Choosing between LLC and Incorporating

[Just H]

Over the years, I've heard lots of varying ideas and opinions on whether to set up a self-biz as an LLC or to incorporate. One costs more to set up, one protects more of your assets if someone comes after you, one seems to have tax benefits (espec if you set up in Nevada, which can supposedly be done for any biz anywhere and have no need to step foot in Nevada).

Can anyone with knowledge in this area break down the basics of determining which is right for a small biz? For example, graphic design, done from my computer, ordering the printed products and having them shipped and delivering the rest online. Are there some guidelines to see which type of legal setup would function well for this? Thanks! ~H

[Evan]

There are numerous articles on the web regarding this. To prevent re-inventing the wheel, I'll point to those numerous resources. Limited Liability Company - Incorporate - Ask the experts | Incorporate.com (http://www.incorporate.com/comparing_corporations_llcs.html) is one of many.

Legal aspects aside, it generally makes sense to incorporate or organize (LLC) in the state you plan on doing business in. Doing it in a foreign state isn't beneficial as you have to register in your home state if you plan on doing business there anyways. Often times the costs are identical -- so you really aren't saving any money.

From a tax perspective, corporations (specifically S-Corps) provide more benefits than an LLC. Of course an LLC is flexible with taxation.

Let's compare a company that has net income (income - expenses) of $75,000. We'll assume this is before any salary, and that the owner would like to take a $35,000 salary. Under this scenerio, about $4,700 savings could be yielded with an S-Corp.

LLC
Net Income Before Salary -- $75,000
Less Reasonable Salary -- $0
Income After Salary -- $75,000
Employment Taxes (15.3%) -- $11,475
Income Taxes (25%) -- $11,000 (estimated and rounded)
Total Taxes Paid -- $22,475

With an LLC, it is disregarded as an entity and a salary cannot be taken. This is because the LLC is treated as a sole proprietorship. So all $75,000 of the company's profits are subject to employment taxes. The good news is that all of the company's profits may now be withdrawn as taxes have been paid.

S-Corp
Net Income Before Salary -- $75,000
Less Reasonable Salary -- $35,000
Income After Salary -- $40,000
Employment Taxes (15.3%) -- $5,355
Income Taxes (25%) -- $12,400 (estimated and rounded)
Total Taxes Paid -- $17,755

With the S-Corp, we assume that a $35,000 salary is reasonable. Employment taxes only need to be paid on that portion. Income tax will be paid on the $75,000 either through your W-2, or when it passes through from your 1120S to 1040 Schedule E. The only reason why you pay more income tax as an S-Corp over an LLC is because they get a credit for one-half of self-employment, but the business gets an expense on their tax return. The benefit now is that the remaining $40,000 can be declared as a "dividend" (distribution), and you won't pay any further tax on it.

The numbers I've crunched aren't perfect, as there are lot of variables involved. But there can be considerable savings with an S-Corp over an LLC.

[Just H]

Thanks Evan, that makes it much more clear and the article helps too by pointing out the pros and cons. I know for certain that my biz at this level should be an LLC. Since mine is an online biz I can do from anywhere, should I try to get an accountant in the state I work from most or is that not really applicable?

[vangogh]

I'm glad you asked H. I almost started a thread asking the same questions last week. I've been a sole proprietor since the beginning, but have been thinking lately an LLC might be the better way to go. I'm still gathering info in order to make an informed decision, but I'm leaning toward becoming an LLC.

Thanks for the info Evan. Is any S-Corp any more difficult to set up than an LLC. Other than the tax savings, what are the advantages and disadvantages of each? Would you recommend an S-Corp over an LLC in general?

[Evan]

An LLC requires much less maintenance. You can just create an operating agreement (even if it's just you) and cover most of your bases with how the business is to be run.

With a corporation, you have to have all the formalities. This includes an annual shareholders meeting, and an annual board of directors meeting. There may be ways to waive the requirements if you have some type of agreement drafted together, but it's knowing how such an agreement needs to be worded to be legal.

There can also be some aggravation with payroll instead of just taking money out of the business at your pleasure and not having to worry about taxes.

You need to go with what you're comfortable with.

[vangogh]

Makes sense that the LLC would be easier to set up and maintain. Do you know of any good sources of information I could read and learn about how to set one up and the pros and cons of an LLC. I'm thinking it's how my business should be organized. I'm not in a hurry to set up as an LLC, but I'd like to read up more on them in preparation for setting things up later this year.

Now if I were an S-Corp and the entire corporation was me, could those annual shareholder meetings be conducted when I lay down in bed to go to sleep? I'm pretty sure I'd be able to count on the entire corporation being there and on time. :)

[Steve B]

I think Business Attorney's website has some articles on this subject Steve.

[Evan]

David has an excellent article here: LLC vs S Corporation :: Limited Liability Company Center (http://www.limitedliabilitycompanycenter.com/llc_vs_s_corp.html)

He does discuss the tax effects as well.

[billbenson]

As a sole proprietor, what is the advantage of doing either? Why not just operate as a sole proprietor?

[vangogh]

Thanks for the link Evan and Steve thanks for pointing me to David's site. I should spend a little time there reading.

Bill it's mostly the extra level of personal protection you get. As a sole proprietor if a customer or client sues you for some reason they could come after your personal property, including your home. If you've incorporated then they could only go after the business assets. Basically you're separating your personal and business assets more.

That's not the only advantage, but it's a big one.

[Evan]

Bill -- from a tax perspective, there is generally no difference between a SP and LLC. Schedule C is still filed, unless the LLC elects some other tax method.

The link I provided details benefits of an LLC vs an S-Corporation.

Many businesses operate as SP's. There is nothing wrong with a SP, as it is very easy to "form".

[billbenson]

I was under the impression that as a sole proprietor, even if you incorporate, they can come after you. Also, I have been told that the only way a you can loose your house is by nonpayment of your mortgage. If you sell your house, however, you will need to pay anything owed at that time. A friend who ran a corporation for 30 years told me not to incorporate unless I have employees. Could vary from state to state though.

[vangogh]

I think one of the main points of the LLC is to limit your liability, hence the LL. I'm not sure about the house thing. Maybe you're right, but I was under the impression as a sole proprietor all of your personal property could be included in a lawsuit since the lawsuit would be filed against you personally. As an LLC any lawsuit would be filed against the LLC and not the individual.

The above may not be accurate, but it's the general sense I've gotten from the little reading I've done.

[Evan]

Of course they could go after you. But generally speaking, your liability is limited unless they can prove a few certain elements. Think, for example, of the whole Enron scandal. Sure, limited liability should have protected the officers from that scheme. But it doesn't protect you from conducting illegal activities, which is what made them personally responsible.

If I sued you for $4 million dollars for something legitimate (we'll just pretend it is), and you cannot pay it -- I could get your home, and not through a lien either. Courts certainly have a lot of power.

[Steve B]

The Home question depends on the state. Some (like Texas) have a Homestead Act that prevents the loss of your home under many circumstances. (the history of that act in Texas has to do with guys losing their homes in poker games).

But, short of illegal activities, incorporating has the huge benefit of protecting your personal assets.

[vangogh]

Evan that makes sense. I realize there are still ways people could come after your personal property. One simple way is if you fail to keep you and the LLC as separate entities by using the same bank account for both. But it strikes me that one of the main ideas behind the LLC is you are granted limited liability protection. You should have more personal protection as an LLC than you do as a Sole Proprietor.

Is that right?

Maybe my example of being sued for your home wasn't the best since there are likely other protections granted and apparently in Texas I can't wager my home in a poker game anymore.

[billbenson]

However, I'm not the owner of my home, the bank is. I have negative equity as well, so that would be difficult. My attorney told me that the only way I could loose my home is by nonpayment of the mortgage. He didn't specify why. Sounds like it is a state by state thing.

[Business Attorney]

I'll point out another page on my website: How Limited is Limited Liability? (http://www.limitedliabilitycompanycenter.com/how_limited_is_limited_liability.html)

The short answer is that an LLC or a corporation will generally offer better protection for your personal assets than you can get with a sole proprietorship, but the protection is not perfect. Particularly where the owner of the membership interest in the LLC (or shares in the corporation) is the only person who is active in the business, many of the acts attributable to the entity can also be attributed directly to the owner.

Normally, the entity will protect you from contractual liability. So a customer suing for a breach of contract will generally only be able to sue the entity, not the owner. A landlord or a trade creditor likewise would only be able to go after the entity. On the other hand, where there is tort liability (personal injury or damage to property) caused by the personal negligence of the owner or fraud committed by the owner, the owner can't use the entity to avoid responsibility for his own wrongful actions.

The article goes into more detail of other specifics, such as personal guarantees and tax liabilities.

[vangogh]

Thanks David. Your article was helpful. I've been reading through your LLC section for a few days now.

I have a specific question. I do have separate bank accounts for both business and personal. If at some point I do become an LLC would it count as a draw if I moved money between accounts online? I'm assuming that's fine and an actual check isn't needed, but thought I'd ask.

[Evan]

You don't need an actual check. If you withdraw money from the business (online) and transfer it to your personal account, it'd still be considered a draw.

[vangogh]

I figured as much, but thought it worthwhile to double check. You never know.

[Business Attorney]

You don't need an actual check. If you withdraw money from the business (online) and transfer it to your personal account, it'd still be considered a draw.

I agree with Evan.