Money Talk

Episode 28

Forms of Business Organizations

Should I set up a Corporation? Which type? “Muffins by Sue” Do you have a business plan? Buy a new pair of shoes? Watch out for academic excellence. Should I get NetJets? Where’s my limo? Shine my shoes.

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.

Chuck: This is Chuck.

Ed: I’m Ed.

Chuck: Ed, I guess we’re talking about how to grow it today, at least I’d like to talk about something. In particular, the question that comes up on a fairly regular basis about business organizations in different forms. I think it’s very confusing for people, that are starting a business; Corporation, limited liability company, limited partnership, limited liability, limited partnership. Tell us, Ed, you’ve been doing this for 50 years, just pick one. Tell us which one is the best.

Ed: Well, tell me what your concerns are and I’ll tell you which one to do. Having said that, the issue is really right to tax. That is who’s to be the owner? How long are you going to keep the business alive? What are the transactions? What’s the liability? There’s a whole range of issues that you must consider. If you’ve done this more than once or twice, they pop out to you. It’s not rocket science. I like to say it is but it’s really not. My dog– not that my dog Jack could do it but it’s not too far from that, in the simplest form for the proprietorship. June Bug, my cousin manufactures widgets. She either sells them or manufactures or both. She said, “Should I incorporate it?” I said, the questions were what, Chuck?

Chuck: First of all, are you looking for other investors? Is there a liability concern there? Is there a reason to create a separate taxpayer? Meaning they have a corporation that’s a separate taxpayer from the owner? Do you want to take advantage of employment and retirement planning? I guess the big question that surrounds all those, how much money are you making?

Ed: Not only that but before we proceed, let’s see your game plan. Let’s see your business plan. You don’t have a business plan? Well, you don’t need me, just go ahead and open a checking account or go to the Secretary of State register your names. We’ll call them Muffins by Sue or whatever you care to call it, and you’re off and running. You have no liabilities. You’re just manufacturing or cooking or baking muffins. Big deal, right?

Chuck: Well, let’s cover this right upfront. That person who says, “Well, yes, I’m baking muffins. It’s not a very big business but I want to make sure that I’m protected in case someone sues me.” I read somewhere that if I turn this into a corporation that no one can sue me anymore.

Ed: First, how many of these are going to sell? Let’s see the business plan. Are you going to make money? Are you going to lose money? Is this a hobby? Is it something you’ll do full-time and are you going to have other employees? Where is this going? What are your concerns? First question, what are your concerns? Second question, what are your fears? I heard about your fears, now your concerns, let’s put them into dollars and cents. If you just do nothing, just use your EIN number, there are no fees, costs, and expenses.

You’ll report all your activities on a schedule to your income tax return, end of story. Let’s assume that you expect profits of a million dollars. Now, Chuck, what should the forms– what should we consider? She’s just going to do it alone. No investors.

Chuck: I think before I answer that question, I’d want to know, are we talking, what kind of assets are going to be held inside this entity? Are you talking about strictly depreciable assets? Are you also talking about assets that are going to appreciate in value, because that would inform my decision? I’m always a little nervous about seeing anyone create a corporation that’s going to hold assets that appreciate. Depreciable assets are a different story. I think that’s just fine. I’m always worried about, you put an asset in a corporation that’s going to appreciate, you have a hard time ever getting it back out.

Ed: Well, Chuck, the issue as I said, let’s assume Sue the baker has some ovens, we’re going to hold those out and lease them to the organization. We want to keep the organization whether it’s a partnership, or any form of business organization is as slim as possible. We don’t put real estate into it, we don’t put the ovens into it, maybe lease the intangible property to it. As the bank account receivables, payables end of story, keeping it thin is the best way of organizing a business.

Now, this is not a public company, we’re not talking about where capital is a big deal. We’re talking about a mom and pop perhaps bakery or grocery store. Now, let’s go to the next level where we do have significant capital investment. Should we have a partnership, a general partnership, a limited partnership? What would be your view and what kind of form should we use assuming there’s a big deal in terms of capital requirements, revenues, and product liability?

Chuck: This is where I think it’s helpful to take a step back, and recognize that from a tax standpoint, even though there’s maybe a dozen or so different business entity forms that are out there and available to people, they really all come down to one of three forms from a tax standpoint. It’s either taxed as a partnership or taxed as a so-called C Corp or taxed as a so-called S Corp. Unless you’re talking about a disregarded entity, which is basically, not taxed at all. It’s simply treated as the owner’s–

Ed: As if it were a single member.

Chuck: Yes. Just is indistinguishable from the owner’s own tax reporting.

Ed: That’s taxed, that doesn’t mean liability, though.

Chuck: That doesn’t– right.

Ed: There’s all kinds of confusion. From a tax perspective, we don’t even think it exists in Illinois State, federal, but for liability purposes, it does exist. When we’re talking about a corporation, it’s typically taxed under subchapter C of the Internal Revenue Code, or a C Corp. It’s really an Illinois Corporation, or Nevada or Delaware, taxed under subchapter C. It’s a corporation. Now, if it’s taxed under Subchapter S, it’s essentially disregarded from a tax perspective, but it’s still a corporation that is subject to tax under subchapter of the Internal Revenue Code S vs C.

I seem to not be able to get that through to folks that I visit with, but the point is, there’s a difference between the form of the organization, the associated liability from third party claims, and how it’s taxed.

Chuck: I think the tax question is in some ways easier to answer in the sense that the number of choices there are fairly limited. It strikes me– tell me if you think I’m thinking about this wrong, but I always think about the capital structure in terms of, again, is this something that’s going to require big capital investment, and the nature of the capital in there is going to govern, whether I think a corporate form versus some type of entity that’s taxed as a partnership is a better choice. Then the income stream, the way the income, the cash flows are going to go in and out, informs a lot if it’s going to be a corporation that informs the question is, are you better off as a C Corp or an S Corp. Does that make sense to you, Ed?

Ed: Yes, it does. The issues that I confront face to face seems like every week, is where is this going? What is the ultimate destination of this organization? Your children, your spouse, a series of trusts, a combination of those, you can have a combination of an S corporation, a C corporation, a partnership, all in one business organization. Just because you have a business, that doesn’t mean it must be in a single organization. It can be a combination of organizations. The issue is where is this going? Folks tend to overstate where it’s going. Expectations seem to not necessarily come to fruition.

Chuck: I think we shouldn’t brush past that comment you just made too quickly about having multiple organizations. For anything that has a lot of complexity to it, it really, I think pays on the front end to think about, you want different components of this to be different entities, because it’s hard later to pull the pieces apart if you decide down the road that “Oh, gee, it would be better off if we had our rolling stock in one entity and then we had real estate in a different entity.” Well, good luck doing that down the road without paying some tax consequences versus you can set that upfront. Yes, there are some more fees and expenses on the front but they’re not huge.

Ed: No. When you look at the result, if you don’t do it, if you don’t get your shoes repaired, you’re going to have to buy a new pair of shoes which is the way to go.

Chuck: In general, it seems like we’re narrowing in on, so you can have one entity that owns the capital, so to speak. You’re talking about someone who’s making muffins for a living, you’ve got all the kitchen equipment and that kind of thing could be owned by one entity. You’ve got another one that’s actually the operating business.

Ed: The question is what is the business. What is the business plan, what are the assets? Who’s providing the capital? Uncle Tom, Charlie, the surviving spouse? What’s going on here? Bear in mind that that client is going to overstate their expectations.

Chuck: Especially when they’re just starting.

Ed: The question is, well, let me hear about your accounting background. Let me hear about the businesses that you’ve been involved in. Have you ever had to borrow money to make a payroll? Have you ever sustained a loss? What is your constitution, your intellectual constitution to go to this opportunity to take advantage? All you can see is you’re going to take this public, it could be the next Apple. No, 80% of the restaurants fail within five years, easy to get into, but what’s going on here?

Chuck: Ed, let’s say you’ve got somebody who comes in. They’ve got a good business plan. They’ve got- they “Oh, gosh. This is the third business I’ve started. The first two I’ve taken my lumps, and you can see them bruised and scarred from those experiences.” This is somebody that it looks like they’ve got a plan together. They’ve got the history, there’s a market for what they’re going to do. They’re saying, “Look, I expect this thing to be making- let’s pick a number a million dollars a year.” What should I do, Ed?

Ed: Well, that’s great. The issue is if that’s someone who is just starting the business, the answers are the same as we’ve expressed. Ideally, we’ve got an organization running as a proprietorship, maybe a mother and father or a husband and wife, that’s making a million dollars. Now the question is, Chuck what do I do with this? What’s the next step? We’ve got a business organization that’s making money. Cash is coming out of there. It’s got real estate, it’s got maybe some intellectual property. It’s got inventory, it’s got some employees. Now the question is what should be the form of business? Same question. Where’s this going?

Chuck: What would be at the top of your list in terms of what would drive you towards, for instance, a corporate form with someone like that versus either a disregarded entity, like a single-member LLC, or some entity that’s taxed as a partnership?

Ed: That’s a great question. By that, great in the sense that it suggests the future. We have real estate, are we going to keep that out of the organization? Let’s assume we have a family with a son who’s active in the business or will be, and we have three daughters. Well, we put the son and the three daughters with the real estate in a separate limited liability company. That’s going to be leased to NewCo that manufactures these widgets. Now, as far as NewCo is concerned, it’s a family organization. The son is going to be active in the management of the organization. What’s the son’s compensation? What’s the ownership? We’ll get into it in the next podcast, the issue of sibling rivalry but I must tell you that rears its ugly head whenever we have a business organization. The question is should the passive owners have a say so in the management of their organization, A and B how do you buy out the active owners or the passive owners? In other words, when you have all these assets, real estate out of the corporation, you got a regular co never in the corporation, a C corporation or an S corporation, how do you allocate incoming expense which is W2. The range of questions have to be addressed upfront. People don’t want to do that.

Chuck: Well, the other thing I find that people are very hesitant to do is to think about a retirement plan as part of their initial planning for a business. In my mind, that’s an important thing to think about even if it’s a very small business, and the only employees are also going to be the owners, or there maybe just a handful of other people. That’s a big deal, isn’t it if it’s going to be something that’s making a lot of money,

Ed: That’s my hobby horse. You hit my hobby horse. In as much as the vast majority of folks that I have been involved in over decades find their substantial portion of their assets are in one or more tax-qualified arrangements, an Esop 401k plan, cash bounce, a simple IRA. It goes on and on and on why? It’s the ultimate flexibility. Yes, you’re getting an ordinary income when it comes out, but you’ve got this deferral under the owner law. Currently, the owner law, the pensions are not subject to tax, but that all may be different going forward. We may not have an Illinois state tax. The point is things change constantly, but the aspects that do not change are put the money, put the dollars and cents away in a tax-sheltered arrangement, free of the claims of creditors, and just let it grow. Warren Buffet was the subject of a great article in today’s Wall Street Journal. Today’s the 31st. It’s got to be read, you really should. Everyone should take a look at it. The idea of how things can grow. If you have the discipline not to spend everything, multiple homes, multiple marriages, and whatever, you’re going to be a very, very wealthy person if that’s an objective by simply deferring self-gratification. Put the business together in such a fashion that it satisfies the needs and concerns, not expectations of the people that own the business organization. Then take it public but there trust me, that is a rare event in today’s world.

Chuck: Very rare. Yes. It seems to me like this is one area where the corporate form does seem to provide a good planning opportunity when you’re talking about laying a retirement plan on top of a business that you expect to be profitable, or that you already know is profitable. First of all, do you agree with that comment? Second of all, you want to add some color to that?

Ed: Sure. I agree. The color is let’s look at the three stages of the business organization where the proprietorships stage, very simple, hardly any legal worker, accounting work, make sure you have good books and records. Make sure you know what your cost of sales is, what your gross profit is but it’s a simple organization. The second stage, it’s grown, the widgets have turned into a profitable business organization making a million dollars, nominal salary. You’ve got siblings involved, but then the third stage, it’s not a million dollars a year. It’s a million dollars a month. Now, how do you transition it? Should it be an S corporation that is a corporation taxed under subchapter S, taxed under subchapter C? How do you motivate your employees with a limited liability company maybe formed by the corporation? The employees get these units in the limited liability company, but they don’t vote. You have voting and nonvoting shares, restricted stock, a whole range of options available if you want to make the business hum. My favorite story relates to gentlemen who went public with his company and I received a call. This is years ago on a Thursday, said, “Ed, I understand you know some stuff about tax-qualified.” “Oh yes, yes, yes.”

Having done some postgraduate work because “I know the words.” Well, I want to talk about an Aesop, and oh my gosh an Esop, I don’t know about that. That’s a pretty tough– listen, I’m very busy.” I was alone in my office. There was no one there. My secretary came in a half-day a week seems like it. I said, “Jerry–” we’ll call him Jerry. I wasn’t his name. “I’m very busy, but let’s meet late Monday because I’ve got some appointments.” I got on my horse and over the champagne read everything I could about Esop’s became an instant expert. Guess what? Why did you want to do this, Charlie, we’ll call him? Well, the only way to succeed is getting the employees in the group, in with skin in the game. Well, I must say that company is enormously successful now. The point is no matter what you do, don’t be cheap. The more you give away, the more you receive, but you’ve got to make sure there are some constraints on the element ownership. It’s not immediate participation, but you never, never can grow the business alone. Surround yourself with people that are as bright, if not brighter and you make sure they’re in the deal. They’ve got skin in the game. That’s a long-winded explanation of a short question, but the point is overriding this whole range of opportunities in terms of how you’re structured is, tell me about you, Charlie, what’s your view towards sharing the wealth?

Chuck: Your story touches on something I think I’ve noticed which is that it really seems like some of the most successful people I’ve run across have been people who have really placed an emphasis. Through one mechanism or another, they’ve really placed an emphasis on treating their employees very well. There are some very high profile publicly traded companies that are maybe good counterexamples to this, but it seems like for the small locally owned or smallish locally owned businesses that end up being terrifically successful, it seems like one of the things that those owners do from the word go is they really look after their employees. One of the ways of doing that is through creating the Esop plan, and then the employees become owners. I’ve seen others where they just have tremendous benefits for their employees, sometimes really great health care plans, or just really good salary structures. It just comes out in conversing with them where they’re just really focused on, I have got to treat my employees well, because I can’t make this thing run without them.

Ed: That’s the beautiful definition of a beautiful client that understands value is a two-sided coin. There is value in a quantitative sense, the dollars, and cents the progression, the asset accumulation process and you compare what you’re doing this month over what you did last month. That’s the quantitative side. The qualitative side, which unfortunately sometimes is lacking in many of the professions, is lacking with some business people, is what’s the nature of the qualitative value that you’ve created and you’ve conferred? Have you made someone else’s life just a little bit better than that life was before that person came into your office? We can’t lose sight of that because if that qualitative benefit is being conferred, I must tell you that quantitative dollars and cents grow, not arithmetically, but quadratically. Have you seen that, Chuck?

Chuck: Oh yes, absolutely. I mean, it’s really fascinating sometimes these conversations with people how– you can tell the difference between the ones who are just are saying the words and the ones who really have internalized this idea that this whole operation is not about me. It’s about this entire group of people that are pushing this thing forward.

Ed: Watch out for academic excellence. In other words, the folks I don’t want to say engineers, but I want to say there are some folks that we’ve encountered– encountered doesn’t sound right, worked with that have answers to the solutions that the questions haven’t even been raised. You have to watch out for the academically gifted, it doesn’t necessarily translate into how you make money. That process is an interesting process, but you can’t learn it from a textbook. You’ve got to do it. You’ve got to suffer. Wisdom is defined as having endured notwithstanding losses. No such thing as a failure, economic failure, it’s that opportunity didn’t work out, but what did you learn from it? There is a pony down there and the day is not over as long as you’re alive and you’ve got an opportunity to do something different. Am I overstating this, Chuck?

Chuck: No, I don’t think you are. The other thing I’ve noticed is that there’s just of this drive to get the work done with the people that you’re talking about, that when you talk to them, there’s always– obviously the financial conversation is taking place somewhere in the back of their mind, but where that’s never the focus of what is at the front of their mind. The front of their mind is always, I’ve got to get this thing done. I’ve got to get this thing done. I’ve got to get this thing done, let’s roll out this new project. Let’s clean up this floor and let’s– I mean, it’s just the blocking and tackling.

Ed: That’s what it’s all about. You can surround yourself with people that are brighter. They can do things you can’t do. Never do something that someone else can do when you’re at the interim stage of the business, stage B, a; being a proprietorship, b; it’s the million dollars a year, c; is a million dollars a month, but we’re at the C stage. You’re being paid to think to come up with something that’s insightful. That’s why you don’t want to have NetJets, but you may want to charter if it’s more than a six-hour drive. You want to be able to come up with something different, unique, and everyone sees this opportunity but very few people can see it with the correct set of eyes. The value, the qualitative value that results in enormous opportunities, creating value, people– second question. What’s the second question someone asked you, Chuck?

Chuck: What do you do?

Ed: What do you do, because what you do defines you as a human being. When you find out some of these professionals that are out of the business organization, I’m speaking about lawyers, accountants, actuaries, their mandatory retirement in that sense is death, but not physical death, intellectual death. They have no value to themselves or to the people around them.

Chuck: I’m really astonished at what I see. This seems to happen in the accounting professional a lot, where there’s a mandatory retirement age. Then they’ve got this– a lot of these accounting firms have these self-funded retirement plans. They’re non-qualified plans that it’s just–

Ed: By non-qualified you mean?

Chuck: I mean, it’s not like a 401k plan where you’re making contributions during someone’s working years and taking tax deductions for that. It’s just the partners that are currently working are just paying a salary to a retired partner.

Ed: That you never see.

Chuck: It’s like social security, the working people are paying an annuity to the ones who have already retired.

Ed: Pay as you go.

Chuck: Pay as you go. I’ve never, I mean, it’s a good example in my mind of overthinking a problem because you would think that these are accountants. You would think these are people who have really, I guess carefully thought about the consequences of that kind of planning, and yet they’re not taking advantage of some of the really most magnificent opportunities that the tax code provides a successful organization, and that is the participation in these qualified plans.

Ed: Well, I don’t mean to limit our inquiry and castigating people to accountants. I think large law firms are equal– lawyers in general. I don’t get it. The way they structure the coming in and going out, and the value, and how you allocate income and expense, it’s an accountant’s dream with all kinds of spreadsheets. Wait a minute, why don’t you just allocate it in a simple fashion and realize that you better understand that you’re getting only ordinary income. Charlie, who is a partner in a Wall Street firm is making $5 million a year, but what’s the take-home versus if he were making X and putting away $500,000, $300,000 a year.

When he hits 62 or 65, he’s got 3 million or 4 million in his IRA, and he doesn’t have to put pressure on the organization. It’s so backwards, but I’ve seen this time and time– personal injury lawyers, business lawyer’s tax, you forget that you’ve got to put money away, but they don’t. They have multiple homes, multiple cars, multiple boats, multiple marriages. It’s incredible to me.

Chuck: Well, that gets back to that delaying gratification conversation and how important that is, and how one way to make sure you do that is to structure it on the front end so that it’s baked into the way the organization is structured.

Ed: We had a discussion just this morning about the culture and your topic, your discussion about Anheuser Busch. Talk about that again. I thought it was fascinating.

Chuck: This is when that new CEO flew in from Germany. The story is he flew into St. Louis for his first visit to the headquarters, for Anheuser Busch in St. Louis. He flies from Germany, he flies coach across the Atlantic and lands in Lambert Field and gets on his cell phone and calls up the headquarters. “Hey, wait, I’m not sure is there a train that I should take to in order to get to the headquarters, what’s the best way to get there?” The people at the headquarters are, “Oh, wait a minute. We have limousines, we can send a limousine for you.” “Oh, no, no. Those days are over, just tell me which train I need to get on?” Just culturally how different that is. My understanding was that the corporate jets disappeared and all the perks and that kind of thing. It’s just the idea, it’s a much more austere method of approaching the management of a business. Not from the standpoint of we as managers are kings and should live like kings, but this is a job, we’re stewards of this company. We’re going to do a good job, but this isn’t about self-aggrandizement.

Ed: You remember years and years ago when you were a summer associate, you worked for an undisclosed utility.

Chuck: I remember this.

Ed: All the problems. You and I spent I don’t know how much time figuring out the benefits for these executives, remember that?

Chuck: Oh, yes I remember and this provision of the tax code that essentially puts in place a penalty, not for every golden parachute, but a golden parachute that is just–

Ed: Excessive.

Chuck: Yes. Ridiculous enough.

Ed: Someone in Washington said, “This is excessive.” What I make is not excessive, but what you make is excessive. We had that 269 day to worry about.

Chuck: It was just amazing, and it’s just the standpoint from some of these organizations is, well, that’s just extra, we just spend money on this penalty tax, then.

Ed: Yes, we’ll just gross it up. I couldn’t believe it. What is going on? What is it about this American culture that populates these business organizations with all these perks? I mean, do you have to get your shoes shined every Wednesday, bring someone in?

Chuck: I’m sure that in many of these places, that’s exactly what they do. You’re saying that facetiously, but I don’t think of that that is probably all that unusual.

Ed: Well, it’s almost like these are divine superhuman beings. They’re gods not in the Greek sense but everyone’s a god. This activity is so difficult, so time-consuming, that you must be rewarded by way of these perks. Anyone listening to this podcast if they’re in the corporate section, we’re not going to get here in law business. Then again, I sleep very well at night for the most part. The bottom line is why do these executives versus the gentleman that you described coming over from Germany, he understands what it’s about? Why should there be a multiple of 100 times the average salary of the lower-paid, if that’s what the executive gets? I don’t get that but that’s stage C of the transaction. A the simple, B the million dollars a year, and C a million dollars a month. That’s understanding, it could be a million dollars a day. I’m in the right business organization. Apple, for example, or Amazon or Microsoft, those puppies can grow quadratically day over day. We’re not talking about those guys.

Chuck: Yes, well, the vast majority of businesses are not those guys, the vast majority of businesses are one misstep away from having a difficult year, or maybe missing a payroll. You can’t afford to be that careless in many cases. The astonishing thing to me is that we can sound a little judgmental talking about these stories, and all these perks and everything like that, but the thing that I think is a real shame about that is that you’ve got a very small number of people at the very top, who really do get such high compensation. That despite how inefficiently they do it, they still accumulate pretty substantial wealth. There’s an awful lot of these people that are in this universe that you’re describing, that at the end of the day, they’re actually not accumulating any real wealth, and they don’t actually get a lot of economic security out of this. They lose that job, and they’re just like anybody else. They’re suffering. That’s really amazing when you think about the fact that the opportunity is there, that instead of all of those perks, they could be building real financial security. In the vast majority of cases they’re not doing that.

Ed: For themselves not only the quantitative side but the qualitative side, you feel good about what you’ve done for the day when you’re left for the day. I don’t know. It’s very easy, very easy to give away other people’s money. That’s the secret of these large corporations and their compensation. I love to be able to give away your money but especially when you’re not around.

Chuck: Exactly.

Ed: You see these close hell business organizations that owner is not giving away money. The larger the organization, the greater the propensity. I’m not saying it’s always the case, to give away someone else’s money.

Chuck: Oh, I agree. I’ve seen it.

Ed: Well. Next topic. I think our next topic is probably my favorite. That’s sibling rivalry, we’ll talk about that.

Chuck: Can’t wait.

Ed: Okay, Chuck.

Thank you for listening to Money Talk. Please join us again and do check out our previous Money Talk topics.


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