Do your small business clients understand S corporation status?
Although tax status significantly impacts businesses, many small business owners are unaware or ill-informed about their tax statuses. You can educate and help your clients obtain a better tax status for their companies, and you can offer lucrative advisory services in the process.
Here at Gusto, we help accountants gain essential tools for improving their firms and assisting their clients, and that’s why we, along with our partners at CPA Academy, delivered an edifying webinar all about S corporations and advising your clients. We released our webinar titled, “How to Increase Advisory Opportunities Through S Corp (Form 2553) Conversions,” and you can watch the full presentation here.
In this article, you’ll learn all about S corps and client advisory from Will Lopez, founder of AdvisorFi and head of Gusto’s accountant community. This article shares helpful highlights from Will’s presentation, including the disadvantages and advantages of S corp status and how you can advise clients through the process of becoming an S corporation.
Explaining S corp disadvantages to your clients
S corporation status can be highly beneficial to your small business clients. S corporations are businesses that pass their income, deductions, losses, and credits to their shareholders. The IRS taxes shareholders’ individual incomes rather than tax the income of the entire business. Electing to become an S corporation can often be a daunting task for small businesses, so it’s important to walk them through the initial election process and advise them through their fears:
“The hurdles of starting something really do scare people, and they do need somebody to explain … [S corporations] and how you will guide them. … Advisory helps quench the fear, and it helps settle in a little bit more of a realistic approach to owning a business. … What you want to do is support them in the journey and explain [that] you want to assist them in the formation.”– Will Lopez
A critical part of advising your small business clients is helping them maintain their tax status. After your clients become S corporations, you need to continue supporting them by educating them about the different factors and mistakes that will end their S corporation status.
“Mistakes can terminate the S corp status—making sure that you’re helping [your clients] with that and making it less cumbersome is extremely important. And then as you’re managing them and supporting them as the advisor, they stay clear of the termination items, the triggers of the S corp status.”– Will Lopez
One termination item that will end your clients’ S corporation status involves ownership restrictions:
“S corp can only have one class of stock, for example, no more than a hundred shareholders, … [and] foreign ownership is prohibited. So as you’re explaining the journey, qualify them [and] ask them the questions: ‘Are you trying to do angel investing? Are you trying to do series A, B, and C? Are you trying to go public? S corp is not going to be for you.’ … 98% of small businesses will be eligible for the S corp status.”– Will Lopez
Most small businesses are eligible to become S corporations, but you need to explain the shareholder and stock restrictions to your clients to ensure that the status is right for them.
Another disadvantage of becoming an S corp is harsher IRS scrutiny. You need to advise your clients through reasonable compensation in order to prevent them from losing their S corp status:
“IRS scrutinizes payments to make sure that the characterization of distributions conforms to reality. People do get themselves in the S corp [status], don’t realize that they have to run reasonable compensation, and then ten years later, [the] IRS [comes] in. [They] do an audit and then reclassify distributions as salary. … So support [your clients] in that journey. … You need greater intensity of advising when it comes to reasonable compensation [and] when it comes to tax planning.”– Will Lopez
You need to assist your clients in understanding what can disqualify them from maintaining their S corp status. Your clients can benefit greatly from becoming S corps if they qualify, but you need to demystify the qualifications and restrictions of S corp status so that your clients avoid issues with the IRS.
S corporation advantages
Although there are drawbacks to becoming an S corp, your small business clients can experience significant benefits from becoming S corporations.
“The S corp protects the personal assets of its shareholders. … Also, at the same time, the company at a federal level doesn’t pay … [the] corporate federal income tax. … S corp passes … down to you, and you receive the benefits.”– Will Lopez
Your small business clients can benefit from S corp status by avoiding corporate federal income taxes and having shareholders pay individual income taxes. When you help your clients reap the benefits of becoming an S corporation, you can also strengthen your advisory relationship with them:
“Corporate shareholders can be employees of the business and draw salaries as employees. … You’re going to help them do the 401k deductions or salary [and] help them with tax planning. … There [are] so many things in the tax-favored side of the S corporations that you can speak into as a tax professional that gets you into higher and higher levels of advisory work.”– Will Lopez
When you focus on explaining S corporations and helping your clients gain S corporation status, you also show your dedication to their businesses. Will noted that you can explain and calculate the money that your small business clients will save by electing to become S corps:
“[Helping them with] S corps shows formal commitment to their businesses, establishing credibility. … [Plug in] a net income for the business [so] they understand [how much money they can save by filing as an S corp]. … What you’ve done here is you’ve helped them visualize an opportunity to save money as a business owner.”– Will Lopez
When you help your clients understand how much money they can save by electing to become S corporations, they’ll be more inclined to use your accounting services. By explaining S corporations, you show your clients that they can net more money by utilizing your advisory services. The amount of money your clients will save by becoming S corporations will likely be greater than the cost of your advisory services, so they’ll use your services to save money.
Assisting businesses to become S corporations
When advising businesses, it’s important to note that the benefits of S corp status will depend on their type of business. Will observed that sole proprietorships benefit from becoming S corps, and most businesses are sole proprietorships:
“According to [the] Tax Foundation, about 75% of the businesses out there [are sole proprietorships]. When you are in front of an unincorporated sole proprietor, this is the most ideal situation because you can walk them through … the benefits and how you [can] support them.”– Will Lopez
In addition to sole proprietorships, you can also help incorporations become S corporations. Many incorporation owners fail to realize that their business starts as a C corporation. The major difference between S corporations and C corporations is taxation. Unlike S corps, C corps pay corporate income taxes rather than have shareholders pay individual income taxes. Although C corps pay corporate taxes, the IRS requires shareholders to pay taxes on dividends. C corp status can benefit small businesses because shareholders don’t have restrictions, like with S corps. However, your small business clients may benefit by switching their C corp status to S corp:
“When they form [incorporations], they don’t realize that the default tax status is a C corp. … They don’t have the intention of using their inc. and all of the C corp benefits the way they think it’s going to play out. When you get yourself in front of an organized inc. [that’s] being taxed as C corp … and you end up … figuring out [that the tax status isn’t suitable for their business, you can communicate], ‘I don’t think C corp really is for you. You’re not utilizing anything that … [requires] C corp [status]. … Let’s consider S corporation.’”– Will Lopez
If your small business clients don’t benefit from C corp status, you can advise them to obtain S corp status if they qualify. When you explain to your small business clients that their current tax status is holding back their business from maximizing its profitability, you can formulate an advisory relationship with them. You can package your advisory services to help them become S corps, and you can help them maintain their S corp status.
Learn more about the advantages and disadvantages of becoming an S corporation
Your small business clients may be unaware of how their tax status affects their company. You can educate your clients about the benefits and drawbacks of S corp status, and you can help through the election process. If they obtain S corp status, you also need to help them maintain their tax position. The IRS can reclassify their status if they break ownership and shareholder rules, so you need to continue educating your clients. By assisting your clients with their tax status, you can step into an advisory role, which can be highly lucrative for your accounting firm.
If you’re ready to learn more about S corporations and how to become a trusted advisor for your clients, read Part One and Part Three of this webinar article series. You can also watch the entire webinar here.
Offering advisory services to your small business clients can be highly beneficial to the success and growth of your accounting firm, and you need to learn critical personal advisory tools to assist your clients effectively. Fortunately, Gusto offers an exceptional People Advisory Certification program to help get you started with advising your clients. You’ll learn critical advisory tools, such as payroll, benefits, and HR, through the program. If you’re ready to learn more about how you can become a trusted advisor for your clients while expanding your firm, check out our Gusto for accountants page.