank account. But where people get confused or where people get stopped a lot is this idea of paying yourself. And so remember, with an S corporation, we have to take a reasonable salary. So we're going to use payroll software that's going to pay us a reasonable salary, and that's going to come out of the business bank account. But our reasonable salary is not 100% of our income in most cases. And that's the beauty behind and the power behind an S corporation.
So in our example, before we said profit of $80,000, let's say your salary was $36,000. Now we have $44,000 in profit that is just sitting in that business bank account. How does that get to me? And that's what we call an owner's draw, a distribution. And basically, that's just transferring the money from the business account to your personal account. It's as simple as that. That's what an owner's draw or an owner's distribution is. Even if you're set up as a sole proprietorship, the same way as a sole proprietorship or a single member LLC. You're not paying payroll to yourself, but you're just taking owner draws every time you need money, and that's just transferring money from the business account to your personal account. Now with a sole proprietorship, single member LLC, or S Corporation, all these entities are considered pass-through entities, which means that for the most part, at least on the federal level, you're not paying any taxes. That S Corporation is not paying any taxes at the corporate level. At the business level, it all flows through to you on your personal return, where you pay taxes on the profit of that business, on your personal tax return. So when you go, the question is should I pay taxes if I'm paying estimated taxes? If I'm paying my regular taxes, should I pay it out of my business or my S Corporation? Technically you should be paying it out of your business or personally. Technically, you should be paying for those taxes personally. Now if you pay for it in your business because that's where you have that $44,000 sitting, that's fine. Just mark that payment of taxes as an owner's draw or a distribution. So taxes are not a tax deduction to your business, so they don't reduce your profit. The taxes that you pay you pay taxes on the profit of the business regardless of if you take that money out of the business or leave it in there. And that tax on the profit is not an expense to that business. That's just a tax that you pay on your personal tax return.
00:25:02 - Cameron Valadez
Right. I think that's the big hang-up for people is, okay, I got this money in my business, but I don't want to take it out because I haven't paid taxes on it yet. Well, you may not physically have gone in on the computer online or sent to check into the IRS or whomever to pay the tax, but it doesn't necessarily need to work that way. When that money has come in and earned, as you said, it's a flow-through entity. So it's seen as, hey, you've earned that as an individual. Yes, you're going to owe taxes, but you don't need to actually pay them first before you pull money out of the business per se. So yeah, that's a really important thing to know. And then, as you said, when you pull the money out of the business, that's not yet another transaction that's going to change a bunch of things. Yeah, you might just have to code it differently on your books, but that doesn't cause you to, say, pay taxes again on that money because you took it out of your S Corp.
00:25:59 - Mike Jesowshek
And that's a part that so many people get confused about. When you're a business owner in a flow-through entity, which most business owners across the country, unless you're a C corporation are considered a flow-through entity, you pay taxes on the profit of your business. Whether you take that money out or leave it in the businesses, you're paying taxes on it. And so that can come as a disadvantage.
Let's say you have that $44,000, and you're saying, I don't need it. I'm living good off of my reasonable salary that I took, I'm going to leave in the business. Well, you're still going to pay taxes on that $44,000. But the cool thing about that is next year, when you do need that $44,000, you can take it out of that business. You already paid taxes on it, so you're not paying taxes on it again. And that's why there is some confusion. Are you taxed on an owner's draw or distribution when you transfer money from your business account to your personal account, are you taxed directly on that amount? The answer is no. Now, indirectly you kind of are because you're taxed on the profit of your business. But that transaction of moving from the business account to your personal account is not a taxable transaction. It's just the profit of the business.
00:27:00 - Cameron Valadez
Awesome. Okay, so what are some of the advantages of having an S Corp structure in place? If you're a business owner, when deciding to maybe take more time away from the business and spend more time with family or enjoy some of your hobbies and maybe semi-retire or even selling it completely, are there any advantages that the S Corp would have over something like just having an LLC or being a sole proprietor?
00:27:26 - Mike Jesowshek
Yeah, so we look at the S Corporation. Again, the sole purpose and main purpose of an S Corporation is to minimize self-employment taxes or at least lower some of that amount of self-employment taxes that you pay. So when we look at whether you're in the business working or you're kind of semi-retired, and this maybe this is a side gig that's still generating good income that you're working a little bit on. But running an S Corporation, the goal first is let's make sure that we're minimizing the amount of self-employment tax. That's what we're trying to do with an S Corporation. Now, if you've gotten to a point or you're going to be in a point where you're not even involved in that business, let's say you're retiring, you got a little bit of a nest egg, and you say, hey, I want to start a franchise. I have a friend that's going to be running it, and I am just going to fund that franchise. I'm going to be the funder of that. So you're a silent partner. You're not active in the business at all. You're not doing anything in that business.
Well, in your situation, you're not going to get hit with self-employment taxes. Self-employment taxes are for activities that you're active in. So if you're just a silent investor in a business, but you're not actively operating that you're not going to get hit with self-employment taxes. So in a scenario like that, I would say no need for an S corporation because why do we do an S corporation to minimize self-employment taxes? If you're not going to get hit with self-employment taxes, there's no need for that S corporation.
And so this comes in a lot with real estate. I have a long-term rental. Should I put that in an S corp or not? Absolutely not. With a long-term rental, that's a passive activity. You're not active in it. We would say, don't put that in an S corporation. Put it in an LLC. Create some protection there, but it doesn't need to be taxed as an S corporation. When we look at your income, we want to say, okay, what is active income? What are the things that you're actively participating in? This could be W2 income. This could be a business again that you're part of the day-to-day on. We want to have all that on one side of the equation. Any active business activity, we'd want to be rolling through an S corporation, assuming you hit the profit numbers that make sense for an S corporation. But anything passive, things that you're not actively involved with, things that you're not part of the day-to-day with, would be on the other side, and that would be an LLC. That's not an S corporation. So it very well could be that you have an LLC for active activity, that you have taxes in S Corporation, and you have an LLC over here that you use for rental properties, maybe businesses you're invested in, things like that, that you're not active in. That's more on that passive side.
00:29:43 - Cameron Valadez
Yeah. Fantastic. Yeah. Thank you. I think our listeners will find that extremely helpful because that's always a point of confusion, is, hey if I want to exit my business, how do I do it? And that confusion sometimes stops people from stepping away sooner, right? And enjoying more of their life, and they get sucked into the business and think, I can't get out of this vortex because I have to work in this thing every day. And it's just because they don't know the initial steps to take to even begin to step away. Right. So very helpful.
Okay, now let's talk about some strategies that you could use with the S Corp. I want to start this one off with one of what I think are the main benefits when it comes to saving and accumulating wealth. So aside from just tax savings, actually putting away money to accumulate wealth, and that, of course, is the retirement plan for the business. This also happens to be one of the lowest-hanging fruit for tax savings for a business. The best example I can think of to illustrate this is one that I hear about all the time, literally all the time, where I'm working with a business owner and their tax preparer or bookkeeper, whoever tells them that they should go buy something useful for the business so that they get more deductions, maybe because they're having a phenomenal year that's a lot different than maybe the previous year, the last couple of years, and they're just making more money than expected.
Well, the thing is that that doesn't always make sense. As you know, Mike, you don't want to just spend money to spend money because a tax deduction does not offset the entire cost of a business asset dollar for dollar. So it's not like it's free, right? You might have heard somebody say, oh, don't worry about it. It's a tax deduction, or I'll write it off on the business. Yeah, well, that doesn't mean it's free. It's still going to cost that person money for whatever that is.
However, yes, sometimes you do actually need to buy certain assets, but again, not always. As a basic example, let's say you own a plumbing company, and you already have ten trucks in the field, and you're having a phenomenal year doing all kinds of business, and you're expecting to therefore pay more in taxes by the end of the year. Or your tax preparer tells you, hey, you're going to pay a lot more in taxes. Well, what you could do is you could buy more trucks, let's say, to get a deduction. And again, you would be buying a truck. So that means that you would need a real use for the truck, or you will need more employees so that they could drive the truck and operate it. You would need enough ongoing work in the future to warrant that ongoing expense, for example. But let's say ten trucks are just right for right now. Instead of randomly buying equipment or other assets just to get a tax deduction, that money could easily be directed into a company retirement plan which would provide you, the business owner, and or the business owner's spouse with a tax deduction. Not only that, but you would be building up another asset that's not related to your business that has the ability to grow and compound over time. Now, it's not exactly that simple as, depending on how you structure your business's plan. You will likely need to also contribute towards your employee's retirement savings to an extent if you have any. But again, that's a tax deduction for the business, too, and it helps with employee retention and attractiveness when competing for talent out there for new hires. In fact, I have seen plan structures where there's a family business with maybe ten employees or so, and some of the employees are children of the business owners, and sometimes they even have grandkids involved. And of the total amount of money that that employer puts into their retirement plan, over 90% of it has gone to members of the family. So 90% of the money stayed in the family, and the business owners got tax deductions for all of it. So this can be a great way to build generational wealth and keep the family business going and also help you build that legacy that you likely want to build. Mike, what are your thoughts on this?
00:34:06 - Mike Jesowshek
Yeah, I think that this is an area that's so important to touch on because, as business owners, we oftentimes don't think about retirement. We're busy people. We're always moving. We're always thinking about new ways to expand our business, to do better in our business. And this retirement thing can sometimes be an afterthought. And oftentimes it's like, well, my retirement plan is my business, and so I'm just going to work in my business all my life, or I'm going to sell my business eventually one day, and that sale of the business is going to be my retirement plan. I just want to say sometimes, that idea of a sale of the business being your retirement plan doesn't work out. Sometimes it doesn't quite end up how you want it to be.
And I've seen a lot of business owners that are in their 70s still running their business because that amount that they can sell it for just doesn't fulfill what they need to be able to retire. It's a balance with everything. I think retirement is not only just an important aspect of, okay, let's start thinking about the future. And if we sell our business, great. We've seen a lot of business sales, a lot of exits that have been incredible, great. Send people way off into retirement and create generational wealth. That's awesome. But why not also, in the same time, plan for retirement in case something does happen? Not only that, but now, as you mentioned, there's a lot of tax savings around a retirement plan, and there are different ways that we can design that retirement plan to be beneficial to the owner, to do a Roth, to do all sorts of things within that business retirement plan that can be so beneficial.
And I think one thing you mentioned was this idea of I cringe really hard when a business owner comes to me and says, hey, my accountant told me to buy a truck to buy a piece of equipment because I need to lower my tax liability. That is not what we want to talk about. That's not what we want to think about when we think about maximizing deductions. Maximizing deductions, I think, is one strategy that is completely overlooked by business owners, and that's this idea of how can I reduce my business income by doing spending that's going to go to me but get a business deduction for it or spending that I'm already doing? How can I shift it from an after-tax spending into a pretax spending? Part of maximizing deductions is a retirement plan. Part of maximizing deductions may be hiring your kids in your business. You're supporting your kids anyways. Now, how can I hire them in my business and get a tax deduction for that idea of supporting them? You have a home office. You have an automobile. You have all these different things. You have all these items that you're spending money on. How can we find a business purpose for it and get a business deduction? So we talk a lot about maximizing deductions, and basically, that's saying how can we take money that's considered after-tax spending that we've typically been spending, we look at as a personal expense. How can we find a business purpose for this, find a way to tie it back to our business, and bring support to back that up? And now, instead of using after-tax dollars, we're getting a pretax expense, reducing our income, reducing our taxes, so that's this idea of maximizing deductions. Retirement plans fit exactly into that idea as well of how can we fund our retirement plan future money for us while potentially getting a business deduction today.
00:37:02 - Cameron Valadez
Right. And a lot of the times, just to add really quick, one of the things, and I don't normally expect people to realize this unless they've gone through some true financial or business planning, but a lot of times, business owners, they fail to see the benefit of saving into these plans. Because once they learn that, hey, I put this money in, I get a tax deduction today, but when I take it out later, I have to pay taxes on it. They say, oh, well, what's the point? Well oftentimes. Just as a simple example, if you're a business owner and you're doing pretty well, and let's say in personal income taxes, you're paying anywhere from 35% to 50%, all in taxes. And you're likely to be in a lower tax bracket later, maybe eventually, when you step away from the business, or you sell it. Whatever the case is, you may be in the low 20s or even lower later in life. And what you can do is you can take the money out of those plans to an extent. There are certain ages where you have to begin taking money out, but you can take the money out later at a lower tax rate. And so it can be beneficial, very beneficial. You just have to do some of that planning ahead of time and talk with all of your different advisors, your CPA or your EA or your attorneys, and your financial advisors.
Moving on, another strategy for those of you who are charitably inclined and have a business is that you can possibly donate to charity via the business rather than personally. Mike, how would this work, and why would it be beneficial or possibly be beneficial from a tax perspective?
00:38:44 - Mike Jesowshek
Yeah, so a general statement, if we're just giving money to a charity, whether you do that in the business or whether you do that personally, you get the same tax advantage for it. You get a charitable deduction. But what we do is we say, okay, let's look at the spending we're doing and how can we be creative with it, how can we find different categories that we can put it in? And so this is part of that. When we look at maximizing deductions, this might be an area we say, okay, let's look at some category changes that we can make using charitable deductions. And so a charitable deduction, whether you do it personally or on the business side, is an itemized deduction on your tax return. So if you are taking a standard deduction on your tax return, you're not even utilizing the tax advantage of that charitable deduction that you're gaining. Now, if you give a lot to charity or you have a lot of other items that show up as itemized deductions, then you're going to get the advantage of that. But for that reason, we say, okay, is there a better way we can give to charity where we can get a straight deduction for it instead of having to even worry about itemized or standard deduction or anything like that? And that's if we can find a business purpose to this giving that we're doing.
So let's give an example. Let's say you want to support a local chapter of some nonprofit that you have. Could you sponsor them in some sort of way? Could you pay them for sponsorship opportunities? Maybe put your banner on something? Maybe it's a youth sports team. Could you buy T-shirts for them? Support that youth sports team by buying T-shirts and putting your logo on them. Now, that's not a charitable deduction. That's an advertising expense. I'll give you another example of what we did. We do a charity drive, usually every year of some sort. One we did one year is we said, hey, for every tax return we file, we're going to donate ten meals to the homeless. And we used a nonprofit charitable partner that was facilitating that giving of meals to the homeless. We said, for every tax return that we file, we're going to give ten meals to the homeless. And so as part of that, we looked at that as saying, hey, this is an advertising expense. That gift that we give to that charity is an advertising expense because someone might find us, they might hear that we're doing that and being like, OOH, I love that charity that they're working with. I love that idea that they're giving back some of the money that they're making, and I want to work with that account. And so, for us, it was a way to say, hey, we're growing our business by doing this charity drive.
Sometimes it might be, hey, if you leave a review for our podcast, we're going to donate $10 to this charity, XYZ. Well, that's an advertising expense we're giving to a charity, but we're utilizing it as a business expense by changing the category of that to advertising. Now, of course, you need support. You need to back that up. You need to say, okay, the IRS comes knocking and say, hey, you're giving to this charity. How is this advertising? You have to have support to say, well, more reviews means more listeners, which means more people come and follow us and take in the information we give. So that's why it's an advertising expense. So we want to be careful with this. We want to, you know, how our business is actually benefiting from this to make it an advertising expense. But now, when we move it from that, we're getting an expense that's offsetting our business income directly. We're not worrying about itemized deductions. We're not worrying about any of that because we're getting it directly on our business tax return.
00:41:48 - Cameron Valadez
Right. So another way of saying this is, hey, when you're trying to get the charitable deduction and a tax benefit on your personal return, it depends on your income and to even be able to get that deduction whether or not you itemize or not in the first place. And there are limitations on how much can be deducted. And so by doing it this way, you kind of work around all of those limitations if you're able to attach a different business purpose for it. So that's just one really great strategy for those of you out there that are charitably inclined. Mike, one more thing I want to back up on. You hinted at it earlier, it's another type of strategy, but I want to bring it back up because I want you to dive just a little bit deeper into it. It’s hiring children in the business or the family management business. How does that work? Can you explain that for our audience?
00:42:39 - Mike Jesowshek
I think this is one of the biggest tax strategies that is missed by small business owners is hiring our children. Now, we're supporting our children every day of their life, and we're sending them to baseball camps. We're giving them money to go out on field trips, go out to amusement parks with their friends. We're doing this support of our children in everyday life. And typically, we're doing that with after-tax dollars. We're paying that out of our personal account. But wouldn't it be great if we could find a way to get a business deduction and support our children at the same time? And that's this idea of hiring our kids in our business. Now we can't hire our kids and then have them pay us rent or have them buy groceries for the family or things like that. But all those extracurricular type activities, that's full game of where they could use that money that you're paying them for working in their business.
Now there are some things that to be a certain age, but typically we say seven or older, they must actually be doing work in your business. We need to pay them a reasonable rate, so we can't pay our child $150 an hour to mow the lawn unless that’s the going rate for mowing lawn in your area. So we need to kind of dot our I's and cross our T's. But it provides a great opportunity to get a business deduction. And our kids potentially pay no income taxes on that because if they're under the standard deduction of roughly $13,000, they pay no income taxes. So we're getting a business deduction, we're transferring it to our kids, and they're paying no taxes on it, potentially. And now they can go fund or support or pay for those things that they're doing.
The other kind of way that we like to just explode this even further is to fund a Roth IRA. Now, one of the problems or concerns with a Roth IRA is that you don't get a tax deduction when you contribute money to it. Well, if you're not paying taxes, who cares if you get a tax deduction or not? The other problem with a Roth IRA is you need earned income. Well, if you're not working, you don't have earned income. But now your child's working for you and your business. They have earned income from that. They're not paying taxes on it. What if we fund a Roth IRA? What if we start funding a Roth IRA at the age of eight years old, nine years old, or ten years old, and we're putting $5,000, $6,000 into it every year? That amount of that Roth IRA that's growing tax-free into retirement is going to compound significantly, not only to mention with a Roth IRA, the beauty behind a Roth IRA is that if you need to access some of those funds you put in, you can pull the principal portion out. So if you fund it with $25,000 from the age of ten to seventeen and you have $25,000 in there, now your child gets to college, and they need some cash, they could, in theory, pull some of that $25,000 out of there if they wanted to. Now, I would say, if there are other resources, let's let that thing compound tax-free and let that thing go. But it does provide an opportunity where those funds can be available. So hiring your kids is such a strategy that every business owner can take advantage of and get a lot of people that say, Mike, I own a law firm. What's my eight-year-old going to do in my law firm? And I said, let's get creative about this. Let's think about what they can do. Can they shred papers? Can they stuff envelopes? Can they do some advertising for you? I've had a law firm that says I don't need advertising. I grow from referrals. Like, I don't go on social media. I don't do any of that stuff. I don't need it because I grow so well from referrals. And I say, well, would it really hurt if your twelve-year-old was managing your social media accounts? Is that going to hurt your business? But even if nobody comes from that work that they're doing through that social media account, because everything's from referrals, we're still getting a business deduction for it. They're potentially paying no income tax. It's a complete shift of money that's creating it tax-free.
So again, there's some work that you need to do. You need to make sure you're doing this right. But the tax advantages of hiring your kids can just be so beneficial. Not to mention now they're getting to know the family business a little bit. That could be a bad thing where they're like, I don't want nothing to do with that down the road. Or it could be a good thing where they're really starting to get involved with that family business at a really young age.
00:46:26 - Cameron Valadez
Yeah, I love the social media one, especially for teenagers. It's perfect, right? Because they're already doing it anyway. More than likely, just give them a good purpose to do it. Whether or not they care doesn't matter. And as you said, it doesn't mean that whatever they're doing actually has to be successful. Right? If they're doing the advertising, you don't need to tie back to the business and be able to say, hey, I got X amount of business from this ad. It doesn't really matter. Not all advertising works anyway. So just get them going. And then, as I mentioned, whether or not your child sees the benefit now of doing that doesn't necessarily matter as long as you know the benefit, right? If you're doing those strategies like funding a Roth IRA or something like that for a younger child or a teenager, I mean, the power of that by the time they hit their retirement age can be magnificent. And as you said, yeah, don't be deterred from doing those things because you have a lack of understanding of how they work. Just go research it or talk to people that know, and they'll explain to you the benefits.
Another idea that I've tossed around before with, for example, dental offices is a good example. Sometimes they have pictures on the windows of some parents with their kids, and they're smiling and things like that. Well, in those pictures, what if those were your kids in the actual picture? Could you consider them now a model that they're advertising for the business? I mean, there's probably a lot of creative and cool ways that you could do this. So don't also just kind of poo poo the strategy just because you can't think of something at the moment. Eventually, something will come up, but you won't get the advantage or the benefits of the strategy unless you actually do it. Right? I talk about that a lot on the podcast. Implementing is everything. You can know all this stuff, or you can go on Google all day and find some of this stuff. But if you don't actually do it or talk to the professionals to help you get it done, you're never going to get the tax advantage.
00:48:28 - Mike Jesowshek
Yeah, and that's one thing that I always say to our listeners is we do weekly episodes, listen to the stuff we're doing, write down the topics, the tax strategies that make sense to you. Just write them in a note app on your phone. But every month on your phone or on your calendar, put a little meeting that says, revisit tax strategies. So as you're listening in the car, you're like, oh, that hiring the kids. I really like that idea. Just put a little note in your note app or wherever. You kind of keep something that you can come back to. Put a little note hiring your kids. And then when that calendar thing pops up at the beginning of every month or Friday of every month when you have some open time in your schedule, it says, look to implement strategies.
And so that's the key part, is that you can learn all day, you can listen to podcasts all day. We can research all these different things, but if an action is never taken on it, it doesn't produce any results to it. You just know a lot of good tax strategies from that standpoint, but you're not providing any tax savings because all you do is know you're not doing so. That is such a key part. And I would say when you go back to the hiring your kids as an example, I have yet to find a business that I cannot find a way or something that their kid can do within their business. Now, with that being said, not all the time is it worth $12,000 a year or maybe even $6,000 a year. Maybe it's only $800 for that child. Maybe they're seven years old, and they're just doing a few modeling pictures, and yeah, it's $800. That's the value of what they're doing. Regardless of that, it's still a business expense and tax-free income to them. And a great way to do that shift of spending that you're already doing, spending you're going to do no matter what. But now you're getting a business deduction for it. So don't think of it that way. When we look at tax planning, one final note on that is that a lot of people say, well, seems like a lot of work. Hiring our kids for a $800 deduction seems like a lot of work. First off, it's not a ton of work. You just have to learn that strategy. But once you do it once, you do it the next year, and you do it the next year, you set an S Corp up this year, fifteen years down the road, you're still seeing the advantage of that S Corp that you set up now. So don't necessarily look at it as a one-year savings. Look at it to see how many years is this going to compound into savings, and what can you do with those savings then? And also, most tax strategies they're not as hard as you might think they are to actually do that implementation piece.
00:50:41 - Cameron Valadez
Right. And I know we've covered quite a bit, and there's a ton of tax strategies out there and different things that you can do, whether you have an LLC or you're taxed as an S Corp, or you're not. And obviously, we can't cover them all on today's podcast, but I think we hit on some of the big ones. Is there anything else that you want to add, Mike? Anything that we missed that's real low-hanging fruit, easy to take advantage of?
00:51:06 - Mike Jesowshek
I mean, we could talk all day about tax strategies, but I think a good parting point is this idea, again, of maximizing deductions. And I think one thing to think about is every time you swipe that card, every time you swipe a card of yours or make a cash payment, whatever it might be, think of, is there a business purpose for this? There are a lot of missed opportunities in that situation. I'm looking around my office, and I have a cell phone, I have water bottles, I have microphones. I have all these different things. There's a lot of missed opportunities of, if I go and buy that microphone, I'm like, this is personal. Is there a business purpose for this? Is there a way that I can find a business purpose for this and tie it back again? I just want business owners to be thinking, you go out to dinner, and you're maybe with a friend. Maybe that friend's a client of yours. Are you guys talking business at that meeting? Let's take a business deduction for that. So there's a lot of opportunities out there that people just need to think about, get it a little bit deeper in that they can really take advantage of, and that's this whole idea of maximizing deductions. Again, that $30 meal might not seem like it's really worth it. What did you save on taxes there? I don't know, a few dollars. But you add that up, and how easy was that to just swipe your business card instead of your personal card right on the receipt? I met with Bob, and we talked about his current account with our business. Done. IRS doesn't care or know that Bob's a friend of yours because you guys are talking business. Whether he's a friend or not, it was still a business meeting. So, again, just this idea of maximizing deduction is something I just want to drive home and start to get people thinking about. And we talk about all sorts of ways on how you can explore different tax opportunities and tax strategies within that idea.
00:52:40 - Cameron Valadez
Awesome. Yes. Thank you for sharing that. We definitely, as business owners, we need to consistently be in that mindset. Wow. I mean, we covered quite a bit. I think that's all for today's show. I really hope that this motivates you. If you're a business owner out there, talk with your professionals, your team, your advisors, and your tax professionals about some of these strategies we've discussed today. As Mike said, write these things down, put them on your calendar, and take that step toward implementation. Whether or not some of these are right for you or they're not, everyone's going to be different. You got to start somewhere. So start taking those baby steps today and figure out which ones pertain to your situation. Right? And if you don't know, talk to your professionals. And Mike, thanks for joining us today again. I really appreciate it. Your knowledge has been very insightful. I'm sure our listeners will really appreciate it.
00:53:34 - Mike Jesowshek
Yeah. Thanks for having me, Cameron. It's been a lot of fun. And I love talking about tax savings when it comes to business owners.
00:53:40 - Cameron Valadez
Awesome. Well, if anyone has any more questions regarding today's discussion, whether it has to do with tax savings strategies or investing, saving for retirement, or things like that, if you have any questions on those things, and we didn't answer some of those in today's episode, feel free to ask me a question on Retiredishpodcast.com. There you can go to the Ask a Question page at the top. I will also include a link in today's show notes and ask a question. I will do my best to answer it in a future episode. Or even better, reach out to Mike at www.taxsavingspodcast.com. Check out the amazing resources he has to offer. Thanks for tuning in and following along. See you next time on Retired-ish.
00:54:46 - Disclaimer
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