From time to time, we receive questions via email or posted on the TAE Blog from show listeners; the answers to which would seem to serve more than just that one individual.

One such blog comment comes to us from a gentlemen named Dwayne … in fact, as Dwayne mentions, he actually worked for me at one of my previous start-ups - JD Warren. You can read Dwayne’s posting here.

The following is my response that resulted from a conversation I had with Mr. Dave Wilke, my favorite accountant and of course the host of the extremely popular TAE show segment, “Ask the Accountant”. (Actually, Dave was lecturing my Introduction to Entrepreneurism class at Duquesne University the same day we reviewed Dwayne’s posting, so in effect three distinct groups benefitted from his question!)

Dwayne, you are one of a couple hundred guys who seem to get in touch with The American Entrepreneur each year, essentially asking the question, “What should I do vis-à-vis forming my own protective corporation? Should I go with an LLC, or maybe a subchapter-“S” type corporation? HELP!”

So, here are my thoughts.

First off, let’s rule out the Sub-C Corporation. Why? Well, because, and at least here in Pennsylvania, Sub-C’s aren’t really too sweet a deal for a start-up.  Although they are good for fringe benefits (i.e. owners can deduct out of pocket medical expenses, long-term care insurance, and child care costs), one of the most immediate stinkers is the 9.9% CNIT (Corporate Net Income Tax). Add to this the Capital Stock and Franchise Tax (onerous and ridiculous!) and a few other superfluous compliance-related expenses and you’ll see why I hate Sub-C’s. Also, a Sub-C isn’t a pass-through (meaning that the tax rate is bracketed by state statute, rather than at the personal rate of the individual taxpayer), and pass-through is one of your stipulations.

Both of your stated options are “pass-through” type entities. What this means, and very simply, is that all of the profits and losses of the entity pass through to the individual shareholders and the shareholders list those gains and losses on their personal tax return. This is just as true for an LLC as it is for a Sub-S. The losses and gains of both an LLC and a Sub-S are not taxed at the corporate level, as they would be in the case of a Sub-C.

One other small quirk of the LLC is that LLC shareholders are called Members, and if any Member should die or file for bankruptcy (having done so once, I can testify that death and bankruptcy are not all that dissimilar!) while owning an interest in the LLC, that LLC is immediately dissolved. Poof!

So, how’s about we build a type of chart … comparing the LLC to the Sub-S … and let that be a guide to our thinking.

Of course, the phrase “limits liability” means just what it says (remember – to help limit liability an LLC requires an operating agreement, while an S Corp needs a shareholders agreement) … both of these structures will protect you and your family from bankruptcy in the event of some unforeseen catastrophe or lawsuit. There is not enough insurance in the world to allow you to sleep at night should you forego your “corporate armor”. It’s there for the taking --- take it!

Now for the explanations:

1. The Sub-S requires you to advertise the existence of your new corporation. A lot. This is definitely a hassle and, if you give the incorporating job to an attorney, it can be an expensive line-item on his invoice to you for work that will likely be done by a clerk. (In other words, you can pay through the nose!). On the other hand, do it yourself-ers can get into plenty of trouble if they don’t do these and other incorporation-related things to the letter of the law (which is one of a myriad number of reasons why I scratch my head when people self-incorporate over the internet). There is no such advertising required when you form an LLC.
2. Stock classes – this is a big one. You want preferred stock (and thus be at the head of the line, come liquidation and/or dilution)? Then you want an LLC. Sub-S-ers have no such advantage. LLC’s allow for separate stock classes and Sub-S-ers don’t. Simple as that. This is a big one, especially if you are looking for investors.
3. Corporate Minutes – No great shakes, but it still becomes annoying to have to hold regular board meetings and then document those meetings with detailed minutes. (Heck, most start-ups don’t even HAVE board meetings --- not that I am saying they shouldn’t! --- boards and board meetings are extremely important to a start-up and you can immediately tell when you are dealing with a company that has an intelligent and relevant board in place.)
4. Corporate Resolutions – See above. Again, most significant actions in a Sub-S first require a stated resolution, signed off by an officer and documented in the minutes. More hassle, but the kind of discipline I personally like in my start-ups!
5. Regulated Shareholders – This can be a big one, too. In a sub-S, you are limited to seventy-five total shareholders, none of whom can be foreigners. There is no such limitation in an LLC.
6. Taxes – Finally, the LLC must pay social security and medical taxes (including the matching 7.65%) equaling 15.3% of each employee’s gross wage while these are not due payable under the Subchapter-S structure. This can become a big number and this means regular deposits and more structure/discipline! (Again, not a bad thing.) I would also like to add two little known facts: First: LLC’s can elect to be taxed as either C Corporations or S Corporations. And second: In an S Corp – shareholders can only deduct their own capital and personal loan contributions. But, by making a personal guarantee on its debt, members of an LLC could be taxed as either a sole proprietorship or as a partnership to deduct losses even though they did not lose their own money.
   

A very important note regarding a Sub-S (and David and I just entertained a call from a listener who had this issue) is that the employees – and especially the owner --- within a Sub-S must pay him or herself a wage that is proximate to that which would be paid to a typical “outsider” doing that same job. In other words, the owner cannot simply take out his or her pay “at the end” of the year via distribution. Instead, he or she must decide upon a fair wage at the beginning of the cycle and then pay that wage, along with all relevant taxes, each and every pay period.

Too often, owners of Sub-S corporations look at the tasty option known as Distributions, and then pay themselves a “year-end bonus” equal to six months worth of pay. Do this (and get caught) and the IRS may well re-classify all profits of the corporation as wages --- subject to all payroll and other taxes --- and also make you pay a penalty! This tends to happen a lot lately, and the IRS sees this as a “lay-up”, in terms of collecting money for the agency.

So, what to do? Well, that’s between you, your business/tax strategy, and your accountant (which I insist you speak to before making any kind of declaration of this magnitude.) And in fact, while I’m on the topic, why not contact Dave Wilke himself at (412) 278-2200 or www.wilkecpa.com.

As mentioned, tax strategy is paramount. And so if you think that you are going to lose a lot of money in your start-up year(s), then an LLC is a great choice. If not, then you might look to a Sub-S. Again, I would stay clear of the Sub-C option.

There are other options, too; although these two are by far the most popular. One of the remaining options worth considering in certain circumstances is an “LP”, or “Limited Partnership” structure. The LP is generally great when a number of big-money investors are needed. Oftentimes, this structure can be exploited to enable the Managing Partner to actually control the destiny and management of the business without interference from other “owners”, whose equity stake actually dwarfs that of the MP. (Think Al Davis … Oakland Raiders!)

But that’s a whole new show.

Dwayne, I sincerely hope this helps, just as I hope it helps any and all others who read this missive. In the meantime, thanks for being a loyal listener, please keep on listening, and please keep on sending me e-mails and commenting on the blog (just like this one). Heck, it beats having me sit down and dream up what exactly it is that is giving you “brain cramps” as you go through the day-to-day of running your successful start-up!

My Best,

Ron