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Beyond Sole Proprietorship
Posted Wednesday, July 8, 2020
Ahhhh… what a cute picture. These are not business owners or two accidental sole proprietorship operators. They might be business sellers though. Sarcastically, business ownership does not mean you own a business; it means a business owns you, but that can be a good thing!
Pursuing a passion and making it into a business is a great way of life, but certain foundational steps need to be in place for long-term success. Liability, self-employment taxes, tax planning and estimated tax payments, retirement savings and solo 401k plans, accountable plans, exit strategies, business valuations, etc. are all considerations that many small business owners neglect. LLC? A good old fashioned C Corp? S Corp Formation? Keep it a sole proprietorship? Perhaps a Limited Partnership? We can help.
Business entity selection is important, but it is not cast in stone. Many businesses often start off as one entity type, and then later convert. WCG did just that; we were an LLC until the founding partners expanded ownership to include other partners and employees. At that point it was better to convert to a corporation so that shares may be sold versus member interest.
First, we’ll talk about some basic business entity concepts.
Liability Protection (Fallacy)
Some sole proprietorships are concerned about being sued and therefore they create an LLC. Good or bad? It depends of course. Can I be sued if I take the steps of an LLC formation? Yes. How about a corporation? Yes!
And you can easily lose on a personal level. And while consultation with an experienced attorney is strongly recommended for your unique situation, as business owners ourselves we feel the excitement of the LLC, especially the words “limited liability,” has overshadowed the reality of our litigious society. In other words, if your careless acts, errors or omissions injure someone even though it was under the auspice of your LLC good chances you will be personally named in the lawsuit and held liable as the owner of the LLC. Remember that injury is not limited to just bodily injury; it could also mean financial injury.
How about corporations?
Officers and directors of corporations are routinely held liable for the actions of the corporation. This is called piercing the corporate veil. Can you say Enron? Piercing the corporate veil typically is most effective with smaller privately held business entities (close corporations) in which a) the corporation has a small number of shareholders, b) has limited assets, and c) separating the corporation from its shareholders would promote fraud or an inequitable result. Sounds like about 99% of the corporations out there, right? Right! LLCs are similar.
Therefore keep in mind that a sole proprietorship versus an LLC or corporation in many liability ways is indistinguishable. Then again, there are fundamental differences that can benefit you (and that we will discuss).
So, what do you do? First, securing a decent umbrella policy, both at the personal and commercial level, is our strong recommendation for liability arising from your acts, errors and omissions. Speak to your insurance agent, but typical umbrella policies are $500-$700 per year. Second, speak to a qualified business law attorney.
We’ve expanded this LLC fallacy in our KB articles.
The power of advertising, the ease and the hype have created this fervor surrounding the limited liability company. Do you know what LLC really stands for? That’s right.. Lawyer’s Likely Choice. We like to poke fun at attorneys- creating an LLC is an easy way to get your small business off the ground and it instantly moves you past the sole proprietorship. While there are significant benefits there are many things to consider.
Just like 401k’s are not IRAs, LLC’s are not corporations. The C stands for company not corporation. LLCs file Articles of Formation or Organization… not Incorporation. You don’t issue shares in an LLC nor do you have shareholders. You have members who own an interest (economic or equity, or both). Sorry to be snooty, but there are some strong technical differences.
Quick myth buster- As mentioned above, LLCs do NOT automagically protect you from all lawsuits- limited liability does not mean tort liability. Huge misconception! Do you really think the world would go ’round if your errors and omissions could be wiped clean through an LLC? Nope. Turn the tables for a moment. What if you were on the receiving end of a car accident and the bozo waives some formation documents and says, “You can’t sue me. This is a business car!” We doubt our justice system and our demands for equity would allow that.
You do receive some liability protection. For example, if you sign a contract with an internet provider as a member of the LLC and you are not signing as an individual, then if your business fails your personal assets should be shielded from liability for the internet contract. This is one of the fundamental differences between a sole proprietor and an LLC.
You should always seek the advice of a competent business law attorney.
Entity Formations and Considerations Podcast
C Corp Formation
Historically C corporations, or just corporation for short, had be created with the guidance of a skillful attorney. Articles of Incorporation needed to be drafted and stock certificates were printed, and the whole thing was a big deal. Today, and thanks to LLCs and the online creation tools offered by most Secretary of States, corporations are just as easy to form as an LLC. Boilerplate Articles of Incorporation and Bylaws are available online, and satisfy most situations out of the gate. However, if you have multiple shareholders beyond you or you and your spouse, then an attorney should be consulted to draft these documents.
S Corp Formation
As mentioned elsewhere, an S corporation does not exist as an entity. Some other underlying entity must exist, such as an LLC or corporation, that then chooses to be taxed as an S Corp. People say “I have an S Corp” all the time… and there is nothing wrong with that, but technically you have some other recognized entity being taxed as an S corporation. You won’t see “S Corp” listed on a Secretary of State’s website. You also won’t see sole proprietorship listed on the SOS website either… and therefore you cannot S Corp elect your sole proprietorship. You need a recognized business entity.
Reducing your self-employment taxes is the main reason business owners want to be taxed as an S Corp. There are some issues such as payroll, corporate tax return requirements and passive incomes. But if you have over $30,000 in net business income after expenses, you might want to give it some serious consideration. Why? You could save about 8% to 10% of your net business income in taxes… so, if you earn $100,000 in your business after expenses, either as a sole proprietorship or LLC, you could save $8,000 to $10,000 in taxes. Does an S Corp make sense? The buttons below will explain more.
Conversely, unless you are guaranteed to make a bunch of money we do not immediately file Form 2553 (S Corp election) to perfect the S Corp formation. Since we can always file a late S Corp election back to the inception of the entity, we commonly do a wait and see. We can also go back to January of the current year if the entity was formed in a prior year. There is no sense lighting all the fires that go along with an S corporation unless you are experiencing net profits. If you lose money your first year or two, an S Corp does nothing except add to your tax preparation bill.
Sole Proprietorship Summary
We just outlined a bunch of different entity types beyond the sole proprietorship. In addition we strongly suggest you read our business entity type selection article for a comparison table as well. In the meantime, here is a summary of the benefits (or lack thereof) of the sole proprietorship-
|Employer Identification Number (EIN)||Yes, but under your SSN|
|Bank Account||No, but you can get a separate personal checking account|
|Process Payroll||Yes, provided you have an EIN|
|401k, SEP IRA||Yes|
|Wholesale Transfer of Ownership||Yes (provided it is an asset sale)|
|Partial Transfer of Ownership||Nearly impossible (ie, cannot add partners)|
|Financial Liability Protection||None|
|S Corp Election||No|
|Tax Rate||15.3% + ordinary income tax (10% to 37%)|
|Ability to Deduct Expenses||Same as any other LLC, corporation, etc.|
|California Franchise Tax||No (the one benefit of a sole proprietorship)|
|Other States Franchise, Business Tax||Varies|
The California thing is a conundrum. If you just starting out, and have no idea if you will make money, a sole proprietorship might make sense? Why? You still get to deduct all your business expenses and you also get to avoid the $800 annual California Franchise Tax. Often our recommendation is to gain some traction and then re-assess the efficacy of the LLC formation in California. Other states have expensive filing and “pleasure to do business in our state” taxes as well.
Entity Selection and Multi-Entity Arrangements
Should you pick an LLC or a corporation? Good question! What LLC vs. S Corp? Does that make sense? Perhaps.
What about you and another partner… should you consider a multi-entity arrangement instead of one entity? Do you want to split up your business interests so common expenses are split, but company cars and other fringe benefits are handled individually? Maybe! Multi-entity business structures are common among physician groups, financial advisors, insurance agents, and other production-based groups.
Please click on the buttons below for more information on business entity selection and multi-entity arrangements.
Adding My Spouse
Should you form an LLC with your spouse? No. Don’t you see enough of each other at the house? All kidding aside, there are two scenarios at play here. First, adding your spouse as an owner and second, adding your spouse to payroll as an employee only. Just because your spouse is an owner does not mean he or she needs a salary, and he or she does not need to be an owner to receive a salary.
We’ll look at ownership first, and touch on the payroll component in a later chapter. Two primary reasons for adding your spouse to the business as an owner are-
- Leverage the minority owned small business benefits (usually with government contracts).
- Asset protection through Charging Orders and the associated rules with multi-member LLCs (attorney stuff).
Please note how tax savings or other big “wow” things are not listed. In other words, adding your spouse as an owner only has two super narrow bands of benefits. But if you add your spouse you instantly become a partnership which might require a partnership tax return (Form 1065).
But there are exceptions! S Corp tax returns (Form 1120S) and partnership tax returns (Form 1065) enjoy a substantially lower audit rate (0.4% versus 2-3%, 2017 data). So adding your spouse to your LLC might be worth something to you. And… While the days of simply adding your female spouse in the hope of being labeled a minority owned business are few and far between (governments now want certifications), there are times where adding your spouse makes a bunch of sense. Here is some more reading material-
LLC Operating Agreements
Are you considering going into business with a partner other than your wife? Wait! You need to consider some things. What happens if your partner dies? Are you now in business with your partner’s widow… you know, the crazy one that you could never stand in the first place? Or his kids? You need to strongly consider an Operating Agreement that details death and divorce clauses, corporate waste, and first rights of refusal. You must have language that allows the remaining partners or members to buy back the interest but how will the business be valued? What is the dispute resolution process?
What about distributions? You would hate to get phantom income on paper without the cash. Do you require distributions to at least cover the tax consequence? For example, you and your partners decide to keep all the money in the business for growth purposes. Later, you and your partners argue about it and you are the minority interest. Now what? They can freeze you out from distributions but you still receive phantom income on your K-1. Yuck!
There are many many more examples of not-so-good situations. Discussing and deciding on these issues during your LLC formation and not after there is a big pile of money sitting between the owners is ideal!
Also, please keep in mind that with an S Corp formation, you are still operating under the auspice of the underlying entity’s rules. In most cases this is an LLC. So, your S Corp might truly be an LLC taxed as an S corporation such that an Operating Agreement (as opposed to Bylaws) is the governing and controlling document.
We can work with your attorney to draft this correctly. Here is our KB article on things to consider with Operating Agreements-
Corporation Bylaws and Shareholder Agreements
Operating Agreements govern how the internal workings of an LLC operate, generally combine the aspects of Bylaws and Shareholder Agreements. Bylaws are drafted to provide structure to the corporation by defining the purpose of the entity, the Board of Directors, Meetings among other things. Bylaws can be viewed as a operations manual for the corporation. Shareholder Agreements are optional, but are strongly encouraged when you have more than one shareholder. A Shareholder Agreement is an agreement by and for the shareholders, and outlines certain rights and obligations. For example, in WCG’s Shareholder Agreement, we have provisions for shareholders who want to exit the business; the agreement determines the valuation of the stock redemption and the payment terms for the exiting shareholder.
Again, LLC Operating Agreements generally combine both the internal operations manual similar to Bylaws with members’ rights and obligations similar to Shareholder Agreements into one document.
One of the common statements we get from clients at WCG is, “I have a guy who is giving me $100,000 to help me start my business.” Our next response is, “Will the guy be an investor, lender or both?” And then stunned silence… which is certainly re-assuring. Not!
There are many ways to handle this, and no one way is always the best. It depends on humans, emotions and personal objectives. Don’t forget the golden rule where the person with the gold makes the rules. As you kick around your LLC formation, here are some ideas-
Beyond Sole Proprietorship Consultation
How does business formation work? Do you need an LLC? If so, when should you do it? When should you delay it? Let’s chat!
LLCs and S Corps Book
Shameless self-promotion alert! We have written a dorky book called Taxpayer’s Comprehensive Guide to LLCs and S Corps. Over 300 pages of pure pleasure. It is available online, for free, within our KB articles, or from Amazon and other less than average retailers. Please click on the button below for more information-
LLC Formation or Incorporation Fees
WCG can do all the LLC or corporate filings with the Secretary of State (for any state), and our fee is $425 plus the state filing fees. We can file your paperwork in all 50 states plus the District of Columbia. If you have foreign owners (ie, not U.S. citizens or non-resident aliens), then our fee is $750 plus the state file fees.
Some states are fast, some still require paper submissions (such as Pennsylvania). Some are slow for no reason, like California. You might also have to file an Initial Report. States such as Nevada and California have an Initial Report Filing requirement and our fee to prepare this filing is $100 plus the state filing fee.
We’ll also obtain your Employer Identification Number (EIN) from the IRS, create an Operating Agreement (for single member LLCs only) and draft an Accountable Plan for expense reimbursements (including the corporate resolution should one be needed). Three documents (Articles of Organization or Certificate of Formation, EIN and Operating Agreement) are required by most banks for a business checking account (some don’t need the Operating Agreement). The Patriotic Act, Bank Security Act and Homeland Security want to clamp down on illegitimate business accounts and financial holdings. This fee also includes your S Corp election should you need it. Please click on the button below to complete a simple digital form and get going!
Yes, LegalZoom might appear cheaper for your LLC formation. But after you add on all the bells and whistles, our fee is very reasonable. And, you get excellent business consultation by using WCG. Way too often people run out and do the LegalZoom thing, and then need to us to unravel a bad decision and put things back together. That gets expensive really quickly. So, forming a business is not the kind of thing to be stingy on- get solid answers and solid advice from a trusted business consultation and tax preparation firm. We’ve unraveled enough LegalZoom filings to choke a small horse. Do you know what it takes to choke a small horse? A lot.
On the other hand, we see some business owners spending $1,500 for an attorney to create an LLC. Unnecessary! Sure, the attorney needs to eat but let’s be smart with our money. We create business entities all the time. Having said, we are the first to punt on a complicated situation. A trust owning an LLC? A multi-member LLC which requires a robust Operating Agreement? An LLC that deals with alcohol, tobacco, firearms or marijuana? There are a handful of situations where we recommend using an experienced attorney but an LLC formation for your new Amazon reseller business is not one of them.
Don’t forget that WCG also consults with you on how to account for your business transactions, what tax savings strategies to deploy (forget cars, cars usually stink as tax havens), what tax deferral plans to implement such as self employed 401k plans or profit sharing plans, and basic business operations. Small business consultation is what we do, and we do it well by catering to your unique needs. You are not special, but you are unique.
Benefits of Business Formation
Many advantages are available to you when you form an LLC, partnership or corporation, or elect to be taxed as an S Corp. Section 105 Health Reimbursement Arrangements (HRA), retirement contributions and Section 127 Education Assistance are some of the big ones. Avoiding self-employment taxes through an S corporation. Pulling tax-free money out through an Accountable Plan for your home office. All good stuff.
Business Advisory Service Plans
WCG specializes in small businesses who generally have fewer than 100 employees. Why? We want to help people, and more importantly we want to help the business owner directly. Frankly speaking, once a business gets to a certain size management layers get in the way of owner access. Access allows us to ensure the owner(s) are leveraging the most out of their business for themselves and their families.
Because small business is a core competency for us, we have created business advisory service plans which include these really cool things-
|A la Carte*||Vail||Telluride||Aspen|
2020 Tax Planning and Preparation
|Tax Planning, Tax Projection Worksheets||$350 to $500|
|Small Business Tax Deductions Optimization||Included|
|Section 199A QBI Tax and Salary Optimization||$300|
|Estimated Tax Payments (thru payroll or directly)||inc. or $75 per|
|2020 Business Entity Tax Prep (Form 1065, 1120, 1120S)||$800 to $1,200|
|2020 Individual Tax Prep (Form 1040), One Owner||$500 to $700|
|Expat / Foreign Income Calcs (Form 2555, FBAR, Form 8938)||$300 to $500||Add-On||Add-On||Add-On|
|IRS Audit Defense||NA|
|Situational Tax Law Research (up to 3 hours annually)||$750|
|Reasonable Shareholder Salary Calculation (RCReports)||$400|
|Monthly Shareholder Payroll Processing (up to 3 shareholders)||$1,200|
|Employee Payroll Processing (up to 25 employees, bi-weekly, direct)||$300 per month||Add-On|
|Annual Payroll Processing (W2s, other filings, up to five 1099’s)||Included|
Business Advisory Services
|Business Consultation, Periodic Business Reviews (PBR)||$1,000||Quarterly||Unlimited||Unlimited|
|Complimentary Quick Chats (CQC)||Included||Unlimited||Unlimited||Unlimited|
|Interfacing with Lenders, Attorneys, Financial Planners||$500||Unlimited||Unlimited|
|QuickBooks, Xero Consulting||$500|
|Fractional Controller (Bookkeeping)||NA||Add-On||Add-On||Add-On|
|Financial Statements Analysis, Comparisons||$1,200||Quarterly||Quarterly|
|Cash Flow Management and Analysis||$750 to $1,000|
|First Research Industry Reports, Industry-Focused Consulting||$250|
|National and Metro Economic Reports||$150|
|KPI Analysis, Benchmarking, Hot Sheets, Trend Analysis||$750 to $1,000|
|Budgeting, Forecasting, Goal-Setting||$750 to $1,000|
|Strategy and Maintenance|
|C-Level Financial Advice and Strategic Planning||Included|
|Succession Planning, Ownership Changes Consultation||$750 to $1,000|
|Annual Business Valuation||$2,500 to $3,000|
|Annual Corporate Governance, Resolutions, Meetings||$150|
Custom! Unlike the modern day new car packages where you have to spend $8,000 for the moonroof, our Business Advisory Service plans can be customized specifically for you. The array above is simply a starting point. If you need more from us, let’s chat about it! The following are teased out separately as one and done fees like formation and onboarding stuff.
|Articles of Organization or Incorporation, Domestic Owners||$425 + state filing fee|
|Articles of Organization or Incorporation, Foreign Owners||$725 + state filing fee|
|Initial Report (if required)||$125 + state filing fee|
|Employer Identification Number||Included|
|Single Member Operating Agreement (SMLLC)||Included|
|MS Word Templated Bylaws Agreement (Corporations)||Included|
|S Corp Election, Timely Election (made with formation)||Included|
|Payroll Accounts Setup or Transfer||$300 to $450|
|Bookkeeping Setup or Transfer (Fractional Controller)||$300|
|QuickStart QuickBooks Setup and Support (90 days)||$550|
|S Corp Election, Timely Election (within 75 days)||$250|
|Late S Corp Election Back to January 2020||$450|
|Examine Prior Tax Returns||Included|
Note: A la Carte fee ranges are approximates. 90% of our clients fit into these fee ranges, but there are outliers. We have a handful of clients with over 30 rentals; their individual tax return is north of $2,500. We also are assuming one state; if your business spans the galaxy (keeping with our stormtrooper motif) then additional fees will be discussed with you prior to payroll setup or tax preparation. Typically each state is around $250 for tax preparation since it affects both your business and individual tax returns (frankly, state apportionment is a pain in the butt, but it is our pain).
Couple of other things to keep in mind- we make very little profits on payroll processing... we offer it as a convenience to our clients. One throat to choke with a single call can be reassuring but if you want to run your payroll, go for it! Everyone thinks payroll is a piece of cake; write a check and done. Nope... we see a lot of mistakes being made by clients especially the handling of health insurance and HSA contributions since there are special rules for greater than 2% S Corp shareholders.
You can prepare your own individual tax return as well... but the benefit WCG preparing both tax returns is that we slide things around depending on income limitations, phaseouts, alternative minimum tax (AMT), Section 199A deduction optimization, etc. Having our arms around both can yield some good tax savings!
Some more things to consider- when a partial year remains, our usual annual fee is pro-rated to not charge you for services you didn’t use (like payroll and consultation). However, a large chunk of our annual fee is tax preparation which is typically a built-in fixed amount of $1,300 (both business entity and individual tax returns). Whether we onboard you in January, July or December, we have to prepare a full year tax return. This increases the monthly fee for the remaining months of 2020 but the monthly fee will later decrease in January of 2021 to reflect the amounts above. Yeah, we make it sound like 2021 is just around the corner.
We are not salespeople. We are not putting lipstick on a pig, and trying to convince you to love it, even if Tom Ford’s Wild Ginger looks amazing. Our job remains being professionally detached, giving you information and letting you decide.
We see far too many crazy schemes and half-baked ideas from attorneys and wealth managers. In some cases, they are good ideas. In most cases, all the entities, layering and mixed ownership is only the illusion of precision. Just because you can complicate the crap out of your life doesn’t mean you must. Just like Chris Rock says, just because you can drive your car with your feet doesn't make it a good idea.