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IRA Financial Blog

Choosing the Right Entity For My Start-Up – Episode 356

Adam Talks

In this episode of Adam Talks, IRA Financial’s Adam Bergman Esq. discusses the different types of entities used for a business, the pros and cons of each, and how to choose the best one for your start-up.

Selecting the Right Entity for your New Business

Hey, everyone, Adam Bergman here, tax attorney and founder of IRA Financial, and on today’s podcast, want to go back to basics. Been asked a bunch of times over the last couple of months, hey, Adam, please, can you just do a podcast that helps entrepreneurs, potential business owners, including my son, who’s actually trying to start a business, and has questions on which should they set up. Should it be a sole proprietor; should they do an LLC; should they do an S corp or C corp or a partnership? What makes sense? What are some of the advantages/disadvantages, some key characteristics about each type of entity?

So I said, you know what? It’s a great, great time, because actually the third quarter is the most popular quarter for setting up a business. This is based off stats from 2020 and 2021, it was very close second and third quarter. So, we’re still in the third quarter, technically for a week or so. So, I thought this would be a really good time to kind of go through the basics; if you are looking to start a business or have a business, maybe as a sole proprietor and want to potentially think about an LLC or an S or C Corp, then spend some time with me, and I will teach you. As a tax attorney, someone that started multiple businesses, someone that’s probably helped many hundreds of clients over the last 20 or so years set up businesses. Let me share what I know.

So, interesting enough, America is one of the best countries in the world for starting a business. It ranks 91.6 out of 100, which is almost at the top, for the relatively ease in opening a business. And it’s true, if you want to open a business in India, China, even Canada, it’s not as easy as just clicking on a state website, putting in some information, paying a very small fee, and generally, in some cases within hours, days, maybe even a few days, you’ll have your entity set up. Then you can go to the IRS website for free and get a tax ID number for that entity. And then you can potentially get an LLC operating agreement if you’re going to have partners or a shareholder agreement, if you’re going to have shareholders. But if it’s just you, or you and a spouse, then pretty much once you set up the LLC, you have a tax ID number or set up the corp and have a tax ID number, or even if you just operate as a sole proprietor, you’re good to go. You can literally start your business right then, right there. Where, trust me, I remember setting up a business for a client in India. It took six months. We needed a local director. We have to get the accounting firm to give an opinion letter. It costs approximately $10,000 to $15,000, and it took like, six months. So, be glad for this reason and many more reasons that you live in America and want to open a business and have the ability to open a business in America, because not everyone can.

So, let’s talk about how many businesses are formed in the United States. So in 2010, the number of new business applications were 2.5 million; 2020, they’re 4.38 million. That’s 75% increase. And there’s also a 24.7% increase from 2019. Okay, so, people want to set up businesses, four and a half, 4.38 million new businesses in 2020. It’s super exciting. So, just for example, quarter two in 2022, 1.24 million businesses were set up; quarter one: 1.2. So, we’re looking, ’22 is probably going to blow away ’21 in terms of number of businesses set up. We potentially get to about 5 million, high 4 million plus in terms of new businesses set up. So, this is a great time to start a business, right? Yeah, the economy is kind of tough; we’re dealing with inflation. But my belief is if you can be successful and start a business in a challenging economic time, forces you to learn good habits, forces you to be super focused and tight with not only your money, but tight in terms of your priorities and your diligence, than when times are a little smoother, you’re going to be coasting and pretty much set and off to the races.

So, let’s start with the sole proprietor. Okay? That’s the basic default form. If you want to start a business and you don’t want to set up an LLC or Corp, you automatically default to a sole proprietor. You don’t have to file anything; it’s automatically formed upon start of the business. No filings necessary. You will manage it, right? Generally, it’s a sole proprietor. So, in Adam Bergman business, Adam Bergman will be the manager. There’s no limited liability, so you’re personally liable for all the business debts, which is the major downfall of the sole proprietor, right? That’s the major, major disadvantage of being a sole proprietor is you got to deal with all liabilities. You can do a DBA. Some people think you have to operate as Adam Bergman business, you don’t. You can do a DBA and call yourself Blue Sky Ice Cream. It doesn’t matter. But the limited liability limitation is a problem.

Your taxed as the sole proprietor, so it’s a Schedule C on your 1040. You have no, obviously corporate minutes or maintenance because it’s not an entity and you generally have one owner. The whole idea of a sole proprietor, you can have employees, but you generally have one owner which would be you, for example and the entire business is owned by the owner – all the property, personal property, is the owner’s. And all profits and losses would generally flow to the owner. So, you automatically are a sole proprietor.

Like my kid is super into starting a business. He’s young, he’s so entrepreneurial, him and his friends. One of his friends lives adjacent to a golf course, so the kid literally puts on scuba gear, jumps into this murky, disgusting water and collects golf balls. And they sell them, and they sell them for like a dollar a golf ball, and they share profits. They want to start a business. So I was telling them about an LLC maybe versus an S Corp and they were really interested. Why not Corp? Why is Apple a C Corp? Why should I not be a C Corp? Why should I be a C Corp? Can’t be a sole proprietor because there’s two partners. So, really spent like 40 minutes with these kids and it’s great to see; these are like twelve year old kids that are interested in entrepreneurship. Hopefully, they’re focused as much on school, but they want to make money and they love doing it and they’re looking for new business ideas.

So, this is part of the American fabric. This is what makes America one of the greatest countries in the world –  that all you need’s an idea, some luck, a little bit of money, and you could be the next Elon Musk, right? You can be the next Obama. You can be the next Trump. You can be the next great entrepreneur. You just need to have a passion, a little bit of luck, and a whole lot of hard work and you can do it. So that’s the sole proprietor.

Let’s start with the LLC. The LLC is the most popular entity. I would say probably 95% of all new entities are LLCs and there’s good reason for it. It’s funny, when I started practicing law in 2000-2001, there were still questions about LLC. A lot of small businesses were still using corps or S corps. LLCs were still seen as a little bit edgy, a little bit out there. The check the box regulations just came out a year earlier or so. That got people more excited because you can set up an LLC and taxed as a corp. And then obviously at that point, all states recognized LLCs, but some foreign jurisdictions didn’t, and that still continues to be the case. But, it was around that time, the late 90s, early 2000s, where more and more small businesses were focused on LLCs.

But prior to that, LLCs were not that popular. They were for investment funds. A lot of businesses just automatically kind of went to a C or S corp, and it’s taken accountants the last 20 or so years to kind of start to get familiar with LLCs. There’s a lot to get familiar with, and there’s a lot to like because they’re super flexible.

So, to set up an LLC, you file articles of formation organization with the state; all 50 states and the District of Columbia recognizes LLCs. LLCs are pass-throughs, so they are corporate entities; they have limited liability protection, but there’s no corporate level tax. We’ll get to the C corp in a minute, but it’s kind of a funnel; think of it as a funnel. All the income funnels and passes through to the owners. The owners of the LLC are known as members. The LLC can be managed by one person or multiple managers, which is often known as a board of managers. But there’s no essential corporate formality. There’s no requirement for member meetings or annual member meetings. So that’s unlike a corp, which has corporate formalities, an LLC does not.

LLC also has limited liability protection like a corporation. So, it has the advantages of the limited liability protection as a corp, but you get the pass-through taxation that a corp does not have. That means there’s one layer of tax. There’s no entity level tax. So, for example, if an LLC makes $100, there’s no entity level federal income tax. The only tax is at the member/owner level. So, if we assume 30% tax, it’s $100. The member would pay tax on $100, let’s say pay $30 in tax; is left with $70. We’ll get to the corporation, and we’ll see that the corporation has a 21% entity level tax. So, if you take that same $100 example with a 30% individual tax rate, company generates $100, left with $79. The $79 gets dividend up to the shareholder who pays 30% tax on that, that’s another, let’s say $23, so they just paid $44 in tax, whereas an LLC, maybe they only paid $30, okay? So, you can see right there, from a tax standpoint, the LLC is super advantageous. Yes, you can do an S corp and we’ll get to there, which is a lot closer to an LLC than a C Corp.

Single member LLCs do not file tax returns. They kind of get taxed like sole proprietors; it’s on a Schedule C, which is attached to the 1040, your tax return, and then whatever net income is there subject to self employment, Social Security, FICA taxes, and it gets added to your 1040. But it’s a business, just like a sole proprietor, you can take business deductions to reduce your taxable income.

Multiple member LLC files a partnership return, a Form 1065. Again, no taxes due, but it’s essentially an information return that’s due March 15; you can get an extension to September 15. And essentially it shows the income and losses of the partnership and then each member or partner would get what’s called a K-1, which gives the partner and the IRS a snapshot as to the activity of the partnership during the year. For example, who the member is, their capital count, their basis, any income allocated: capital gains, rental income, and the like. So, it lets the IRS know that, hey, Adam was allocated $100 of income, better check his 1040 to make sure he reported it. So, it keeps the IRS abreast of what’s going on within that partnership.

There’s very few, as I mentioned, corporate formalities, which people really like. Owners of the LLCs are known as members, same as the shareholder of the corp, but also could be known as partners; we’ll get to a partnership in a bit, but it’s essentially the same thing. There are some flexibility in terms of allocation of profits and losses. There needs to still be economic substance to the allocation. So, you can’t just say, okay, I get all the losses because I have a lot of income to absorb, and then you get all the gains, or you get all the capital gains, I get all the ordinary income. You can’t allocate just based on tax characteristics, but you do have more flexibility than a corporation. Okay?

So, obviously, LLCs have become the most popular entity type, whether it’s a single member or multiple member LLC, basically because of the flexibility in pass-through taxation, one level of tax, and you still get the benefits of limited liability protection, which obviously is super important.

What’s limited liability protection? Well, say you have $100,000 in your LLC and you own a house and you’re renting out an Airbnb, and God forbid, there’s a horrific disaster and you owe creditors more than you have in insurance. Basically, if the LLC is respected as an entity separate from its members, the creditors are not going to be able to go after the members. All they’ll be able to go after is what’s in the LLC. So if you had a house or a dog, a cat, a million dollars in another bank account, they wouldn’t be able to go after that because of the limited liability protection. Note: some states, like Florida, do not offer full limit liability protection to single member LLCs. So, if you’re in Florida, you probably want to have a spouse or someone take a 1% to make it a partnership. In some states, other states other than Florida, have certain peculiar limited liability protection rules versus single versus multiple member. But in general, multiple member LLCs have a more entrenched limited liability protection framework than single member LLCs.

How do you pierce the veil where, you basically, if you’re treating the LLC as your own piggy bank, there’s not a separation between your personal life and your business life, you could run into an issue where a creditor can pierce the corporate veil, so just got to be cautious about that.

Let’s start with, now let’s go to corporations: C corps. Prior to the late 70s, early 80s, every new business was essentially a corp: C or an S corp. It’s just the way it was. LLCs seemed new. Case law wasn’t established. It wasn’t as safe, at least from a perception standpoint, than the corporation. C corp essentially is, and it’s still used by almost every publicly traded company, is a C Corp, and I’ll tell you in a minute why it’s not an S corp; there’s reasons why they’re not LLCs. There were some private equity funds that set up LLCs and went public with LLCs, but they’ve actually just reverted to corporations. So, it’s very few publicly traded partnerships or LLCs. Most are corporations. Even a REIT, real estate investment trust, is treated as a corporation, essentially.

So, a corporation, the most important advantage is limited liability protection. That’s why people set up corps, dating back to 100 or so years ago when companies were set up. It was to protect the owners and shareholders from liability. An LLC owner is known as a member; in a corporation standpoint, they’re known as a shareholder. Same thing, okay? You set up a C corp by filing a certificate of formation with the state, kind of like an LLC, very similar. Management is run by a corporate management, a board of directors; you need officers, directors. In some cases, one person can serve as all of the officers, and that’s where you’d want to check with local/state rules in terms of the bylaws and the corporate structure in terms of what is permitted from an officer and director standpoint. So, definitely a little bit more complex than an LLC, where there’s absolutely very, very little corporate formality. The limited liability protection is super important.

Tax treatment – C corps are, think of it as a big box; it’s the easiest way to identify, at least that’s what I use in my head to picture what a corp looks like. There’s the entity level tax, which is in the box. That’s 21% federal; there’s also state tax, depending on where you live. And then there’s a shareholder tax – that’s the second layer of tax on dividends. Now, in an LLC, the income that passes through, that’s called pass-through income, or any cash that’s sent from the LLC bank account to the owner, that’s called a distribution.

LLC owners pay tax on profits. They don’t pay tax on distributions. Okay? So, if you start off with $100 and you get allocated of $50 in profit, your capital account goes to $150. If you got a $50 distribution, the capital account goes down to $100. So, you actually pay tax on profits, not distributions. In a corp, C corp, standpoint, you pay tax on dividends, and there’s a dividend tax. So, that’s where the two layer tax comes in,okay? So, corporation’s known as a double taxation regime, and a LLC is known as a single taxation regime.

The corporate maintenance is important. Again, you want to make sure you’re respecting the corporate formalities. You don’t want to have a creditor pierce the corporate veil by not respecting the fact that you need annual board meetings, quarterly board meetings, and there needs to be a separation between the corporation and the shareholders. Corporations pay tax on 1120. It’s due April 15, or on extension, October 15. And the corporation, again, is separate from a shareholder, so the corporation pays the 21% plus, some states have a state corporate tax as well.

Corporations could have multiple classes of shares: common, preferred, multiple common shares, and profits and losses are generally allocated pro rata. When you think of a corporation, think of Apple or Tesla. It’s very rare that startups set up C corps. When would you ever set up a C corp? So, my kids wanted to know, dad, when should I set up a C Corp? Well, excuse me, only very few instances. I think, number one, if you’re looking for foreign investors; foreign investors don’t want LLCs generally, they don’t want pass-through income. They don’t want to be having to file US tax return and have effectively connected income. That’s number one. Number two, if you’re going to raise money and you hope this startup is going to be super big like an Uber or a Tesla, then generally a lot of venture capital firms, private equity firms, will prefer a corps, like a Delaware Corp. So, that’s another instance. And then in some cases, if you’re an owner and you expect the business to do really well, and you don’t want to have to deal with paying tax on pass-through income, phantom income, income you don’t really need.

So, what’s phantom income? In an LLC, let’s say the LLC makes $1,000. Let’s just use real numbers. Let’s say the LLC makes a million dollars in profit, but you really don’t need the million bucks, right? You want the money to stay in the company because you need the million bucks to pay employees, to hire more employees, to buy more inventory, open new stores. So, you take your salary; everyone takes their salary and net net, the business makes a million bucks. Well, guess what? The owners of the LLC pay tax on that million bucks. That’s phantom income because the LLC, the cash is still in the LLC, so what happens is the LLC can issue what’s called a tax distribution, where they send the LLC owner enough cash from the LLC to pay the tax. That’s called a tax distribution, very common. But, the million bucks is phantom income because they’re paying tax on income that they’re actually not receiving in their hands, right? The money is not in their hand., It’s in the LLC bank account. So, in the corporation, you don’t have phantom income because the corporation pays the 21% on the million bucks and the company has that money. It can then dividend to the shareholder, and the shareholder pays more tax, but the shareholder is not going to pay tax on anything other than a dividend. The company would pay the 21%.

So, if you’re going to start a business, you think it’s going to be a cash cow, you’re not sure you’re going to really need that money to live off. You’re okay with a nice salary, then in that case, maybe a C corp works.

The S corp. Okay, S corps are super popular. Essentially, an S corp is a corporation with an S election, so it’s not a separate type of company. All it is, it’s a C Corp with an S election. You file an 1120-S; that’s actually due March 15, not April 15, with an extension to September 15. S corps have some shareholder eligibility rules. Need to be a domestic corp. Shareholders generally have to be US persons. It can only be individuals, certain trusts and estates. A single member LLC could be a shareholder, a 401(k) technically can, an IRA cannot, a partnership cannot, a corporation cannot, and nonresident alien shareholders are not allowed. Cannot have more than 100 shareholders. That’s why S corps are not publicly traded. You can only have one class of stock, can’t have two classes, a common or a preferred. So, those are the limitations on the S corp.

S Corps are very popular with small businesses. Why? Because you get the flow-through taxation of an LLC, and you get the limited liability protection of a C corp. So you kind of get the best of both worlds. You still have corporate formality, because it is an S corp, so that’s one disadvantage of the S corp over the LLC. LLC doesn’t really have corporate formality. You file the S corp, again, if it’s a C corp, you just do an S election with the IRS; that’s how you treat the corporation as an S corp; you do an S selection, and that is what the IRS needs in order to be treated as an S corp, right? It’s essentially a form that you’ll file with the IRS to let the IRS know, but again, it’s not a different type of company. It’s just a C corp that is treated as an S corp, okay? So, you don’t need to get it all bent over, oh my God, it’s a different type of company. No, it’s not. It’s just a corp that’s treated as an S.

The advantage, obviously, is the pass-through treatment. The major advantage, this is just getting to the nuts and bolts, the major advantage, and by the way, it’s called the Form 2553; that’s the form you submit to the IRS to do the S election. You essentially, got to do it two months and 15 days after it’s filed, but you can still file it for later years. But why do people like the S Corp? This is it. Bottom line is C corp and S corp, you get paid through a W-2. If you’re a sole proprietor, you don’t get a W-2, you get a Schedule C and all that income subject to self-employment tax. If you’re a member of a multiple member LLC, you’re not supposed to get a W-2; some people get it, but you either get a guaranteed payment or all the net business income is treated as self-employment a and so does the Social Security. Most people will just do the guaranteed payment.

C and S corps, you get W-2s, okay? So, if the LLC generate a million dollars a year, okay, you may have to pay a million dollars, or at least the self-employment and Social Security would be on that million dollars. In the case of a C or S corp, you can say, okay, I’m only going to take $100,000 salary, so maybe I’m only going to owe Social Security and FICA on that hundred K, and then the rest will just be subject to regular ordinary income tax. And that’s what the S corp play is. The S Corp play is, hey, I don’t want to pay Social Security and FICA on all this income, like I would an LLC, so what I’ll do is I’ll take a salary from the S corp, reasonable salary, and then I’ll pay Social Security and FICA on that, and then everything that’s left will just be subject to regular, ordinary income tax.

Now, the IRS isn’t stupid, and they want to make sure you’re taking a reasonable salary, and they’ll audit you. There’s cases, actually an abundance of cases, where business owners are taking unreasonably low salaries. I’ve used this example before, but I don’t know if anyone ever, if people still remember John Edwards. He was a North Carolina lawyer, and he ran for public office. And basically what he did is he was a successful lawyer, and he had years where he had major income from successful lawsuits. And what he did is he took a super low salary through an S Corp and pay tax, Social Security, Medicare on that very low W-2 salary, and then basically had all the other income in his S corp, not subject to Social Security and FICA. And he thought he was good, but the IRS didn’t think so they audited him, and they won. So basically, I think the numbers were he had net income in three years of $25 million, and he made about $1.2 million in salary a year. So he said, hey, that’s all I need and the IRS said, well, that’s not enough. You earn $25 million in three years, you needed to take more than like $3 million in W-2.

So, the IRS wants it to be reasonable, and they’re not messing around. Why do they care? Well, Social Security and FICA is taxes; means something to the IRS, and they don’t mess around when it comes to taxes. So, that’s the only thing to be aware of if you’re doing an S corp. Make sure you’re taking a reasonable salary. Make sure you’re respecting corporate formalities. Obviously, you have those shareholder restrictions: 100 shareholders, no foreign shareholders. The shareholders can’t be corporations or single member or trust, certain trusts or IRAs, for example. So, just be aware of that.

The last entity type I want to mention is general partnerships, which no one really does for businesses, unless you have to. You’re a law firm or accounting firm, depending on your state; medical practice or architecture firm; some hedge funds, venture capital funds still are GPs. A general partnership means you have an entity that’s a general partner that has no limited liability protection, and then you have limited partners that have limited protection and receive limited liability protection. Generally, what people do is they’ll set up an LLC to be the GP so that the general partner has limited liability protection, and then the limited partners have the limited liability protection as a limited partner.

So, general partnerships are still being used by hedge funds, private equity funds. They don’t have to; they can just use an LLC. But, I think people just get comfortable; lawyers like to use the same documents over and over, right? It’s just easier. Charge the same amount and have to do less work. But, that’s going to go away eventually; you’ll just see LLCs for major hedge funds, private equity funds, venture capital funds. The general partnership structure is on the decline significantly. So, that’s the only thing just if someone mentions the GP, if you want to do a general partnership, make sure that the general partners set up like through an LLC to give that general partner limited liability protection, and the LPs will have the limited liability protection.

So, that’s kind of it. In sum, you default to sole proprietor if you don’t have an entity. You can do a sole proprietor if you’re just selling golf balls to your friends and neighbors, but if you want to do something, have a website, sell to the general public, you want to be either an LLC or S corp. The only reason to do a C Corp is if you’re going to raise money from foreign investors or you want to go public at some point, or you think your business is going to be a cash cow and you don’t need to deal with that income and the phantom income and pay tax and get tax distributions on that income. You just rather the corporation pay 21% tax because you don’t plan on taking a dividend for a while. Your exit strategy is just selling the corporate stock. That’s fine.

But honestly, the LLC and the S Corp, I’d say 99% of all new businesses should be LLCs or S corps. Either one works. Actually, I do have a preference, I’d rather the LLC and I have both, just because you don’t deal with corporate formality and I’ve seen issues where people don’t respect corporate formality and you have a lawsuit and there’s a threat that they’ll pierce the corporate veil, which for LLCs is much, much more difficult because there is no corporate formality.

There’s also more flexibility in terms of operating the LLC from a profit/loss standpoint, management structure. So, the only disadvantage of the LLC is you can’t play around with the W-2, Social Security, FICA or the S corp; you still can, you just don’t be a John Edwards; don’t be super aggressive. But again, if your business maybe does a million in revenue and maybe $200,000 in profit, you can take a $40, $50, $60,000 salary; that’s probably reasonable. A $2,000 salary, maybe not.

So anyways, there’s a lot to discuss. I can probably keep going for another 30, 40 minutes. This is not to do with retirement accounts. This is all about: hey, start a business if you’re confident, if you believe in something, you’re passionate, go for it. That’s what America is built on. I was a lawyer for nine years. I liked it the first five years; I really enjoyed what I was doing. After that, really kind of the golden handcuffs; doing it for the paycheck, which sucks. It sucks. I remember waking up Monday morning just not being excited to go to work. And when you have your own business, it’s hard, it’s stressful, but it’s so rewarding if you, hopefully, get to be in an industry you believe in and are passionate about and love, which I am. So, I am super, super fortunate to have found my passion. I hope all you do and keep trying until you do. Don’t give up. But setting up the right company is not hard. America makes it; we’re in the best country for starting a business. If you have to choose from the LLC and S corp, as I mentioned, I gave you some options, but I don’t think go wrong with either. Definitely talk to an advisor, tax professional, attorney; CPAs are really good at this stuff. So, if you have a CPA, everyone should have a really good CPA, that’s number one. If you’re starting a business, you need a good CPA; that’s one of the first things you should do. They’re not super expensive like lawyers, but they’re very valuable in terms of helping you start your business the right way; making sure you’re taking advantage of all available deductions, start-up expenses, things like that, that could really make a difference.

So, thank you for listening; if you’re watching, I appreciate it. Definitely subscribe to our YouTube channel. It’s awesome. And I know it was kind of a long one, but it’s a super important topic. So, thank you, have a great day and talk to everyone again next week.

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