As the chart illustrates, the C corporation pays a tax at the corporate level and another tax, if profits are distributed, at the shareholder level. Accordingly, we have double taxation. Conversely, on the right taxes are just paid once, at the member level. The tax obligation ‘flows through’ the LLC, LP or S corporation to the member owners.
John and Liz take the advice of their accountant on the use of a flow-through entity. To be able to deduct $70,000 in losses and offset income from other sources is good tax planning for them.
Another issue arises in that John and Liz have decided that they will issue founder’s equity not only to themselves but to their respective spouses as well. Liz’s husband is a Canadian citizen and because he works most of the year in Vancouver, British Columbia, he is classified as a nonresident alien. This precludes them from using an S Corporation, since foreign nationals that are non-residents and not a part of the United States tax system cannot own stock in such an entity. (Foreign nationals can, however, own stock in a C Corporation, LP or LLC.)
Thus, with the desire to utilize a tax flow-through entity and the need to issue shares to a non-United States citizen, John and Liz are required to form a Limited Liability Company.
Both the accountant and lawyer advise John and Liz that an LLC is their best choice anyway, irrespective of the Canadian citizenship issue. Their professional advisors indicate that an LLC offers the beneficial features of limited liability, management control and flexible operations. Some advisors prefer to use an S corporation for business operations, on the grounds that all profits flowing through an LLC may be subject to payroll taxes. Other advisors prefer to pay the owners of the business a salary (on which payroll taxes apply) and then flow profits (without payroll taxes) through an S corporation. Other practitioners, who like certain LLC benefits, will have the membership interests owned by an S corporation, thus negating the payroll tax issue an individual owner would have. As is evident, there are a number of choices here.
Still, with the Canadian citizenship issue, John and Liz are pleased with their advice and decide to form J & L Consulting, LLC. We will come back to John and Liz’s consulting business to see how they benefit from operating as an LLC.
Case Number 2 – Mary and Gary
Mary and Gary have been married for over ten years, have three children, a dog and a mortgage. They have done well in their business careers and investments and have accumulated assets. Gary is involved in a business in which he deals with the public, which therefore means he can be sued by almost anyone for any reason. The two of them want to protect their assets. They know that if they try to shelter their assets once they have been sued, it will be considered a fraudulent conveyance and could be set aside by a court order. (We shall have a more comprehensive discussion of this concept in Chapter Seventeen.) They know that the time to protect their assets is when they are not being sued, and so they decide to move ahead with an asset protection plan. The sooner the better is their feeling.
After speaking with their accountant and lawyer they decide to form a Limited Partnership (LP). A key benefit of the LP is that it allows one party – the general partner – to maintain almost absolute control. By definition the other limited partners are limited in their management and control. They cannot tell the general partner how to run the business or to make distributions of monies received. It is an excellent vehicle for holding family assets whereby the children do, or eventually will, hold a majority interest but the parents still want to control the assets.
In Mary and Gary’s case, they want to start gifting interests to their children in order to reduce their estate tax obligations. But they also want to control the assets in order to avoid them being squandered while their children aren’t yet old enough to know money does not grow on trees.
There is one issue involving a Limited Partnership which they have to deal with: The general partner is personally liable for the debts of the LP. If you list your personal name as the general partner you are liable for everything that happens in the LP. This is easily overcome by creating a Corporation or LLC to serve as the corporate general partner, thus encapsulating the risk in a limited liability entity.
But to do it right we need to form two entities, the LP and a Corporation or LLC to be the general partner. With an LLC we only need to form one entity, the LLC itself. Advantage LLC.
Still, there are other advantages to the Limited Partnership that Mary and Gary like, including restrictions on transfers and limited liability. Mary and Gary decide to form M & G Holdings, LP to hold and protect their assets. As with John and Liz, we will come back to Mary and Gary’s holding entity to see how they benefit from holding assets in a Limited Partnership.
Comparison of Entities
Sole Proprietorship
The easiest means of getting into business is to become a Sole Proprietor. You obtain a business license and a sales tax permit, comply with regulations that any other business has to follow and you are in business.
However, easier is not always better. The major drawback of a Sole Proprietorship is that its sole owner is completely liable for all business debts and claims. If someone falls at your business location and your insurance does not cover it, your personal assets are at risk for the satisfaction of judgment. If you have a rough month and cannot pay the bills or the credit line to the bank, your personal bank account, and the equity in your house, your car and other personal assets can be attached for the repayment of judgments and debts.
In lectures given to aspiring entrepreneurs, I am always asked the question: “If I’m just starting out, why not be a Sole Proprietorship?” The answer is that you are never just starting out. You have accumulated assets throughout your life, and by using a Sole Proprietorship you are putting them at risk. As well, you are putting your future at risk if you are sued as a sole proprietor. The cost to form and maintain an LLC or Corporation is minimal compared to the risks involved in operating any form of business.
There are two statistics that support this position:
1. There are over 1,310,000 lawyers in America today.
2. One-third of all Americans will be sued at least once during their lifetime.
If you have ever been sued, you well know that it can be an extremely stressful and costly proposition. As an attorney I find many of my colleagues are honorable, but the sad truth is that the elements of justice, civility and fair play are often lost when certain lawyers are involved. In addition, as many of you know, there are economic incentives in the system for lawyers to bring frivolous lawsuits. Until the courts start punishing improper lawyering, the only way to protect yourself is to remove all the assets you can from risk. Using a Sole Proprietorship or a General Partnership is not the way to do this.
If you have never been sued, please attempt to keep it that way. And as protection against it ever happening, take the legal and reasonable steps to put all of your personal assets out of the reach of potential business creditors and predators.
The extra step needed to protect your personal assets from business risk is to setup an LLC, LP, or Corporation. Our firm provides this service for a very reasonable fee. There is even a discount for the readers of this book in the back pages. By taking this step, and by following the minimal record keeping requirements associated with each entity, you can easily avoid the problems you may encounter with a Sole Proprietorship.
Another downside is that Sole Proprietorships are audited by the IRS at a much higher rate than more protective entities. The latest IRS statistics reveal that Sole Proprietorships are audited five times more often than LLCs and S corporations. The IRS has found it very easy to collect extra monies from entrepreneurs operating as sole proprietors. Why put yourself at such a risk?
Another feature of the Sole Proprietorship