You have a great idea, you've crafted your business plan, and your business is in full swing. But wait, depending upon what your business does and what your personal goals are for the business, you may be looking at forming a legal business entity for your venture.
You may be asking yourself whether you should form an LLC? Maybe a C-Corp? Or what about that weird S-Corp variation I keep hearing about? What type of business structure do I need?
We're here to tell you, those are good questions, but those are the wrong questions to be asking yourself if you haven't yet legally organized your business, and aren't sure which structure is right for you. Today we're going to go over all the *right* questions to ask yourself, and the issues you need to seriously consider so that when you do organize, you'll be choosing the right entity for you.
Pamela: Hey everybody this is Pamela.
Tracy: And this is Tracy.
Pamela: And we are here to discuss How Business Really Works.
Tracy: In today’s episode we are going to answer the question “LLC or INC?” But Pamela is that really the question?
Pamela: No Tracy it is not actually really the question. Actually, you want to be asking yourself several different questions about your business and about your intentions for your business that will answer the main questions LLC or INC.
Tracy: Okay so the first question is going to be “How does your business need to be structured?” In other words, how many owners are there going to be? And what are their level of involvement going to be? And are they going to have a say so in operating or are they going to basically just be an investor? So Pam what’s my options if say I want several owners and I want some of them to just be investors and not be able to deal with the operations of my business?
[Time – 1:04]
Pamela: Well if you want several owners you could go the route of an LLC or a C-corp. If it’s several as in three or four I would go with an LLC. So for an LLC, you can have voting members, you can have non-voting members and paperwork is kind of straight forward. We’ll get to that in a minute. But it’s really more of a cut and dried structure. If you have, however, I don’t know a hundred and fifty or two hundred members of the business, that’s a different story. Then you want to look at getting a C-corp. You can have an unlimited number of members, you can have an unlimited number of shares, and those shares can be different levels of voting, non-voting, etc., etc., However, you what to set up your business.
[Time – 1:45]
There is an advantage to doing a C-corp. with so many members as opposed to an LLC however. And that advantage is that let’s say you have a hundred and fifty people in the business. If you structure it as an LLC and one person wants out, and that one person wants to go to Alaska and you know live in the snow for the rest of their life and they want out of the business, in that case for the LLC you would have to get the other one hundred and forty-nine members all to agree to buy this person out at the same percentage rate. So they have to split this person’s membership among the one forty-nine. They’d have to agree to do that and they would have to buy the person out or all one hundred and forty-nine people would have to agree that I don’t know, Tracy is going to buy this person out or Tracy and Pamela are going to buy this person out. But still, you would have to get a hundred and forty-nine people to agree on the approach that is going to be taken and see that through. That’s just a logistical nightmare. I guess in theory it’s possible, but it’s simply not practical.
Tracy: Umm…I really don’t think that is possible.
Pamela: Yeah it might not be.
Tracy: Not from my life experience anyway.
Alright, well now what about do you even have to LLC or INC if you want to have multiple owners? What about an S-corp.?
[Time – 3:02]
Pamela: So an S-corp. it’s a little bit different circumstance than a C-corp. It’s similar in a lot of ways but as far as the members go, you can only have 100 shareholders and they all are voting members. There is just one class of stock and you can only have 100 shareholders. Now you can an unlimited number of shares, that is true but as far as the number of shareholders go, limited to 100 and they are all the same class.
Tracy: Ah, so they all have a say in the operations that way.
Pamela: Yes, they are all voting shares.
Tracy: Okay, alright well now you mentioned paperwork. So what’s the difference in the paperwork involved in an LLC versus an INC.?
Pamela: Well, Okay there is a pretty big difference and this is where we get into one of the other big questions you have to ask yourself is “How much paperwork do I really want to do for this on an ongoing basis, not just upfront?”
[Time – 3:58}
So for an LLC, when you file the business legally, you have to file what is called Articles of Organization with your Secretary of State. And you have to pay a filing fee. And then every year or so, you have to renew that Articles of Organization document, just in case anything has changed. You also have to pay an annual fee to keep it updated. That’s about it from a legal perspective however you really, really, really, and I can’t stress enough, need an operating agreement as well. This is not something that’s required to file to create the business but if you and the other members of the LLC ever get into a disagreement over anything and God forbid you end up in court or mediation or whatever, you need something to refer to, to settle the disagreement, the dispute, especially if there is some liability involved. So you really need an operating agreement that governs how the members interact with each other and rules and the responsibilities and all of that stuff.
Tracy: So sounds like a good bit of work in the setup, but ongoing?
[Time – 5:00]
Pamela: Yes, but then you are done. Yeah after that you are pretty much done except paying your annual fees which you’re never going to get away from. And you know unless there is some major shift in the structure of the business, you’re not going to be looking at any more paperwork than that on an ongoing basis.
Pamela: Now it’s a little bit different with a C-corp. You, in order to file the business, in order to create the business you have to file what are called Articles of Incorporation with your Secretary of State. You also have to pay the filing fee for that. You have to get your tax ID number, which you also have to do with the LLC. I think I forgot to mention that with the LLC. You always have to get your tax ID number for the business.
But with a corporation there comes added paperwork that you have to do now and on an ongoing basis. So some of that, for example, are bylaws, you have to have bylaws that governs how the business operates, that governs how many share there are and what class of share there are, how many, who gets them. It will govern whether these are voting shares, you know, non-voting.
[Time – 6:00]
In addition the bylaws how many officers there are; what their level of responsibility is. How often you have a meeting of the board of directors, which can be the same people as the officers or it might be different or there might be overlap between those two sets of people. It also governs stockholder meetings. How often you are going to have those. What you are going to cover. So you can see the bylaws really get you into the nitty-gritty details of the business much more so than an LLC or other types in incorporations.
And if that weren’t enough, annually going forward you will have to refile every year to keep your Articles of Incorporation current with the Secretary of State and that includes any annual fees. So you have to update that paperwork and you absolutely must have an annual shareholders meeting at which minutes are recorded and kept for the life of the company.
[Time – 6:50]
So without these things, you could be in legal trouble if there were ever a dispute in your company. You really need to be able to prove that you are running your company as a C-corporation. If you don’t do those things and you get into some legal dispute, some judge could easily look into your corporate records, they call it piercing the corporate veil, and if they determine that you are not running your corporations as a C-corporation, you could be liable in other ways you really don’t want to find out. So there is all this paperwork and management that you have to do ongoing for a C-corporation.
And it can be worth the effort if that is the type of business that you determine you need to run. I’m not saying to not do a C-corporation for those reasons; you just have to be very aware of what yourself into.
Tracy: Alright Pamela, so the second thing to take into consideration is risk or liability. You know a lot of people think that if they do an LLC or INC they have eliminated their risk.
So what is risk? What is liability? Let’s say you have to deal with client’s confidential information and therefore you are duty bound to keep it secure. And you don’t – liability. You have a place of business and someone comes there and they trip and fall and get hurt – liability. Someone, you have a business where you go out to someone’s home or office and work, so you’ve got a cleaning business or you’re in the construction business or some sort of service business where you go out and perform a service, and while you’re in someone’s home you damage something, and you know – liability. You’re responsible. What if you produce a product? Can the product harm someone?
Pamela: That’s right yeah.
Tracy: Even in ways you haven’t thought of. People can come up with unusual uses for products.
Pamela: It’s true.
Tracy: You know, there is constant liability when you are in business. So which is better, LLC or INC?
[Time – 8:45]
Pamela: So that in part depends on how likely you think you are to be getting into one of these situations. However, let’s just go over what they protect you from. So in both an LLC and INC or C-corp., you are protected from having your personal assets seized should your business be sued for negligence, malpractice, whatever it is. Your product harmed or killed somebody. Your business could be sued for those things, but that business structure protects your personal assets from seizure in a lawsuit.
So that is one thing to be aware of. In both business structures, you do get that limited liability, limited personal liability. However, say Tracy works for me in my cleaning business and she goes to a client’s house and she …. What do you do that’s like really bad?
Tracy: Well you know me; I can do all kinds of bad things. But let’s say I break something that’s very valuable.
[Time – 9:45]
Pamela: Yeah, she breaks a 500,000 dollar ancient vase from ancient Rome or something. It’s probably going to be more like a five million dollar vase from ancient Rome but Tracy breaks it while she is cleaning the house. Now my client can sue not only my business for that, and while I personally will be protected from asset seizure in that lawsuit, Tracy can also be sued for that as well because she was the one that was performing the work.
Tracy: But since I am an employee I probably don’t have as many assets as the company so they’re going to sue both.
Pamela: That’s true but they are going to sue both and you could still be harmed by that. Now if it was me going to do that work, even though I am the business owner, I could still be personally liable because I was the one doing the work. So while you have liability protection in either an LLC or a C-corp., it’s not a panacea, it’s not a guarantee that you actually won’t be liable for something; A) If you are the one performing the work or if it is due to some gross negligence you could still be liable. Or as we mention when we talked about paperwork, if the person who is suing you suspects that you are not running your business like it’s supposed to be run, like I mentioned earlier, then you could be liable there.
[Time – 11:02]
Tracy: So that is where the lawyer starts proving that you really aren’t running a corporation, you just running a sole proprietor and you have filed.
Pamela: Yeah, you’re treating your C-corp. like it’s your personal bank account. You’re taking money out of the C-corp. and paying your car loan or something like that. Rather than taking dividends or taking a paycheck from the corporation, you’re just disbursing money from a corporate check and using it directly to pay for things. If you’re doing stuff like that you won’t be protected.
Tracy: Yeah, a good lawyer will say…
Pamela: Yeah, they’ll find that out.
Tracy: A good lawyer will say it doesn’t matter you filed the paperwork, that’s not how you are operating.
Pamela: That’s right.
Tracy: So in other words, if you are going to go to the trouble of LLCing or INCing, do your paperwork, keep your money separate…
Pamela: That’s right.
Tracy: Or you basically negated everything you just did to protect yourself.
Pamela: Yeah, yeah why bother then? Just go out as a freelancer and take your chances.
[Time – 11:56]
Now I will say there is a way you can protect yourself and that is to get some insurance. And we’re going to cover that in a future episode. So we are not going to go into insurance here. But insurance can step in where an LLC or C-corp. leaves off. Where your personal protection is concerned. Again it’s not going to cover you 100% of the time in 100% of the circumstances, but it will help and we’ll cover that in another episode.
Tracy: Well and it also kind of helps protect the assets of the corporation, to a degree.
Pamela: Yes, definitely.
Tracy: Alright now the third thing you have to take into consideration when deciding between an LLC and an INC are taxes.
So, how much money is your business likely to make in profits? How quickly is your business likely to grow? Do you want to leave the majority of the money you make in your business in order to grow your business faster? Or do you want to take it out for personal use?
All of these things have to be taken into consideration. And you have to decide which taxable entity, which tax structure would be to your benefit and that helps you make the decision about the LLC or INC.
[Time – 13:03]
Pamela: That’s right.
Tracy: So Pam, what are the differences?
Pamela: So in an LLC 100% of the profits from your business are recorded as personal income on your personal income taxes. It’s what’s called pass-through. The profits from your business pass through to your personal tax returns. It’s actually pretty straight forward and easy and can be advantageous depending on what tax bracket you are in both as a person and a company. It can be advantageous to do it that way and it makes the paperwork easier.
In addition to the pass-through, you are also going to be paying Social Security and Medicare taxes which are called self-employment taxes.
Now I use to work in consulting and as an employee of a consulting company they paid part of my Social Security and Medicare. They paid half and then I paid the other half as an employee. Now that I am a business owner, I have to pay100% of that.
[Time – 13:56]
Pamela: Yeah, so again it depends on your level of income and profits how much you are paying. And we can include some links to tax tables that will help you figure that out. But it is not going to be as straight forward as being an employee cause now you have to worry about paying all of those self-employment taxes.
What about an S-corp?
Tracy: Well you know S-corps are one of my favorite things. I love S-corps but then you know….
Pamela: I love shoes.
Tracy: Well, S-corp. is kind of like the best of both worlds. So, I get the benefits of an LLC and I get the benefits of a corporation. Because with an LLC (this was misspoken, it was supposed to be corporation) I can put myself on salary. Now, there is a caveat there. It has to be a reasonable salary, meaning it has to be what I could make out in the workforce do the same job I do for my company or what I would have to pay someone else to do that job. But let’s say the revenues of my company are large enough, high enough, that a reasonable salary is significantly less than the revenue; well I shouldn’t say revenues, I should say profits, the profits of the company.
[Time – 15:12]
So let’s just throw some numbers out there. Okay, let’s say that this year my company is going to make 250,000 dollars in profits. And let’s say I can reasonably hire someone to do all the work I do for 100,000 dollars.
That means I can pay myself a salary of 100,000 dollars of which I pay regular tax rates, my personal tax rates and I pay self-employment taxes, 15.3%. But that other 150,000 dollars I get to claim just like an investor would. Like I had invested in my company and it is somewhat passive. So it becomes dividend income which is taxable at capital gains rates. No self-employment taxes, no 15.3%. It's just taxed at 15 to 20 percent capital gains rates depending on your situation.
[Time – 16:10]
So thinks about how much taxes I just saved. I don’t even know what the personal tax rate would be on 100,000. That’s pretty bad on my part, but anyway…
Pamela: I think that’s up to 28 percent.
Tracy: It’s like 28 percent?
Pamela: Something like that.
Tracy: So even if I had to pay at 20 percent capital gains, I just saved myself eight percent.
Pamela: Assuming I am correct.
Tracy: Assuming you are correct. We’re just throwing some numbers out there. Yeah, plus I just saved the fifteen and a half percent of self-employment taxes, Social Security and Medicare.
Pamela: Right, right.
Tracy: So if you are going to have a fairly high income. More than is necessary for the payment of the job you do in your company. Then, in that case, a lot of times you are better off with an S-corp. but like you said, S-corps have a lot of limitations in that one class of stock, only 100 shareholders, that sort of thing. So you have to balance those things out.
[Time – 17:05]
And like mentioned earlier, if you want to retain most of your profits into your company for fast growth and all that kind of stuff and you don’t really need to take all that money home, you’re more interested in growth, then you have to really weigh the corporate tax rates for a C-corp. against personal tax rates and plus the self-employment and see where you are going to come out better. Because, a lot of times, if that money is staying in the business anyway, pay the lower corporate tax rates rather than paying your personal tax rate plus self-employment, cause those two together are usually higher than corporate tax rates.
Pamela: So you have to decide A) if you are going to leave most of your money in the business or take it out and how much of each. And then depending on your income and or profits, what tax rate you are at, both from a personal perspective and the corporate tax rate perspective and compare those two amounts against each other and figure out what combination of salary versus dividends versus hiring somebody is best for you.
[Time – 18:15]
Tracy: Okay, and there is one other thing to take into consideration when it comes to an S-corp. It is called an S-corp. but it’s technically a corporation that has a special tax classification.
Tracy: So basically, when you file your Articles of Incorporation with the Secretary of States, you are just incorporating. You then have to file a form with the IRS to elect to be taxed as an S-corp. And interestingly, now LLCs can also do that.
Pamela: Yeah, that’s a new development.
Tracy: Yeah, so basically, you can have all liability benefits of an LLC, the reduced paperwork of an LLC, and be taxed as an S-corp.
[Time – 19:00]
Pamela: That’s right, yeah, yeah.
Tracy: So yeah that’s my new favorite way of doing things.
Pamela: I still like shoes.
But, Tracy’s right there is this new combination you can look into. And it is really appropriate for a lot of small business owners, or even larger business owners depending upon how many people are in your business, what kind of paperwork you want to do, you should look at that combination as well.
Tracy: So I know we haven’t really answered the question LLC or INC, only thing we have done is told you it’s now really the question. You have to answer the other three first.
And Pamela has written a book on the subject.
Pamela: I have.
Tracy: Pamela, tell us about your book.
Pamela: I wrote this book when I was looking at different legal structures for a business I was looking at incorporating at the time. And all I really knew was that a bunch of my friends had done LLCs and they seemed to be okay with that and that’s all I knew.
[Time – 19:58]
But I didn’t know if it was appropriate for me, so I started digging into. And I learned so much that I thought that I can’t possibly be the only person who wants to go into business for themselves who like “I don’t know what my options are, and what do these all mean for me.” And so I started taking notes and eventually wrote a book about this. It’s called “Get Incorporated?” and it is on Amazon and I’ve gotten some sales from it.
Tracy: And the great thing is, Pamela put all these nice worksheets with that book.
Pamela: Oh yeah, yeah I have, yes, a couple of worksheets in the book. One is a simple series of question that you are going to ask yourself. You can take these to your accountant, to your business planner. You can just do them on your own to give yourself a great sense of which corporate structure is best for you. And questions you are going to ask yourself about risk, about how much paperwork you want to do, all these things that we’ve been talking about. There is a list of questions you need to ask yourself so you don’t have to forget anything.
[Time – 20:58]
And the other worksheet is actually a breakdown; it’s like a cheat sheet of everything that is in the book. Everything we have discussed here, plus a lot more information that is covered in the book, I put it all in this really simple cheat sheet kind of spreadsheet that you can see like - LLC – here are the pros, the cons, what’s my paperwork, what’s my liability. It’s all right there in a really nice concise cheat sheet form and you can print these out. They’re very helpful and I think that it’s a great value-add for the book as well.
Tracy: Yeah. And if for some reason you don’t want the Kindle version, we will also have it on the website, under this episode, which will be titled “LLC or INC, Is That Really the Question?”, and you’ll be able to get a PDF version that also contains all the worksheets with it. So whichever way you prefer.
And of course, we value your questions and comments about this or anything we have covered. So be sure to put those questions down below or head on over to the website and chat us up there’s plenty of places there that you can get in touch with us.
Well, hope you enjoyed the episode …
Pamela: Yeah, please like this video and don’t forget to subscribe and we will see you on the next one.