S-corp vs. LLC: Allocation of income and losses

As you have now discovered, there are a number of differences between S-corporations and LLCs. S-corporations have to follow the traditional corporate formalities, while the formalities that LLCs have to follow are far more relaxed.  There are also differences in the taxes and fees that they have to pay to California, and the types of compensation that the owners of each can take. The amount of flexibility you have in allocating income and losses between the owners is also a key difference.

The shareholders (owners) of an S-corporation must divide all income, gains, losses, and deductions in proportion to their ownership percentage.  Therefore, if you own 30% of an S-corporation then you will pick up 30% of the corporation's taxable net income on your tax return, and you are entitled to 30% of all the distributions made.

The members (owners) of an LLC, on the other hand, are allowed to have unequal allocation of income, gains, losses, and deductions as long as certain criteria are met. For example, you and your co-owner each own 50% of the LLC. You may have decided among yourselves that all of the depreciation deductions will be allocated to you, while all of the other items of income, gain, losses, and deductions will be split 50:50. You are allowed to do that as long as several requirements are met.  Those requirements are too complex to discuss in this blog, so I strongly recommend talking to a CPA if you are considering establishing an LLC whose operating agreement authorizes non-proportional allocation of income, gains, losses, and deductions.

If you have questions about the tax differences between S-corporations and LLCs, or if you would to talk about the requirements necessary in order to have non-proportional allocations in your LLC, please send me an e-mail.

S-corp vs. LLC: Income

In last week's blog, we discussed how California taxes S-corporations and LLCs differently.  In this blog, we will be discussing the differences in how the owner's compensation is classified.

Image borrowed from
www.nanohealthtechnology.com

The owner of an LLC will likely spend countless hours working for the business. However, the owner is not treated as an employee, so the owner does not receive wages or a salary. Instead, for tax purposes, the owner is treated as receiving the entire profits of the LLC as compensation regardless of whether or not any money is taken out of the business. These profits are treated as self-employment income, and therefore are subject to self-employment taxes. While they will be discussed in more detail in a future post, it is important to understand that self-employment taxes are an additional tax assessed on your normal income tax return that is designed to imitate payroll taxes.

On the other hand, the owner of an S-corporation can be compensated by the corporation in two different ways.  The first, like LLC members (owners), is through ownership distributions.  These are withdrawals of the business' profits.  The second method, which is not available to LLC members, is through a salary.  In fact, an owner-employee of an S-corporation is required to take a "reasonable salary" before taking distributions from the business. What is a reasonable salary varies from business to business, so I would recommend talking to a corporate attorney to determine what is a reasonable salary for your business.  The factors that helps to determine what is a reasonable salary include: your position (title) in the business, the compensation of those with a similar position within your field, and the number of employees a business has. However, you are not required to take any money out of the business, whether through salary or distributions.  This means that even if you should have a reasonable salary of $50,000, you do not have to take $50,000 out of the business.  You could, for example, take out $20,000.  However, up to that hypothetical $50,000 everything should be taken through payroll as a salary.

An S-corporation's net profits is reduced by the amount of salary paid to the owners- the same as it would be by the salary of any other employee.

Regardless of whether your business is structured as an LLC or as an S-corporation, the business's profits are passed through to the owners and subject  to income taxes.  They are subject to income taxes regardless of whether the profits are retained by the business or distributed to the owners. However, only LLC owners pay self-employment taxes on the net profits of the business.

If you would like to know more about the differences between S-corporations and LLCs and how it can affect your taxes, please send me an e-mail.

S-corp vs. LLC: CA Minimum Taxes

Besides the formalities that S-corporations have to observe, there are a few other differences between S-corporations and LLCs.  One difference that will affect your bank account is how California assesses taxes.

Image borrowed from www.alliancetrustcompany.com

The amount of California taxes that an S-corporation will pay is based upon its net income.  An S-corporation pays the greater of $800 or 1.5% of its net income.

An LLC, on the other hand, pays $800 of California taxes and may be assessed an LLC fee based upon its revenue.  The table below shows the LLC fee for the various revenue ranges.

Revenue	LLC Fee
$0 - $249,999	$0
$250,000 - $499,999	$900
$500,000 - $999,999	$2,500
$1,000,000 - $4,999,999	$6,000
$5,000,000 +	$11,790

Therefore, whether an S-corporation or an LLC makes more sense for your business (based purely on the amount of taxes you will pay to California) depends on what you expect you revenues to look like compared to your net income.  Lets look at a few examples.

Example 1

You expect your business to have $600,000 of revenue but only $60,000 of net profit.  In this case, it makes more sense to operate as an S-corporation.  As an S-corporation you would be paying $900 in taxes to California ($60,000 x 1.5%).  However, as an LLC you would pay $3,300 ($800 of taxes plus a $2,500 LLC fee).

Example 2

You expect your business to have $900,000 of revenue and $300,000 of net profit.  In this example, it makes more sense to operate your business as an LLC.  As an LLC, you will be paying $3,300 to California ($800 of taxes play a $2,500 LLC fee).  However, as an S-corporation you would be paying $4,500 in California taxes ($300,000 x 1.5%).

If you would like a further understanding of the tax differences between LLCs and S-corporations, please send me an e-mail.

Can You Own an LLC By Yourself?

Sometimes the number of owners a business has affects what types of entities it is allowed to operate as.  While a corporation can have one or more owners (shareholders), a partnership by definition must have two or more owners.  An LLC can be thought of as a hybrid between corporations and partnerships, so can it have only a single owner (member)?  It depends.

Image borrowed from www.corporatedirect.com

The federal government's position changes depending upon how an LLC elects to be taxed.  LLCs have the option to be taxed as either a corporation or a partnership, but the default rule is that LLCs are taxed as partnerships.  If a single-member LLC elects to be taxed as a corporation, then the federal government will recognize the LLC as a corporation. However, if a single-member LLC elects to be taxed as a partnership, then the federal government will treat the LLC as a "disregarded entity".

The federal government essentially creates a legal fiction that the disregarded entity does not exist. It looks through the disregarded entity and attributes all of the entity's actions to its owner.  The owner is required to report the entity's income on its own tax return.

California, however, does not treat a single-member LLC any differently than any other LLC.  The LLC is required to file its own tax return for California.  In addition, because LLCs are created under state law, a single-member LLC has all of the same legal protections that any other LLC would have, such as limited liability protection.  If you would like a better understanding of a single-member LLC's legal rights, I would recommend talking to a business law attorney.

If you have any questions regarding how a sigle-member LLC is taxed, please send me an e-mail.

Is an LLC the Right Choice for You?

Your business has reached the point where you are no longer comfortable operating it as a sole proprietor and you know that you need to form a business entity, but which structure is right for you? You thought about a C-corporation, but you do not the double taxation or all of the corporate formalities that would have to be observed. A general partnership does not work for you because you want to have limited liability protection.  A limited partnership sounds great, but you and your partners all want to be actively involved in the management of the business and each partner who is involved in management decisions is then a general partner who does not have limited liability protection.  An S-corporation sounds great because you still have all the protections that C-corporations have, including limited liability, and there is only a single level of taxation.  However, you would still have to follow all of the corporate formalities and that is not appealing to you. What option is left to you?

Image borrowed from bluemavenlaw.com

You could form a Limited Liability Company (LLC).  An LLC can be thought of as a hybrid between a corporation and a partnership.  Like a corporation, an LLC has limited liability protection, can enter into contracts, purchase assets, loan and borrow money, and sue and be sued. However, like a partnership, the taxable income and losses of the LLC flows through to the owners so that the LLC does not have to pay income taxes itself.   (Note: California assesses a "minimum tax" and an LLC fee, as we will discuss in detail in a future post). LLCs also do not have to follow the same corporate formalities that C-corporations and S-corporations do.

To form an LLC in California, you will have to file Form LLC-1 "Articles of Organization of a Limited Liability Company (LLC)".  I would also recommend talking to a business attorney and having that attorney help draft an Operating Agreement between the members (owners) of the LLC.

Unlike an S-corporation, there are no restrictions on the number of owners that an LLC can have. Also, unlike S-corporations, corporations, partnerships, and foreign residents are allowed to be owners in an LLC.

As I previously mentioned, an LLC does not have to follow the same corporate formalities that a corporation does.  However, this does not mean that an LLC does not have any formalities that it has to follow- it is just very relaxed in comparison to a corporation.  A California LLC still has to file Articles of Organization with the Secretary of State, pay taxes and fees assessed by California, maintain adequate business records, and maintain separate bank accounts for the business. However, because the corporate formalities required of an LLC are so relaxed, one of the main factors that will be considered if a litigant is attempting to "pierce the corporate veil" and remove your LLC's limited liability protection is whether the LLC is adequately capitalized.  You will want to speak to a business attorney to determine what is adequate capitalization for your business.

One drawback of LLCs is that not everyone is allowed to form them.  Doctors, lawyers, and accountants are just a few examples of professions that cannot operate their business through an LLC.

There are a number of differences that exist between S-corporations and LLCs that are not addressed here that may affect your tax situation.  We will be discussing them in detail in future posts.  In the meantime, if you have any questions about LLCs please send me an e-mail.

Protect Your Liability Shield!

You set up your business and made sure that you have limited liability protection.  That means you do not have to worry about someone suing you personally for something that happened through your business, right?  Wrong!

Picture borrowed from the Indiana Business Law Blog

(www.michaelsmithlaw.com)

Plaintiffs will try to get around your liability shield through a legal concept known as "piercing the corporate veil." You will want to talk to a business attorney to get a thorough understanding of this, but this blog post will attempt to give you an overview.

Essentially, a plaintiff will attempt to sue you personally instead of suing your business by claiming that your business is really your "alter ego" and not truly its own separate entity.  This tactic is known as "piercing the corporate veil."  Courts will look at a number of different factors to determine whether or not to pierce the corporate veil and allow the plaintiff to proceed to sue a business owner personally.  These factors, and how they are interpreted, vary significantly from state to state as case law in each state continues to evolve.  Therefore, I would again like to emphasize that you should talk to a business attorney to make sure that you are operating your business in a way that will protect your liability shield under the state laws that your business is operating under.

One factor that courts will generally consider is whether the corporation or limited liability company (LLC) engaged in fraudulent behavior.  This should be common sense; you cannot expect to use your business to defraud others and then expect to escape personal civil liability just because it was done through a corporation or LLC.

Another major factor that courts will generally consider is whether the business followed the required formalities.  In California, this primarily applies to corporations because the formalities for LLCs tend to be relaxed.  As I mentioned in a prior post, What is a Corporation?, these formalities generally include, but are not limited to:

• Filing Articles of Incorporation with the California Secretary of State;
• Electing a Board of Directors;
• Enacting Corporate Bylaws;
• Holding Board meetings at least once a year;
• Holding shareholder meetings at least once a year;
• Maintaining separate bank accounts for the corporation; and
• Maintaining corporate records.

The general concept is that if you want your business to be treated as a separate legal entity by others, then you have to treat it as a separate legal entity yourself.  That means that even if you are the sole shareholder in the corporation, you must hold a Board meeting at least once a year (and maintain minutes of the meeting) to make major decisions for the corporation.  It is not enough that you make the decision because you are not the corporation- the Board must be the one to make the decision (even if you are the only Board member).

Likewise, you must be sure to not commingle funds. Have a separate bank account for your business (corporation, S-corporation, or LLC), and only pay business expenses out of that bank account.  If you put all of your personal funds and business funds in the same bank account, it strongly indicates to a court that you do not consider your business to be its own separate entity.  Similarly, if you pay personal expenses out of your business bank account, such as your mortgage, it gives a court the impression that it is just another personal account.

Another major factor that courts will evaluate when determining whether to allow a plaintiff to pierce the corporate veil is whether the business is undercapitalized.  This means that when you are first contributing money to the new business it must be a reasonable amount.  For example, if you expect your business to have $5,000 of operational expenses a month, an initial capitalization of $1,000 does not appear to be reasonable.

Finally, a factor that will be considered is the amount of control you are able to exert over the business.  For example, if you are the sole owner of the business you are fully in control of the business, and it would be easier for a plaintiff to argue that the business is really just an extension of yourself, your "alter ego".  On the other hand, if you are one of 100 co-owners each owning 1% of the business, it would be very difficult for a plaintiff to argue that the business is your alter ego.

So, as you see forming an entity that has limited liability protection is great, but you must protect your liability shield.  That means you must maintain all the required formalities, including maintaining separate bank accounts and not commingling funds, and you must adequately capitalize your business.

I would strongly recommending talking to an attorney to determine what specifically your business will have to do to protect your liability shield.  If you would like a referral, please send me an e-mail.

Limited Liability Protection

It has been promised for the last few blog posts, and at long last it is here: a detailed discussion of limited liability protection!

While this will be a more detailed discussion of limited liability protection, it is not possible to cover everything and all situations in one blog post.  I strongly recommend that you talk to a business attorney to learn more about this topic.

One of the main advantages of the corporations, S-corporations, limited liability companies (LLCs), and limited partnerships (for the limited partners) is limited liability protection.

What protection limited liability provides varies from state to state, so we will focus on California law.  As the name implies, the protection offered is limited to certain types of liabilities.  It primarily applies to protection from personal liability for the entity's debts and protection from personal liability for the actions of co-owners or employees of the business.

So what type of liability is not covered?  Personal liability for your own actions.  If you, for example, personally injure another person you are the one potentially liable.  While I would recommend having insurance anyways, this is another reason to look into purchasing insurance.

Lets go back to what is covered.  Limited liability protection means that you are not personally liable for the entity's debts.  So, for example, let's say that Jason has a corporation, ABC Inc.  ABC Inc.  has been in business for a number of years, but recently business hasn't been good for ABC Inc.  It borrowed $100,000 from XYZ Lending, but burned through its cash and no longer has any money left to repay XYZ Lending.  ABC Inc. has $20,000 worth of other assets.  XYZ Lending can sue ABC Inc. to seize the $20,000 worth of other assets, but cannot go after Jason's personal assets.  Unfortunately for XYZ Lending, they are unable to recover the remaining $80,000.

As previously mentioned, limited liability protection also means that the business owner is protected from personal liability for the actions of his or her co-owners and employees.  Let's look at another example.  Steven owns Delivery, Inc., a successful package delivery corporation.  Delivery, Inc. has hired several drivers to deliver packages.  One day, Rob, one of Delivery, Inc.'s drivers ran a red light while delivering packages and hit a pedestrian.  That pedestrian sued Delivery, Inc. for $500,000.  Delivery, Inc. only has $200,000 in cash and other assets, so the pedestrian is only able to seize that $200,000 worth of assets and cannot go after Steven's personal assets.  On the other hand, if Steven had decided to run the business as a sole proprietorship instead of forming a corporation he could have been held personally liable and had his personal assets seized due to the reckless behavior of his employee.

As you can see limited liability protection is a great benefit to business owners.  However, plaintiffs will try to get around this liability shield by "piercing the corporate veil."  I will explain that legal concept, and how you can maintain your liability shield, in the next blog post.

If you would like a referral to a great business transactions attorney, or you would like to talk to me about your tax situation please send me an e-mail.

Why Form a Business Entity?

Congratulations!  You decided to turn your passion into a business, and you are doing everything you can to make sure that it is a success.  You've heard people talk about incorporating their business or forming a partnership or LLC, and now you are wondering if that is the right thing for your business.

Table borrowed from www.strategicofficesupport.com

The answer is...maybe.  It is a cliche, but every business and every business owner is different and has different needs that must be considered.

However, there are some factors that impact this decision.

One factor is whether you would like your company to have limited liability protection. Corporations, S-corporations, limited liability companies (LLCs), and limited partnerships (for the limited partners) all provide limited liability protection.  Sole proprietorships and general partnerships do not.

Limited liability protection will be discussed in great detail in a future blog post, but in very general terms it means that only the entity's assets (i.e., not your personal assets) are at risk of loss.  For example, let's say that your business has $10,000 worth of assets and you have $250,000 of personal assets outside of the business.  If your business is sued, the plaintiffs can only attempt to collect on the $10,000 of business assets and cannot seize your personal assets.

You may feel that it is very unlikely that you will be sued or that if you are that is the reason why you have insurance.  You may be right, but you also want to keep in mind that your business is not only potentially liable for your actions but for the actions of your employees.  For many business owners, the desire to hire employees makes having limited liability protection a more significant factor to consider.

Another factor that you must consider is whether the business will have multiple owners.  The general rule is that if a business has multiple owners and no action has been taken to form a different type of entity (such as a corporation or LLC), it is a general partnership.  In a general partnership, each partner is personally liable for the actions of every other partner, their employees, and the business.  While for various reasons it may make sense to you to be in a general partnership, you want to make sure that it is a conscious decision and not simply the default because your business has multiple owners.  Therefore, if your business has multiple owners generally it will be an entity, so the decision then is what type of entity.

A third factor to consider are the tax implications to either operating your business as a sole proprietorship or as a business entity.  There are a number of different tax implications, not the least of which is whether or not you are then considered "self employed" and subject to the self-employment tax, that are outside of the scope of this blog post.  The important thing to remember is that there are a number of tax implications to how you choose to structure your business.  I would recommend talking to a CPA to discuss the specific impact that operating your business as a sole proprietorship versus a partnership, corporation, S-corporation, or LLC will have on your tax situation.

The final factor to consider when deciding to operate your business as a sole proprietor or as a separate business entity is the likelihood of an IRS audit.  There is a widespread belief among tax professionals, for various reasons, that a sole proprietorship is more likely to be subjected to an IRS audit than a business entity.  This is not to say that business entities are not audited by the IRS- they are all the time- but many tax professionals believe that sole proprietors are audited more frequently.  Of course you will be filing your taxes properly, but an IRS audit can be expensive for taxpayers even if the IRS does not make any changes to your tax return.

I highly recommend talking to a business transactions attorney about whether forming a separate entity for your business makes sense for you.  Please also feel free to e-mail me if you have any questions about the tax implications of how you structure your business.

What Type of Business Entity is Right for My Business?

Are you considering starting your own business?

According to data released from the U.S. Small Business Administration, hundreds of thousands of businesses are created  in the United States every year.  Every one of these new business owners must decide whether they want to operate as a sole proprietorship or whether they would prefer to operate the business as a separate entity.  Then, they have to decide what type of business entity best serves their needs.

Over the following weeks, I will assist you in answering these critical questions by discussing the factors that business owners should consider in determining whether they should form an entity, and the differences that exist between corporations, S-corporations, partnerships, and limited liability companies (LLCs).

If you are currently going through this process, I would be happy to talk to you about the tax implications of forming a business and to refer you to a business transaction attorney to answer any legal questions you may have.  Just send me an e-mail.