O/T -Business advice

I hope I posted this in the right area...

The discussions coming from the corp. tax thread over in the manufacturing forum hit near some questions I have, and I realized that there are quite a few knowledgable and experienced people here that could possiply shed some light on what is a confusing subject for me.

Here's my question(s)...

For a small business (contractor) that will have only the owner as an employee to begin with, with an eye to possible future expansion(employees, equipment, etc), my choice of business forms appear to be:
1. "S" Corp
2. LLC

However, upon further research, I realise that an LLC is a broad term, because an LLC can elect how it is taxed.( It can be treated like a sole proprietership, partnership, "C" Corp or "S" Corp.)

At this point, then, I would say my choices are:
1. "S" Corp
2. LLC as a sole prop.
3. LLC as an "S" Corp

The information I currently have tells me to change from any type of LLC to an "S" Corp in the future will cost thousands in set-up fees. (basically, all of the money I am spending now will have to be re-spent to set up a new company).

I have yet to verify if the LLC elects to be treated as a sole prop. if it can later elect to change it's tax form to "S" Corp. And if there are any penalties for this, if it's even possible.

As I understand it, the benifit of an LLC "S" Corp over a "S" Corp are more flexibility, less formal paperwork, and slightly cheaper incorporation fees.

And it seems the one drawback to the LLC is it has a definate, limited life span.

And all of the above is about what I currently understand.

So my question is:
What, in your opinion, is the best choice for a beginning business like the one proposed to select to operate under? And why?

Tax laws, and how they affect a small business/owner/employee have left my head spinning with what little I have been able to comprehend. I don't want to make a selection now that will leave me stranded or strangled down the road if success and expansion occur, yet I don't want to choose something that is cumbersome and too complex while the company is small and struggling.

Now I know there is no substitute for a lawyer or CPA, but in the meantime I am trying to educate myself as much as possible so that I can ask intelligent questions and (hopefully) make intelligent decisions.

I really look forward to your responses and experiences, and thanks in advance for any help/insight you can provide!

Sole proprietorship is another option. Keeps your life simpler. May let you keep more of your money. Typically not difficult to change the form of ownership if you later decide to add partners etc. The biggest disadvantage is that a LLC etc. may give you an additional layer of protection if your business has high liability risks.

setup an S corp. the LLC is ok, but you will pay to set that up and have to do it later when you want to incorporate. really not much difference in the tax structure for either. at a minimum you can do a DBA but really an S corp is a legal entity, can have employees, can own other businesses, etc.

In Ky there is no limited life span of an LLC. Many of the building contractors and gov. branches here are LLC and they will last untill the last person on Earth dies as long as they are renewed each year.

PeteM said:

Sole proprietorship is another option. Keeps your life simpler. May let you keep more of your money. Typically not difficult to change the form of ownership if you later decide to add partners etc. The biggest disadvantage is that a LLC etc. may give you an additional layer of protection if your business has high liability risks.

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Definatly need the liability sheild. A straight sole proprietorship is not an option. I am learning that there are just too many people happy to sue you for the damndest things. Sad, but true. I thought that would be the "easy" way as well. Come to find out it is, until...

Thanks for your input though.

Also, while I am not sure yet, the sole proprietor pays additional self-employment taxes, whereas a shareholder does not. I understand this to be a considerable amount.(?)

It is soooo important to pay a good CPA $100.00 for good advise. You will never regret it.

John

Either way, you pay the same amount in employee taxes- 15.3% to the feds.

BUT- and its a big but- (as PeeWee Herman once said, everybody has a big But, lets talk about yours)

If you are a sole proprietor, you, personally, pay both halves of your social security and medicare taxes to the Feds.
If you are an employee, even an employee of a business you yourself own, they you have half of that amount deducted from your paycheck, just like any other employee.
The other half, the business pays.
The business, in this case, is still you.
But you dont have to count the amount the business pays as income, and pay income taxes on it.
So, assuming you are making money, you save somewhere around a quarter to a third of the the half of the taxes the business is paying.

Clear as mud, eh?

Basically, its a legal way to pay a bit less taxes.

There are other, equally legal ways to pay less taxes as a corporation. Mostly thru the business paying for things with tax deductible, pre tax money, as opposed to you, personally, getting paid, paying taxes on your income, then paying for it.
You can, for example, pay for medical insurance with pre-taxed money.
You might be able to rent your business space from yourself, as long as its a fair, market rent- and you, personally, pay less income taxes, and no social security or medicare, on rent, as opposed to salary.

In all of these cases, a good accountant, as mentioned above, doesnt cost money, he or she will pay for themselves and save you money.

I dont know about the LLC versus full corporation thing, but my guess is that its probably worth going full corporation if your gross is over a hundred grand a year- thats what my accountant told me was the point where it saves you money to be incorporated.
This may vary a bit depending on location and type of biz.

JOHN1 said:

It is soooo important to pay a good CPA $100.00 for good advise. You will never regret it.
John

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Maybe in your part of the country $100. will pay for some time with someone that really understands incorporation law, but around here if that's all you have to spend you're better off reading up on this topic on the Internet and making the decision yourself.

When we first started my business, I tried twice spending about $200. a pop trying to get some reasonable advice on the best structure for the business and it was a big waste of time, those "experts" didn't seem to understand the area any better than we did after we had studied up on it for a few days, and that was around fifteen years ago, it would probably be close to double that in cost now. (Note, to do self-study, there are some good books available from www.nolopress.com).

Unfortunately just because an attorney has a suit on and is willing to take your money doesn't mean they necessarily know what they are doing. My opinion is that there are more bad attorneys out there than good ones, so if you try to hire one out of the yellow pages (like we did) you are often wasting your time and money. If you have a good personal recommendation for an attorney from someone you know and trust then maybe you'll have a better experience.

My 2 cents on the business structure situation is that there aren't any huge advantages or disadvantages of a type S corp versus an LLC. The LLC has some ownership aspects that can sometimes make more sense for a mulitple partner type company, but in general I feel for most small companies the type S corp is the best and simplist way to go, especially if there is a single owner. There aren't really any big tax breaks to be had in going one way or the other, they pulled all that stuff out after the 70's when any idiot could make a pile of money and not pay any taxes on it.

Good luck-

Paul T.

One thing on the liability side of things...

Irrelevant of structure... if someone goes after you, and say in this case, you are the sole person involved - any lawyer out after a nice paycheck will do their damnedest to "pierce the corporate veil" - which means, they cut through the structure and "limited liability" to get to what ever it is that they want. That of course all boils down to the basis for the suit. If it can be made to appear like a justified suit, they will get after it, you, and your assets... Yes, an LLC or corp will give you a certain layer of protection, but there are still ways to get through that. So dont be lulled by the protection of a corp or llc - because they can and will find ways around it.

In some instances, where you are going to be the only one for a while, if its something you did, they would ultimately try to get to the point where they could pierce the veil and or go after you personally. Then both sides of the Corp/LLC are open to them. If they go after you personally, they get access to your holding share of the corp. If they get through the veil of the corp... there you are, the sole share holder.


On the LLC side, being involved in many, at least here in colorado... as and LLC you can not be an employee of the LLC. Its not set up that way. (at least this is what I was told by our CPA) A corp has no "owners" only share holders - and therefore you can be an employee of the corp even if you own 100% of the shares.


Cheers
Wade

S-corp all the way. The IRS, and the courts, prefer S-corps to LLC's. Rich folk use a lot of LLC's to hide and shuffle money, and the IRS obviously frowns upon that.

You can incorporate as an S-corp yourself. There are books out there on how to do it in your specific state, and include the necessary forms. It's really pretty simple. Just starting out, save yourself some money and diy.

I agree with the assessment of attorneys and accountants. The majority are a bunch of clowns, who don't really care about their job or their clients. Only hire one after getting a good recommendation, and only then after "interviewing" them for free. If any "professional" attorney or accountant refuses to give you an initial session for free, tell 'em to blow off.

The best way to find lawyers or accountants is by word of mouth. Ask people who started their own business and have grown who they use and if they are happy with them. Both professions have their specialists, just like machinists. Just because someone is the worlds best grinder hand doesn't make him a good programmer for a cnc lathe. The best criminal defense lawyer isn't going to know squat about best business structures.

Work to find a good business structure accountant (accounting firm), and have him help you find a good law firm. (could be vice versa). Especially if you are forming a sub S corp it is very important to get it done right the first time. Your first years will probably have losses. If you have to redo your business structure to accommodate your growth or fix previous errors you will most likely lose all those losses as deductions.

In addition to what Wade said; the LLC, S Corp, and Sole Proprietorship all have the same protection against liability in the face of any competent trial lawyer. Here's why:

You are the actuary of the event that caused the incident. Period. It all comes back to you. If the business doesn't have the assets to cover the judgement, then their next step is to go after you directly. You being president, you being janitor, you being alive - it's all the same when you were the responsible party for whatever happened to cause the incident. Negligence is negligence.

I'm not aware of any case law (precedent) that will refute this omission from the panacea of liability free bliss the LLC's supposedly provide. If the business has little or no assets, you're being liquidated next.

The true reason for an LLC is to protect yourself from the actions of your partners, but even that isn't certain as you may be found partially liable for their actions in the end anyway (depends on what exactly happened to cause the suit).

This is how it was spelled out to me by a retired judge, and 3 lawyers. I'm not a definitive resource on this stuff, so feel free to check it yourself.

S-Corp

I'm 1/2 owner of an S-Corp here in Massachusetts. We make electronics.
For me, the benefits of incorporation are that the corporation is able to pay for some things with pre-tax money. This includes my health insurance, cell phone, etc. Essentially, I get about 33% more value out of these dollars.

The S-Corp provides an easy path to convert to a C-Corp. This is attractive if you ever plan to take investment money, as you'll need to sell shares to do so. C-Corp companies have different classes of shares; S-Corp do not.

As regards incorporation protecting you assets, I would strongly suggest that you consult with a lawyer that's certified to practice in your state.

My lawyer pointed out a couple things:
1) Anyone can sue anyone for anything at anytime.
2) A contract cannot shift liability due to negligence, illegality, and some other factors.
3) There are any number of ways to invalidate a corporation which puts personal assets at risk. Generally this is considered "piercing the corporate veil". Usually these actions involve money transfers between a Corporation and its Principals, Directors, and Owners.
4) Just being Incorporated does not automatically protect one's personal property; see point #1. If some person sues the company (which, say, has no money), that person will be sure to add the owners of the company to the lawsuit.

The useful reasons to incorporate are, for me, I am not automatically personally responsible for the Company's debts; however, in practice, the owners of a company will be required to co-sign for loans to the company*. Normal trade credit, though, I'm not responsible for. (ie, the company has a line of credit with McMaster-Carr, should the company go out of business owing McMaster a bunch of $$$ they cannot simply ask me for the $$$, though they could sue [see point #1 above].)

I did not find NOLO or SCORE to be of much assistance when I incorporated.
My S-Corp incorporation cost a couple hundred (eight hundred, I think), five years ago. This was using a highly recommended lawyer, supposedly the "best in Worcester, MA".
Regards,
Aaron

* = I realize that larger corporations will not have their owners co-signing loans. I'm making this statement in the context of a small company, privately held, say less than $1M/year sales. Larger companies with proven, continuing revenue streams, will take loans against future revenues or issue more stock.

PS,
Don't forget the insurances you will need.
My company has E&O insurance, which supposedly protects against, well, Errors and Omissions. This does not protect against negligence, wilful wrongdoing, etc. Nothing does.
The company has D&O Insurance. This is Directors and Officers Insurance. This protects ME against things that the Company might be sued for, that as an Officer, I could be held responsible for. Harassment lawsuits brought by employees against the company is the example my lawyer used.
The company has Product Liability insurance. Enough said there.

"This is how it was spelled out to me by a retired judge, and 3 lawyers. I'm not a definitive resource on this stuff, so feel free to check it yourself."


That's how it was explained to me also by 2 lawyers and 2 accountants when I started out 10 years ago. I got this warm fuzzy feeling from the "limited liability" part of LLC. It was explained to me that the LLC worked best in partnerships. This prevents one partner from getting drunk one night, loosing his ass at the casino, and financially bringing down the rest of his business partners due to his problems. It does not protect you as a shop owner from any responsibility should a product you made fail and cause injury to someone. Product liability insurance would be used to defend you in a lawsuit of that nature. I was told that something like 80% of defendants named in lawsuits never actually pay a dime, but may pay as much as $20,000 or more to defend themselves, and get themselves thrown out of the suit, or the suit itself dismissed. So I believe good business insurance is more important for the small shop owner in a lawsuit than whether they are a sole-prop., LLC, or S-Corp.

Thanks for everyone's input so far! As usual, I am amazed by the depth and bredth of many of this forum's posters' experiences and knowledge.
Even if your responses are not really answers to my particular situation, they often point a direction or give me an idea as to what to be looking for.

It's almost funny, I joined this forum to learn more about machining, which I have, but the wide array of other topics and knowledge that I glean from here is nothing short of amazing. I check this site at least once a day in search of new posts with new tidbits. I swear I learn something everyday!

I look forward to more thoughts and stories and ideas on this subject(and others too!)

Thanks again, I knew you guys wouldn't let me down!

I worked for a guy (for two days) who built halloween rides for haunted houses and theme parks. I asked him about liability for a contraption he was selling that basically threw the occupants of an air ride platform about as violently as the operator felt so inclined. No padding, a simple single bar hand rail, and a framed wooden "box" around it representing an "elevator."

So what happens when someone falls under the railing and gets maimed by the ride? His response: "No one in this industry has ever been successfully sued."

I quit.

I operate as an LLC tax elected as an S Corp. So, basically it operates like an S Corp for taxes, but everything else with the LLC.

So, Basically the LLC is the Legal Structure of it, and the S Corp part of it when done that way is the Tax Structure.

I THINK thats probably best for you. I am not an expert, but have been doing it for a while. It was the easiest to set up, and I think the easiest to maintain.

The only hard par may be actually paying yourself a salary at first, but, you can always adjust that. Here is how it works: (with an LLC Taxed as an S Corp, OR just an S Corp)

Say you pay yourself a salary of $40,000 a year. And at the end of the year, your company actually made an additional $20,000 profit. So about $60,000 total goes to you.
Well on the $40,000, you already paid yourself salary, so you paid normal income taxes on. like anyone else that works as an employee.
On the additional $20,000, its like paying yourself a bonus, but its payed at the S Corp Dividends rate WHICH IS CHEAPER than what you would have paid before on your salary (I believe thats what its called)
When you look at your salary, Remember, in your actual salary, you are paying Half of the Federal Tax, and your emplyer (also you) is paying the other half.

If you just elect to be an LLC Taxed as a sole prop., You would have paid the full rate of wage tax just like on your $40,000 AND ALSO on the additional $20,000 of profit. So you would be paying more tax this way.

So it costs the same on the first $40,000, but more on the last $20,000 with a Sole Prop.

I HOPE that I did not make it too confusing, its sometimes hard to explain in words at midnight while I am typing this.

So as I am NOT an expert, I run 3 LLC's Taxed as S Corps, (none of them huge companies don't get that idea) and its the easiest to start, seems to be the best for me, and I have never had any problem.
The only drawback I see is I cannot sell stock to investors, but I never plan to sell stock, and if I get that large, I will not be worried about it, I will have someone else take care of it then.

They are right about the liability, however it does limit it much more than a sole proprieter.

I have a good lawyer, and you know what he tells me? If you do not have anything to take, you will never get sued. He tells me having product liability insurance makes you even more of a target! I don't know for sure though. I know a local bar that got sued for $250,000 or something like that because someone got drunk and fell down the steps. It happens at another run down bar down the street from there almost weekly (falling down the steps a lot, I know this cause I am a firefighter and hear the medics all the time on the fire radio), and have never once heard of them getting sued, because you'd be lucky if they have $200 in their name.

"but its payed at the capital gains rate"

Quality, my understanding is that any profits from the normal operation of the business that are paid out to an owner of the business will be regarded by the IRS as normal income and are subject to income taxes, not capital gain taxes. Believe me, I wish it was the other way around as it would save me lots of money.

Capital gains would typically only come into play with a small business if and when the business is sold, at that point capital gains tax rates would be applied to any profit you made from the sale of the business. Remember that the purpose of the lower capital gains tax rate is to incentivise people to invest in companies, so you have to fit the model of having invested some money into a company to get it started and then showing an overall "capital gain" when all or parts of that company are sold for more than you put into it.

Paul T.

Hi Paul,
Yes I think you are right, I just forget exactly what they called it, but thats how my accountant explained it to me, I just foget what he used to call it. Its been a while. It works how I explained it, just did not use the right wording! Thats why I am not an accountant! I was thinking S Corp Gains, but said Capital Gains that is whole different, think thats only on C Corp Shareholders.

This may help what I mean if you tax as an S Corp and get a salary:
Because shareholder-employees receive both wages and profits from the S-Corporation, there is a strong temptation to pay a lower salary and a higher profit distribution. Wages are subject to FICA payroll taxes. The S-Corporation (Employer is YOU) will pay the employer's share of FICA taxes (7.65%), and the employee (also YOU) will pay the other share of FICA taxes (also 7.65%). Between the S-Corporation and the shareholder, wages are subject to a combined 15.3% payroll tax, plus the shareholder's income tax rate. Profit distributions, however, are not subject to FICA payroll taxes; they are subject only to the shareholder's income tax rate. So all things considered, the shareholder-employee will have a strong preference to pay herself a minimal salary and thereby increase the profit distribution.

So on that first $40,000, you would have paid the 15.3% in addition to the 28% Federal (Example, just whatever the federal tax rate is there), plus state and local obviously.
On the $20,000 in the S Corp, you would have only paid the 28% plus local and State, saving you 15.3 on this portion of it%.

So if you were a sole prop making $60,000, you would have paid $9180 in this tax. (not including the Federal Income Tax, State, and Local)
If an S Corp, you would have paid $6120.00 in this tax plus your federal, state and local.

So, the direct savings on this S Corp over a Sole Prop. is 15.3% of the 20,000. ($3060,00 savings)

But, do not get the idea of paying yourself $100 a week, then paying yourself the dividend at the end of the year as $100,000.00, that won't work. You will get audited, and bent over when they see that. Make it look right.

Another note about S-corp profits and loss. Once you complete the company's S-corp tax return (which is usually pretty straightforward), the profit or loss goes directly to the shareholder's 1040.

Thus, if you're the only shareholder, your S-Corp's profit or loss goes to a specific line on your personal tax return. A couple of big benefits here:

1.)As said prior, if your S-Corp made a profit, it gets added into your personal Adjusted Gross Income, and no FICA taxes are paid on it (15.3%).

2.)If your S-Corp had a loss, this loss reduces your Adjusted Gross Income, which helps lower your personal taxes. Sweet! So, a "loss" by your S-Corp can be a good thing...