MBA Perspectives: When to LLC, Common Sense for Entrepreneurs
|Illustration of a brown bear attacking |
Russian hunters (Photo credit: Wikipedia)
A Modest Proposal
Let us say that after graduation from school I begin a business repairing and retrofitting vacuum cleaners in my garage. At first, as a sole proprietorship, I may not need to file any additional paperwork if my business fails to make a profit large enough to trigger IRS reporting requirements. In this case, my income from the business, if there were any, would be filed as a part of my personal taxes or those of myself and my spouse were I married.
Covering Your Assets: DBA, LLC, and Other Considerations
- A limited liability company is a hybrid type of legal structure that provides the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership.
- The "owners" of an LLC are referred to as "members." Depending on the state, the members can consist of a single individual (one owner), two or more individuals, corporations or other LLCs.
- Unlike shareholders in a corporation, LLCs are not taxed as a separate business entity. Instead, all profits and losses are "passed through" the business to each member of the LLC. LLC members report profits and losses on their personal federal tax returns, just like the owners of a partnership would. (SBA.gov)
- LLC's don't prevent liability due to bear attacks.
Depending on the laws of the town in which my home is located, I may not need to seek any additional permits to begin a business such as this. If I use any name when conducting business other than my own, I will need to file a fictitious name certificate specifying that I am “Doing Business As” (D.B.A.*) the name of my company. All financing at this point would be via cash on hand, personal loans, savings, and credit cards. My finances and the finances of the business can remain commingled (though it is best if they are separated) and no special banking or reporting is required. One disadvantage of not being an incorporated business is that if the business incurs debt, I am personally responsible for that debt and my personal assets (such as my house) are liable. Equally, if I damage a vacuum cleaner in attempting to repair it, I am personally responsible for replacing the vacuum cleaner and there is no legal protection for me through the business. Even if the business did well, retail businesses tend not to make a profit until about the fifth year. Whether my business would be any different depends on the volume of work being completed and the cost of overhead (parts, business expenses, etc.). I could artificially lower overhead of course by failing to take a salary, but that would only increase the business’ cash on hand, not actually make the business more profitable and I would likely have to work a second full time job to support myself in addition.
*A fictitious name (or assumed name, trade name or DBA name) is a business name that is different from your personal name, the names of your partners or the officially registered name of your LLC or corporation. (SBA.gov)
Employing and Reporting, IRS Fundamentals
- Commonly known as consultants, freelancers and self-employed, independent contractors are individuals who are hired to do a particular job, receiving payment only for the work being done. Independent contractors are business owners, and are not their clients' employees. They do not receive employee benefits or the same legal protections as employees, and are often responsible for their own expenses. (SBA.gov)
After a time, I may have enough repeat vacuum repair customers in the form of hotels and movie theaters (who frequently break and wear out vacuum cleaners) that I would wish to pay others to complete work for my business while I handle the ever increasing volume of billing and scheduling (management tasks) that the small business requires. I can choose to pay my workers as independent contractors, which means that they receive no benefits and that I withhold no taxes for them, but I will still have to report to the IRS how much I pay these workers and as independent contractors they can make many of their own choices without my control. This increased volume of repairs combined with the number of workers coming to my residential garage to carry out work makes it likely that I will wish to incorporate and to rent a commercial space, since the town in which I am located likely does not permit commercial businesses in residential zones.
LLC: Making the Small Leap Forward
If I incorporate as an LLC or Limited Liability Corporation, this provides the minimum requirements for reporting and paperwork to separate legally my assets from that of the company. However, as an LLC, I would need to file articles of incorporation, follow the licensing requirements for the state in which I am incorporating (including applications and fees), almost certain require a D.B.A. certificate, and would need to file taxes for my LLC separately over a certain earnings threshold. I would be ill-advised to pursue this business venture without a business plan and probably a marketing plan in place as well.
At this point, to finance my LLC I can pursue loans based upon my company’s assets, which can be difficult to calculate for such a small, specialized business and would likely require the expense of an accountant to do correctly. Banks might then consider loaning the business money against its assets, but banks are in the money making business and they would know that with an LLC I am not personally liable to pay back the loans. Thus, banks might not be willing to loan my small LLC any money. Credit cards are still an option for day to day financing, but the interest rates are terrible. If I decide to take a leap and open several repair shops at once in diverse locations or develop a vacuum that does not break as often so that I can sell it to my customers, I would need a larger investment from a private investor, possibly an angel investor. These investors, like the bank, would want to determine the business’ profitability and assets as well as reviewing essential business documents like my articles of incorporation, business plan, and possibly the marketing plan. If any of these documents is less than amazing, there’s a good chance they’ll invest with a safer prospective business.
S-Corps and More
- An S corp is a corporation with the Subchapter S designation from the IRS.
- To be considered an S corp, you must first charter a business as a corporation in the state where it is headquartered.
- According to the IRS, S corporations are "considered by law to be a unique entity, separate and apart from those who own it."
- This limits the financial liability for which you (the owner, or "shareholder") are responsible.
- Nevertheless, liability protection is limited - S corps do not necessarily shield you from all litigation such as an employee’s tort actions as a result of a workplace incident. (SBA.gov)
To obtain any significant financing, my company would probably want to accept a private investment, either in the form of a silent partner who provides financing directly, or more likely by issuing stock privately or publicly to shareholders in exchange for financing. At this point, my once small vacuum repair business would become large and involved indeed, certain requiring an accountant to file its corporate taxes and likely needing to be incorporated as an S Corp. This would be a major endeavor and might include radically altering the business plan to support multiple retail locations, or else multiple dispatch centers sending out technicians to repair business’ vacuum machines on site, based upon geographic territories. Short of this scale / volume of work, it might be more profitable to do less volume and keep overhead low. With a larger business, competition, product diversification, growth, marketing, and many other factors would play a major role in profitability and would need to be taken into account early on.
At ChristopherLotito.Org, subscribers will find all the information they need to educate themselves and their families about the issues that effect their lives. A Drew University graduate, Christopher Lotito is a 10 year veteran volunteer within his municipal government in Pequannock, New Jersey. Lotito is also an accomplished local author and possesses a great depth of knowledge in both New Jersey history and flood control issues which he puts to use as an independent researcher.