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Thread: LLC/S-Corp vs. Sole Proprietor

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    Default LLC/S-Corp vs. Sole Proprietor

    Alright, I kind of asked this question before last year in a thread about partnerships vs. SP, but I met a friend of mine last night that told me a little more about how his business is structured, and I just can't think it is legal. Maybe it is. This is the second time that the same tax person has been recommended to me, as I discussed this somewhat previously. But, I'd love to see what others think of this model.

    Basically, the way my friend explained it, a sole proprietor pays the highest amount of tax possible. That is just the fact as he stated it.

    He said that basically under his LLC/S-corp setup (which cost about $800 to set up the first time) he brings in money, pays all of his bills through the business, and then gives himself a tiny salary ($100/week for groceries, his wife has her own job). But he's paying his house payment and utilities and all life expenses through the business. For example, he said that he's got it set up so that his business owns the house and leases it back to him, thus making it all business expenses, including utilities and such.

    I thought that you had to actually use the house in the business (which he doesn't) in order to take the whole mortgage payment off. Otherwise, you could deduct a small portion based on whatever the percentage of the house your office qualified as.

    Yes, he's paying far less taxes than I am. But does that sound kosher to you? Also, isn't a reason for filing an LLC to keep the liability away from your personal assets like your house? By putting his house in the business name, doesn't that put his house at risk if anything ever happens?

    Thanks for any feedback. Everyone keeps telling me to get an accountant, and this particular person has now been recommended to me twice, but it sounds shady to me. I'm all for taking whatever LEGAL means I can to lower what I pay in taxes, but not if it is shady or puts my personal assets at risk.

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    On the liability exposure question, your thinking is on the right track. The actual magnitude of the risk is, of course, dependent on the inherent risks of his business, whatever that may be.

    But by packaging his residence and his business into a single LLC entity, he's theoretically exposing the house to any claims that may arise against the business. (There's also the question of whether his mortgage contract allows him to do so, but that's a different matter.) It's possible that there are some "personal residence" protection statutes in his state of residence, but why roll those dice when there's no upside? His arrangement is 180 opposite of the paradigm strategy of using (e.g.) trusts or ltd partnerships to separate business and personal assets.

    On the tax question, your friend is an unpleasant IRS audit waiting to happen. And he won't like the outcome.

    As it's structured, all of the income the LLC receives is taxable income. But those expenses being paid from the LLC checkbook (utilities, e.g.) are nondeductible personal expenses. They should be treated as nondeductible draws to him on the LLC's books. No tax advantage there, vis-a-vis a sole proprietor setup.

    Alternatively, envision a scenario in which IRS allowed his "rent to self" arrangement with his LLC to stand. This would require, at a minimum, his paying a fair-value rental to his LLC. This condition is necessary, but probably not sufficient by itself---but we'll go with it for now. Now the LLC has rental income which offsets all those expenses of the rental property (utilities, et al.).

    However, your friend couldn't deduct on his personal return the rental payments made to the LLC, as those are just personal living expenses.

    When you run the numbers on this alternate scenario, your friend is just right back where he'd be, generally, as a sole proprietor: Owing tax on his business revenues, minus whatever legitimate business expenses he incurs in producing that revenue.

    Bottom line: If for the mere outlay of $800 one could convert personal living expenses into tax deductions, you couldn't find anyone in the US not doing it. 314M citizens (and a million or so accountants) couldn't have all missed that one.

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    Yes, having your home owned by your business does open it up to liability in the event of a law suite. It is not illegal to take deductions for a home office. This could include utilities, rent, mortgage payment, telephone, internet, etc. However, you are usually only allowed to take a portion of those expenses. Specifically, the portion used by the business.

    I would not right off this accountant friend just yet. It is possible you are misunderstanding him. If you feel unsure, start researching his background. What degrees does he have? What certifications? Is he a CPA? or does he just have a degree in accounting? Finally, ask this person for references of people you can actually talk with. Preferably, you want references from outside your own circle of acquaintances. Finally, there are plenty of good accountants in the world. If this person seems sketching, go find someone else.
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    Yeah, I figured that my friend is screwed if hit with an audit. He believes anything that his accountant says. He was telling me that he also makes out great on this arrangement because he doesn't have to pay the self-employment tax like I do. He based it on the fact that he basically gives himself a little salary of $100 a week or so, so he therefore only pays social security on that $100. But if you are an employee of an LLC, the company has to pay that portion anyway, doesn't it? I mean, he isn't saving anything yet again if the company is paying it out. He's only looking at it from his end, but not from the business end, right?

    I think this accountant is getting business by promising the moon but will have a bunch of unhappy clients if they ever get caught.

    Thanks for the replies that already came in.

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    You're correct in essence re the self-employment tax, except that the way it works is that an active owner of an LLC pays SE tax on his full share of the LLC's profits, not just on whatever portion thereof he pulls out in the form of salary.

    E.g., a sole owner of an LLC which has a 50K net taxable profit for the year, pays SE tax on the 50K, whether he extracts all, some, or none, of those profits in the form of salary.

    (This assumes that he actively participates in the business operation. A purely passive investor in an LLC doesn't pay SE tax on those profits.)

    Tmerrill mentions a good point earlier re a possible home office deduction, and there may be an element of this at work in your friend's scenario. But of course, pursuant to the home-office-deduction rules, only a small fraction of of the utilities, prop tax, etc., will be deductible---certainly not the entire set of household expenses. Further, if his business activity qualified for such a deduction, he'd have the same deduction as a sole proprietor.

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    Quote Originally Posted by ArcSine View Post

    Tmerrill mentions a good point earlier re a possible home office deduction, and there may be an element of this at work in your friend's scenario. But of course, pursuant to the home-office-deduction rules, only a small fraction of of the utilities, prop tax, etc., will be deductible---certainly not the entire set of household expenses. Further, if his business activity qualified for such a deduction, he'd have the same deduction as a sole proprietor.
    Yes, I already had mentioned that in my original post. I realize that you can deduct a portion of your house in the form of utilities, mortgage payment, etc. for the percentage of the home that you use as part of your business, a dedicated office would be one example. However, that is NOT what he is doing. He is deducting everything, letting the business pay for all of his bills, period, and then drawing a tiny payment every week for things like groceries. He put his house in the business, under it's name, and is leasing it back to himself. My other friend that uses this same accountant has his vehicles, his house, etc. put into his business as well. One friend pinstripes cars for a living, at the dealer's lot. The other washes windows for restaurants. NEITHER uses their entire home, or really probably needs to use much of it at all, for their business.

    Their accountant seems to have convinced them that they are saving things that they aren't. If the LLC is paying the self-employment tax anyway, then he isn't saving anything. If he put his house back in the company name he has effectively avoided the protection of the LLC for his assets.

    I've screwed up my taxes in the past, and paid dearly for it. It was just an honest rookie mistake and some disorganization on my part, but I'm making that right. My friends keep wanting me to use their person because clearly (in their minds) I'm an idiot for being a sole proprietor as they think I'm paying way more taxes than them. Maybe I am, but that's because I'm doing everything above board, not trying to skirt things with shady tactics, and in the end it doesn't even look like they are getting out of taxes with their methods. They pay hundreds of dollars for professional accounting services that I don't pay, and $800 to set up LLC's and such to then turn around and put their assets all at risk.

    I'll just stick to doing them myself. Everyone tells me that I need an accountant, and everyone that tells me that goes on to elaborate incredibly shady things that their accountant is doing for them. The window washing family even got money back somehow on their taxes, if memory serves me from a previous conversation with them. I have no idea how, but I hope they don't get caught. They think that they are doing the right things, believing whatever their accountant tells them, and I'm sure that they won't listen to me. I'm just an idiot that pays my taxes and messed up years ago on my own, so I don't have much influence there. I'd love to get a refund, or to not have to pay as much, but I'm not going to use their person, and the more I'm recommended people the more I see a need to just do it myself, which is unfortunate. I'd love to find a pro that would save me money legally and with my welfare in mind at some point, but everyone that recommends them makes me re-think that.

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    Hi fellow Kentuckian. I'm in Lexington, not too far from you. I loved your websites, especially the blogs. Good information. Sorry to hear about your problems with finding an accountant. I definitely wouldn't trust the accountant your friends are recommending. Doesn't sound like he is steering them in the right direction. But, I do think you should have an accountant file your tax returns. The accountant is experienced with taxes and may find legitimate deductions for you that you wouldn't even think of. Since you have three businesses and have had problems in the past filing your return yourself it would be a good return on your investment. The problem would be finding an accountant you trusted. If you would be interested in talking to an accountant in Lexington, I have an accountant that I collaborate with for my bookkeeping business. If you are interested send me a PM.

    Where did you get that it cost $800 to file as a corporation here in Kentucky? It only costs $40 to file Articles of Incorporation with the Secretary of State. After you did that, then you would file Registration papers with the State of Kentucky to get your account numbers. This doesn't cost anything. Here is the link to the Secretary of State's website: Kentucky: Secretary of State - Business Filings Overview and here is the link to the State of Kentucky's website:Kentucky: Department of Revenue - Register A Business/Update Account Information/Cancel Accounts. I am a sole proprietor now, but a few years ago I had another business and registered as a corporation, and did not pay $800 to register the business. Hope this helps and good luck.

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    Basically, the way my friend explained it, a sole proprietor pays the highest amount of tax possible. That is just the fact as he stated it.
    That isn't factually correct. Technically individuals have tax brackets that go higher than corporations, but the comment still isn't factual.

    He said that basically under his LLC/S-corp setup he brings in money, pays all of his bills through the business, and then gives himself a tiny salary ($100/week for groceries, his wife has her own job). But he's paying his house payment and utilities and all life expenses through the business. For example, he said that he's got it set up so that his business owns the house and leases it back to him, thus making it all business expenses, including utilities and such.
    What is the business of this LLC/S-Corp? And he put the house in an LLC taxed as an S-Corp? Is it legally held by the LLC? Has he ensured he met any zoning regulations, as that may mean he is putting a commercial property in a residential area and it'd need to be zoned appropriately.

    I thought that you had to actually use the house in the business (which he doesn't) in order to take the whole mortgage payment off. Otherwise, you could deduct a small portion based on whatever the percentage of the house your office qualified as.
    The mortgage isn't deductible, it's the mortgage interest. Generally, this is prorated based on the square footage. If taxed as an S-Corp, he would need to have some agreement in place to have that reimbursement arrangement.

    But does that sound kosher to you? Also, isn't a reason for filing an LLC to keep the liability away from your personal assets like your house? By putting his house in the business name, doesn't that put his house at risk if anything ever happens?
    No, that doesn't sound kosher. I'm still not sure what the purpose of the LLC is, or if it's running a legitimate operation. The maintenance of your personal residence wouldn't qualify.

    I'm all for taking whatever LEGAL means I can to lower what I pay in taxes, but not if it is shady or puts my personal assets at risk.
    You could report him to the IRS. There can be a nice benefit of reporting this.

    As it's structured, all of the income the LLC receives is taxable income. But those expenses being paid from the LLC checkbook (utilities, e.g.) are nondeductible personal expenses. They should be treated as nondeductible draws to him on the LLC's books. No tax advantage there, vis-a-vis a sole proprietor setup.
    Further, if the LLC has legal title to the house, when he sells it, he won't be able to exclude its gains from his tax return. If it's being depreciated, he'll have a gain/loss depending on it's book value at the time of the sale. Plus if he decides he wants to transfer it out of the LLC, it is now a taxable event, and he'll have to pay tax on it.
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    He lives in a mobile home in a mobile home community. He once had a HUGE portfolio of real estate rentals locally following many of the Robert Kiyosaki philosophies and bought everything with debt. When the market took a dive a few years ago, he told me that he handed it all back to the bank and walked away. I assumed that meant bankruptcy. Since then he went back to striping cars on dealer's lots, and as far as I know, that's pretty much all he does. None of which makes any sense with the way his business is set up.

    My other friend (maybe I should say acquaintance, as I'm not necessarily tight with any of these people) has a window washing business, and said that his home and vehicles and everything were owned by his business since he started using this tax preparer.

    The tax person is in KY, and we all live in Southern Indiana. The window washing friend said that he just sends everything in to this lady and she sends it all back to him in a nice folder with everything prepared, which sounded shady to me. Seems like they may have never even met in person.

    It is all just very strange, and I do worry for my friends if it all came crashing down someday. I don't know for sure that I have everything right either, just bits and pieces given to me when they were advising me as to how I was doing it all wrong by being a sole proprietor. My guess is that there is more to the story, but it is still shady at best, and I truly believe that these people think they are doing the right thing. They are very honest people, but I think they believe whatever this tax person tells them and just go with it, probably particularly since they save so much money by doing so. Maybe they don't make much, and get money back because they have kids on top of all of these maneuvers. It just seemed crazy and I wanted to get some feedback here since I was told that this was the way to go, and I knew better and had concerns for their well being.

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    Quote Originally Posted by jamesray50 View Post
    Hi fellow Kentuckian. I'm in Lexington, not too far from you. I loved your websites, especially the blogs. Good information. Sorry to hear about your problems with finding an accountant. I definitely wouldn't trust the accountant your friends are recommending. Doesn't sound like he is steering them in the right direction. But, I do think you should have an accountant file your tax returns. The accountant is experienced with taxes and may find legitimate deductions for you that you wouldn't even think of. Since you have three businesses and have had problems in the past filing your return yourself it would be a good return on your investment. The problem would be finding an accountant you trusted. If you would be interested in talking to an accountant in Lexington, I have an accountant that I collaborate with for my bookkeeping business. If you are interested send me a PM.

    Where did you get that it cost $800 to file as a corporation here in Kentucky? It only costs $40 to file Articles of Incorporation with the Secretary of State. After you did that, then you would file Registration papers with the State of Kentucky to get your account numbers. This doesn't cost anything. Here is the link to the Secretary of State's website: Kentucky: Secretary of State - Business Filings Overview and here is the link to the State of Kentucky's website:Kentucky: Department of Revenue - Register A Business/Update Account Information/Cancel Accounts. I am a sole proprietor now, but a few years ago I had another business and registered as a corporation, and did not pay $800 to register the business. Hope this helps and good luck.
    Hi Jo Ellen,

    Sorry, not a fellow Kentuckian anymore. I grew up in Louisville but moved across the bridge 16 years ago or so, and my wife and I reside in Clarksville. We can still be friends though, lol. I'm glad you like my sites. I put a lot of work into our cleaning site. The detailing site will be getting an overhaul soon, as will the handyman site.

    Everyone tells me that an accountant will get me deductions that I wouldn't know to take myself, but then they all show me this shady crap that makes me wonder what is going on. My tax situation is really quite straightforward, and I don't have any investments or anything to worry about. I just bring in money, buy supplies and other various business expenses (that are actually used in my business), and go from there. My return is quite simple for being business oriented.

    My sins of the past were more along the lines of forgetting the whole Schedule C thing the first year or two I was in business back 12 years ago, and then just being generally disorganized in my finances, plus one really bad year in the business. Basically, it was all my fault and primarily my issues were simple non-payment, not on purpose, but because I was just bad (that's an understatement) with money. I grew up poor and had no clue what to do with money. I'm much better now, have paid my quarterlies and have added no further debt, but my old debt grew. Starting last April my wife and I decided to sell out our life and work constantly to pay our old tax debt off, and we're almost there now, which is exciting. I'm scared to death to hire someone to do my taxes now because the last thing I need or want is some shady accountant getting me in hot water again with the IRS.

    My friend is the one that said he paid $800 to file his LLC and S-corp. He didn't break it down for me, just said that is what it initially costs. He is in Indiana, if that makes a difference, but I'm sure it doesn't make that much difference. I really thing that he and my window washing acquaintance are getting taken for a ride on all of this. They probably wouldn't listen to me if I tried to advise them though. They know I'm in a tax mess, so who am I to offer advice. I just don't want to see them get hurt someday because of their ignorance. Lord knows I've done it to myself, I don't want them to end up in a mess.

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