STRUCTURING YOUR COMPANY
Rodney Nash has been part of his family’s painting and contracting business, W.W. Nash & Sons, Inc., in Richmond, VA since 1963. His father started the original company in 1946 and, through the years, Nash has seen several family members come and go as partners in the enterprise. Today, at 74, the company VP is nearing retirement himself, and is now readying W.W. Nash’s next generation of leaders to run the company, which includes his own son and daughter.
Through the years, W.W. Nash has adhered to a simple, straightforward business structure. It has operated as an S corporation (S corp) for quite some time, a move primarily driven by tax savings, Nash said. Further, every time a family member is added to the company as a partner, internal documents, reviewed by an attorney, are drawn up to explain that person’s duties and title within the company. In addition, language is crafted that spells out payments to a surviving spouse if the partner passes away.
“If I pass away, my wife gets paid the book value of my part of the company’s current value,” Nash said. A surviving spouse does not automatically become a partner, he clarified. The payout approach, he adds, is a better way to keep the company operating smoothly. “You don’t want someone’s spouse to come in and start calling the shots. That person doesn’t necessarily know the business.”
Unfortunately, there are plenty of contractors who are less meticulous with their company structure and governing documents. These business owners may end up making mistakes that could result in overpaying on taxes or, even worse, legal disputes with partners or clients. Several small-business experts recently weighed in on exactly how the right business structure and documentation can help you minimize risk and reap tax rewards.
THE LLC ADVANTAGE
Karen Mitchell, CPA, coauthor of Contractor’s Guide to QuickBooks Pro, and author of The Organized New Business and other books for small-business owners, says it’s important to pay attention to that time when the business is no longer a part-time side gig or hobby. That’s usually the time you should start thinking of filing paperwork with the state to protect your small, but growing, enterprise.
“You shouldn’t hesitate setting up an LLC (limited liability company) as soon as you know this is not a hobby anymore,” she added.
An LLC brings legal protection. If a client or competitor wants to sue a business owner, he or she can only go after the assets of the business, not the owner’s personal assets, explains Eric Franklin, an associate professor of law at University of Nevada, Las Vegas’ William S. Boyd School of Law, and director of the university’s Small Business & Nonprofit Legal Clinic.
Franklin says paint pros can be vulnerable to liability due to the very nature of their business. Working at a home, for example, a resident could trip on equipment. A property owner’s personal items could be damaged by workers. These are only a couple of examples of things that can go wrong—and lead to legal problems—for a painting contractor.
“When I meet with all businesses for the first time, the first questions I ask involve trying to figure out how much liability they have,” Franklin added. “The LLC was designed by lawyers and accountants with the small business in mind.”
Each state’s filing fees are different but it’s usually only a few hundred dollars annually to create and maintain an LLC; most of it can be done on a state’s secretary of state web site.
After setting up the LLC, make sure you open a checking account for the business and maintain all business expenses and revenues separately from personal finances, Mitchell added. Avoid commingling company dollars with personal funds. Commingling could compromise the legal protections afforded to an LLC and allow a plaintiff to argue that seizing a business owner’s personal assets is justified since the owner did not separate personal and business funds.
“That’s where we see guys go wrong. Someone sets up the LLC and is a single member. They don’t go through the formality of setting up a business bank account with the business tax ID and are commingling personal funds with business funds,” added Ken Van Bree, partner-in-charge with RubinBrown LLP’s Construction Services Group in St. Louis, MO.
SOLE PROPRIETORSHIPS, S CORPS, TAX ADVANTAGES
After creating an LLC, many small businesses will be taxed as a sole proprietorship. It’s the default business form, adds Franklin, if you do not choose to incorporate or file additional paperwork with the state. Under a sole proprietorship, an owner would simply include his or her business revenue and expenses on their personal tax return by incorporating a Schedule C, or ‘Profit or Loss From Business’ form.
But once you reach a certain revenue level, you can find tax benefits by becoming an LLC with an S corp election through the IRS, Mitchell notes.
“You only move from a sole proprietorship once your net income is $50,000 or more; then it’s worth it to move to an S corp,” she explained.
An S corp election allows you to pay yourself a salary so that you are paying taxes throughout the year and are not surprised with a high tax bill later. But the greatest S corp tax benefit comes with the net income your company posts after your salary and other expenses are paid. Under an S corp, these funds are not subject to the IRS’ 15.3% (12.4% to Social Security and 2.9% to Medicare) self-employment tax.
So, for example, if you have $140,000 in total business revenue, but material and labor costs are $25,000; your payroll is $50,000 and there are overhead (business) expenses of $15,000, you would have a net profit of $50,000 that would be taxed at your personal income tax rate. If you were operating as a sole proprietorship, however, that $50,000 would be subject to the additional 15.3% tax.
S corps, however, come with some limitations. The entity must have fewer than 100 shareholders and the members of the S corp must have payroll processed with taxes taken out and paid during the year, or at least twice during the year, not just at year-end.
C Corps are an entity that is taxed separately from its owners. Because a C corp has two levels of tax—on the income it earns and on the dividends to shareholders—it is usually not preferred by most business owners. Most small businesses and family businesses are operated as S corps.
It’s very uncommon to see a contractor operating as a C corp, says Chris Coleman, a partner in RubinBrown LLP’s Construction Services Group. The consultant does, however, sometimes see smaller contractors operating under this structure. It is usually a case where the entity was formed as a C corp a long time ago and new leaders may not yet understand the benefits of switching to an S corp.
“You’ll see some legacy institutions where inertia has gotten the best of them and they have not converted yet,” he added.
PARTNERSHIP TRIP UPS
Franklin cautions small-business owners with partnerships. In order for an entity to become a general partnership, no written agreements are required, he explained, which “brings with it legal defaults with potentially dire consequences,” he noted. For example, two people could have an oral agreement to be partners, then open a storefront or lease space together. If one partner does not fulfill his financial requirements, the other person may be left paying the whole bill without much of a chance at recourse.
“I think a lot of people form a general partnership without knowing it,” Franklin said. He adds, “You can have a partnership hoisted on you based on action and agreements without signing anything.”
Franklin recommends creating internal documents like operating agreements that clearly divvy up expenses, decision-making authority, and other responsibilities. W.W. Nash is a good example of how partnership documentation can really work to keep every member on the same page about their responsibilities to the business.
For more information about business structures, tax benefits and corporate documents for partnerships, contractors can also visit the U.S. Small Business Administration at SBA.gov; and valuable tax information can also be found by searching IRS.gov using key words like ‘S corp’ and ‘C corp.’
Nash says his team consults with attorneys and accountants when company documents are added or changed. Mitchell said many legal or accounting experts are open to doing free initial consultations. “Most accountants and attorneys will spend half an hour free just to go over some of this stuff,” she added.