It’s daunting at times to consider how to go about starting with all the nitty-gritties of running a successful business. When it comes to determining which business entity to use, this can add to the already complex mix of decisions involved in starting your business. Here in Part 1, we’ll go over some of the options available to you as well as their pro’s and con’s. We’ll start with the Single-Member LLC and an LLC Partnership. In Part 2 of the series, we’ll consider the C corporation and the S corporation.
The Basics
The worse of all options is to have no business entity at all. Being a sole-proprietor or even general partnership without an LLC or other business entity leaves you exposed. You’re without any kind of legal protection separating your business from yourself or your partners.
In other words, if someone were to sue your business they would really be suing YOU. Because there’s no layer of protection separating you from your business and business activities.
By putting your business inside a business entity, you are clearly separating it from you. When business is being transacted, the clients and vendors are not legally dealing with a physical person. They’re dealing with what you may call an entity or moral person.
This allows for what is called limited liability. This means that the creditors suing the company will be prevented from being paid from the business owner’s personal funds. Rather, creditors are being limited to getting at the assets of the business itself, and not the business owner. But in order to achieve this a business entity must be formed. The assets and bank accounts intended for business must be put under this entity.
Here’s a breakdown of the different business structures and the pro’s and con’s of each of them.
The Single-Member LLC
If you’re a sole-proprietor business starting out with modest revenue, the Single-Member LLC is one of the good options. A limited liability company (LLC) offers you the limited liability protection that we discussed above. This is as long as you’re clearly establishing the separateness of you and the business.
This structure has the benefit of being simple and straightforward. For example, as a sole-owner, you would pay yourself via a simple distribution of funds from the bank account. That could be through an ATM withdrawal, bank transfer, wire transfer, or even Zelle from your business bank account to your personal bank account. No need to pay yourself through a payroll processor like ADP or Paychex.
There is also minimal to no corporate formalities that need to be maintained. Although, I recommend my clients to keep a corporate binder even while being an LLC. This makes for a stronger case in establishing your company as a separate entity. It also just makes for good record-keeping.
A Single-Member LLC is what is called a “disregarded entity” for tax purposes. Meaning that, for tax purposes, it’s treated as the same as if you were running your business as an individual. It’s also called a “flow-through” entity, meaning that the LLC’s financials flow-through to your individual finances and to your tax return.
Disadvantages of the Single-Member LLC
There’s one common “disadvantage” for forming or operating any of the entity structures in the state of California. There’s a minimum Franchise Tax Board $800 tax imposed on LLCs and corporations. Instead of “disadvantage,” however, I would call it a cost. It’s part of the cost of doing business in the state and I would not use that as an excuse not to protect yourself legally and financially and run your business unprotected.
Other states have similar minimum taxes imposed; keep in mind that even if you formed your entity in another state, if you run it out of California you are still liable to pay the $800 minimum Franchise tax. Also, newly formed businesses are not required to pay the Franchise tax in their first year of operation.
With this in mind, the first and “true” disadvantage of the Single-Member LLC are the self-employment taxes imposed on small business owners. Essentially, because you are now both the employer and the employee in your business, the 7.65% you used to get withheld from your paycheck when you were an employee will now double. You will now have to pay both the employee (7.65%) and the employer (7.65%) portions of the Social Security and Medicare payroll taxes, in this case also called self-employment taxes. That comes up to a whooping 15.3% of taxes in addition to income taxes!
Surprise Taxation for Business Owners Starting Out
The same problem applies to Sole-Proprietors, General Partnerships, Single-Member LLCs, and General Partnerships alike. This can come as a surprise to many small business owners starting out, especially during the first year or the first year with major net profits left over after any expenses. This is because when you start out by yourself, you’re used to someone else (your employer) withholding money from you to cover your taxes. Since now no one is doing that for you, and no one tells you to, and there’s a hefty extra 7.65% of taxes to your bill at the end of the year, many business owners struggle to cover it.
And while this can be largely handled by paying in quarterly estimated taxes and having your accountant help you project any extra tax when you’re having a great year, one tax-planning solution to this problem is to become an S Corporation or have your LLC elect to be taxed as an S Corporation. The intended effect in that arrangement is to lower the amount of self-employment taxes that you have to pay. More on that below.
The LLC Partnership
If you’re looking to start a partnership, an LLC partnership has some really tremendous benefits of flexibility which can be advantageous to partners looking to compensate for lack of capital or simply reward “sweat equity” or expertise.
The Problem
First let’s look at the drawback of a general partnership. When you form a partnership without a written agreement, most state will legally consider you a 50/50 partnership, by default. An oral agreement or handshake will not help you here. In other words, 50% of the profits and 50% of the losses will go to each of the partners, even if they agreed verbally on some other arrangement.
The second major drawback is the liability problem. Think back to the last section’s bad entity where you’re just a sole-proprietor. Remember this is still a “bad entity.” But because that entity is still yourself, at least any liabilities that you incur fall back to none but you. You’re responsible for any bad acts you may incur, but no one else’s. In the case of a general partnership, you’ll not only be responsible for your own acts, but those of your partners as well! This is because the liability in a general partnership is unlimited: all the partners in the business are equally responsible for all the bad acts and liabilities incurred thereof from all of the partners.
Consider This Business Scenario
Let’s look at one of the best benefits of an LLC partnership. Let’s say you and two other partners want to start a herbal remedy business. One of the partners, Herb, is an ace as a herbal doctor and has an amazing formula that’s been in his family for generations. He comes from a long line of traditional naturopaths. He would be minimally involved in the business, except in new product development, and would invest no capital.
Another partner, Richie, has $100,000 to invest. His main concern is to get his money back and then reap the benefits of continuing to be a partner and earning dividends from the profits.
That leaves you, the third partner. You have $25,000 to invest and time to get the operations and sales part of the business up and running. You would be putting in more hours than the other two partners.
The Choices
In a general partnership with no written agreement, each partner would automatically be deemed a 33.33% partner, no matter the initial invested capital or any other consideration.
Now let’s consider another possibility. Let’s say Juanito Perez, your tax preparer friend, suggests you should become an S-Corporation. He tells you about it’s tax advantages and it’s simplicity in terms of also providing flow-through status to the partners.
The problem in this case with an S-Corporation, though, is that profits have to be allocated proportionally to the ownership. It would be allocated based on the percentage of the each partner.
The big $100,000 capitalist partner Richie would not be able to draw his $100,000 until the business reached the ability to give each of the partners $100,000.
In comes the LLC partnership to save the day. The LLC partnership is flexible in two areas. First, the partnership percentage allocation and second on how the owners choose to distribute the company’s profits. Thus, Richie could be paid out the $100,000 before any profits went out to the other partners, while still retaining his partnership percentage.
Here’s an example breakdown of how allocations and profit distributions could go according to each entity.
| Percentage of Ownership | Year 1: $60,000 profits/distributions to partners | Year 2: $60,000 profits/distributions to partners | Year 3: $60,000 profits/distributions to partners | |
|---|---|---|---|---|
| General Partnership | 33.33% each | $20,000 each | $20,000 each | $20,000 each |
| S-Corporation | Richie 40%, Herb 35%, You 25% | Richie $24,000, Herb $21,000, You $15,000 | Richie $24,000, Herb $21,000, You $15,000 | Richie $24,000, Herb $21,000, You $15,000 |
| LLC Partnership | 33.33% each | Richie: $60,000 | Richie: $40,000, Herb $10,000, You $10,000 | $20,000 each |
The Solution
In the general partnership and S-Corp scenarios, Richie would not be able to get his $100,000 back quickly. Even in the first three years of operations he would not get it back. That’s because in both a general partnership with no written agreement and an S-Corp, distributions would have to be proportional to the ownership percentages (most state laws provide this for general partnerships with no written agreement).
Richie would get $60,000 in the general partnership in the first three years of the general partnership. He would get $72,000 in the S-Corp because he became a 40% owner in the business.
Take a look at the LLC though. In an LLC partnership, distributions don’t have to be proportional to ownership percentage. Let’s say Richie wanted to be a 1/3 partner of the business after getting his $100K back. In the first year he gets all the profits to himself of $60,000. In year 2, he only needs $40,000 of the profits to get his full $100K, so the other partners get the remaining $20K. Then finally, in year 3, the partners can settle back into distributing the profits equally, based on the partnership percentage of 33.33%
This arrangement is quite flexible, and therefore in these kinds of cases where creative solutions are called for to satisfy the different parties, an LLC partnership can be a great option.
Note also that in the LLC partnership, the partners could have agreed to different ownership percentages as in the case of the S-Corp, depending on the interests and objectives of the partners.
Conclusion
Remember that the worst entity is having no entity at all. You’re personal assets are exposed to creditors and you are putting yourself and your family at risk. If you are a solo business owner, forming a Single-Member LLC is a great start and in many cases could be the way to go, specially if you’re planning to stay solo and don’t expect to be generating more than $50K a year in net income from the business.
If you are planning to generate more than $50K net a year, consider the option of the S-Corp to reduce the heavy burden of self-employment taxes. Stay tuned to Part 2 of this series to learn more about the S-Corporation.
Also remember that general partnerships are what we would consider a “bad entity.” They compound your liability exposure and can give over a lot of your decision making. In many cases, an LLC partnership could be a great solution since it limits your liability. It also allows for a great deal of flexibility not available in other entities.
For more details about the S-Corporation and the C-Corporation, stay tuned for the next article. Get a full overview on which business entity to use by reading Part 2 coming up soon.