Donald Paris, CPA

The smartest clients call me before establishing a new business. Though the question "What is the best way for me to organize my business?" is really simple, the answer is often complicated and contingent on other factors. Some of the issues that need to be explored include a) who should be taxed, b) is the entity going to be capitalized with permanent funds, loans, or loan guarantees, c) will the owners receive distributions, and d) who are the owners, just to name a few.

Let’s first talk about Bob, who wanted to start a chain of dry cleaning stores. He heard that the S Corporation was the way to go. So, off he went to the IRS website and with a simple form registered his company as an S Corporation. Then he called me. While we talked, I found out that, in addition to the cash contributions his investors would make, his contribution would only be to personally guarantee the bank equipment loans that the company needed (he wasn’t planning on contributing any cash). When I told him that he would not be able to take advantage of any losses, he was pretty unhappy. I told him that, if he wanted to take advantage of the losses, the entity should be a partnership, and that the easiest way to get there is to form the entity as a Limited Liability Company (LLC). So, Bob then changed all the documentation to incorporate as an LLC. Thank goodness we talked before the company did any substantive business.

My next case deals with Sue, who was forming a company to make a documentary film. The problem here was that, she anticipated having more than a dozen investors who were each promised different shares of income and losses and distributions. Again, the most flexible vehicle is an LLC taxed as a partnership, where Sue can allocate investors the benefits each were looking for in exchange for their capital.

Another client is Steve, who has a successful consulting business, which was already set up as an LLC. He was concerned that his really high income would be taxed at the maximum personal income tax rate, plus the self-employment tax, which pushed the effective rate to nearly 50%. To address this issue, a possible alternative is to convert the LLC to an S Corporation, and establish a reasonable salary for Steve. The remaining profit could then be distributed without incurring the self-employment tax because S shareholders are taxed personally on their distributive share of the income of the entity. However, the portion that they do not take as salary will not incur the self-employment tax.

Bill also wanted to discuss his new company which supplies construction materials to contractors. The company was set up as a standard C Corporation by his father many years ago (before the LLC rules were even available). He had heard so much about the S Corporation concept, he wanted to talk more about it with me. He has other shareholders in the company, most of which are high income individuals. When we compared the tax rates of the shareholders to the same tax rate that the corporation pays, we found that the corporation pays tax at rates lower than the shareholders. So, I suggested that he not make any changes, and to leave the corporation status the same.

June also wanted to talk about her new company that would loan money to individuals who would not otherwise qualify for traditional bank financing (she was a hard money lender). She had the investors ready to go. I found out that one of the investors was really a partnership of individuals who pooled their investment together. I told her that, though she was interested in forming the entity as an S Corporation, she couldn’t because the partnership investor does not qualify as an acceptable owner of S Corporation stock. She could set the company up as either a corporation or as partnership, just not as an S Corporation.

There are a myriad of complex tax and legal issues that need to be explored in order to properly determine the best choice of entity (we only explored a few issues in this article). To properly set up your business, we strongly recommend meeting with your advisors, lawyers, and CPA’s to discuss your unique business needs. Not doing so exposes you to not getting the most out of this long-term decision.