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Business Structure Basics

Discussion in 'Asset Protection/Taxes/Legal' started by Diane Kennedy, Oct 17, 2007.

  1. Diane Kennedy
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    Diane Kennedy Bronze Contributor

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    I see some common questions coming up regarding the best business structures for investing and business. I thought it would be helpful to run through some of the basics for business structures.

    There are good, bad and really bad business structures:

    Good: LLC (limited liability companies), S Corporations, C Corporations, Limited Partnerships

    Bad: Sole Proprietorships

    Really Bad: General Partnerships

    The good ones all provide some form of asset protection. I consider the Sole Proprietorship bad because it (1) puts all of your other assets at risk (2) costs you self-employment tax of 15.3% on taxable income and (3) means you are 10 times more likely to have an IRS audit.

    As bad as Sole Proprietorships are, General Partnerships are even worse. You have all the risks above, but it's times two because you have a partner. So, you're not only liable for your decisions but those of your partner as well.

    WARNING: If you and someone else go into a business venture without a business structure, you will be considered to have a General Partnership. Beware!

    BUSINESS INCOME:

    Of the good ones: LLC, LP, S Corp and C Corp, there are still more differences. An LLC can elect how it wants to be taxed. The default for a single member LLC is a Sole Prop (but with asset protection) and the defaul for a multi-member LLC is a partnership (but it's a good one because you have asset protection).

    If you have a business, you are subject to self-employment tax UNLESS you elect to be taxed as an S Corp or a C Corp. Partnerships and LLCs (not electing S or C) with business income will be subject to self-employment tax.

    For a beginning business: typically LLC taxed as an S Corp or an S Corp itself.
    For a beginning business with partners: I like an LLC with the members holding their interest in S Corp or C Corp structures.

    For a mid-level business: (Taxable income at approx $150K - $350K), it makes sense to either change your S Corp to a C Corp or add a C Corp to your business structure. A C Corp is the only structure that pays tax at its own level (LLC, LP, S Corp are all flow-through entities with the taxable income reported on your personal return). So, as your income increases, you can make use of the tax bracket of the C Corp and move $50K from your personal return to your C Corp and move from a 35% to 15%. That means $10,000 of tax savings right away.

    REAL ESTATE PASSIVE INCOME:

    If you hold property (as an investment), you do not have business income, so the self-employment tax is not an issue. Typically the default LLC structure is best for real estate ownership.

    OTHER CONCERNS:

    There are special rules on who can own an S Corporation - must be US residents, limited to 75 individual and other rules.

    An S corp or a C corp protects you against judgements from the business in most cases, but does not protect the stock you hold in S Corp or C Corp from personal judgements. An LLC protects both your business assets from personal judgements as well as your personal assets from business judgements. (There are exceptions to this as well. This is a broad general statement.)

    In general, I like to use an LLC electing to be taxed as an S or as an C, instead of just owning an S or C directly.

    I thought it might be easier to put all the basics in one thread.
     
    rwhyan, Bekit, AF77 and 15 others like this.
  2. Russ H
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    Russ H Gold Contributor Read Millionaire Fastlane Speedway Pass

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    Nice to see I'm not the only one up at this hour. ;)

    This is one of my favorite topics. One of our current business entities is an S corp, and I fought to make it a C corp, but was advised against it (I still have a C corp that Sharon and I use for medical expense reimbursement and the like).

    The logic given to me was that by having an S corp vs a C corp, we were avoiding a certain amount of soc sec taxes-- to the tune of about $18K a year, I believe.

    I probably have this a bit bassackwards, but the social sec savings was the reason we decided to keep the S instead of making it a C (I love C corps, in part b/c I know more about them than other corporate structures).

    Does the Soc Sec stuff make sense, Diane, or do I have to go back and check my notes? :)

    -Russ H.
     
  3. azzuri
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    azzuri PARKED

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    Great post Diane!

    Since we addressed entities and asset protections - is that protection sufficient for a typical consulting business (1 person LLC running as S-corp), providing IT services for large Fortune 500 companies, or an additional errors & ommisions policy is a good idea here? If so, how should coverage be determined? Based on LLC income/value or personal net worth?

    Another question on investment property - is it always the best idea to keep it under an LLC or keeping it under my name with sufficient umbrella liability coverage would also work? I guess the cost of financing if property held by LLC would be higher especially at the startup.
     
  4. azzuri
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    azzuri PARKED

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    I did mine as S-Corp to save on social security tax. Also, New Jersey has skyrocket high corporate taxes.
    Wouldn't it be a good idea to to have an option to elect not to pay social security tax at all, decline the benefit in the future and invest the money ourselves?
     
  5. Diane Kennedy
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    Diane Kennedy Bronze Contributor

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    Russ: You've got it right.

    Here's the deal. Let's say you make $300,000 in business income (taxable, after all expenses). If you have an S Corporation, you can take part of the income out as salary (and pay payroll taxes) and part as distribution (and pay no payroll taxes.)

    If you have a C Corporation, you won't want to keep more than $50,000 in income inside the company, so you'll have to take a salary of $250,000.

    In the first example, salary (and payroll taxes) were based on $150,000 (half of the income in the S Corp).

    In the second example, salary (and payroll taxes) were based on $250,000. More payroll taxes here.

    Best case, if your income is high enough is to do BOTH an S Corp and a C Corp and take advantage of less social security plus the $50K tax bracket in a C Corp.

    (Sorry for the delay in getting back to you - pretty exciting week... I did an eBay online workshop and now have the world's record for views of an online workshop - over 210K people showed up! Servers were crashing and all kind of fun things)
     
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  6. CRBFL
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    CRBFL New Contributor

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    You inspire me, just thought I'd let you know.

    I recently read an article the was touting the benefit of forming an LLC for each investment property that you own. The reasoning was that any issue with a tenet that escalated to you being sued would not jeopardize any of your other properties. Thoughts?
     
  7. Walley
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    Walley New Contributor Read Millionaire Fastlane

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    What would you suggest for an ebay business working from home?
     
  8. Diane Kennedy
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    Diane Kennedy Bronze Contributor

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    Good question - I grapple with it every time I talk to one of my real estate clients. The absolute safest thing you can do is to leverage the property to the hilt and put each property in its own LLC.

    But, you have to weigh that with practicality. Is it worth the cost and hassle of setting up and running each LLC? For some people, the answer is "yes". They can't sleep at night unless they have that extra security.
     
  9. Diane Kennedy
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    Diane Kennedy Bronze Contributor

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    It depends on where you are right now. If you have a regular bricks and mortar business, changing over to an eBay store is a great way to reduce costs. (You don't have the upkeep of a showroom.)

    I've been a speaker at eBay Live! for about 5 years now. Some of the rags to riches stories that I've heard and observed:

    - One guy started out with the free giveaway things like computer programs or free packets of soap (I am NOT kidding) that he sold on eBay. Friends and family gave him things to sell. Most of the time he didn't pay a dime for the things he sold, he just had to clean out their garage or something. The first year he had sales of over $150,000...and costs of less than $1,000. I'm not sure cleaning out someone's garage is Fast Lane, but it created a first business for him and changed his perception about himself and business.

    - One couple took $1,800 and turned it into $6 million in less than 3 years. They bought up land in the middle of nowhere in California and then sold it via eBay. Most of the buyers were from other countries and the fact that the land couldn't be developed, reasonably, didn't matter. For $5,000, someone in Japan could say they owned land in California! It was a piece of the American dream. They branched into financing anybody and that's when the money really started rolling in.

    - One of my clients makes (net) over $1 mill per year, selling office equipment. He buys from businesses that are getting rid of their stock (closing down temporary offices or just plain closing down) and then sells through eBay. He has a core group of about 3,000 customers that he sells to again and again. he could set up his own website, run his own shopping cart, etc... but he stays with eBay because they do that back end for him. He makes enough money and he just wants to keep it easy.

    Selling on eBay gives you a way to start out with an online business without having to set up all of the systems. It's also a way to sell excess inventory.
     
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  10. Diane Kennedy
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    Diane Kennedy Bronze Contributor

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    If something went wrong, you would risk everything within that LLC structure. An LLC can't protect you if you commit fraud, though. As I read this case, I thought of my own case. I have an S Corporation for my CPA practice (way back when I formed it, there weren't LLCs around....) and I carry malpractice insurance as well. But I think advising about taxes might have more risk than other forms of consulting. Medical practitioners, for example, would want to make sure they not only operated in the right structure, had the maximum amount of malpractice, but stripped out assets as well.

    Easy Money and I had a long thread about this subject somewhere a month or so ago. The answer is "it depends." Financing a property doesn't cost a cent more if you have an LLC, if you personally guarantee it. (At least, I've never had a case where it did.) But there is additional cost and hassle of having the LLC. Debt is also a great way to protect your asset.
     
  11. kwerner
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    kwerner Bronze Contributor Read Millionaire Fastlane Speedway Pass

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    Diane - I have a quick question for you, if you don't mind....

    I'm starting out as a real estate investor and I've decided to create 2 single-member LLC's, the first one for properties that I'll be holding for a year or more (primarily selling on L/O's, then 1031 exchanging into another), and the second one for short term flips (buying at discount, then wholesaling or selling retail).

    The LLC that I'm going to use for my flips I want to be taxed as an S-Corp, obviously, but do I need to file any additional paperwork stating that I wish to be taxed as an S-Corp? When I checked it out on my state's LLC filing website, there was no mention of it on the form (I'm guessing it's because I'm filing as a single-member LLC). If there is no extra paperwork to file, will all income from the business just be filed on my Schedule C's at the end of the year?

    Thanks!
     
  12. Diane Kennedy
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    Diane Kennedy Bronze Contributor

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    The "flip" single member LLC will be taxed as a Sch C unless you elect to be taxed as an S. This is an election you make with the IRS (off the top of my head I think it's Form 8832 - go to irs.gov and search on LLC election). That will make you a corp and then you need to elect S Corp status for your corp. Form 2553 ....I think

    To be honest, I can't ever remember the forms without looking them up. LMK and I'll correct if someone can research it really quickly. Otherwise, go to the IRS website and you'll find them.
     
  13. kwerner
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    kwerner Bronze Contributor Read Millionaire Fastlane Speedway Pass

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    Thanks Diane!

    BTW - For anyone else that may be interested... Diane is correct: IRS forms 8832 and 2553 were just what I was looking for.

    Thanks again!
     
  14. azzuri
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    azzuri PARKED

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    I have recently changed election in my LLC to S-Corp. IRS only asked me to submit 2553.
     
  15. Diane Kennedy
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    Diane Kennedy Bronze Contributor

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    Hmmmm???? How did you file your LLC last year? ie...How did the IRS recognize the taxation of the LLC prior to the S Corp election (Form 2553)? If it was a C Corp first, than that is correct. Otherwise, there is a hole here. The S Corp election is for a C Corp to elect to be taxed as S Corp. The LLC election is Form 8832.

    BTW - did you know that the survey last year found that over 20% of information given by the IRS over the phone was incorrect? (Over the past 10 years it's gone from 10% wrong to 20% wrong.) AND if you rely on it, you have no recourse. In other words, if an IRS employee tells you something wrong and you do it - you still face interest and penalties.
     
  16. M-M
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    M-M New Contributor

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    Let me add a question:
    I currently am the president (and only employee) of an S-Corp. Before the end of the year I will have a website running that should bring in revenue, and I'm planning on having several more sites.
    Would it makes sense to set up a separate LLC or SC for the sites?
     
  17. JesseO
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    JesseO Contributor

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    Pulling over the information from the other (Auto shop) thread: Single owner with no employees, small business. What would be the advantages tax and security-wise to having an LLC as an S Corp or C Corp? Also, he would probably have an employee in the next year or two, so would an LLC still work out well with payroll and such things, or should he plan on simply shooting straight for S Corp?Thanks for taking your time to help out, Diane =)
     
  18. Russ H
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    Russ H Gold Contributor Read Millionaire Fastlane Speedway Pass

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    Hey, I missed this post:
    Wow-- how cool is that?!

    Thanks for the response as well. I like the idea of both the C and S-- kinda like getting the best of both worlds.

    I still have my C-corp from my electronics biz, so we're doing some things in there that make sense.

    -Russ H.
     
  19. Russ H
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    Russ H Gold Contributor Read Millionaire Fastlane Speedway Pass

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    America.

    What a country! :)

    -Russ H.
     
  20. Diane Kennedy
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    Diane Kennedy Bronze Contributor

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    The S Corp is a flow-through entity. Typically these are best for a company with a loss or income of less than $200K or so. (That's taxable income) That's because the C Corp adds additional hassle in keeping the books, pulling money out, etc... The one exception would be if you have a lot of medical expenses. If you do, the C Corp is the better choice because you can have a Medical Expense Reimbursement Plan that has 100% deductibility at the corporate level. Otherwise, the C Corporation is a better choice at higher income because you can take advantage of the C Corporate lower tax rate.

    Think of one bucket - the water is at different levels. First part is 0%, then it gradually goes up until the last layer is 35%. You can take some of that top level of 35% and put it in a second bucket where the first level is 15%. The first $50K is taxed at 15% at the C Corp level. You effectively move 35% taxed money to 15% taxed money. (On $50K, that will save you $10K)

    That's just one of the strategies you can use with S Corps and C Corps. There is a lot to selection of the right business structure for the right time in your business's lifestyle.
     
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  21. Diane Kennedy
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    Diane Kennedy Bronze Contributor

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    Just realized I didn't fully answer the question.

    Businesses almost always should be an S Corp or a C Corp...or LLC electing to be taxed as an S Corp or C Corp. That's because if you use just a straight LLC, you'll have self-employment tax of 15.3%. Corps don't have self-employment tax.

    LLCs, on the other hand, are great for holding real estate because the income off of real estate is not subject to self-employment tax.
     
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  22. JesseO
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    JesseO Contributor

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    So if he has a business with no employees that makes a profit of less than $200k a year, he should go as either S Corp or LLC taxed as an S Corp? Was that 200k profit or revenue? Thanks again Diane. ++
     
  23. Diane Kennedy
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    Diane Kennedy Bronze Contributor

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    Yes on the S Corp - $200K net profit (taxable income)
     
  24. Rawr
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    Rawr Gold Contributor Speedway Pass

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    Diane, I have a question for you :)

    I have a vision of having a company that dabs in various business ventures. I feel like I need the company for the legal reasons and to be taken more serious.

    Here are the things I want to achieve with it now, with more to come later:

    - Sell a few domains/websites to other major companies and clients
    - Get high credit lines for RE purchases
    - Tax shelters for the future.

    My question is - is it possible to register 1 company and do all that under it? What is the best form - LLC? Is there anything special I need to do when filing?

    Thank you so much.
     
  25. Diane Kennedy
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    Diane Kennedy Bronze Contributor

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    I think this looks like a business. The tax shelter part makes me a little nervous. But, I'll let that go for now.

    If it's a business you want to have an S Corp (or LLC taxed as an S) or a C Corp (or LLC taxed as a C). In the beginning, most likely it'll be an S Corp (or LLC taxed as an S). I think you can do everything under one in the beginning. If you need to split out a "department" to another S that has the same ownership, you can do a tax free reorganization. So you have the flexibility you'll need.

    The only reason why you'd want to split it out (at least at this point) is for asset protection reasons. In other words, one division might have a liability associated with it and so you want to keep it separate from another division.

    For starters, I think an LLC taxed as an S is the way to go. (I like those better than just a straight S Corp)
     

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