Main Street Business

#527 Tax Advisors Playbook: Moving Your Client From An LLC To an S-Corp

• Mark J Kohler and Mat Sorensen

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In this latest episode of the Main Street Business Podcast, Mark J. Kohler explores the benefits and processes involved in converting to an S Corporation. Learn how making the switch can save your clients money, the critical timelines for filing, and how the Kohler Payroll Matrix can guide setting reasonable compensation. 

Here are some of the highlights:

  • Mark recommends converting to S Corporations when net income reaches $40,000-$50,000.
  • Mark advises and breaks down how to convert an LLC to S Corp using Forms 8832 and 2553.
  • How tax professionals can present the S Corporation strategy as a new tax-saving opportunity to clients.
  • The significance of implementing payroll before year-end for retroactive elections.
  • How to use the Kohler Payroll Matrix as a tool for determining reasonable compensation.
  • Using retroactive S election with Rev. Rule 2013-30 for mid-year conversions
  • After-the-fact quarterly payroll recommended for flexibility.
Speaker 1:

Welcome to the Main Street Business Podcast with your distinguished hosts, mark J Kohler and Matt Sorenson. Both are best-selling authors and have over 25 years of industry experience, with 10,000 client consultations, making them the leading tax and legal experts in the nation. Together, they'll unpack the most complex tax, legal and financial strategies crucial for saving more, stressing less and building generational wealth. Today they're your personal advisors, ready to break it down for you and make the tax and legal game easier than ever. Here is Mark and Matt.

Speaker 2:

Tax professionals. In today's video, I'm going to help you identify when your client should convert from an LLC to an S-Corp, why they're going to convert to an S-Corp, and then how to carry it out and audit proof the process moving forward. I'm a registered CPA attorney, best-selling author, and have owned multiple tax and legal businesses, and this process of the S-Corporation is the gold standard that we use every day, helping our clients succeed and take advantage of the tax strategy. The problem is many accountants are far too conservative in this area or don't understand the strategy, and then we've got the problem of dealing with clients that won't listen to us or follow through with the process. But I'm going to help resolve all of these issues and help you carry out the number one tax strategy for operational businesses in America today. Why is this so cool? Because you're going to make more money as a tax advisor and build the advisory practice you dream of, and your clients are going to be more happy. They're going to be satisfied with your services and be excited to sign up for your tax advisory practice year after year.

Speaker 2:

Now, what is an S-Corporation? For some of you that are new to the game, we've got to cover this. The S-Corporation is an election. I can take an LLC and file Form 8832, the entity selection form and the accompanying 2553 and select the date I want my LLC to become an S-Corp. Now the LLC remains the same with the state. It might be best produce LLC. It's going to keep the same EIN and the world still sees it as an LLC from the outside, but on the inside we've made this S-selection and so now, based on the date we select, we're going to be an S-corporation moving forward and have to file an 1120S tax return. Now, why would we do all this? This is going to be the golden question we're going to answer next and unlock all the benefits of the S-Corporation. Now some people may think you have to be an Inc or a professional corp, pc or a PLLC or something like that in order to be an S-Corporation. That doesn't matter. You can be an LLC in an S-Corporation by using Form 8832. You're going to use that form to say eh, I would like to be an S-corp and file that form in conjunction with the 2553. So the S-corporation is not an entity filed with the state. It's an election to change the character of that entity with the IRS and the state taxing authority and that's it. That's what an S-corporation is. Now, when do we pull the trigger with this?

Speaker 2:

What is the indicator, the key indicator where we want to reach out to our clients and or, if we discover this with a client interview, bring up the S-corp conversation. The figure I like to use is $40,000 of net income in their LLC, 40 to 50, certainly by the time they hit 50,000 of net income. So example say, you've got a realtor as a client. They're bringing in 60 grand on a 1099, they may have $20,000 in write-off their auto, home office, cell phone, some computers, electronics, blah, blah, blah and you're going to see them netting around $40,000. Well, if you run the self-employment tax on that $40,000 and compare it as just a plain old LLC on a Schedule C and throw it into an S corporation with reasonable comp, you're going to see savings. That pays for the cost of the tax return and the payroll service Two topics we're going to come to a little later and I will break down what I believe to be that reasonable comp.

Speaker 2:

But the point is when a client has $40,000 to $50,000 of net income, they are ready for that conversation. The scary part is I've had clients come in and go well. My CPA said I've got to be making 200 grand before we can talk about an S-corp Net not gross, but net. I completely disagree with that. Now, for some of you that disagree with me on this point, please hang tight. We're going to talk a little bit more about reasonable comp, my credentials and why I'm going to be recommending the S-corporation. But the outset I wanted to answer the question of when, and that. When is you see that net profit climbing for your client and it's going to exceed 50,000 before your end.

Speaker 2:

Now why do we do this? The number one reason is to save on self-employment tax. See if we normally just report their operations on a schedule C that LLC, single member, llc or even a 1065, we've got partners, maybe husband. A Schedule C, that LLC, single member, llc, or even a 1065, we've got partners, maybe husband, wife, whatever. In that LLC we're going to be paying self-employment tax on the first $168,000 and then Medicare on everything. After that it starts to add up and so by converting to an S corporation we're able to bifurcate the profit. We can take some of that profit and allocate it to payroll, pay our fair share of FICA under reasonable comp, and then everything else falls out below as profit or pass-through or K-1. That's why we use the S-corporation first and foremost because we want to take that income and separate it between FICA income and pass-through income.

Speaker 2:

The problem is a lot of accountants, sometimes old school or some, that are a little too conservative and I apologize I may be calling out some of you here, but I want you to hear me out is that we think reasonable comp needs to be all the way up here and the threshold of when we convert to an S corporation, in my opinion, can be too far out there. We need to accelerate that process Now. This is a good point for me to make this little point, I have been a CPA now for over 24 years, an attorney for 23 years. I passed my CPA exam in law school, then I worked for KPMG, the tax court, had my own tax practice for 15 years and been a senior partner in my law firm since 2000. Now, through that entire process, I have never had a client audited for taking too little reasonable comp. I have read every case on reasonable comp. I teach classes on reasonable comp. I teach CE in our 360 conference every six months and on our tax pro certification program, which you're going to be amazed to hear about. I teach all of this as continuing education, with classes certified by the IRS for enrolled.

Speaker 2:

Agents have written countless articles on this in multiple publications. Agents have written countless articles on this in multiple publications and never had a problem of paying too little reasonable comp. Please give me a chance to persuade you that the S Corporation strategy is overlooked and often not utilized enough by the average small business owner, operational business. I can't tell you how many times and I've done my 10,000 consultations how many times I've seen clients come in paying far too much in FICA and by simply making an S election on their LLC, we saved them thousands. Now why is this so important? Because when you make this election, you move to the other side of the table with your client. You're helping them solve a problem. You're helping them better live their American dream. You're helping them save taxes and use that money to pay off debt, pay medical bills, build wealth. You become their advocate, not their adversary. You become a real tax advisor and they will love you for life.

Speaker 2:

This is the opportunity to start providing advisory services at the next level and people. This is only one of so many strategies I teach in my Tax Pro program and I have seen people turn to tears in meetings in person, on Zoom and in workshops when they catch the vision of this strategy alone. I cannot emphasize this enough. The why to use an S-corp is absolutely critical for the success of a small business owner, and you get to be the one to deliver that good news. It's amazing. Now you know what's even more incredible. The S-Corporation has 15 times less chance of an audit 1,500% less chance of an audit than an LLC. A single member LLC on a Schedule C is 15 times more likely to get audited than the S-Corporation. You are reducing their chances of an audit by making this election. You are saving them taxes. By making this election. You are becoming their advocate and their tax advisor. By making this election.

Speaker 2:

People, I'm here for you. I know the stress and pain you're under as a tax professional, stuck in compliance, trying to keep your clients happy, taking on way too many clients, working way too many hours and frustrated by the process. The S-corporation makes you a hero and it starts to allow you to transition your practice into an advisory practice, which we'll talk more about later, and I have so much to share with you. Okay, now let's get to the how. There's several steps in this process. The first thing is we've got to talk to the client about this. I want to talk a little bit about that relationship and how you present this. We've got to take the right actions to make the election and then we've got to follow through the proper procedures payroll, the 1120S, choosing reasonable comp. Through these steps that I'm going to walk you through, you're going to know exactly what to do to be successful with this strategy.

Speaker 2:

Now, talking with your client I know this is scary for some of you and you may not know where I'm coming from on this, because I know you. The scary part is when you sit down with them and go. I think we need to make an S election and save some taxes here, and what you're afraid of is they're going to go. Why didn't we do this sooner? Why didn't we do this a year ago? People, it is not malpractice to make a new tax strategy available to your clients. Whether you knew it or didn't know it, whether you could have implemented it earlier or not is irrelevant. It's a tax strategy. You want to present it and let them know you learned something new or that you have a new strategy that you'd like to present to them and that you're taking them to the next level, and they will appreciate you. Do not worry about this issue. Worry about doing the wrong thing. Moving forward, now that you learned this, they will love you for this. They will appreciate it.

Speaker 2:

For example, if my doctor called me up and said hey, mark, I've got a new medication I want to introduce you to. I think it's going to help you out with your high blood pressure, I'd be like, great, sign me up. Where do I go to fill it? I'm not going to complain and go. Well, why didn't you call me a year ago and tell me about this? I'm going to be grateful he called me, had me come in and gave me a new prescription.

Speaker 2:

Take the initiative to engage with your client, and when you present this strategy, I want you to couple it with a pitch a pitch for advisory services, which is something I teach in my Tax Pro program on how to pitch advisory, engage, price it and deliver it. With over 80 strategies, this is just one of them. So this is going to unlock the opportunity to have a powerful conversation with your client. That's how you do this. You don't just willy-nilly go hey, I'm going to make you an S-corp. No, take advantage of the opportunity to be their hero. It's a huge opportunity to open the advisory relationship.

Speaker 2:

Now the how of the paperwork is the freaking easy part. You guys know that it's an 8832 and a 2553. But let's talk through a few practicalities Now. If you go through my training and the program, we're going to get into more details about timing and a husband-wife LLC. And if there's partners and maybe you've seen my book here, it's right behind me the Tax and Legal Playbook. It's on Amazon. I can't count how many five stars Legit second edition. Check it out. I back all this up in writing. People, this is the real deal. So a couple of practical methods.

Speaker 2:

If I have a client come into the middle of the year and I can already see they're over that 50,000 threshold and the profit's coming down the barrel, I'm gonna say let's make a retroactive S election to January 1st of that year. That's okay. And I'm gonna start payroll in third and fourth quarter, wrap up the year with the 941, the W-2, 1120s and K-1. They're going to be fine. I can make that retroactive S-selection time during the year back to January 1st and not have any problem whatsoever. Now some accountants will worry about the 75-day rule where if I don't make my S-selection by March 15th, then I missed the window for the year. By March 15th, then I missed the window for the year.

Speaker 2:

That's why, when you file your 2553, you're going to include and reference Rev Rule 2013-30. Yep, got that right. I want to write that down and make sure I got it for you. So when you put that in the request for the retroactive S-election, it's always granted. Now I should say sometimes you'll get a letter back from the IRS what? And then you send it again. You're granted. So make sure that you get that S election back to the first of the year so you can capture the whole year's savings. Now a word of caution I don't like making a retroactive S election after December 31st Because, remember, it's all predicated on the fact you're going to issue payroll from this new S corporation and if I don't kick out a W-2 and a 941 at the end of the year and then I try to do a retroactive S election, maybe in February or March, I've got problems. Now I've missed the deadline to file the payroll. So this is an important opportunity for you this time of year to be reaching out to your clients in third and fourth quarter and making sure we're making that retroactive S selection before the end of the year so we can knock out the payroll procedure Now.

Speaker 2:

As I said, there's a lot of other little issues that can arise Partnerships, marriages, divorces, different income levels from different operational businesses. It's beyond the scope of this video to dive into all those details. I'm sure you can appreciate that. I'm going to highly encourage you to start following me and my podcast, get my book and take advantage of a demo learning about my Tax Pro Advisory Training. It's going to take you to a whole new level. Trust me and what do we call it? The MainStreet TaxPro certification. That will be actual credentials right behind the end of your name. And take your business to that tax advisory practice you've been wanting to build. All right. So you've made the S election, you've backdated the 2553, you had a conversation with your client and now it's time to do payroll.

Speaker 2:

Now we have to talk about reasonable comp and this is why I have my little whiteboard here, because what I created years ago and I think it's taking the country by storm is the Kohler payroll matrix. Now let me write this up for you and I'll walk you through how I approach reasonable comp. Now here's what the rule is in concept, what the IRS Congress under statute has said if you have an S corporation, you have to take reasonable compensation for the work you provide in the business, based on the money you take out of the business. You should pay wages to yourself and pay your fair share of FICA, social Security and Medicare. That's the concept that reasonable comp is supposed to be fair and, regrettably, I think it's wonderful. It's a subjective analysis. Some may argue it's based on the type of business, how much time you put in your age, how many employees you have, the region in the country, la, la, la la, and there's companies out there that will sell software to you and guarantee that this is the way you do it, based on blah, blah, blah, blah. Well, even after interviewing multiple prior IRS agents that worked in the Chicago office on S-corporations for years and doing this work myself, filing thousands of S-corporation tax returns over the last 20 years, I have found that there's an average approach to this, that I've talked to so many IRS agents that say, hey, if you're in this range it's not worth our time, let's just be reasonable, ie reasonable comp. So what I came up with is this matrix to help us find that balance and we can be confident that we're going to generally be okay with our clients and I've never had a client audited in this boundary.

Speaker 2:

On the x-axis we're going to put dollars, Zero dollars up to, let's say, $400,000. Now this dollar is our profit and in fact I'm going to get a little more specific later it's our draws. So I'm going to put profit or draws. On the y-axis, we're going to put the percentage of profit in payroll. So we're going to have zero percentage here up to 100% in payroll. So if I made $1,000, I might take $1,000 in payroll. So that's right here.

Speaker 2:

So what happens that's fascinating is my income goes up. This is the beauty of this. My payroll actually goes down as a percentage. So what's interesting? As my income goes up, my payroll goes down as a percentage and then levels out. It sounds counterintuitive, right? But let's look at an example here.

Speaker 2:

Let's say my profit or draws is about 100 grand, and then we're looking over here at 20%, 30%, 40%, 50%. We're going up our scale here. At about 100 grand, that's our sweet spot I might be at about 40% in payroll. I gotta clean this up a little bit. Now this is printed in my books and countless articles so you can go look at a prettier version. But we'll go 20, 30, 40, 50, yada, yada. So at about a hundred grand I like to see a payroll allocation of about $40,000. That would be the W-2. And then the K-1 would be 60 grand. So we're going to take reasonable comp of 40% when our income is around 100 grand. Well, what's interesting is my payroll percentage. Probably clean up this line too. My payroll percentage starts to go down and I flatline it at about 20%. So I have a client with 400 grand in profit or draws. I might take payroll of around 80 to $100,000.

Speaker 2:

And some of you I know are freaking out right now going oh my gosh, you're gonna take 100 grand in payroll on $400,000 of profit, $300,000 K-1, they're gonna get audited. I haven't seen that. Have you seen that? Or is that just the myth, the fear that's out there? Never had a client audited in this realm. Now you might ramp up the payroll if there's a situation that you subjectively feel it should be a little higher or ramp it down a little.

Speaker 2:

But here's some interesting points. When I have a client that hasn't taken any draws at all and the $400,000 stayed in the business. There is a zero requirement for payroll. Now, an interesting point here is that this matrix is really not based on profit. It's based on draws. So if you have a client that made $400,000 and they didn't take out any money, no distributions at all they put all the money back into the business. Do you know what? Their payroll requirement is? Zero Because they didn't take compensation. There is no reasonable comp. Is that interesting? So 400 grand in profit, all put back in the business, zero payments to shareholders. So what you're really comparing is line seven on page one to line seven in the M2. Because you're looking at distributions to compensation, not profit. That's another misnomer.

Speaker 2:

So we're going to be talking to our client throughout the year oh, you made 50 grand this year. How much did you actually take out? Nothing. We've been living off my spouse's day job. We're putting it all back in the business. Now you're going to explain phantom income. They're going to explain phantom income. They're going to have a K-1 with some income, but there may be no payroll requirement. See, these are some of the nuances that you're going to learn as you elevate your practice. So this payroll matrix, in summary, helps us find the right payroll and I want always in this mix, once my client makes about again 40 or 50 grand, we're going to switch from 50-50 to 40-60. I don't know, might be 30-70. We're going to keep pushing down the payroll percentage and ramping up the pass-through. That's the goal. All right Now, with all that said, let me share a couple of examples, because over 10,000 consults I've seen it all and we're doing it every day here in our law office, helping clients around the country and alerting them to the strategy.

Speaker 2:

So let's do kind of a basic one and then more of an advanced one. First one that's super common and I love this when I go speak at a realtor conference, a real estate conference of some sort, there was a realtor a couple of years ago getting brand new back into the business. She was just killing it, having a great time, and she had netted about a hundred grand, probably brought in 150. We were writing off everything cell phone, travel, auto, some training, yada, yada, yada and she had netted a hundred thousand dollars the year before. She paid at least 15 grand 0.153 in self-employment tax. Well, we introduced the S corporation, so let's convert that over that LLC that she already had put her on salary of 40 grand. Kick out the 60 as pass-through, let's go. She's like all right, $10,000 in savings, that's a big deal, $10,000. When you're making 100 grand and you can add 10% to your bottom line, you're changing someone's life.

Speaker 2:

Now, another example was boy. It was here in Arizona. It was a contractor that was doing home development. They had kind of a big crew and they'd been sucked into the LLC concept because a lot of investors and real estate developers think, oh, all I need is an LLC, all I need is an LLC. And they had this old school accountant that'd been around forever and I think they'd literally forgot to just talk about the S corporation. I don't know, but this client was netting 1.5 mil on a schedule C. Now I know some of you are like, well, that's obvious. Oh my gosh, I should have been an S-corp. He wasn't and we see it all the time. So anyway, we put him on salary at 150. Not a big deal. He had a whole management team. He was golfing one day a week, yada, yada. We felt reasonable comp was fine at 150.

Speaker 2:

When we finished that tax return, that first year savings of over $30,000 in FICA you think that's a game changer. It was. And this is again not high risk. Now some of you may go that's way too aggressive in salary Fine, choose another number you're comfortable with, but you're going to save. You're going to save the client far more than the cost of doing the S-corp return and four quarters of payroll. That's all we're talking about here.

Speaker 2:

Now, one major hurdle in this process at the end of the day is clients think they have to put themselves on a W-2 every two weeks. They're stressed about cash flow and all that I'm a huge believer in after the tax payroll. So you meet with the client at the end of first quarter might be right at the end of April or hopefully before then. But you've got through January, february, march and you're going to be doing that first quarter payroll. You ask your client how much did you take out, how much did you take in profit? And they go oh, I took out 30 grand in profit. Okay, let's do payroll at 10. You pop it on the 941, you send it in, you're done. Do payroll at 10. You pop it on the 941, you send it in, you're done. They don't need to take a paycheck along the way, you can just do your quarterly payroll after the fact and allocate a certain number on the 941 for what they should take in reasonable comp. Then at the end of the year you finish out the rest of the payroll reports, kick out the W-2, and you're off to the races. So, after the fact, payroll also makes it easy on the client for them to keep just taking draws when they want, and then you're meeting with them quarterly in a tax advisory capacity to nail their payroll at the same time.

Speaker 2:

Well, you like what you're hearing. I got more. I've got 70, 80 strategies in a 12-module certification program, weekly trainings, white paper, a dashboard with resources, a community, a tribe of like-minded professionals building tax advisory practices. I even have one of my favorites, module 13, which is how to build an advisory practice, how to bill it, how to engage the client, role-playing. It's an amazing training and it's changing the industry. I need to challenge you to please, please, click the link below and do a demo. Check it out. You will be absolutely blown away. It is affordable, it is continuing education. It includes two conferences a year, online training that you can start immediately today, and the S-Corporation strategy is just one of those tax strategies If you want to become a tax advisor, you've got to learn the strategies to teach how to pitch tax advisory and be in a community of other tax advisors. I've got what you're looking for. Thank you so much for watching. I want to see you at the next training, so click that link below and I'll see you next week.

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