039 | Business Entities Uncovered: Benefits, Liabilities, and IRS Requirements

Speaker A [0:06 – 24:52]: Welcome back to the Vital Strategies podcast. I’m your host, Patrick Lonergan, and in today’s episode, we’re going to be talking all about entity setup. We will discuss how you can protect your assets, strategies to pay less tax, and how your entity setup will grow as your business grows. Stay to the end when we talk through how to combine the different entity types to create maximum asset protection along with tax efficiency, let’s dive into the overview of legal structures. On today’s episode, we’re gonna talk about entity selection. There’s so many different entity options out there that it often creates confusion with our clients. And it doesn’t matter if you’re just getting started with your business or you’ve had a going concern for a number of years and you’re still trying to figure out some of these pieces. So let’s dig into the options that are available to us. First, let’s start off with the most basic it’s a sole proprietorship. It’s just you by yourself. Now, you can register an ein for a sole proprietorship with the IR’s, but you have no asset protection. It’s just you. And it’s the best way to get started or the easiest way to get started. I don’t want to say the best way, but the easiest way to get started next is a partnership. You and a friend come together, you can create a partnership. And there’s a number of different ways to do that. There’s general partnerships, limited partnerships, but in general, if two people are coming together unrelated, a partnership is going to be the structure that we’re going to look at there. Next, we’re going to move on to an LLC, a limited liability company. Llcs are probably my favorite on this list. They are so flexible, they can do just about everything you would need. And we can set these up a number of different ways. We’ll get into that in detail. But LLC, probably my favorite entity structure because it’s so flexible in how it can be designed. Next, we have corporation. We open up a corporation, it defaults to what’s called a C corporation. A C corporation has certain rules. We can also make an S corporation election. But a corporation has a lot of structure. There’s dividends paid out of a corporation. We need to have things like annual meetings, board of directors, that type of thing. Corporations are good, but sort of going out of style. And limited liability companies, llcs, are being used instead. And then finally, one that we’ll just mention but not used very often in the world that we work in, is a cooperative a co op. I think the most common example of this would be the, the recreational equipment company, REI. Recreational Equipment, Inc. Is what REI stands for, is a cooperative. And so it’s owned by the members. The members have decision making authority. But this is the last we’re going to talk about cooperative in our discussion today. So let’s dig into the specifics of each one of these. Starting off with the sole proprietorship. Again, it’s a decent place to start. If you get hung up in your entity setup and it takes you an extra month to get going, start as a sole proprietor, get something off the ground, start generating some revenue. You can always move that into an LLC later. The LLC should be quickly on the list of things you should do, but you can start off as a sole proprietor. Not necessarily a problem. It doesn’t offer any asset protection. So if you’re operating your business and somebody comes to sue you, all of your personal assets that aren’t creditor protected by the government are exposed to liability. So not my favorite from an asset protection perspective, by a long stretch, sole proprietor, okay to get started, but a terrible place to run your business cause it exposes you to a number of liabilities. So now let’s move on to partnership. Again, two people come together, you can form a partnership. Generally, an attorney’s gonna help you draft those documents. The nice thing about this is it’s a pass through entity. There’s no taxation. All of the dollars flow through to each of you individually. Now, there can be some benefits to this. One of the problems with a partnership is everything comes through self employment, income. We don’t get the benefit of taking a wage and then taking a dividend off of that. That’s not exposed to that self employment tax. And we’re going to get into that in just a second. But partnerships can be great for a couple of businesses coming together. Partnerships can also be set up to own interest in other entities. So not necessarily a bad way to go. Moving on to partnerships. Looking at partnerships, there’s a number of different partnership opportunities available to us. The first is a general partnership. This is when just two partners come together. They’re formed automatically. You don’t even need formal documentation to set up a partnership. Now, it is highly recommended you have a partnership agreement to figure out all of the details, all of the D’s, death, disability, divorce, disagreement. They go on and on. It’s good to have that in place on the front end. So if things go sideways on the back end, you know how you’re gonna unwind the partnership. But each partner has unlimited personal liability for the debts and obligations of the partnership. And as far as the income and taxes go, it all flows through to the partner’s personal tax returns. Looking at a limited partnership now, there’s two different structures here. First is the general partner that manages the business and he has unlimited, or she has unlimited liability. That’s one person that can be the general partner, and then the limited partner generally provide the capital and don’t manage the day to day operations, and they have limited liability. They don’t take on any personal liability. It all falls on the general partner. Now, similar to the general partnership, the taxation flows through to the partners according to their share in the business. And the formation of the limited partnership is much more organized, requires formal registration with the state, and there’s just specific regulations and requirements that are put together with a limited partnership. So two main structures when it comes to partnerships, general partner and limited partner. And we’ll get into these in a little more detail when we start looking at how to combine structures to create efficiencies. Now we’re going to talk about my favorite entity structure, and that’s the LLC. There are so many ways to structure an LLC that it really is the most flexible tool. Whether we’re looking at asset protection, tax strategy, or even estate planning, it has so many options available to us. So let’s start off with how the management of an LLC can be set up. We can start off with a single member LLC. It’s owned by one person, and the benefit of doing that is now it segregates the liability of an asset and protects all of my personal assets. So I own a rental property and I’m concerned about somebody tripping and falling, or a maintenance person going over there and hooking up the stove incorrectly and there’s a gas leak and there’s a problem. I don’t want my personal assets exposed to that liability. So I’m going to create a single member LLC. That LLC is going to own that piece of real estate, and it’s going to separate out that asset and protect the rest of my assets from liability. Now, this offers me no tax benefit, and that’s okay. The income and expenses all flow through to my personal tax return. And it’s almost like the entity doesn’t exist when it comes to a tax perspective, not filing a separate tax return, it’s all passing through. Next, we move on to a member managed LLC. This is very much when there’s multiple people involved that aren’t family members because a husband and wife in most states can still qualify as a single member LLC. A member managed LLC, generally designed for small businesses. In each of these cases, when I’m setting up an LLC, I think it makes a ton of sense to have an attorney help you set these up so they’re done well and done properly. We generally have multiple members, and they’re all participating in the daily management decision making process of the business. So that’s a member managed LLC. Next, we have a manager, managed LLC, and this is going to be more people are involved, and we have somebody that’s managing the entity, and then the other members are investors, and they’re not involved in the day to day operation. So the manager is managing the LLC, and the members are just invested and not involved in the day to day operations. So that’s how the management can be structured. Let’s talk a little bit about the classifications for tax, the tax classifications for each of these. Like I mentioned earlier, the single member LLC is a disregarded entity. It flows through to the personal tax return. Same thing with a partnership. If there’s multiple members in the LLC, by default, it’s just going to pass through to their individual tax returns. Now, we can decide to make what’s called an s election, or we can decide to make a an election to be taxed as a c corporation. An S election has its pros and cons. If we’re running a service business, for example, and we’re making $150,000 of income, there can be some tax benefit to making the s election, where I pay myself a salary of, let’s say, $50,000, and then the $100,000 is paid out as a distribution. Okay, now, there’s no hard and fast rule from the IR’s on what we have to pay ourselves as far as a reasonable wage goes. But they’re gonna look at other roles in the job market and go, okay, what are they getting paid? Now, if typically that position is making $150,000 for a wage, you’re gonna have a hard time arguing 50,000. But let’s say you can find other people doing your job, they’re making 50,000. Now, you can distribute 100,000, and that will save you over 15% in payroll tax. So that’s $15,000 in payroll tax. You didn’t have to pay to the IR’s by making the s selection. That’s a big number. If I can save myself $15,000 by sending in a form to the IR’s, having my CPA help me with that. That’s a way you should absolutely go. Now, we’ve had clients that have over $2 million flowing through to their personal tax return as a disregarded entity, and they didn’t make the s election. They weren’t paying that 15%. It caps out in 2024 at about 160,000, but they paid 3% over top of that. So 45, $50,000 in payroll tax that was being paid that shouldn’t have been paid in that scenario. So we just like to go get those low hanging fruit opportunities, make the s election in that example, and now we can have more favorable tax treatment. Now, there’s a few requirements. If we make an S election, we can’t have more than 100 shareholders, and they all have to be us citizens if we’re making the s election. So that’s why we would make the s election. We could elect to be taxed as a C corporation. Now, if you make this election, you must be careful. C corporations have the highest tax. If you want to get the dollars to you personally, because there’s two layers of tax. First, you paid at the corporate level. So every dollar that you make at the corporate level, you pay at 21%, and then you distribute it out as a dividend or a wage to yourself. But a wage has payroll tax and then income tax on top of it. Or we pay out the dividend and we haven’t found a way to make this an efficient way to get dollars out of the business. So be very, very careful if you have a C corporation. Generally, we like to have these either be low profit or no profit entities. And we are distributing dollars out to either a management company that’s set up as an LLC that’s either a pass through entity or an s corp. Or we have other reasons for making the C election. But be very, very careful if you make the C election, it’s not something you should do without guidance of both tax and legal professionals. Now, some of the reasons why you would want to elect to taxes a C corporation is there’s a benefit called a 1202, a QSBs, a qualified small business stock exemption that allows you to exempt $10 million of capital gains if you sell, sell your business. This is a tremendous benefit. If I don’t have to pay 20% tax when I go to sell my business on $10 million, that can save me $2 million in the capital gains tax. Again, a tremendous figure. But you should have a strategy designed as soon as you set the business up. There’s a lot of details that go into the QSBs that you should talk to a professional on before you make that election. But you can sell your business capital gains tax free. Do you need to be aware that the income tax issues that that will create are going to be another beast that need to be worked through? Another reason you would make the C election is you’re raising money. You can go raise money from thousands of people if you want, where that would be a burden to try to do as an S corporation. You couldn’t do it as an S corp because you can only have 100 shareholders and it wouldn’t make a lot of sense to do as a partnership or disregarded entity. So the C election, if you’re going to raise a lot of money and have a lot of investors, makes a lot of sense. And we see typically most publicly traded companies are c corporations. Those are a few things to think about. There’s a few things also to consider. These are all state regulated entities. You have to file with the state to get these set up, and then you make the tax election with the federal government there. So again, find good professionals to help you with these things. We help our clients with this all the time. We’ve got great legal counsel that we can get you plugged into, but please don’t make these decisions on your own. There’s a couple nuanced things that we can do with an LLC that make a lot of sense, and some of these depend on state to state regulations and how they’ve decided to handle these. But a series LLC can make a lot of sense. And here’s an example where that makes for a wise thing to do. An attorney, an asset protection attorney, will tell you, own every piece of real estate in its own LLC. And then when you sell that piece of real estate, don’t reuse that entity. Fire up a new one, because what we don’t want to have is skeletons in the closet from that entity come back and attack our new equity in a new property. So the way we can get around that, it can be a hassle to have a checkbook for every single LLC managing all those different accounts. The administrative burden is a pain in the neck. So what we can do is set up a series LLC, and we can have one checkbook. We’ll call it ABC Investments LLC. And then we could have ABC series one, ABC series two, ABC series three, and just keep going on and on. And the administration is much easier there. Now, it costs a lot more money to set up a series LLC, but you’re paying a little bit on the front end to not have to pay an attorney every time you want to get an entity set up on the back end. So it can make an administration a lot easier with your entity setup if you pick a series LLC, but those change from state to state. So talk to your local legal counsel to see which one makes the most sense for you. Now we’re going to move on to corporations. Corporations are very similar to llcs. There’s really two types of corporation. We either have a C corporation or an S corporation. We talked a little bit about the tax benefits of each of those in the previous example with the LLC, but. But we’re going to dig into the structure a little bit more. So a C corporation, the real benefits are it’s easier to raise capital. I can sell stock, I can attract investors that are looking for ownership, but not operational involvement. The only downside is there’s a lot more formal governance involved. Need a board of directors responsible for making major decisions. And then there’s mandatory annual meetings, detailed record keeping that are required. And then if it’s publicly traded, I’ve got public reporting that needs to be done as well. So a C corporation can be a great tool. If we’re raising a bunch of money and thinking about going public, it can be a great opportunity. It also going back to the IR’s code, section 1202, the qualified small business stock sale example. There’s capital gains tax free treatment to $10 million, which is tremendous opportunity. Both you and your spouse and even your children, you can expand that capital gains treatment out a long ways and avoid a lot of capital gains tax. So it can be a tremendous, tremendous tool. Another important benefit to the LLC is you can start dividing up the profits interest. So, for example, I was looking at a client’s tax return. They had a k one and the ownership was 50 50, but the profit interest was 99,000, $100,000, which is really interesting. Now, you can divide up the profit interest, you can divide up the tax benefits, you can divide up controlling interest, all in an LLC that doesn’t necessarily match the ownership interest. So there’s lots of different ways to slice and dice an LLC in a way to accomplish very unique outcomes depending on your situation. So another reason that an LLC can make a lot of sense is because of this flexibility on how it can be designed and how all of the benefits can be distributed in different ways by pulling different levers. Again, this needs to be done with legal counsel that knows how to set these things up and execute on them, but very, very flexible tool at the end of the day. Next is the S corporation. Again, very similar to a C corporation. There’s a fair amount of government governance. I’ve got a board of directors, I’ve got officers, I’ve got annual meetings, some regulatory requirements there, but we’re limited to 100 shareholders and must be us citizens or residents. Now, going back to the C Corp, if I’m going to pick a C Corp over an LLC, a few different reasons why I would do that. Again, raising money, growth and expansion. It’s an easier way to go public is to have a C corporation. I can also be an international business which llcs might not be universally recognized under different foreign markets where the C Corporation has been around a really long time. And so if I’m doing some international business, that might be something to consider. Corporations can also have perpetual existence. Even with ownership changes. They can be designed to last for long, long time, well after the founders are dead and gone. So again, C Corporation and S corporation, not my favorite cause of the administrative complexities, but they do have their roles. But I would have to look long and hard before I made that decision over an LLC taxed as an S corp or a C Corp. Now let’s take a look at how we can combine some of these structures to create maximum efficiency. Now, in most of these cases, the reason we’re setting them up are twofold. A, we want some liability protection, and b, we want to create some tax benefit. So let’s talk about asset protection first. Any entity that we set up is going to have the equity that’s in that entity exposed to liability, okay? Now there’s different ways we can protect that with insurance and debt and that type of thing. But for example, if I own a piece of real estate, it’s worth $5 million and I only have a million dollars of debt on it. I’ve got $4 million of equity that’s exposed to creditors. Now, there’s things I can do to protect that. But if I just go out, buy another property in that LLC and another property and another property, and my equity just continues to grow and grow and grow, all of that equity is exposed to liability. If somebody trips and falls at one property, or heaven forbid, dies at a property and I’m found liable, all of that equity is exposed. So I like to segregate the equity as much as humanly possible by putting things into their own separate llcs. So when I’m thinking about that, for example, we own all of our real estate in separate llcs. Sometimes there’s multiple llcs involved in that ownership, depending on the partnership formation and the structure and how all those pieces are coming together. Again, all of our real estate is owned in a LLC that’s either taxed as a pass through entity or a partnership. So all the tax benefit just flows through to us individually. Next, we might have a holding company, an LLC that owns all of those generally going to also be a pass through entity. We could make an S selection in this case, if it’s the management company, and we’ve got lots of management fees flowing up to that entity and we want to pay less payroll tax, that would be a reason why we would do that. Now, if we have a business development corporation that does all the marketing for our business, that might be a C corporation, and we might change the ownership structure of that depending on what benefits we’re trying to get out of it. We might be minority owners in that business, but we could create retirement plans in there, offer health benefits through there. Would want that to be a very low profit entity, but we could provide a ton of benefit to the employees, which could be me and my family through that entity. Could be a fantastic tax tool as well. If it has a different tax year, a C Corp can have a different tax year, so it could be 1131 year end tax date. That could give us eleven more months if we pre fund expenses into the end of the year. To be able to spend those dollars and not have to pay tax on it again, it could be another strategy that we consider. We did a podcast episode with Walt Dallas on that entire concept, was one of our early episodes. We’ll make sure there’s a link in the show notes to that episode, but the episode with Walt talking about how to set up the business. Development Corp is a great tool, great use of the C Corporation. Another use for the C Corporation is we set up captive insurance companies for our clients that have an insurance need and can’t find those opportunities in the marketplace. Again, there’s some tax efficiency that comes there, but a C corporation can be great for that opportunity as well. Let’s talk a little bit about limited partnership. A limited partnership has a general partner which is exposed to unlimited liability. So that general partner is often an LLC. The manager of that partnership, their personal assets aren’t exposed to liability. So in that scenario, we can bring in the LLC in as the general partner, and then the limited partners aren’t exposed to liabilities. So it can be a way to again separate the liability for that general partner so all of their personal assets aren’t exposed. Oftentimes general partnerships come into play when we’re looking at large real estate developments. There’s some money being raised in those scenarios. Everybody wants the profit, interest and the tax benefits flowing through to them, and a limited partnership can be a great way to do that. We’ve also set them up as llcs. We get the exact same structure, but we can do an LLC setup. Again, it probably depends on your state. You might want to consider a Delaware LLC in those scenarios. Delaware has very favorable corporate and LLC structures, so we need to be very careful when we’re looking at how we structure these different entities and what entity owns what. Now an S Corp can own an LLC, but an LLC can’t own an S corp. If that’s the case, then it reverts back to a C corporation, which creates all sorts of problems from a taxation perspective. We also can’t have an s corp own an S corp. And this reality played out for us. We had a client that was merging. We had the client sign off along with their legal counsel, that their entity was not an S corp, was not taxed as an S corp. It was an LLC taxed as an S corp. They said, nope, it’s not. It’s just a pass through entity. Well, that was not the case. And so an s corp can’t own an s corp. And it was going to create some massive problems. There was going to be a million dollar tax bill from this mistake. There was ways that it was worked out where at the end of the day it all turned out just fine. But again, you don’t want an unintended million dollar tax bill. So talk to wise counsel, have them help you set up these structures. Well, have them be very clear on what you own. We create what’s called a cash flow map for all of our clients that outlines the entity type, the ownership percentages, whether it’s passive or an active income structure. And we make sure that all of those things are aligned in the entity flow chart to make sure that when we’re adding new entities, they get put in the right place, owned by the right thing. So at the end of the day, as your business grows, as your complexity grows, you will continue to add new entities to the mix. They will have different taxation structures. LLC is probably my favorite. It has the most flexibility. One thing to consider when you’re making some of those elections to S Corp and C Corp, those can’t be undone easily. So again, make wise decisions. Talk to good legal counsel, good tax counsel. Make sure they’re on the same page. Cause you might find that your attorney’s going to give you the best asset protection advice. Your CPA is going to give you the best tax advice. You need to have the best advice with both of those things taken into consideration. So we help our clients with that all the time. We get everybody at the table, we work through those details and end up with good outcomes for our clients and avoid those million dollar tax problems that can pop up if you’re not paying attention. So entity structure makes a ton of sense. Do it well. As your business and your operation grows, you’re going to continue to add new entities, to separate out liability, to have different tax treatments, and at the end of the day, your assets will be very protected. You’ll also be very tax efficient and it will allow you to pay less tax, build more wealth and live a great life. Thank you for listening to the Vital Strategies podcast. If you want to learn more about this topic. We are building out a community where you can come learn about entity setup and get connected with professionals that can help you get set up properly so your assets are protected and you’re paying the least amount of tax possible. We want to give you the first look at the tools we are developing, so go to vitalstrategies.com cornerstones and sign up today. You’ll be the first in line to get access. These tools are designed to help you pay less tax so you can build more wealth and live a great life again. That website is vitalstrategies.com cornerstones. 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