Ask a business owner why he or she restructured their business from a sole proprietorship to some other entity — C-corp, S-corp, LLC, ESOP — and the first answer is always: liability. In a sole proprietorship (even a partnership) you, the owner(s), are the business. If, for example, you shortcut building practices or use unlicensed trade partners and something goes wrong, it is you and your personal assets that the insurance companies will go after.
“As a sole proprietor your personal residence is exposed, your children's education is exposed,” says Jeff King, who, after five years as a sole proprietor, made his San Francisco company a C-corporation. “You don't want that exposure to go beyond your immediate business. If I'm hit by a bus, the creditors can't go after my home and family, only the business.”
SO MANY CHOICES
The C-corp is a separate entity from the business owner. It reports its income and pays taxes on profits. Owners are stockholders and receive dividends, which they report on their personal income tax returns. One drawback: Dividends are taxed as part of the corporation's income and as part of the owner's personal income — referred to as “double taxation.” Usually larger businesses become C-corporations, especially those that foresee issuing public stock.
About 25 years ago, the IRS created the Subchapter S-corporation to help smaller businesses incorporate. There can be up to 75 shareholders in an S-corp, and there is no double taxation. The business maintains the limited liability of the C-corp but is taxed like a partnership, i.e., it pays no corporate income tax; instead, it passes taxable income or loss on to stockholders.
Many remodelers restructure as an S-corporation, which, Striebich says, “has lower filing and accounting fees. It's sort of ‘corporation light.'”
When JD Coussens Inc., in Davenport, Iowa, became an S-corp, owner Jerry Coussens dreamt of one day selling the company to his employees. Currently he owns 100% of the stock. “I had options as a sole proprietor,” he says, “but now I have shares I can easily and legally divide.”
Like the S-corp, the Limited Liability Company (LLC) does not pay corporate income taxes. Owners are taxed on their personal income tax like a sole proprietor or a partnership, but an LLC is similar to a corporation in that the owner has liability protection. An LLC is more flexible and easier to set up than an S-corp, which has many more requirements. For instance, profits in an S-corp must be distributed among owners based on the ratio of stock ownership — even if the owners would like to see profits distributed differently.
An LLC, however, does not issue stock and there are no restrictions on ownership. Profits can be distributed any way management sees fit. On the other hand, since the LLC doesn't issue stock, stock ownershipcan't be used as an incentive for employees.
Iris Harrell, owner of Harrell Remodeling, in Mountain View, Calif., has structured her 25-year-old business at different times as an S-corp and a C-corp In 2000 the company went to an Employee Stock Ownership Plan, or ESOP. “I want to take care of my employees and have them share in the profits,” Harrell says. The company is now 23% employee-owned and Harrell hopes to get to 100% in the next five years. Shares are bought with company profits so there are no large out-of-pocket expenditures for employee-owners.
The most well-known ESOP may be United Airlines. It became 55% employee owned in 1995 and profits went up. Unfortunately, the good times ended five years later, giving ESOPs a black eye. It's generally acknowledged that United Airlines' ESOP difficulties stemmed from the way in which the process was introduced to employees as a way to company solvency.
Harrell hopes to avoid that by moving slowly and making the ESOP idea part of the company culture. Education is a big part of the process. “I have to get employees to think like owners,” she says. “The dignity and choices that come with having financial independence are fantastic. [There are] people who have spent 25 years in the company helping it become the dream we've put together. They should be sharing in the outcome when they want to retire.”
JUST DO IT Starting your sole proprietorship was easy. But somewhere between three and six years in business and you're likely to see growth and profit. “It's almost like a revelation,” says Striebich who sees this time and again with the business owners with whom he consults. “Suddenly you become more successful and you wake up scared. Now you have something to lose and you'd better protect yourself.”
There are online incorporation sites and there is Web-based information about the various entities, but after doing some research on your own, you should consult an accountant to help you understand the tax implications of each business structure. Then consult an attorney. Although some states that don't require that a lawyer file your papers, it's worth your while to have the filing done by an attorney. Costs vary, but the investment pays for itself in protection and peace of mind.