LLCs vs. S-Corporations

Last year I wrote a post about the benefits of using an LLC with an S-election as a business owner to limit employment taxes. The question I received in response was, why not just use a corporation instead?

An LLC is a state-created entity. The IRS doesn't recognize it as a specific taxable class and requires you to elect how it should be taxed or the IRS will give it default tax treatment based on the number of owners. I explained the benefits of choosing to be taxed as an S-corp in the post referenced above. So what's wrong with just creating an S-corp from the start? That depends on what you're looking for.

If you want simple maintenance, the LLC is the way to go. Maintenance, in this context, refers to keeping the formalities necessary to maintain corporate status. Losing corporate status means losing the veil between you as an individual and you as a business owner. That translates to personal assets and business assets being vulnerable in a lawsuit against either the individual or the business. Corporate formalities include naming a board of directors, performing meetings of the directors and officers and maintaining meeting minutes. You will also need a stock ledger and stock certificates. An LLC requires none of these.

An LLC is also more flexible. In single member LLCs this is less important, but for partnerships, the operating agreement is much more malleable than the bylaws of a corporation. An LLC allows for adjustable distributions between owners whereas the corporation must distribute in amounts proportional to stock ownership. That means that if Adam contributes 10% of the capital and Bill contributes 90%, Bill must receive 90% of the profits, even if Adam does 90% of the work going forward. An LLC operating agreement can adjust this.

An S-corporation has its advantages too. Its easier to transfer stock to new owners than it is to transfer LLC ownership interest. The requirement of annual meetings can be beneficial by forcing the owners to discuss business beyond the day to day operation. This site provides a nice comparison matrix of the three types of entities discussed here. A C-corporation is extremely advantageous for a whole host of reasons that are beyond the scope of this blog post. Suffice to say, I very rarely recommend C-corps for small business owners

To conclude, I want to emphasize the importance of a competent CPA to advise your business. When I create a simple LLC for a client, I explain that the LLC is a pass-through entity, meaning that all LLC income is reflected directly on the individual's tax return. On the other hand, LLCs with S-elections and corporations come with a lot more explanation and encouragement to retain a CPA. The tax treatment is unique, the formalities are more involved and rules are more complex. A good CPA will attend to all of this, plus help take advantage of many additional corporate benefits not addressed here.

Most Americans don't have a Will

Are you the type that feels validated when you aren't doing something you know you should and you discover you're actually part of the majority? Like failing to floss daily or not exercising enough? If so, this short article from CNBC.com will probably be a good read for you. To summarize, most Americans do not have wills. Read my website or attend one of my seminars and you'll hear a dozen reasons why you should, but what the article highlights is just how awful people believe drafting a will to be. According to the article quoting a survey, one out of three respondents would rather do their taxes, get a root canal, or give up sex for a month instead of creating or updating a will!

Estate planning is only as difficult and complicated as you want it to be. Meeting with an estate planning attorney will lift the burden and ease the confusion of drafting a will and trust. I've explained in a prior post the steps a typical client follows in meeting with me. The process is smooth and I've never had a client disappointed with the outcome. So join the superior minority who have taken action and created their wills. I'm confident you'll be surprised at how stress-free the task really is.

Piercing the corporate veil

Piercing the corporate veil (PCV) is the technique a creditor will use to attempt to reach the personal assets of a business owner whose business interest is on the wrong side of a judgment. In the context of small business owners, its a single member business or partnership that can't satisfy a debt or judgment incurred by the business with business assets. In such an occasion, assuming the debt or judgment is valid, the creditor is stopped when all business assets are liquidated. That is the benefit of the corporate (of LLC) form. It is a completely separate entity from the individual owner. However, if the creditor can prove the owner(s) abused the corporate form, the creditor may succeed in piercing the corporate veil and reaching the individual's personal assets to satisfy the debt. It's a worst case scenario for a business owner, but it can be avoided if specific formalities are followed, the entity is adequately capitalized and the entity is formed, funded, and carried on for a legitimate purpose.

First, don't get lazy. If you don't respect the division between yourself and your business, you can't expect a creditor to either. If you run a corporation, maintain annual meeting minutes, keep an accurate stock ledger, file your annual reports with the Secretary of State and pay your fees. An LLC requires less, but it's recommended to maintain similar administrative habits. Even more critical is keeping business bank accounts and expenses separate from personal debts. If you treat the business account as your personal piggy bank, forget about a court respecting the corporate identity.

Next, insure the business. That may include insuring the property, product liability insurance, and professional and general liability policies. A commercial umbrella policy doesn't hurt either. In the same way you insure your own car and home from liabilities that may arise, you must think the similarly about your business. Undercapitalization invites a successful veil piercing action. Adequately capitalizing your business such that it can reasonably meet prospective liabilities is a must and insurance is a terrific way to accomplish this.

Finally, forget about a court of equity respecting the corporate form when it was opened or funded for unethical or dishonest purposes. This may be a no-brainer, but stuffing real property or cash in an LLC to hide it from known creditors is never going to work.

When successful veil piercing happens, frequently it's the result of a lackadaisical, ignorant or dishonest owner treating the business as an alter ego of himself. If you think of the business as a distinct and separate individual from yourself and deal with it as such (don't steal from its accounts, contract with it at arms length, etc.), a lot of the mistakes that lead to veil piercing can be avoided.

Health care powers of attorney are more critical than ever

The US Department of Health and Human and Services has been ramping up their enforcement of HIPAA privacy rules as of late. Most recently significant fines have been levied against UCLA Medical Center. What this means to you is that health care providers are going to scrutinize ever more who receives your personal health information. In general, that's good news. The primary purpose of HIPAA is to protect your confidential health information. However, there are times when you want others to have access to your that information. Hospitals will be less likely to cooperate (to some extent out of fear of incurring the wrath of the USDHHS) unless you have formally authorized it.

That's where a well-drafted health care power of attorney comes in. Any time you check in to a hospital, they have you complete a stack of forms. Among them is a HIPAA waiver for identified parties. However, if you enter a hospital in an incapacitated condition, obviously you're not completing those forms. Having done so in advance as part of your estate plan will alleviate the issues that may arise. Moreover, completing those intake forms upon entry to a hospital is rarely done in a fully lucid state of mind anyway, since most hospital stays are not initiated deliberately. By completing a health care directive or medical power of attorney, you will have made all the pertinent decisions in advance, free of the stress of the hospital waiting room.

Choosing a retirement account

I don't often advise my clients on choosing a retirement account to fund. Your financial planner is usually in a better position to advise. Instead I focus on the impact to your estate planning after the fact. Of course, this knowledge will help inform you as to which is your best option, but ultimately I will leave that decision to you and your financial planner.

The above notwithstanding, I can't help but point out this IRA matrix found on Wikipedia. Generally, Wikipedia is a great source for objective (and generally correct) information. I believe this to be no exception. Apply your unique circumstances against this table to help guide you to the right account.

One thing I'd like to point out is about seven rows from the top of the table in the "Forced Distributions" row. Notice that Roth IRAs do not require forced distributions. For estate planning, this can be extremely valuable. While generally the guidelines are drawn up so that your retirement account is used up before you die based on actuarial tables and effected through Required Minimum Distributions ("RMDs"), Roth IRAs do not require distributions during the contributor's life. This allows a Roth IRA owner to pass on her account to her children who can withdraw tax-free (Roth IRAs are built on after-tax contributions). Naming an IRA trust as a beneficiary where the oldest beneficiary is relatively young, can allow the account to grow substantially. Since the the distribution rate is based on the life expectancy of the eldest trust beneficiary, the minimum payouts can be minimal depending on the beneficiary's age.

Over time, as payouts are made to the trust, the funds may be reinvested and held based on the discretion of the trustee and distributed for certain life events and/or at different ages. A good article ran in Forbes a while back extolling the virtues of such an arrangement.

Of course such a strategy should be examined on a case by case basis, but it's just one more factor to consider when creating and funding that all-important retirement account.