Choice of Entity

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Choosing the right entity when you're in business is one of the most important things you can do, other than picking the right spouse! Getting it right isn't terribly exciting, but getting it wrong can be catastrophic. Let me break down some of the key issues and options so that you can follow along.

Real Estate should never ever go into a corporation. They go in easy, and come out horribly. Double taxes are only one of the problems. Business or rental real estate generally should go into an LLC that is organized for that express purpose: to hold it, and collect rent and pay the expenses. It's cheap liability separation from your business or personal assets. The neat thing is that if this is husband/wife owned, or owned by an individual, there is no separate tax reporting. It's reported as if you didn't have an LLC, so it's easy and inexpensive on the accounting front.

So what is an LLC anyway? Limited Liability Companies popped up about 20 years ago, first in Wyoming. Their express purpose is to treat your ownership as a limited liability interest, as in a limited partnership or corporation, without some of the difficulties of those tax rules. An LLC allows for a lot flexibility in how profits and losses are split, and even how the company is split up on sale. And yet, the owner is not open to personal liability unless he or she signs for something personally. An LLC can be taxed in a number of ways, which is unfortunate, since many web sites now tout the LLC as the solution for everything, leading many people into trouble and high costs unnecessarily. IRS has refused to create a new set of forms for the LLC, which has led to the options to have it taxed any number of ways. Generally, we consider an LLC to file as a partnership and come under the partnership rules, tho'. And just like a real estate LLC, a single member or husband/wife LLC is disregarded for tax filings, so no separate filing is required. The LLC is very useful for smaller businesses like those since it again can shield you from personal liability at low cost. Nothing replaces insurance, of course, but it's another layer of protection. When two or more partners are going into business, and where either they're not investing the same amount of money, or they want to split up profits other than by pure ownership, the LLC is the easy pick. Owners pay taxes personally, unless there's a state tax assessed. And the owners are not employees, do not file payroll returns for themselves, etc. They usually will make estimated quarterly payments personally.

So when should you incorporate and why is that an option now? The corporate form has been around the longest. In some states, the LLC and corp form are identical by law in terms of shielding owners from liability. But that's not true in all states. And where there isn't clarity on that issue, the corporation still rules. Even where the LLC/Inc. is the same, there are many advantages of a corporation, and because it's been around so long, it's simpler to understand and operate in many respects. Partnership tax law is goofy! Corp. tax law usually isn't. But, profits must be allocated according to ownership without exception. So if one owner has the cash, and the other is going to work the biz, there's a problem since the money guy owns all the stock! Bonuses can be used to balance out a fair split, but whatever profit remains after bonus belongs to stockholders by ownership. In the small business world, I'm thinking only of the S Corp (used to be called subchapter S), where again, all taxes will generally be paid by owners personally, except for any state taxes. However, in contrast to the LLC, an S corp owner will usually be on payroll and draw a salary unless they're a silent owner. This opens up the payroll tax filings, withholdings, and the need to determine a reasonable salary, which is assessed for social security tax. Profits remaining after the salary are NOT subject to SS taxes. This is a contentious area with IRS, and good documentation of the salary level decision is a must. The other huge advantage of a corporation is when there's a change in ownership. In a corp, shareholders can buy each other out, or the corp can buy out a shareholder. The corp continues doing business. That is NOT true of LLC rules.

Here's how I view this from a flow chart way of thinking: Are you owning real estate? If yes, LLC. If no, go on. Do you have a partner (other than a spouse)? If no, go on. If yes, will the partners invest equally and share profits equally? If yes, S corp. If no, LLC. Are you just starting up? Is this a part-time venture? If so, maybe do nothing right now, save your cash. If not, opt for the LLC perhaps since you'll have the shield of protection at low cost and no added tax filings. Or wait until incorporating makes sense. So when DO you incorporate in that case? Generally, the last moment is when your profits hit your reasonable salary level, for then, social security savings will pay off. Prior to that, it's a matter of how much aggravation you're willing to bear in paperwork and costs, versus how much liability protection you require. All these decisions should be made in conjunction with a good business attorney since state laws can affect the choices significantly. JR1 Oct. 1, 2007

Many S Corps are now created. They are a little more work as a beginning entity than an LLC. I find many S Corp owners do not like all of the necessary paperwork. An LLC is usually easier to set up and the owner does not have to setup himself on a payroll to get started. It can also be easier to manage the office in home deduction and automobile deductions as an LLC. A single-owner LLC does not even have to get off of the 1040 to file his taxes. An S Corp always needs another tax return that usually costs a significant amount each year to file. If the spouse or other family works in the business, a Section 105 Health Reimbursement Arrangement keeps the self-employment taxes lower and health deductions as business deductions. Yes, a LLC owner will have to pay the full self-employment tax on all of his net earnings. But the S Corp owner faces challenges to the amount of wages he is paying himself, if not considered adequate anyway. The LLC owner does not face a similar challenge on this issue. The bottom line for me is that until the business owner knows that the business will make more than seems like a reasonable realistic salary for himself, he should start as an LLC. It is fairly easy to then incorporate to save taxes after that, at a time that it makes sense in the business. Sheldon 15:47, 30 Sep 2005 (CDT)

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