This month we're taking a little different approach to our topic. Instead of remodelers, Tom Swartz talks to a CPA and an attorney who counsel remodelers and help them choose the correct business structure for their company.
Tom: Today's topic is one that I get asked about a lot. I call it one of my unspeakables. When you talk about the structure of your remodeling company, you get different answers. So we're going to talk about business structure. I think we'll hear terms like sole proprietor, S-Corporation, C-Corporation and LLC. We are going to be joined today by a CPA, Marilyn Mobley. We're also going to be talking with an attorney that is very well versed in this particular area that will bring a new dimension for remodeling contractors. That is Laurie Hedrich.
Tom: Marilyn, one of your major clients is a remodeling company in Farmington, N.M. Is that correct?
Marilyn: I have several clients in Farmington in the construction industry. Lonnie Rutherford is my husband and a client; he owns Legacy Construction. He is a small remodeling contractor; I think in his peak he had 12 people. He's gone more into using subcontractors rather than employees.
Tom: His business would be volume-wise about what?
Marilyn: It really depends on the year, whether he throws in a couple of new constructions in there. Range would be $1 million to $2 million.
Tom: Would you describe from a remodeling standpoint and a small business standpoint, major differences between the types of corporation setups that are available to the remodelers in small business today?
Marilyn: Primarily, we have the sole proprietor, which is a lot of times how people start. They just throw the hammer in the back of the truck and they're in business. So there's no formal entity, no liability protection — they're just out there. Then there is the corporate structure. And within this, they can elect Subchapter S status. And then there's the partnership or the LLC (Limited Liability Company).
Tom: Why don't you set us up as to the differences between corporate structure and Subchapter S. Are there other corporate structures?
Marilyn Mobley, CPA
Marilyn: There's a C-Corporation. The part for me is how are those different entities taxed; what are the tax ramifications for each one of those situations. The C-Corp is taxed at the entity level, so if there are profits in the corporation, those are taxed in the corporation and that's it. If the remodeler chooses to be a corporation but decides to elect S-Corp, all that does is change that to what in the tax laws is called a pass-through entity. Partnerships are pass-through entities, LLCs are pass-through entities, as are S-Corps. They're taxed a little bit differently: the LLCs are taxed with the partnership rules as are partnerships; the S-Corps, virtually everything passes through and is taxed on the individual's individual return. All of those separate items kind of flow through separately. It's not just one lump number that pops on their returns.
Tom: If there's one person that owns the company and he has a Subchapter S, that would come to that one person and be taxed to that one person. Can there be two people in that S-corporation?
Marilyn: There can be up to 100 — that's one of the limitations of S-Corp. There can only be 100 shareholders. Typically this is not a problem with startups or small businesses.
Tom: The partnership — how does it get taxed?
Marilyn: It's similar — different rules apply to a lot of the income and the ability to specially allocate items of income or expenses. That also flows through and is taxed to the individual partners on their personal return.
Tom: Similar to Subchapter S. Talk to me about an LLC, not corporation. Why would you do it for tax purposes?
Marilyn: It's a limited liability company, not a corporation. Tax-wise, you have more flexibility. There're a couple of reasons. One is that if you are a single member in the LLC — if there's just one owner, they're called a member — you can treat it as a disregarded entity and everything is still taxed on their personal returns but slightly differently than a pass-through entity. As a single-member LLC, you would have Schedule C reporting in a remodeler business. You're as if it's disregarded for tax purposes so you don't have to file a separate return, which is a cost savings. Then it's reported on your Schedule C. And then you still have that legal risk of that limited liability because you do have that recognized entity. So that's one of the reasons that people starting out as a sole proprietor with no formal structure; they might want to form an LLC to get some limited liability but still do the same income tax reporting that they did the day before.
Laurie: I have a question for Marilyn, actually. There are certain assets that you would prefer not be owned in an S-Corp, right?
Marilyn: Yes, real estate being one.
Laurie: If a remodeler owns the building that they're working out of, for example, that might be an asset you would put into an LLC, separate from doing an LLC for the business, right?
Marilyn: Just because of the tax treatment of any appreciable property, typically real estate as we've seen over the past few years has escalated in price and value. So there is potentially a double taxation on that real estate if you wanted to get it out of the S-Corp.
Tom: So what Laurie is saying — let's say you're operating out of an office building; you put that office building as an LLC, the remodeler as the single member, and then he rents to himself as an S-Corp and the S-Corp pays rent to the LLC for the building. Is that correct?
Marilyn: That's perfect.
Tom: Laurie, talk to us about the legal benefits of each one of these.
Laurie: If a client asks about choice of entity, comes in and has been operating as a sole proprietor, I have a duty to explain to them that to the extent that there is any kind of accident or loss and it exceeds the amount of their liability insurance or in the instance they are not carrying liability — I have to explain to them that (under New Mexico law) they would be personally liable if there was a judgment against them and that the only asset that would escape that judgment would be any qualified retirement that they've established, or any insurance policies. We, like a number of jurisdictions, have homestead rules — but you can certainly file a lien against houses, against real property.
Tom: And in today's world of suing, that wouldn't be something you would probably recommend.
Laurie: I tell clients that if they still want to operate "out of sole proprietor" we need to at least form an LLC, and they can be a single-member LLC filer. The reason why is that both LLCs and corporations, if properly formed and properly maintained, should afford the remodeler with limitations on liability. The caveat is with corporations and with LLCs you have to observe the formalities that you build into a document. I think the reason why clients in general like LLCs a little bit more from a practical standpoint than corporations is that there are fewer required corporate formalities. Again each state will differ. In New Mexico, there's no requirement that you hold meetings, that you file annual reports (in an LLC).
Tom: But there are requirements for annual meetings and other things in corporate structures.
Laurie: Right. In a C-Corp or an S-Corp, there is a requirement that you hold annual meetings, that you maintain a minute book, that you observe corporate formalities. And if you fail to observe corporate formalities, if you fail to keep the entity in good standing with the New Mexico public regulation commission (differs with states), you may lose that limitation on liability. The legal term is called "piercing the corporate veil." It is when someone fails to observe those formalities, or even more troubling, is when someone fails to keep their personal records, personal finances separate from the entities. And that is particularly difficult for small businesses who have been operating using their own checking account and are used to loaning money each month to make payroll and suddenly they find themselves in an LLC or corporation and they run short. They've lent money in a prior month and they're flush for a month, and then go and write a check to themselves personally. They won't document it and maybe they'll go and pay for something personal. If down the road litigation ensues, one of the problems that can happen is that an attorney will review their books and review their banking records and then will ask the court to enter an alter-ego theory — make the person personally liable because they really weren't exercising corporate formalities. They weren't treating the corporation as a separate entity.
Tom: I want to expound on this just a bit. A lot of remodeling contractors that I talk to at shows and seminars, some of the remodeling contractor owners are what they are because of advice from people like you as an attorney or like Marilyn as a CPA. I'm not sure they understand all the ramifications, so in this particular exchange, you've just hit a nerve. You're saying to me that if a company is an S-Corp, which I think a lot of them are — and Marilyn the question is going to be coming to you: I want you to see if the S-Corp is the most popular — we happen to be a C-Corp. However, to keep that you have to keep certain corporate entities that you have. And you mentioned minutes in a corporate book, an annual meeting. And, if you don't do that, you could be open for liability if somebody gets into a problem, and they say wait a minute, you say you're a C-Corp — but you're not. Now you're going to be judged as what? So you have to document it, and if you don't, what happens?
Laurie: Again, it's a potential for liability. Each case is going to court and look at the facts and make decisions, but, for example, the things that I look for when I look through sombody's records are did they enter into contracts, did they just sign their own name or did they sign their own name as president of Legacy Construction. That's one of the things I've talked to Lonnie about. Don't sign your own name. Make sure when you sign it, it says Legacy Construction and then you can sign it.
Tom: What entity, Marilyn, is Legacy Construction?
Marilyn: They're an S-Corp.
Tom: Don't get caught up in using your personal credit card to get miles and expect it to go over. What happens then — does the corporation reimburse him?
Marilyn: I remember once I was in a class where I was speaking and there was also an attorney speaking, and it was to a group of small business owners. His comment was that the very first thing that he does if he is suing a contractor is to get hold of their books and ask for their minutes because he's looking to see if they respected that corporate entity — were they operating as a corporation, were they acting as a corporation. One thing that I try to give people when I counsel them, I try and give them a visual. I say, you're no different than General Motors once you form a corporation. And if you think of that — would you just go into GM and say give me some cash? They would just start laughing. So there're formalities, and we try and encourage everyone to think that way and react that way, even though it's their pair of pants, they own the entire pair of pants. This is my corporate pocket, this is my personal pocket, and keep those separate.
Laurie: And sometimes with small businesses, there are going to be times for cash flow reasons that the small business owner is going to have to lend money to the entity. In those cases, at least document — if you're not going to do the minutes at that moment — at least document: "On such and such date, I personally lent the corporation the sum of $5,000, which is payable back to me at such and such a time." Just put a note in the corporate notebook to demonstrate. The problem is from a legal and an accounting perspective it becomes very difficult after the fact to go back and try to re-create what somebody did six months or a year later to go back and try to figure out, why did this $5,000 come into the corporation? What was the intention here? Was it treated as a loan? Are we keeping the pockets separate?
Tom: What would you suggest to someone coming to you and asking how to set up his business?
Marilyn: It's very specific to that individual. That's one of the things I wanted them to come away from this with, the whole point is that they find people in their area that they can talk to about these issues — an attorney and a CPA — just kick around those things as they relate to themselves. What do you think you are going to make a year?
Tom: If I come to you and say my business plan says I'm going to do $500,000 a year and when I pay all the labor, material, subs, cleanup and permits, I'll have a gross profit of $200,000, and my expenses are $150,000, and included in that is my salary of $50,000. And I have $50,000 profit. Typical of a small guy just starting up. What are you going to do to him?
Marilyn: Typically the entity I suggest is the S-Corporation. If I feel like they're going to be very cavalier and not do the formalities, we might suggest an LLC but one of the reasons that I like the S-Corp is that the taxation is straightforward — easy for them to understand — and I think it's critical that they understand the taxation. Under partnership taxation, it's far more flexible and therefore far more complex. If they're a single person, if there's just the one shareholder or member, typically if we get them early enough we can get them structured so that they clearly understand the few things that they absolutely have to do. Then we can get them started on the right path. As far as the S-Corp, only the amount that they pay to themselves as wages is going to be taxed for payroll taxes for the social security and Medicare — that's all that's going to be taxed. The $50,000 that comes out and is taxed on their personal returns is not subject to self-employment tax. There's still a lot of discussion happening in the LLC arena, but right now all of the profits would be subject to self-employment tax. In the LLC, it flows through and is taxed on their personal returns as a Schedule C, so then the bottom line basically is that it's all subject to self-employment tax. But the S-Corp is fairly straightforward, fairly similar reporting; it's a preferred entity for me.
Tom: What advice would you have for someone who is going to start a partnership? Do you recommend a partnership agreement to be in writing, and what's the first step? What's the advice you could give someone to stay partners?
Laurie: Let me say that if there is no written partnership agreement, I tell my clients that they are general partners (a general partnership); they are each individually and mutually liable for any mistakes that their partner makes. And, that it is in my view, the very worst way for them to do business. I recommend that if they don't want to be involved with the formalities of forming a corporation that they form an LLC and that they can each be a managing member of the LLC. But in terms of maintaining that entity, whatever it is, I think that it's imperative to have a written agreement, whether it's a written operating agreement or a partnership agreement that spells out what I like to call the road rules. Who's going to make the decisions? How are the decisions going to be made? How are profits and losses going to be allocated? What will happen if somebody dies or retires or remarries? What will happen if somebody becomes disabled? What will happen if somebody wants to leave? What are we going to do if one of us doesn't like the other person and wants to get out? To have that discussion and figure out and draft a document that addresses those things. How are we going to value a member's interest if he dies? Are we going to obtain insurance so that we have some mechanism? Because I know that a lot of my clients come in and say, "I love John to death; but if he dies, I don't want to be a partner with his wife. But I want to make sure that if I die, that my spouse is going to get paid for my interest in this company." Include buy/sell language, which is what happens if somebody wants to or needs to get out; include some clarification. How are you going to value the corporation or the LLC or the partnership? There're all sorts of different formulas. Are you going to require an appraiser come in? Are you going to do it based upon certain percentage of the last three years prior gross receipts? There are all sorts of different ways. That's where it's beneficial to have an attorney assist you on the front end in getting your business established. It's always difficult because claims come to you at a point in time when they're wanting all of their capital to be invested in getting their business off the ground, and sometimes you have to really arm-wrestle them to understand that it's really to their benefit to pay an attorney to advise them, and to sit down with a CPA, and to sit down with somebody that will provide them with insurance, and to take a team approach. I think their chances of surviving in the long run are really aided by having those professionals.
Tom: You've touched upon 15 or more areas of all the things that will probably give the readers chills as to what happens to one of the partners and how they deal with the other spouse and things of that nature.
Laurie: What if they get divorced? Those are the things I like to sit back — Marilyn and I talk about this all the time — from a very practical perspective. We've seen businesses crater and the causes for it.
Continuation of the discussion from the magazine article:
Tom: Do it upfront while we're kind of still friends and not when something drastically changes down the line and we assumed that it would be one way and in fact there isn't a legal document that supports that.
Marilyn: There are horror stories that I try and pass on to people. I had a 50/50 partnership, which is a problem because if you disagree, who wins? The second part was that one of the partners worked very hard, threw his heart and soul into it. The other just kind of kicked back, put his feet up on the desk and said, this is a nice ride. And so this went on for a number of years and finally the hardworking partner said, I want you gone — I'm going to buy you out. They looked at the partnership documents and didn't really address specifically, they were just kind of the boilerplate partnership agreement. So when the dust settled, the one that wanted the other one gone had to pay through the nose. It was very similar to a very nasty divorce where one wanted out and the other one said, fine, pay me the big money. And they did. So when you see those kinds of things happening, you go back to Laurie's comment — let's do the what-if game. What if, what if, and let's document what the partnership agreement's going to say for all those what ifs or as many as we can come up with.
Tom: We have time for one more area — one that pops off the page. A lot of these are unspeakables — no one wants to talk about divorce the day they get married, no one wants to talk about separating from a partner the day they decide to be one. But what about benefits, like 401k and profit sharing, health insurance and expenses that are paid, such as meals and lodging? How are they treated differently within this concept of S-Corp, C-Corp, LLC and sole proprietor?
Marilyn: Let's start at the bottom. Expense reimbursements — again we kind of look in taxation to the ordinary, necessary cost of doing business. Again, if you were GM, if you had submitted an expense report for your travel to the International Builders Show, they would reimburse you. The same type of thing goes for the S-Corp; the LLC, it doesn't matter as long as they are documented — the who, what, when, where, why. Typically to give them something to hang on to, I always say "if you are submitting an expense report to a large entity, what would they require?" If they follow that same formality in their own business, everything is fine. As far as medical, health and accident insurance, for a 2 percent or more shareholder in a sub-chapter S-Corporation, that amount goes on their W2 form in box one, gross wages, but it is not subject to FICA and Medicare. But then the corporation gets to deduct that to the bottom line, so the 2 percent or more shareholder picks it up as income through their W2 rather than just the net income of the business. For any other employees, that's deductible by the corporation.
Tom: But it's not for the owner?
Marilyn: Not for the 2 percent or more shareholder, no. Well, it is and it isn't. It's deductible as wages but they have to pick it up as income, whereas your employees, if it's a qualified plan, typically they don't have to pick it up as income.
Tom: You're saying that if I owned more than 2 percent of the corporation I'm a partner in this S-Corporation, could I deduct medical insurance?
Marilyn: You can but it ends up on your W2.
Tom: It becomes an income to me.
Laurie: But that individual then may or may not be able to deduct.
Marilyn: Exactly right. You have a deduction on the 1040 and adjustments so all of those things pass through from that entity and they flop in different places on your return. So yes, there is a deduction — right now it is 100 percent for that shareholder as well. Sometimes you know I'm thinking that the readers of this article are just starting in the business, typically what I have seen in those first couple of years when they are purchasing all their equipment, they're really getting established, so often there are no profits. So sometimes, those kinds of deduction don't really help them because if they have 12 kids, they have no taxable income. But if they're a Schedule C, a sole proprietor, they could have self-employment income but no taxable income. They end up paying self-employment tax, and they're coming to me and saying, why? I don't owe any tax but you show I owe $6,000. What is this? That's the self-employment income.
Tom: Those are the ones that hit some friends of ours — people who have worked here and said, six months after they started a business, I've never made any more than I've ever made, but a year and a half later, they're working for someone else and they come and they blame the government for coming to take all their money.
Marilyn: That's where we try and educate them. If I can show them how that's all going to work — and I do it not just in one sitting but we do it over time — some are able to really absorb that. Others, their eyes glaze over as soon as you mention S-Corp and they're gone. We feel like the more that they are educated on exactly how these things are either taxed or the legal ramifications of doing certain things, the better choices they are going to make. This doesn't happen with just one time: it happens by looking at articles like this, talking to other professionals. And it's very dangerous to talk to other guys on the street — Joe says blah, blah. Well, does Joe really know? I think it's very important to choose qualified professionals. Spend the money — it's an investment in yourself and your future profitability. Those professional fees are very minimal.
Tom: And that's really why we chose this topic for this month. I had a couple of people come up at a seminar that I was doing and they were talking about a number of things. One said he was an LLC and another said he was an S-Corp. So he was asked why he was an S-Corp, and he didn't know. The other guy read about LLCs in an article and said it looked like that's what he needed to be. Then he said it sounds a heck of a lot cooler than being an S-Corp. I thought we needed to have a little bit more input than this. If I'm an S-Corp can I be a C-Corp? For instance, what if I don't like being a C-Corp? I was a C-Corp and wanted to be an S-Corp and they said you can but then if you want to change back I think you have to wait 10 years.
Marilyn: And also there's a formal election that you have to make to be an S-Corp.
Tom: Your answers are not as simple as this is what we do and that's it. They're, this is what we do depending on . . .
Marilyn: That's what I would like to leave you with. One of the critical factors for me is that they maintain an adequate set of books and records. They must get some kind of accounting system that works that does capture all of their transactions. Otherwise at the end of the year, they're pulling receipts out of their hip pocket — it's a nightmare. And talk about expensive!
Tom: What we talked about today. There's some major differences between the entities. We talked about the sole proprietor — a guy starting up can overnight as a sole proprietor start working. But a sole proprietor has no liability protection: there are no liability limits, except for some possibly qualified programs. Laurie, you mentioned some insurance policies, but I know that's New Mexico law and will vary from state to state. We'll qualify this by saying that all the things that I'm about to tell you are based on generalities and local rules and will change from state to state. We talked about corporate structure: Subchapter S was one, and that's taxed as a pass-through. The C-Corporation — from what I see there's not a lot of C-Corp set up as remodelers. Partnership: there's a lot more of these and we suggested these are set up similar to an S-Corp. We talked about LLCs, which is a limited liability company. They have more flexibility. They are known as members instead of owners. You can treat them as a disregarded entity. They are treated differently than a S-Corp because we get into this Schedule C, and it's becoming very evident to me how important CPAs and attorneys are becoming in my life. On the legal side of it, Laurie got into a very interesting discussion — you need whatever you do to document personal versus company spending; you need to hold annual meetings, and observe corporate formalities. And if you don't, if a suit comes up down the line, a lawyer would probably immediately ask for minutes of the annual meetings and the corporate resolutions. It could be you are subject to additional liability that you thought you were guarded against. Document any transaction to be recorded later. If you are going to be an S-Corp and you need to loan the corporation money, document it even if it doesn't go in the minutes right then, at least have it for the end of the year. If a brand new company comes up, spend — even if it's with the Homebuilders' Association attorney on staff — or find a CPA and attorney to keep you from getting in a lot of trouble. A typical company that would get into this business would probably be directed to an S-Corp or an LLC, depending upon what they project for profit. We then talked about partnerships and Laurie for an attorney was so eloquent. If it's not in writing, then she's saying you're a general partner and you are mutually subject to being liable for each other. She would suggest by all means to at least form an LLC and find each one of you a managing member. We then got into how imperative it was to have it in writing. And Laurie, you did a magnificent job of identifying what I think is a problem in this industry: get the rules of the road — the how tos and what ifs — at the front end. We talked about the Schedule C of LLC. We talked about expenses — 401k, profit sharing, health insurance — were affected differently. Marilyn brought up that all expenses you have, whether it be a sole proprietor or corporate structure for sure or LLC — that are ordinary and necessary for business is usually okay. It's when you get into different kinds of entities like health insurance, etc. — it's treated differently in the S-Corporations than it is in other structures. So it's very different. Each person is different and there isn't one master plan for all.
Laurie: I would say a beginner should talk with other people in the industry — find the names of at least one or two attorneys and accountants who have helped others and make an appointment or call them on the phone and find somebody that they think they can work with. And as part of the cost of setting up their company, they should understand that that needs to be part of the business plan. And if they do that, and if they are able to sit down and get a good dialog going, I think that their chances of being successful are dramatically increased.
Marilyn: I think again it's finding someone who they feel comfortable talking with — that is absolutely crucial. Finding someone that deals with the level of business that they are in. I deal primarily with small- and medium-size businesses. When it gets into the big leagues, they have different issues. Also, the builders and remodelers shows — they are good places to talk openly with people about your specific circumstances. These are not your competitors, like the people in your own community where you don't feel like you can share a lot of information with them. These are people from across the country who have faced very similar situations, and they can have some very valuable advice for you.