Startup Incorporation

In my first month working on Pastime, getting everything setup so I could do business took the most time. In this note I will go into detail about the company’s incorporation, the decisions I made, and what I learned during the process.

I had four choices for the structure of my business: sole proprietorship, LLC, S Corporation, or C Corporation. I want personal liability protection, so that immediately ruled out sole proprietorship. I want to minimize tax liability, and as you will see, what structure is best for that can vary.

Taxes

LLCs have the advantage of not being taxed, as business income “flows through” to the owners who then pay self-employment tax (~15%) and personal income tax (up to 35% depending on bracket). Similarly, a S Corporation is not taxed. With a S Corp, there is also no self-employment tax, instead you pay a payroll tax that is approximately 15% of your salary. A C Corporation, on the other hand, is required to pay corporate income tax. This leads to the so called “double tax”, as the company pays tax on its income and each owner pays tax on his salary and any dividends.

So this is where it gets a little complicated. The structure that is best from a tax perspective can shift depending upon how profitable your company is. In the early stages, when income is low, a LLC treated as a “disregarded entity” tends to be the most attractive. You simply pay the 15% self-employment tax and a personal income tax that depends on your tax bracket. If your business has losses, you can use them to offset other sources of personal income.

S Corp Tax Treatment

As income grows, S Corp tax treatment can become more attractive as it allows you to balance income between salary and dividends to better manage the amount owed in employment taxes. This is illustrated by the following example:

Suppose my 2012 income is $50,000. As a disregarded LLC, I will pay $7,500 in self-employment taxes. As a S Corp employee with a fair salary of $50,000, I will pay about the same in payroll taxes.

Now lets say my 2013 income jumps to $100,000 while my fair salary remains the same. As a disregarded LLC, I will pay $15,000 in self-employment taxes. As a S Corp employee, I will continue to pay $7,500 in payroll taxes. S Corp tax treatment saves me around $7,500.

C Corp Tax Treatment

As your income continues to increase, personal income tax can become an issue for two reasons. First, you get bumped up into a higher tax bracket–the highest being 35% with the potential to increase to 39% if and when the Bush tax cuts expire. Second, neither a LLC or a S Corp can retain income for re-investing–all income must be reported and is subject to tax. As a result, in some cases a C Corp structure offers the most attractive tax treatment. This is because the effective corporate tax rate can be lower than your personal tax rate and because income can be retained by the corporation to reinvest.

To illustrate this, lets run some example numbers again:

Suppose my 2012 income is $50,000 and my fair salary is $50,000. As a S Corp, I’ll be looking at a tax of $28,000 on $100,000 of personal income (28%).

As a C Corp, I’ll pay $7,500 on $50,000 of corporate income (15%). If I retain those earnings, I only pay $12,500 in personal income tax (25% of my $50,000 salary). That saves me $8,000.

Uncle Sam can get you on retained earnings, though. Retain more than $250,000 and you risk being slapped with a 39% retained earning tax.

Two other notes about C Corps: First, a C Corp may deduct 100% of the health insurance it pays for its employees. Second, owners of a C Corp that qualifies as a small business can claim a capital gains tax exemption upon disposition if their stock has been held for five or more years.

Taxation Summary

So what structure wins for taxes? It depends. LLCs offer the most flexible structure. By default, they are treated as “disregarded” and subject to self-employment tax. However, you can elect to have a LLC treated as either a S Corp or a C Corp for tax purposes, depending on what is most appropriate for your situation. In general, this is one of the advantages of LLC’s–they’re flexible.

For a rapidly growing company, C Corp tax treatment tends to win out. This might seem counter-intuitive because you always hear about how corporation’s are “double-taxed”. Yet, as we have seen, corporate income tax rates can be less than personal income tax rates, and the ability to deduct taxable income and retain earnings for growth can make a difference. A shrewd C Corp owner can work to reduce his or her tax liability by paying himself a modest salary and reinvesting profits. Furthermore, many C Corps find ways to exploit various loopholes that get them out of paying income tax all together. As a side note, I believe this to be morally wrong and not fair to the corporations that do pay their share.

While on the subject of right and wrong, I also believe it is wrong for our congressional representatives to fight cuts to payroll taxes that would help all employees (and especially those with lower incomes), while opposing closing corporate income tax loopholes or increasing income tax rates for the most profitable individuals.

Overhead

Besides liability protection and tax favorability, I also want low overhead and flexibility. LLCs win here. Corporations are subject to formalities such as holding annual meetings of shareholders and directors. Processing payroll is also quite complicated. LLCs don’t require any of this. And, as we have seen, LLCs have the flexibility to be treated as corporation for tax purposes, if desired.

Equity

One advantage of Corporations is they can issue stock and stock options. LLCs have a similiar concept in “membership interests” but it is somewhat awkward and less well understood. As an example of this, suppose, as an incentive an LLC awards a key employee some “capital interest”. Upon receipt of the interest, that employee becomes a member of the LLC. In a LLC with default tax treatment, you cannot be an employee and a member at the same time. You go from being an employee on payroll receiving a salary reported on a W-2, to being a partner deriving self-employment income from profits based on your % interest reported on a K-1. This is an awkward transition to make. With a Corporation, nothing really changes. You remain an employee, you now just also happen to have a stake in the company.

C Corporations are generally more suitable for outside investment. I know several VCs, for example, that won’t invest in LLCs.

My Decision

What did I go with? I decided a LLC structure was right for the early stages of Pastime. It provides liability protection, which is essential. It provides simplicity and tax advantages along with the flexibility to be taxed as a corporation later on if desired. The admin overhead is low. I will not be accepting VC funding, so I do not care about that. And when I have the opportunity to hire, I expect to favor compensation via fair salary and benefits to issuing stock.

If I was planning to raise outside funding or issue stock to employees, I would have formed a C Corp. I have the option to convert in the future if I need to, and it is something I will continue to evaluate.

So there we have it! I am now the owner of Pastime Connect, LLC, formed in the fine state of Florida. It is a single-member LLC. I am the member/manager and my wife Keri is also an officer. It is authorized by Brevard County, Florida to do business under the tradename “Pastime”. We have no employees yet, but we hope to make that all important first hire in 2012.

I hope this note has provided you with useful insight into my startup incorporation experience!