The Thing We Never Talk About

Timothy Iseler: Hi everyone, and
welcome to The Thing We Never

Talk About, a podcast about
personal finance for weirdos.

My name is Tim Iseler.

I'm a certified financial planner and
I run my own independent financial

advisory business in Durham, nc,
helping artists, musicians, and

other people with weird jobs take
control of their financial lives.

You can learn more at iselerfinancial.com.

And before we dive in today, if you
have a question about money or personal

finance, I'd love to hear from you.

Please head over to
iselerfinancial.com/podcast

to submit your question and I'll
answer it on a future episode.

A couple of weeks ago, I shared a bunch
of info about self-employment tax.

Here's a quick recap.

Self-employment tax is the equivalent
of fica, but for freelancers,

sole proprietors, partners in
partnerships and members of LLCs.

All of those types of people
have to pay self-employment tax.

And that tax like FICA is used to pay
into Social Security and Medicare.

One point I really leaned into in that
episode was that self-employment tax

is owed on your total net business
profits regardless of whether you treat

that money as compensation or not.

That's true even if all of those profits
live in a dedicated business bank account

and never hit your personal account.

It's all considered earned income.

As a result, there's no way for
those types of business owners to

actually pay themselves a salary.

But at the end of that episode,
I teased out an exception to the

self-employment tax rules, which
is called the S Corp election.

I'll admit this is kind
of a niche topic, alright?

But it's important for anyone who runs
their own business and wants to know

if they're making the right decisions.

I find that lots of people wanna up
their game, want to make their businesses

more legit, but are totally confused
about the differences among business

structure options and what that choice
means for both income and taxes.

Today we're gonna focus on the
differences between LLCs and S Corps.

But let's start with a quick
overview of sole proprietors and

partnerships before diving into LLCs.

A sole proprietor is pretty much anyone
who trades work for money but doesn't

have a formal business structure.

So that certainly includes
freelancers, but it also includes

lots of musicians, artists, writers,
certainly lots of roadies, which is

how I made my living for many years.

And it even includes a kid in your
neighborhood who rakes leaves for cash.

Those are all sole proprietors.

There's absolutely no difference
between the owner and the business

when it comes to income, profits,
or liability for sole proprietors.

Business income is your income business
liabilities are your liabilities.

Partnerships are basically like sole
proprietors, but they have more people.

Partners share in both profits and
losses, and there is no liability

protection between the business and
the owners or among different owners.

A limited liability company
or LLC is organized and

registered at the state level.

It's pretty easy to do and typically costs
a few hundred bucks a year to maintain.

And what it does, as the name implies,
is limit the liability between

the company and the company owner.

So for example, if somebody walks
into your office and slips on

a banana peel, they can sue the
business, but your personal assets

can be excluded from that lawsuit.

That's not the case if you're a sole
proprietor or a partner in a partnership.

that lawsuit might mean the end of your
business, but you'll get to keep your

house and your car and all your stuff.

LLCs also protect members, which
is what LLC owners are called from

liability for and from other members.

One example is if a member in a
multi-member LLC gets divorced, that

person's slice of the business will
get looped into the divorce process,

but the other member's ownership and
personal assets will not be at stake.

Honestly, there are very few
downsides to registering an

LLC if you work for yourself.

It doesn't cost all that much and if
there's any possibility at all that

you might get sued for any part of your
work, you'll be glad that there's some

separation between business and personal.

You don't have to have an LLC
to work for yourself, of course.

And there's situations where the
odds of somebody suing you are so

low that it just doesn't matter.

Or for certain other vocations
where you're required to have a lot

of industry specific professional
insurance just to operate, you might

already have plenty of liability
protection without registering an LLC.

But for everyone else who's self-employed,
I think it's worth considering this as

a move for limiting your personal risk
exposure without a lot of extra hassle.

But what an LLC does not do
is change your tax status.

Even though they offer lots of
protection when it comes to legal and

financial liability, lLCs offer no
benefit when it comes to taxation.

In fact, the IRS term for one
member LLCs is disregarded entity.

Kind of a harsh toke for all
the one member LLCs, right?

But when it comes to taxes, the
IRS does not care whether you

register your business as an LLC.

And that brings us to subchapter s
Corporations also called S-Corps.

While an LLC is a business organization,
but not a tax status, an S corp is a tax

status, but not a business organization.

In other words, you must have already
formed and registered your business before

electing to be treated as an S-corp.

And an LLC can choose to be treated as
an S corp for tax purposes by filling

out and submitting IRS form 2 5 5 3.

There are some rules that go along
with that form and that filing.

They're not super complicated, but
I'm not gonna get into that here.

So why would anyone elect to have
their business treated as an S Corp?

The main reason is that it allows
you to treat yourself as an employee

and therefore pay yourself a salary.

In other words, you can carve out a
portion of your net profits and treat

that as earned income, on which FICA
is due, and the rest of the profits

can flow through as ordinary income.

Now, ordinary income is still
subject to income tax, okay?

You're not avoiding that
with the S-Corp election.

But it avoids that extra 15 ish percent
that you have to pay on top of income

tax in the form of employment tax.

Here's the thing.

The IRS stipulates that with very
few exceptions, an s corp owner

called a shareholder must receive
reasonable compensation unquote, but

the IRS doesn't stipulate exactly what
reasonable looks like for different

industries or even across industries.

What's reasonable compensation for
being a musician or writing a book or

making things that you sell on Etsy?

It's different depending
on your situation, and it's

open to interpretation.

I.

Now I have my own ideas about how
much of your net profits should be

considered reasonable compensation.

But I'm a CFP and I'm not a CPA.

A CPA is an expert in tax law and
is authorized to represent you

in tax court if you get audited.

A CFP can't do that, nor is
there such a thing as advisor

client confidentiality for CFPs.

So if you're considering the S-corp
election, you should 100% get your CPA to

sign off on the process and help decide
what qualifies as reasonable for you and

your business before you get started.

That said, , here's a quick example using
some back of the napkin kind of math.

The calculation for self-employment
tax is kind of complicated,

but it works out to 14.13%

of net profit while
FICA works out to 15.3%

of earned income.

Okay, so let's say that you have a
one person business that generates

a hundred K in net profits.

If you are a sole proprietor freelancer,
or one member LLC, that entire 100 K is

subject to self-employment tax, and you'll
owe about 14,130 in self-employment taxes.

. Now, let's say instead that you
have a one member LLC and elect

to be treated as an S corp.

Let's also say that you and your CPA
decide that 50,000 is a reasonable salary

based on that a hundred K net profit.

You'll owe about 7,650 in FICA
based on that salary with the

remaining profits flowing through as
ordinary income and avoiding fica.

Remember, it's still subject to income
tax, but it avoids that employment tax.

So in the scenarios described above,
you would save in the ballpark of

6,500 bucks in employment taxes
by choosing the S-Corp election.

Not bad, right?

So why doesn't everyone do this?

Well, the easy answer is that the S-Corp
election is a lot more complicated.

When you have a one member LLC, you
don't have to worry about running

payroll because you can't actually
treat yourself as an employee and

so you avoid all kinds of paperwork.

That's not true when your
business is treated as an S-corp.

You have to regularly run payroll, which
means making payments to the IRS and your

state for income tax and paying into fica.

You can't just wait until the end of
the year and see how it shakes out.

You have to do a lot more paperwork
and be more proactive about accounting

and paying taxes in real time.

Another drawback of being treated as an
S-corp is that you can no longer claim

a bunch of business expenses on your
personal tax return like you can if you're

a freelancer, sole proprietor, partner
in a partnership or member of an LLC.

That's not a huge deal because you
can either have the business pay

those expenses directly, or since
you can now treat yourself as an

employee, you can submit receipts to
your business and get reimbursed the

same way that any employee would.

The point is, though, that you'll need
to start thinking about bookkeeping

differently and be more on top of things
as they happen instead of waiting until

next year when it's tax filing time to
start adding up all of those write-offs.

And finally, one downside of treating
only a portion of your business

profits as compensation means that
you are paying less into Social

Security and Medicare, which means
that you'll have lower benefits

from those programs in retirement.

That said, a great way to offset that
risk is to take the money you save on

taxes now and invest it for the future.

Again, it's not super hard, but
it is one more thing that you have

to think about with an S corp.

So how do you know if the S corp
election is a good idea for you?

The most basic answer is pretty much when
you're making more money than you need.

So if your business generates just
enough profits for you to get by,

or maybe even a little bit less
than that, then it probably isn't

worth the extra effort and filing
requirements to be treated as an S corp.

If I had to put a ballpark number on
it, I'd say you could start having

that conversation when your net
business profits approach a hundred k.

Again, this is just ballpark, there's
no hard and fast rules about this,

but below that, it just might be too
much work relative to the benefits.

Another reason you might want
choose the S-corp election is to

avoid surprises at tax filing time.

This is honestly why I chose to
do it that way for my business.

When I was still a roadie, I made more or
less the same amount of money for several

years in a row, but depending on how the
bands I worked for treated compensation,

I might get a big refund one year or
owe a bunch of money the next year.

It was so hard for me to anticipate that
in advance, and I hated that uncertainty.

So I chose the S-Corp election when I
launched Iseler Financial, even though

at that time there was no profit at all.

Okay, so that's probably enough
for now on LLCs and S Corps.

I know that it's kind of complicated,
but I also know that so many of

the people I talk to and work with
want to understand this better and

don't really know where to start.

So hopefully, after listening
to that, you at least understand

the basics when it comes to LLCs
and S-Corp and know what kinds of

conversations you should be having next.

If you have a question about business
structure, feel free to drop me a

line at iselerfinancial.com/podcast,

or you can sign up for weekly
office hours by going to my

homepage, iselerfinancial.com

and scrolling down to the section
that says, have a quick question.

I'll add both of those
links in the show notes.

Okay.

Next week I'll be back with a
conversation with Adam Turla

from the Band murder By Death.

I recorded that band's first
record way back in 2002 and really

enjoyed catching up with Adam.

Now it's time for disclosures.

The Thing We Never Talk
About is for educational and

entertainment purposes only.

It's not legal, investment or tax
advice, but you knew that already, right?

People on the show, including the
host, may have interests for or

against any investments discussed.

So do yourself a favor and don't
make any decisions based on what

you hear on this or any podcast.

If you have a money or finance question
you'd like answered in a future episode,

please visit iselerfinancial.com/podcast.

And of course Iseler
is spelled I-S-E-L-E-R.

And if you like what you hear,
please like and subscribe to this

show wherever you get your podcasts.

And you can get my insights on money and
more delivered directly to your inbox by

subscribing to my Keep It Easy newsletter
at iselerfinancial.com/newsletter.

Thanks for listening.

I appreciate you.