Which business entity for partnership?

[AllOutOrNothing]

A friend / business partner and i are looking to partner up and im unsure which option is best.

We plan on setting up a company so all the assets sit under the company and then we pay out a salary to the two employees me and him. Currently my business is sole prop and mixed in with my personal finances and the goal is to seperate this including debt and put it into a company and than evaluate from there. We are definately going to setup some beforehand aggreements to get things rolling smoothly but we want to make sure legally we have everything squared away.

From my research it seems as if s-corp is the way to go.

 

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[Diane Kennedy]

A friend / business partner and i are looking to partner up and im unsure which option is best.

We plan on setting up a company so all the assets sit under the company and then we pay out a salary to the two employees me and him. Currently my business is sole prop and mixed in with my personal finances and the goal is to seperate this including debt and put it into a company and than evaluate from there. We are definately going to setup some beforehand aggreements to get things rolling smoothly but we want to make sure legally we have everything squared away.

From my research it seems as if s-corp is the way to go.

What is it about the S Corp that you like?

There are a lot of technical issues with S Corp that you can easily find with research, but here are a couple of questions to ask that you might not normally consider:

(1) Will income/loss be divided up based on ownership?
**If so, S Corp can work. If income/losses are divided based on a formula of who does what work, capital contributed, etc...than you will need to use partnership law and in that case an LLC will work better.

(2) Do you have the same needs/desires for benefits from the company?
For example, you are both on the same page for pension plans, employing family, auto allowances/purchases, etc... **If not, consider an LLC & than have each of the members set up their own company structures. For example, you may want to have an expensive car that is paid for by the company and your partner might want to fund a pension plan to build for the future. Frequently with S Corps you end up with the lowest common denominator of benefits. No one is very happy, but no one is very unhappy either.

(3) Will you be building appreciating assets (either tangible or intangible)?
**NEVER NEVER NEVER put appreciating assets into any form of corporate structure if you have a partner. You end up being "stuck" and never being able to move them out without tax consequences.

S Corp is easier to run than the multi-layer business structure I prefer. And it's DEFINITELY a step up from a commingled Sole Prop (yikes).

And just to get it out there, the reason the Sole Prop is such a bad business choice:

(1) You put every single one of your assets at risk.
(2) You pay more in taxes (self employment tax is an extra 15.3%)
(3) You are TEN TIMES more likely to get an IRS audit.

The only thing worse than a Sole Prop is a General Partnership. With a GP, you not only get all the bad things above, you get them times two. That's because you're now not only liable for every stupid thing you might do, you're also liable for every stupid idea your partner might do.

So, big kudos for asking this question and realizing you need a structure.

Regardless of what you end up with, make sure you cover the 4 D's in your agreement:
Death
Divorce
Dissolution
Debt (Insolvency of a partner)

In a partnership, the two biggest problems will be: not enough money and lots of money. Have the conversations on how you will handle both items. Your relationships with your partner will never be better than right now, so get everything hammered out in your agreement. That way if it goes south, you have your agreements in writing and you don't need to end up in court!

 

[Bilgefisher]

(3) Will you be building appreciating assets (either tangible or intangible)?
**NEVER NEVER NEVER put appreciating assets into any form of corporate structure if you have a partner. You end up being "stuck" and never being able to move them out without tax consequences.

Very good post Diane, this was exactly our plan. Guess we need to rethink. Your posts just reaffirm the importance of talking to a qualified CPA.

 

[Diane Kennedy]

Bilgefisher, you highlighted the section on appreciating assets, so I thought I'd elaborate before someone questions why..

- 90% of the time you won't want to put an appreciating asset in a C Corporation. The exceptions would be if you intend to go public or if you can't qualify as a US taxpayer (ie...don't have a social security number to use for the flow-through entity).

** REASON: This is because the sale of an asset would result in ordinary income at the C Corp level. There is no long-term capital gains special tax rate within a C Corporation. You want a flow through entity if you have appreciating assets.

- S corp is kindof "okay" (not ideal) for appreciating assets if you're the only owner, but can be a disaster if you have partner.

** REASON: You may find you need to separate assets out because the company is too successful and you have too many eggs in one basket or you need to separate assets out because the partnership is changing.

If you pull an asset out of an S Corporation, you need to do it at FMV (fair market value). That means if you have a database worth $100,000 (based on a conservative appraisal based on sales) and you want to separate it out from other intellectual property, you will need to distribute out $100,000 out to the partners. That is taxable to the partners. And since the database probably has not basis, the partners just got hit with about $40,000 in taxes.

If instead this was done through an LLC taxed as a partnership, then the distribution occurs at basis. That means the partners don't have to pay any tax on it.

A real case: A family owned a chain of fabric stores & came to my CPA firm with a dilemma. Over time, they had built a chain of about 30 stores with approximately 20 buildings (business was successful and so they purchased the real estate to go along with it). Unfortunately, the parents had done it all through one S Corporation. Now they were concerned about the liability because all the assets were in one structure and they wisely decided to separate them. Plus, the parents were retiring. A couple of their kids were going to take over the business and a couple of other ones just wanted some kind of cash. So, how could they accomplish what they want?

We could design what it needed to look like, but the problem was trying to get from where they were (everything in one S Corp and huge tax penalties if they distributed out) to where they wanted to be. Eventually, in a multi-stage process over the course of a couple of years we figured it out. But the legal and accounting bills were over $50,000. How much easier it would have been to put the appreciating assets (real estate) in an LLC and kept the business in an S Corporation!

 

[Bilgefisher]

Thank you for the reply,
I guess I misread. Our goal is to flip houses and use that money generated to invest in multi-unit complexes for cash flow. We decided to form an LLC in order to do those and continue to form LLC's as we branch out. Each flip we do we will also pay ourselves a small portion of the earnings and keep the rest within the LLC. Rough plan at the moment, but its a start. I think I need to start diving into your books and get myself acquainted better with my options.

 

[Diane Kennedy]

If you're flipping houses, you have a business. I know it seems like real estate investing, but since you're flipping - it's just like flipping burgers...it's a business.

As a business, you want to ultimately have an S Corp or a C Corp. So, it could be an LLC taxed as a partnership between you and your partner and then each of you have an S Corp or a C Corp under that. Or, it could be an S Corp to start with - with the same concerns that I discussed above.

Take a look at "Loopholes of the Rich" - it's my first book and has the best overview of both business and real estate. The real estate books are good if you're just doing real estate, but you've got a combination going on here.

 

[Bilgefisher]

Take a look at "Loopholes of the Rich" - it's my first book and has the best overview of both business and real estate. The real estate books are good if you're just doing real estate, but you've got a combination going on here.

Sounds good, "Loopholes of the Rich" was the first book of yours I bought. I was planning on reading them after I got started investing, but I think it only makes sense to start reading them now. Btw, before you came onto these forums I had no idea these types of books existed. Thanks again.

 

[Corrado79]

Take a look at "Loopholes of the Rich" - it's my first book and has the best overview of both business and real estate. The real estate books are good if you're just doing real estate, but you've got a combination going on here.

I just ordered that book from Amazon and can't wait to dig in! I also ordered your Tax Loophole book for RE investors. Very excited!

As a business, you want to ultimately have an S Corp or a C Corp. So, it could be an LLC taxed as a partnership between you and your partner and then each of you have an S Corp or a C Corp under that.

Why is that? Couldn't there be an LLC and the two members are the partners' personal LLC's. Why should the companies under the main LLC be S or C corps and not LLC's or just the individuals themselves?

 

[Diane Kennedy]

Why is that? Couldn't there be an LLC and the two members are the partners' personal LLC's. Why should the companies under the main LLC be S or C corps and not LLC's or just the individuals themselves?

Great question!

I actually might have misled you on this one. An LLC can elect how it wants to be taxed. If you don't make an election, a sole owner LLC will either go on your Schedule C (business) or Schedule E (real estate). A multi-owner LLC will file a Form 1065, Partnership Return.

So, an LLC electing to be taxed as an S Corp or a C Corp is the same, tax wise as an S Corp or a C Corp.

When I said "LLC" above, I was assuming that you wouldn't be electing to be an S Corp or a C Corp and just going with the default.

That all said - the issue with a business is self-employment tax. It's an extra 15.3%. Sole Props pay it, corporations do not. Real estate investment (not flipping - which is a business) is not a business and so it does not pay self-employment tax. Remember if you're flipping real estate, you have a business and so want a form of corporation.

 

[Diane Kennedy]

Andviv - thanks for the speed rep++.

Funny how those make you happy..... I just want to go as fast as MJ.... :fastlane:

 

[Bilgefisher]

Andviv - thanks for the speed rep++.

Funny how those make you happy..... I just want to go as fast as MJ.... :fastlane:

Truth be told, we like to see it to because the information you two have put out has been outstanding. Please keep on the accelerator.

 

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[Corrado79]

That all said - the issue with a business is self-employment tax. It's an extra 15.3%. Sole Props pay it, corporations do not. Real estate investment (not flipping - which is a business) is not a business and so it does not pay self-employment tax. Remember if you're flipping real estate, you have a business and so want a form of corporation.

Thanks for the thorough answer!

So, just so I understand this, assuming you maintain the default elections, if you are a running a business as a single-member LLC or sole-prop, you must pay self-employment tax, but not if you have a multi-member LLC or S/C corp? Or did I get confused?

 

[Diane Kennedy]

Thanks for the thorough answer!

So, just so I understand this, assuming you maintain the default elections, if you are a running a business as a single-member LLC or sole-prop, you must pay self-employment tax, but not if you have a multi-member LLC or S/C corp? Or did I get confused?

You're 90% of the way there.

Single member LLC, default election, and Sole Prop - if it's business income, they pay self-employment tax.

LLC taxed as an S or a C - NEVER self-employment tax.

Multi-member LLC - if it's business income, they pay self-employment tax.

BUT, if you take the multi-member LLC and have each member have their own corp - then you have NO self-employment tax and maximum flexibility.

Thanks for the question - we've now come full circle to the original post. I was worried we were getting off the original post a little and creating more confusion than answers. Corrado, you brought us back.

 

[Corrado79]

You're 90% of the way there.

Single member LLC, default election, and Sole Prop - if it's business income, they pay self-employment tax.

LLC taxed as an S or a C - NEVER self-employment tax.

Multi-member LLC - if it's business income, they pay self-employment tax.

BUT, if you take the multi-member LLC and have each member have their own corp - then you have NO self-employment tax and maximum flexibility.

Thanks for the question - we've now come full circle to the original post. I was worried we were getting off the original post a little and creating more confusion than answers. Corrado, you brought us back.

Fantastic. That helps quite a bit and explains it very well. Rep++

As you mentioned above, real estate investment, mutual funds, and the like are passive income sources, and thus not business income, so that is a crucial distinction.

Bonus round: If the multi-member LLC has one member who is an individual and the other member is a S/C-Corp, is there any self-employment tax imposed? If so, against who?

BTW, I am not trying to quiz you, I just want to fully understand the relationships. Thanks!

 

[Diane Kennedy]

Bonus round: If the multi-member LLC has one member who is an individual and the other member is a S/C-Corp, is there any self-employment tax imposed? If so, against who?

I wish I could draw a picture on the forum. Picture the LLC at the top of the page - out of it are two arrows to two boxes. The income flows from the LLC and if it's business, it's subject to self-employment tax UNLESS there is an exception. The exception would be an S/C Corp. So, in this case, the individual gets self-employment tax, the Corp does not.

 

[Corrado79]

I wish I could draw a picture on the forum. Picture the LLC at the top of the page - out of it are two arrows to two boxes. The income flows from the LLC and if it's business, it's subject to self-employment tax UNLESS there is an exception. The exception would be an S/C Corp. So, in this case, the individual gets self-employment tax, the Corp does not.

No picture needed. You successfully drew one in my head. Makes perfect sense.

Not to go off topic, or unnecessarily drag this thread on, but my only remaining concern with the S/C corp would be that although it wouldn't pay a 15% self-employment tax, it could pay corporate income tax at a higher rate, which would be worse. I'm probably missing something here.

 

[Diane Kennedy]

No picture needed. You successfully drew one in my head. Makes perfect sense.

Not to go off topic, or unnecessarily drag this thread on, but my only remaining concern with the S/C corp would be that although it wouldn't pay a 15% self-employment tax, it could pay corporate income tax at a higher rate, which would be worse. I'm probably missing something here.

Just looking around old posts and found I never answered this question. Well, I started the Business Structures Basic post because there was some foundational info I wanted to clarify.

In the question about self-employment tax: S Corp and C Corps are not subject to 15.3% self-employment tax. Wages are subject to payroll tax, though. (So secret if you have an S Corp to make sure you don't draw all the income out in the form of salary - make some of it distribution)

Question about corp income tax rate: A C Corp is taxed at its own level, so that could be an issue. An S Corp is a flow-through entity, so it doesn't matter. it all reports on your personal return anyway.