Ed and Chuck discuss the various forms of business organizations. “Should I form a corporation for a business I am starting?” Corporations as liability shields. Jeff Bezos ran over my dog. Sue Amazon and Jeff. No corporate or business organization can insulate you from liability. Accounting magic tricks. Lobsters in a pot.
Welcome to our listener-supported podcast, Money Talk, uncompromised absolute financial truths behind financial perceptions with host, Ed Sutkowski and Chuck LeFebvre. Let’s listen in.
Ed Sutkowski: Hello, I’m Ed.
Chuck LeFebvre: I’m Chuck.
Ed: Today’s discussion will relate to the forms in combination with various business organizations. It’s in phase one, the accumulation of the three stages, and I’d like to start with the self-employed individual. That could be someone who is setting up a candy shop, a florist, an inventor, an author, someone who is one to one and facing the world as an individual without a business organization between the person and the activity. I like to think about directors of corporations, their income as director fees are referred to in the jargon as their earnings from self-employment, and subject to payroll tax and the like, and they’re in a position to do some things, and we’ll get to that later, of installing some sort of a deferred comp arrangement. That could also be, as I say, an artist, a lawyer, an architect, a contractor. In other words, this person doesn’t necessarily work with that person’s hands only, but the intellectual achievements of the self-employed individual generate their earnings from self-employment and a lot of positives, but remember, unlimited liability. That person will typically have property and casualty insurance and other kinds of insurance to guard against this issue that that person’s on the hook for all those business obligations. Chuck, let’s talk about the corporation.
Chuck: Yes. It’s actually one of the most common questions that people will ask if they’re already in a small business or they’re thinking about starting a small business. They’ll come in and they’ll say, “Should I have a corporation for this business that I’m starting or this business that I’m already running?” and the number one thing that they raise when they ask that question is they’re interested in limiting their personal liability. There is a lot of confusion about how these business organizations can assist in insulating the owner from liability relating to the business. It’s easiest to start by talking about the corporate forum because most people just have a general sense of how corporations work, and they’re actually very easy to form. You can almost do them, the whole process online if you don’t care about having really detailed bylaws and that kind of thing, but the corporation is considered to be a separate legal entity from the individual. Because it is a separate legal entity from the individual, it has the ability to own property separately, to incur debt separately, and to pay taxes separately from the individual. I think that there’s largely a bit of a myth here when it comes to the amount that a corporation will shield an individual tradesperson from liability related to that business because typically, when people are asking that question, what they’re really concerned about is, “If I get sued for something that I do in my business, I just want the business assets to be used to pay that lawsuit rather than someone being able to come after my own personal home.” The bottom line on that is that if you’re a solo worker, if you’re somebody who’s– let’s say you’re a carpenter, you’re an artist, or you’re somebody who does lawn care or you’re a farmer and you don’t have any employees, you can individually be sued for anything that you do, you personally do, that would give rise to a lawsuit that involves negligence or some other torte. There’s really limited protection that adding a corporate form on top of your activities will provide. That said, it is true that if the corporation incurs debt, then only the corporation– For instance, we’re talking about a bank loan as an example, if the corporation has a bank loan, then only the corporation is liable to pay that loan and not you as the individual, but typically, that’s not what people are worried about when they’re trying to get this protection from liability. They feel like, “Hey, look, I know I’ll be able to pay off my loans. I’m just worried about being able to pay the judgment on a lawsuit.” Quite often, if you’re the only person who is serving as an employee of that corporation, you’re still going to be on the hook for any liability that arises out of your activity. A little bit different if you have employees, then the negligence of an employee, only the corporation and not you as the individual would be liable for the actions of an employee.
Ed: Let me make sure that I understand. Let’s talk about the doctors, CPA, and a lawyer. The doctor is negligent on some activities, the CPA missed some deadlines, the lawyer has done something that is clearly malpractice, and they all are either employed by their own corporation or by a mega-corporation. Are you suggesting to me that those individuals are likewise individually responsible?
Chuck: Yes, they are. Now, if you have a doctor who commits malpractice and is the employee of the corporation, then the individual doctor who committed malpractice can be sued for malpractice, so can the corporation that employs him, but the other doctors who are also employees of that corporation are insulated in that corporate form. Likewise, if you’re a lawyer, and as a lawyer, you committed malpractice, you individually can be sued for malpractice regardless of whether you’re practicing just as a sole proprietor or if you’ve incorporated your law practice, in which case both you individually and the corporation can be sued. There again, any negligence that is committed by one of the other lawyers in the firm, well, that individual lawyer can be sued and the firm can be sued, but if the firm is a corporation, then other than the one individual who committed the negligence, the other individual lawyers can’t be sued. The liability doesn’t spread in that way when you’re talking about a corporation. Where I see this question come up and what my comments were addressing is when you have somebody who’s literally a solo. You might just have somebody who’s an accountant, they’re not practicing with any other accountants, so they’re just working on their own and they say, “Hey, I’d like to form a corporation for my accounting practice so that nobody can sue me individually for any negligence if I happen to miss a deadline or something like that,” it just doesn’t work that way. In that case, the individual is still going to be sued. There are still some good reasons to have a corporation though, and those are largely tax-driven.
Ed: Before we leave that, let’s assume that I’m a messenger at Caterpillar, I deliver products, tools, and I leave the premises and I’m negligent. I run over X, my dog who’s very valuable. Caterpillar will be sued, but I can be sued also.
Chuck: Yes. Now, I think this is why people are confused about that because in that situation, what we’re accustomed to seeing is only Caterpillar getting sued and the individual not being sued, and of course, the reason the world works that way is because Caterpillar has the deep pockets, but the plaintiff in that suit has–
Ed: That’s the person bringing the suit?
Chuck: Yes, the person bringing the suit would have every right to sue the individual driver who actually committed the negligent act individually if they wanted to. It’s just that if you’re an employee of a mega-corporation, what’s the point of suing the employee when the deep pockets are really in the corporation?
Ed: Well, let’s flip that. Jeff Bezos is driving, he’s got megabucks owning the shares of Amazon. Why would you just bother suing Amazon? Just sue Jeff because he’s the guy that caused the problems, right?
Chuck: Yes, that’s exactly right. In the case of someone like Jeff Bezos, if I were suing, I’d probably sue both Jeff Bezos and Amazon, but it seems like either one of them have deep enough pockets on their own that there really shouldn’t be any reason to have to worry about the ability to pay a judgment unless they’ve started a nuclear war or something. It’s hard to imagine either that company or that individual creating enough damage to exhaust their wealth, but yes, that’s an example. What we’ll find quite often is, again, you see this fairly often with physicians where you may have a physician who has accumulated enough individual wealth where the physician personally has more assets than the malpractice insurance limits that are provided by their malpractice carrier, and so they’re worried about insulating their individual assets from a lawsuit. If it’s a physician practicing as a solo, merely wrapping that practice inside a corporation is not going to prevent the physician from being sued. I recently heard a story about a physician who had been practicing a long time who just happened to get a windfall completely unrelated to this physician’s practice, but suddenly came into about $30 million. Some of the other physicians who are practicing with this person immediately said, “Look, you’re crazy if you want to keep practicing medicine now [laughs] because I don’t care if you enjoy it, it’s just that now, you’re putting that entire $30 million at risk if you continue to practice medicine.” There’s really not a corporate form or any other business organization form that’s going to insulate you from your own personal conduct if that conduct results in liability. Quite often, when we get into conversations about business organizations with clients, the conversation very quickly turns to questions other than liability insulation and gets more into topics like governance issues, how do you manage the organization, and tax issues, how do you use these various forums in order to minimize or manage taxes. There’s a menu of different options there, and they all have different pros and cons to them. In the case of the corporate form, when you wrap a business up in a corporation, that business, the corporation becomes a separate taxpayer. Ever since the passage of the 2017 tax law, what happens is the corporation, it files a separate income tax return, then the owner individually and the corporate tax rate is 21%, which is lower than the top tax rate that can apply to an individual. A corporation suddenly became an opportunity to accumulate income at a lower tax rate by having this corporate form than was the case for individuals. There’s a difference in tax rates that sometimes can be taken advantage of there. The other thing is that when you create a corporation, then you become an employee of that corporation. As an employee, just like working for Caterpillar or any other large company, your wages are going to be paid by the corporation and you will receive from the corporation a W-2 at the end of the year with the corporation making withholdings and the corporation pays part of the Medicare and social security withholdings, and you individually pay the individual side of those withholdings. I think we’ll get into later episodes the availability of different retirement planning opportunities and other employee benefits that work very well in conjunction with the corporate form. Some of those can be done even if it’s just a corporation that has only one employee, one shareholder, one director, and one officer, and that being the person who formed it, you can still create an employee benefit plan. You can still create these top hat plans. You can still create all kinds of perks, so to speak, that would normally apply even for mega-corporations. There are some tax benefits to this particular form. Then, we have a special type of corporation that is often used when you’re talking about these closely-held businesses, and that’s the so-called S corp, which is simply a tax election where when you make an election for the corporation to be an S corp, then it is taxed. It still files a tax return, but all of its tax liabilities pass through and are deemed to be the liabilities of the shareholders instead. That is a little bit different than the traditional so-called C corporation. We see that an awful lot that S corporation form is used. Go ahead.
Ed: No, I was thinking, another approach is the partnership. That is, you can have an entity that is taxed as if it weren’t an entity.
Chuck: Yes, the S corporation is an example of that. Then, really, the most obvious example of that type of thing is a partnership where, let’s say you and I decide that we’re going to form a law firm. We enter into a partnership agreement, and all of the profits, the revenue, the expenses, depreciation, and everything else that would normally go on a tax return, well, that gets reported by the law firm by the partnership on a return, but the partnership doesn’t actually pay any taxes, it just allocates all of those to the individual partners. Then, that flows through onto their individual tax returns. That is an interesting form because you have a separate legal entity that is created under entity law, but from tax treatment, it’s almost like it’s just an accounting trick in a way. You’re just making a consolidated statement on a tax return, and then dividing all these things up among the partners. At the same time, a partner of a partnership can still be an employee and get a W-2 or get what are called guaranteed payments from the partnership which is treated like ordinary income from the partnership. The earnings that are earned from the partnership by the delivery of personal services would still be taxed and would still be subject to the self-employment tax just as if you were a sole proprietorship. These partnerships end up with an interesting amalgam of tax treatments that apply to them. It used to be that this really only occurred if you had two or more people enter into a partnership agreement and join this and make these partnerships. Now, we have this, I say fairly new, although it’s actually been in place for many decades now, is the limited liability company, which is treated from a tax standpoint like a partnership, but like a corporation, it has those same aspects of being a legal entity that provides protection against personal liability.
Ed: To make sure that I understand that, we have a corporation under state law, Delaware, Texas, Wyoming, whatever. It’s an organization formed under a state, and then it makes elections. Either it makes no election in which case be taxed as a separate organization, as a “regular” or a C corporation, or it can elect to be disregarded in a sense. Even though it remains in place for liability purposes, by making this S election, it is almost disregarded.
Chuck: That’s right. It’s not exactly the same, but in many ways, the tax treatment of that S corporation is like a partnership in the sense that the corporation files a tax return where they declare everything that went on economically within the corporation, and then just divvy up among the shareholders the tax treatment of all of those transactions. I don’t want to give people the impression that these are exactly the same thing, there are some nuances between them, but each shareholder of an S corporation ends up having the tax benefits and tax liabilities pass through the corporation down to the shareholder, and so it is referred to as a pass-through entity, which is, it’s an entity because like you said, it’s created under a state’s law. One of the 50 states in the union has sanctioned this as being a separate legal entity. By that phrase, what I mean is it has the power, the ability, the authority to own property and incur debt separately from an individual. It’s an entity, but it’s a pass-through entity in the sense that all of the tax results pass through the entity and are incurred individually by the shareholders.
Ed: Bottom line, see if I can get the sense of these differences, I view the corporation as a bit of a lobster pot. Now, you form a corporation whether it’s a C or even an S. That is a corporation you’ve elected to be treated as an S corporation, and you put assets. Now, let’s assume real estate. The worst possible location for real estate is inside a corporation for this reason. You can live with it, but to get it out is going to attract some form of tax more likely than not. Are there exceptions?
Chuck: You’re talking about a lobster pot where the lobsters have not been boiled. You got to reach into your hand and get pinched if you want to pull something out.
Ed: That’s right, and you’re not going to get the whole lobster out, you’re going to get something missing. You can think about a corporation as a lobster pot. You can live in it, but boy, the exit is going to be tough tax-wise. We get to the combination of various kinds of business organizations, and that’s in a very important aspect of what’s going on here. I’m not suggesting you have to be mister or miss megabucks to think about this, but you embark on a business activity. Let’s assume you have W-2 wages, but you have a side activity. Well, the issue is, should you be a sole proprietor? Should your spouse or significant other join with you in a partnership? Or should you do some kind of a combination? Should your children own the real estate and you lease the real state from the children’s partnership to the regular or the C corporation or an S corporation? In other words, the idea is to fragment income among related parties, including, for example, minor children, but the rental income from the rent is paid by the corporation to the children’s partnership and provides a source of opportunity funds for education and the like. The bottom line here is that the simple question is not only what is the form, but how many forms should you use, and can you modify them going forward? Ideally, people will start as a sole proprietor and then move into some other form of business organization. You do not need a lawyer or an accountant to help you form a self-employed status. You just go do it and that’s who you are. Bear in mind the liabilities that we discussed, all the income is really subject to self-employment tax and you have other limitations in terms of tax-qualified arrangements, but don’t spend all kinds of money with advisors until you know your idea is going to work.
Chuck: Do you think that it pays– When you say until you know your idea is going to work, how much of that is dependent on how much income you’re actually producing or how much tax you really have to manage from that?
Ed: Yes, but when you’re starting something out, you want those losses. I recall visiting with a lawyer from Denver. By the way, lawyers are the worst possible clients.
Ed: They have answers to the questions you haven’t even asked, especially the trial lawyers, but I care about making a recommendation or using a form of business organization. Yes, just saw him the other day, did exactly the opposite, but I think if I had charged him for the advice, he may have taken it. The point is, he will have losses starting up. He’s starting his own practice, and he will have lost as well. I should have said, “Mr. Lawyer, you don’t need any form of business organization, you’re the sole proprietor.” “Well, all the other lawyers in Denver have it.” “Well, I’m sorry.”
Chuck: Right. Well, that’s a perfect example really of where there’s this drive and lawyers actually do this, so they’re probably as guilty as anybody about this. You see, all these solo practitioners out there that form limited liability partnerships where they’re the only partner or they form limited liability companies where they’re the only member, or they form corporations where they’re the only shareholder, even though they’re lawyers, I think a lot of them are under the impression that by doing this, they’re somehow insulating themselves from personal liability when what they really need to be focused on are the different tax treatments of those different entities because if you’re a solo– Am I missing something here or is that really the only difference if you’re a solo, is going to be the tax treatment?
Ed: Absolutely. More specifically, and we’ll get into this later, the wealth accumulation process and what should the average Jane and John Doe be doing in terms of their investment strategy. The bottom line is, the worst possible source of income for tax purposes is W-2. The interim are tax-qualified plan accumulations and distributions, and that can be for all sorts of people that missed that opportunity. The best is, of course, long-term capital gain, but you can have a long term capital loss too. In other words, we have a ladder of the worst kind of income to the best kind of income and something in between, but the in-between the tax-qualified arrangements are best in a regular or a C corporation.
Chuck: Congress doesn’t want you to work, what they want you to do is to own capital for at least a year and then sell it. Correct?
Ed: Yes, that’s right.
Chuck: If you go by what they encourage you to do with the tax code, that’s what they’re telling you.
Ed: It’s upside down. You have a passive investor that has accumulated, won the lottery, for example, an investment in high dividend producing securities, stocks, bonds, whatever, and does nothing, and sells some of those long-term capital gain rates versus the poor soul that’s on W-2 and having 40% of their income taken away by the government.
Chuck: Right. Now, people are going to listen and say, “40%? That’s crazy for someone who’s barely making any money.” Let’s go through that because that’s a real number, isn’t it, Ed?
Ed: It is.
Chuck: What people always forget, this is my pet peeve, is the payroll tax. It’s incredible what that adds up to, which is 12.4% for Medicare, and then an additional 2.9% for– I’m sorry, that’s 12.4% for social security, and then an additional 2.9% for Medicare. If you’re not good at math, you can just add those together and say that’s 15% right off the top. That’s the same as the capital gains tax rate, and that tax applies to the first dollar that you earn if you’re a W-2 wager. Now, I guess some sharp ears will say, “Wait a minute, half of that’s paid by the employer and the employee only pays half.” I happen to subscribe to the views that most economists evidently agree too, which is that the employer portion of that is really reflected in a reduction of what would otherwise be paid to you in salary. Economically, that tax, the full 15% of it is really being borne by the employee.
Ed: We’re relying on government programs to produce the return for those contributions which isn’t always the case.
Chuck: Right. Some of the people who just are getting out of college today may never actually see any benefit from those programs. You never know.
Ed: I want to address just briefly marginal rates because at least I talk about 37%. That’s not quite fair because we look at brackets, and I’m speaking of married family jointly and surviving spouses. We have a 10%, 12%, 22%, 24%, 32%, 35%, and finally a 37% marginal top dollar rate. Well, that marginal rate at 37% is over $612,350. I want to understand, we use that as a shortcut that 37% + X, Y, and Z can come up to 40% or 50% when you count everything. You really have to look at your total, what we call adjusted gross income or how much tax you paid. It may be 33%, but the point is, the marginal rate, top dollar rate is 37% versus from 0% to 19% before, it’s 10%.
Chuck: Right, but if you’re a wage earner and if you add this 15% payroll to that 10%, well, you’re at a 25% tax bracket when you add those together.
Chuck: You only have to make your way up into the 25% tax bracket when you’re talking about income tax brackets for you to effectively be paying 40% tax as a wager, which is a rate you never achieve on capital gains.
Ed: We’ll get into the best and worst kind of income, but it is amazing to me to think that the individual wage earner is burdened and is punished more so than the megabucks individual who, over a period of time, has accumulated a fair amount of wealth.
Chuck: Yes. When we get into these conversations about different business entities, it seems like one of the things that a person should focus on is, first of all, do they want to have the income that they get out of this business, all or part of it, governed as wages? Now, we’ve just spent the last 10 minutes talking about why wages are so bad and so tax-disadvantaged, but the flip side of that, to tuck in the back of your mind for a later episode, is that you need wages in order to participate in a retirement plan. You may find yourself attracting wages purposely through the business organization that you form in order to be able to participate in a retirement plan, but from the tax standpoint, and we want to get as simple as we can on this, Ed, isn’t that come down to your choice of business entity, let’s set aside the liability issues for a second, and your choice of business entity from a tax standpoint comes down to which of these entities allow you to take income that is going to be characterized as investment income versus income that’s going to be characterized as payroll income?
Ed: Right. The problem with all these podcasts is that we have different levels of interest given the different levels of income. What we’re saying are very broad general principles, and one of our next episodes, we’ll deal more specifically with these different types of income and who’s being favored and who is being punished and why.
Chuck: Sounds good.
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