THE FISCAL BLUE PRINT
WITH COACH JEFF MONTGOMERY
Episode 30: LLC’s and S-Corps- Part 3 of Legal Structures for setting up your own business!
This is a topic that obviously doesn’t appeal to a vast audience and YES, I guess I’m kind of a nerd and like to learn new things and find this stuff interesting. However, we can tell by the number of podcast downloads what shows are popular and what shows are not J and suffice it to say these last few shows aren’t breaking any rating records
So, let’s tackle LLCs and S Corps and wrap up this series! Let’s start with LLCS and our format has been to:
- give a quick overview of how they work and are formed
- Talk about taxation
- Talks about liability
So, as a quick overview, LLCs are created under State Law, not federal law. The precise rules will vary from State to State. They are designed to try to get the best of both pass-through taxation like Sole Proprietorships and Partnerships but also have a measure of liability protection at the same time.
You will file Article of Organization typically completed by a lawyer to the secretary of state of your state. The article must include the following:
- LLC’s name and address
- Names of the members of the LLC (usually the owners)
- The nature of the business
- Name and address of the registered agent
Side notes as well……. if you plan to do business in another state other than the one where the LLC is formed you may have to file with that state as well.
Also, as mentioned last week with a partnership. If your LLC is going to have multiple owners/members, you should create an operating agreement as well. Just like the partnership entity with the same basic characteristics
- How expenses will be divided
- How profits will be allocated. Many times, there are multiple partners with different ownership percentages
- How and when profits will be distributed. Sounds like item 3 but as well soon find out how profits are distributed is not always the same as how profits are allocated
- The division of tasks within the business. Who does what?
- Under what instances can one partner sell his or her interest in the partnership
- What occurs in the event of a partner’s death, disability, etc.?
- And how will major disagreements be handled and resolved
(6:20) Taxation: Well this is simple! As far as the Feds are concerned LLC’s don’t really exist. The Internal Revenue Code treats LLCs as if it were SP’s or Partnerships as Pass-Through entities. The income passes through to their personal tax returns.
Now there is a little wrinkle in the fact that an LLC can elect to be taxed as a C-Corp or an S-Corp… which we will get into in a little bit when we talk about those entities. There could be some tax advantages to electing to file your taxes as an S Corp or C Corp. (Refer to our last few shows on how partnerships and Sole Proprietorships are taxed)
(7:30) Liability: Generally speaking, the reason to form an LLC is to obtain some protection from unlimited liability. Sole Proprietorships and General Partnerships as we mentioned last week have Unlimited liability, meaning that the owners could be held personally liable for all debts and lawsuits of the business itself. With an LLC, that protection is afforded to the owners and in general, the LLC does a pretty good job. Rather than talk about all the ways it protects owners let’s talk about what it doesn’t protect:
- Not Protected! Personally guaranteeing business debt; Many start-ups need to borrow funds and when a new company goes to a bank, chances are the bank is going to require the owners to sign personally for the loan.
- So, the lender will be able to hold the owner personally liable
- Not Protected! Liability resulting from a Tort- a legal term referring to wrongful acts that result in legal liability to someone
- Negligence and Fraud
(9:45) Corporations: If you are looking at it from a 30,000-foot view, Corps are either a C-Corp or an S-Corp. The only difference is how they are taxed!!!!
You can do the research and form a corporation on your own, but most would hire an attorney or possibly even use an online service. What makes the situation different than an LLC or other entities is the level of complexity in the formation. It requires more things with the potential of those things getting messed up. I would recommend using an attorney that is familiar with forming a corporation.
It’s also probably a good idea to get your tax professional involved as well especially if you are transferring from one type of entity to the other. Corps are separate entities from owners and when you transfer assets to the corporation there could be some type of tax consequence.
It sounds like a big headache. So why would you want to go that route and not the LLC route? The simple answer is again liability and possibly taxation.
(11:41) Taxation: C-Corporate taxation is different than S-Corp taxation and is unique in that the corporation ITSELF is subject to income tax. Unlike SP, P’s, and LLCs where the owners are subject to income tax, which are pass-through entities. C-Corps are not!
C-Corp income tax is unaffected by the number of owners (called shareholders) it has or how much profit is distributed to the owners. The Corporate tax rate was lowered by the passage of tax cut and jobs act 2017 and lowered it to 21% flat tax. Prior to that, it was a progressive tax just like an individual has.
Now when a corp makes a distribution of profits to its owners/shareholders called a dividend and those shareholders pay tax on those dividends. In other words, Corporate profits are TAXED twice! At the corporate level and when /if profits are distributed to the shareholders as dividends
So, as a result of this taxation C-Corps are NOT USUALLY advantageous compared to pass-thru entities. One way to avoid this double taxation is for the Corp to pay the owners a salary or year-end bonus that would leave the corporation with exactly ZERO income!
Salaries paid to employees count as deductions to the corp. Now, of course, the amount received as a salary or bonus to the employees will be taxed as ordinary income.
Still don’t see the advantage??? Well in certain situations where there are “high earning” owners of a business that be taxed at 37% and they do not need that amount of income to pay personal bills and live. They could choose to organize as a C-corp and leave those profits in the business.
(16:30) Income splitting; so, they would split the profits………. pay themselves a salary taxed as ordinary income rates and leave the rest in the corporation taxed at those lower flat tax rates. The profit is either never distributed or distributed later when the owners are in a much lower income situation and faces a 0% tax rate on dividend’s
(17:30) Liability: For most legal purpose’s corporations are distinct entities. They can own things, rent stuff, sue or be sued……. etc.
The reason behind making them distinct entities is that it allows the owners to NOT WORRY about being personally liable for the debts of the business………that includes lawsuits………. outside of Torts mentioned earlier.
This is one of the fundamental elements that make our economic system the best in the world! Without this protection, it would be hard to imagine anybody investing in a McDonalds, Chipotle, Boeing, Apple, Amazons, etc. Could you imagine being sued as an investor (owner) of McDonald’s stock if someone got sick at one of the restaurants and being held personally liable?
If a corporation didn’t offer that protection hardly anyone would ever invest in new companies and our way of life would be dramatically different!
(19:10) S-Corps and some of the differences compared to a C Corp. S-Corps are simply C-Corps that have elected to receive a special kind of tax treatment. The only difference between S Corp and C corps is taxation
Electing S Corp taxation is as simple as filling out a single tax form 2553. There are some eligibility requirements to elect this type of taxation (example no more than 100 shareholders), etc. So, double-check ALL the rules
S CORPS, like partnerships and LLCs, are pass-through entities. NO FEDERAL TAX AT THE CORPORATE LEVEL!
The big benefit here is NO SELF EMPLOYMENT TAX for the shareholders (owners.) Yes, when you are self-employed the full share of the tax is your responsibility 15.3%. If you recall when you work for an employer and earn a salary/wages, you pay half and the employer pays the other half
Well with an S-corp you as the owner and also an employee has to pay yourself a “reasonable salary” ………. not well defined and very ambiguous from the IRS.
(21:00) So, what’s a reasonable salary? This is often the topic of debate in tax court when the IRS challenges a business owner on the amount of salary, they are paying themselves. So be wary and make sure you are paying yourself a reasonable salary!!!
But everything else (profits) from the business can be paid out to the owners without the extra 15.3% SE TAX. Of course, remember no matter what, the profits are taxed as income whether they are distributed or not BUT you avoid the extra 15.3% SE tax.
WORD OF CAUTION! Definitely consult with your tax advisor and make sure you really nail down an appropriate amount of “reasonable compensation!!!!
(23:00) Coachable Segment: We have an offer for the listening audience for the next 30 days after this show is published for the first time.
For those of you that made it this far through the show ………… I will mail you a FREE copy of Mike Piper’s book titled LLC vs S-Corp vs C-Corp explained in 100 pages or less.
Mike is known in the industry for his series of books explaining difficult subjects in 100 pages or less. They are really well written and easy to read very quickly
So, this is a closed offer and expires in 30 days for US residents only. All you must do is send us an email to firstname.lastname@example.org and in the subject line just write “Great Show! Send me my free book!” Don’t forget your mailing address and we will ship your free copy of Mikes Book!
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Episode 30: LLC’s and S-Corps- Part 3 of Legal Structures for setting up your own business! Montgomery Financial Services, LLC
Disclaimer: Please do not take advice from me on this show. As a licensed Fiduciary I am only allowed to give advice to clients. So, unless you’re a client I can’t give you advice because I don’t know you. So, think of this as helpful hints and education only. And please before implementing any information or ideas you hear on this show always consult your legal adviser, your tax adviser, and your financial adviser…………. right? that’s just common sense.