The IRS requires S-Corp owners to be paid
When you started your business, chances are there weren’t quite as many options for how to organize it as there are now. So whether you’re looking at starting an offshoot business or want to reevaluate your current business organization, you’ll need to know about the various types.
Each business structure, from simple sole proprietorships to C-corps, S-corps and LLCs, offers the owner a unique structure for building a company. It is important to weigh the needs of your company against the various advantages and disadvantages of different business types. How many owners are involved in your particular venture? Which options have tax structures advantageous to your amount of revenue? How can you best protect yourself from liability should the unfortunate occur? What is your long-term vision?
Sole proprietorships partnerships
Lewis Affetto, CPA and managing partner at Bernard Affetto and Company, a Chicago-based accounting firm, advises small businesses setting up shop. For the smallest start-up businesses, a sole proprietorship is the easiest and least expensive business to set up, Affetto explains. “Basically, you only need a Social Security number to start up.”
In a sole proprietorship, the owner is basically self-employed, and the structure doesn’t afford many benefits. If you are doing mainly consulting and a little bit of sales, it may work out. However, the structure offers virtually no tax benefits, and more importantly, no liability protection. General partnerships are similar, except of course with more than one owner.
Unsurprisingly, neither option is seen too often. President and CEO of Castle Wealth Advisors Gary Pittsford, CFP, says you might find one of these in “a small hardware shop, in a small town of maybe 1,000 people in Montana.” Pittsford has worked with small, family-owned businesses for 35 years, and with a number of HDA Truck Pride companies in the past several years.
C-corp vs. s-corp
C-corps and S-corps are a step up from sole proprietorships and partnerships in that they both offer liability protection. This is extremely important. If you sell someone a faulty brake that causes an accident, or a customer is injured on your property, they can sue your corporation. However, your personal assets, such as home and retirement, are protected.
C-corps and S-corps are pretty much the same with respect to liability. It is in tax structure where they begin to diverge.
“Normally, a smaller level of income flows through an S-corp better,” Affetto says. “In a C-corp, [the owner] can’t get money out without a bonus, excessive employment tax or dividends.”
In an S-corp, profits flow directly to the owner and onto his personal income tax statement – in other words, it only gets taxed once. In a C-corp, the company’s income is taxed first. Then the money you take out of the company to pay yourself also gets taxed. In a smaller operation, avoiding the double taxation means more money for you at the end of the day. For this reason, the S-corp structure is most often recommended to small business owners in the aftermarket world.
“Of 200 people in a convention, four or five people [usually] have C-corps,” says Pittsford, who has asked owners to show hands at past business conventions.
He says many of those companies were started prior to 1958, when the S-corp came into being under President Eisenhower. Many companies that began as C-corps in that era choose to remain incorporated that way. (We’ll talk about the possibility of switching later).
C-corps do have some advantages, especially for larger, publicly held companies. If an S-corp has many shareholders, company tax information must flow through to each individual person, which can become a burden. In a C-corp, the company deals with its own corporate taxes first, and passes the personal income tax responsibility onto shareholders, a simpler arrangement.
Limited liability company
Another option for business owners is the limited liability company, or LLC, which was not widely available until the ’90s. However, the option isn’t often the best option for a company’s main business. Like the C-corp and S-corp, the LLC offers liability protection in the event of lawsuit. There are, however, differences in tax structure that make the option unfavorable for many businesses.
“All of the [LLC’s] income is taxable as self-employment income,” Pittsford says. “Therefore if the company is going to be very profitable and has a taxable income each year of more than $300,000 to $400,000, they may want to set up an S-corporation.”
The income of an LLC owner is very similar to the income of a sole proprietorship – all net profits are fully taxable under the Federal Income Contributions Act tax, or what employers and employees pay to Social Security and Medicare. In an S-corp, income can be divided between corporate earnings and wages. Wages are taxable under FICA; corporate earnings are not. So if an S-corp earns $100,000 and you pay yourself $50,000, you only pay FICA taxes on $50,000. In an LLC, FICA tax would be owed on the full amount.
However, as Affetto explains, the division between wages and earnings in an S-corp can be tricky.
“The IRS requires you to pay ‘reasonable compensation,'” he says. Yet the definition of “reasonable compensation” is not codified in law. “We have had auditors say it should be at least 50% [wages], but there is no law.”
The IRS will come after companies trying to cheat the system. According to Affetto, if the S-corp is earning that same $100,000 per year, but the owner consistently pays himself just $10,000, the feds will almost certainly come knocking.
However, there is a very real liability advantage to the LLC, in addition to standard liability protection, when used in combination with a different type of corporation.
Where an LLC makes sense
Pittsford says if the company has a brick-and-motor store, the physical building should not be part of the same corporation as the business itself – it should be its own LLC. In practice, an owner effectively pays rent to himself to use the building. While that may be slightly complex, it protects the building asset in the event of a lawsuit.
Say your company sells brake shoes, and unbeknownst to you hawked a faulty batch that causes several truck accidents. If you are sued for selling faulty product, the main business is liable for damages. However, because the actual shop is a separate entity, it remains protected. It is a relatively simple move that can save a bundle in a worst-case scenario.
Mike Betts, owner and president of Betts Spring in the San Francisco area, uses LLCs in a similar way. Betts Spring is a sixth-generation company and a C-corp.
“The corporation is the mother ship,” Betts says, explaining that all his various subsidiaries are incorporated as LLCs. This way, the main company is not liable in lawsuits that may arise from the actions of other people in the company. As the corporation grows, it is a great way to limit risk.
Ownership
Another difference between the various types of incorporation is the way ownership functions, which can have major implications depending on who is involved in your business.
A C-corp can have many different types of stock, voting and non-voting for example. This is highly advantageous if your company is large enough to consider going public, where people with greatly differing interests may have an ownership stake, however small. S-corps are more limited in the types of stock they may have, and therefore it would be impossible to control voting, according to Affetto.
The ownership issue is a bit more pertinent between S-corps and LLCs. For starters, ownership of S-corps is limited to U.S. citizens. If your aftermarket business will be partially owned by someone from Canada, for example, setting up an S-corp is not an option.
More important, however, is that in an S-corp, business finances are closely linked to the amount of stock held by each individual owner.
“In the corporate arena, normally the shares owned dictates how much you can put in and get out,” Affetto says. “If it’s an LLC, you can override that.”
This is attractive for businesses with one partner who wants only to invest and not be involved in actually running the company, Affetto explains. In this sense, an LLC works something like a partnership, and you can shape it any way you need it to be.
Switching it up
It is possible to transition a company from one type of business structure to another. The level of difficulty depends on the company, but Affetto says it generally isn’t too painful. There are rules, however, particularly when switching from a C-corp to an S-corp. The issue is with a C-corp’s double taxation explained earlier.
Because earnings from a C-corp are taxed twice, any profit made from selling the company will be taxed twice – once on the corporate level, and then again on the owner’s income tax. S-corps do not suffer from this, and as a result it was once possible to flip a C-corp into an S-corp before selling the company to dodge taxes. The IRS caught onto this practice and changed the rules so that if you switch from C-corp to S-corp, it is illegal to sell the firm for 10 years.
Corporate structure and succession planning
“Succession is a big deal right now,” says Gary Pittsford, president and CEO of Castle Wealth Advisors. Around 35% of companies are owned by those in the baby-boomer age bracket approaching retirement.
Passing the torch is usually a good time to make the switch from a C-corp to an S-corp, Pittsford says. Presumably, children in the family will want to run the company for at least the decade required by the IRS before the company can be sold.
The actual decision-making process varies a bit with the type of company, but the most important part is deciding for yourself who gets what. This can be a complex process if there are many children, or if some children are married with a spouse who also works in the business. Pittsford says many families prefer to keep the business in the bloodline. For example if a son-in-law works in the business, he may only get 49% stake, while the owner’s daughter would get 51%.
Pittsford also says a good way to plan for succession is to consider setting up a trust, an entirely separate entity similar to a will. This works well, he says, if you have many children, some of whom want to run the business and others who prefer not to be involved. The trust could set up an agreement where children opting out of the business instead receive an inheritance, for example.
The advantage of going this route is that a trust is non-probated, explains Lewis Affetto, CPA and managing partner of Bernard Affetto and Company, a Chicago-based accounting firm. This means that, unlike a will, there is a lot less room for squabbling. A trust spells out someone’s wishes and carries them out exactly.
Another option is transforming the company to an employee stock ownership plan, or ESOP.
An ESOP transfers part or all of company ownership to its employees, either gradually or all at once. Typically, the company makes tax-deductible contributions to a trust set up to manage the plan. The trust then uses that money to buy stock from the current owners. It costs money to set up, but has tax benefits, retirement benefits for the original owners and for the new employee-owners, and can provide a succession strategy.
Midwest Wheel Companies, Des Moines, Iowa, recently went through a transformation to an ESOP.
“Midwest Wheel is a 100-year-old company. As we’ve grown, it had become increasingly difficult to have all 185 employees relate to the company as the extended family we used to be when we were smaller,” explains President Mike Callison, whose great-grandfather, George Koons, was one of the company’s founders. “The ESOP program was the way my family chose to continue to include all employees in the family ethos.”
(You can read more about ESOPs here.)
From the October/November 2011 issue of HDAJ.
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