It's Your Move
By Mike Seuffert
June 1, 2007
Let's just start this off simple: if you're still running your pest management business as a sole proprietorship or partnership, call a lawyer immediately. Yes, it may cost you some money — up to several thousand dollars in some cases. But with the kind of business risks and legal liabilities pest management professionals (PMPs) face every day, the cost of losing your business, your savings, your homes and your livelihoods will be much more expensive.
"I cannot imagine a scenario where still maintaining a private ownership as a sole proprietorship or partnership would give an advantage to a PMP any longer," says Greg Crosslin, president of Crosslin & Associates, a law firm in Destin, Fla., specializing in the pest management industry. "The normal daily routine of working with chemicals involves litigation risk. It's just part of doing business, and you have to protect yourself by incorporating."
Even if you already have incorporated, there could be a better structure for your company. With a limited liability company (LLC), you are not tied to confusing corporate bylaws. With a small business corporation (S-Corp), you can reduce self-employment taxes. Or with a C-Corporation (C-Corp), you can deduct expenses like travel, health care and entertainment — and now the best structure for your company may very well change along with the times, laws and your company's growth.
Ultimately, you need the right business structure to get the most out of your money now and to prepare for any changes in the future, as the type of corporate structure you choose will affect the way your business deals with taxes, growth, mergers and acquisitions, lawsuits and succession planning.
"You have to take everything into consideration: how many employees you have, your revenues, how long you've been in business, the assets you have or whether you will be selling the business in the next five years," says Nancy W. Stabell, a lawyer with Waller, Lansden, Dortch & Davis in Nashville.
KNOW YOUR OPTIONS
To choose the right structure for your business, you must know all available options. Under any circumstances, you should consult with both a lawyer and a certified public accountant (CPA) before making a decision.
A sole proprietorship is a business owned by one person. It is the easiest and least costly way of starting a business, giving the owner absolute authority over all business decisions, experts say.
A partnership is similar to the sole proprietorship, but with two or more owners. A partnership can be formed by a simple oral agreement, though most companies will have an official partnership agreement put together by a lawyer, Crosslin says. These agreements will stipulate the amount invested by each partner, duties, duration and sharing of assets/profits/losses for the partnership, among other things.
Some small or new companies may choose the sole proprietorship or partnership because of their simplicity and low cost of entry, Stabell explains. The main drawback is that the owners take on personal liability for their companies. So if the businesses lose money or are sued, everything the owners possess is at risk.
"A sole proprietorship is a kid by the side of the road selling lemonade — and that's all the protection you get," Stabell says. "Everybody needs to have a corporate veil as your liability shield. With today's litigious climate, you don't know whose house you are going into."
The two corporate structures that most pest management firms choose are corporations or LLCs, Crosslin says.
Corporations are businesses that exist entirely separate from their owners. This includes the owners filing a separate tax return at the end of the year for their corporations. Corporations must have at least one owner, but there is no upper limit. The owners are called shareholders or stockholders. The ownership interests of the shareholders in a corporation are divided into shares of stock.
The corporate structure usually is the most complex and more costly to organize than the other two business formations, experts say. A corporation is controlled by a board of directors, and records must be kept to document decisions made by the board. Small, closely-held corporations can operate more informally, but record keeping cannot be eliminated entirely.
An LLC is a hybrid business entity, designed to combine the liability protection of a corporation with the tax advantages of a partnership, Stabell says. With the LLC, the business's profits and/or losses are added to the owner's personal tax returns. Moreover, an LLC gives the owner more flexibility in structure, and has fewer formalities and stock complications than a corporation.
BENEFITS OF INC.
"With a corporation, should the worst happen — and I'm talking about a death or a terrible lawsuit that's going to be five times more than you can handle — the idea is you can walk away and close the business," says industry consultant Norm Cooper, president of Rye, N.Y.-based Norman Cooper Associates. "You're not going to be able to take anything out of the business, but they can't take away your home or your car."
Aside from the protection a corporation will give your company, there are other benefits to incorporating.
"When you are a small or new business, banks are going to want you to be in a traditional corporate form of business," says Stabell. "They will be confident in lending money to what they know is a legitimate business.
"Clients will also appreciate and feel safer with the added professionalism that incorporating brings,"she adds.
For those interested in selling their businesses, it's much easier to transfer ownership with a corporation, Stabell says. The stock can be sold easily, and the new owners can come in and run the business with the same name, same checking account and same structure. This is also a benefit in the event the corporation's owner dies.
"Even if you are going to keep your business, a corporation is the best way to acquire capital from outside investors by selling shares of stock," says Jeff Bergerson, a tax expert with Bergerson Tax Services in St. Paul, Minn. "As long as you retain 51 percent of the stock, you will maintain control over your company."
The downside of the corporation is that there are some additional expenses in setting it up, such as various fees that differ from state to state and the legal costs in setting up the structure. There is also added formality with a corporation, which includes holding board of directors meetings, keeping minutes and resolutions — even if there is only one person (you) on the board, Crosslin says.
There are also tax consequences to incorporating, which used to bring tax savings to business owners, though recent reductions in individual tax rates have made the difference less significant.
Here's how it works: as the owner, president, chairman of the board and any other title you can think of, your corporation will pay you an annual salary. Though you will pay personal income tax on this salary, your corporation will receive a deduction for the salary on its tax return, Bergerson says. If your business is highly profitable, this allows you to split business income between yourself and the corporation, keeping both sides out of the higher tax brackets. If the corporation is losing money or breaking even, however, the difference is negligible.
"Because you are paying both personal taxes (on your salary) and a corporate tax that ranges from 15 to 35 percent, based on your state and income, this 'double taxation' can be a drawback," Bergerson says. "On the plus side, corporations may get certain fringe benefits, like deduction on education costs, vehicle purchases, life and health insurance, and more."
If the corporation has a number of stockholders, and chooses to pass along the company's income as dividends, those will also be subject to capital gains taxes, experts say.
"Paying corporate taxes is the price you pay to protect yourself by this corporate shell," Cooper says. "It's worth it every time."
S-CORP OR C-CORP?
Fortunately, most small business owners can avoid a portion of this double taxation by choosing S-Corp status on their tax returns. S-Corps are designed to allow corporate profits and losses to pass straight through the corporation to the shareholders.
"The major difference between a C-Corp and an S-Corp is in how they are taxed," Stabell says. "The structure and everything that goes with the corporation remains the same, but you check a different box on the tax returns. For most small businesses, there will be significant savings for S-Corps."
If you expect to lose money in the first few years after incorporating, S-Corp status is particularly valuable because it will allow you to pass the losses down to you individually, reducing your income on your individual tax return.
Though the S-Corp entity does not pay taxes itself, it must file an informational tax return telling what each shareholder's portion of corporate income is.
"There are a few limits to S-Corps," Bergerson says. "You can't have more than 100 different shareholders of your company's stock. You can only have shareholders that are individuals, which means that you can't get another corporation to invest in you." S-Corps also cannot deduct some expenses like health insurance, travel and entertainment that C-Corps can.
INC. OR LLC?
Both corporations and LLCs will protect business owners from liability for business debts, and both S-Corps and LLCs allow the company's profits and losses to pass through its members for tax purposes. So what's the difference?
"If you are really small and want to keep it really simple, the LLC might be for you," Stabell says. "It's a really popular option right now. You can make your corporate structure look like anything. You don't have to follow all the formalities in place for a corporation."
As an example of flexibility, with an LLC, you can divide the company's profits any way you want. With a corporation, the profits must be divided equally, based on the percentage of stock owned. LLCs also do not have the limits on the number and kinds of investors that S-Corps do. On the other hand, S-Corps minimize self-employment and Social Security taxes.
"With LLCs, all of your profits are subject to a self-employment tax of 15.3 percent which goes toward Social Security and Medicare," Bergerson says. "In an S-Corp, only the salary paid to the employee-owner is subject to employment tax. You are only required to give yourself what is considered a 'fair and reasonable' pay as an employee. The rest can be withdrawn as a dividend, which is not subject to a self-employment tax. This can save thousands of dollars in taxes each year.
"However, with the S-Corp, you must do payroll withholdings for yourself because you are an employee," Bergerson adds. "If you are not familiar with the process and the taxes involved, this can be a big issue, and people may choose LLC to avoid it despite the tax savings."
Also, if your company grows, it is much easier to switch from S-Corp to C-Corp than from an LLC.
Setting up an S-Corp or LLC not only allows you to protect yourself from liabilities incurred by the company, but it can also help protect your business assets as well.
"Ideally, you don't keep a whole lot of assets within the corporate shell," Bergerson says. "If you lease major capital assets that you own personally to the company, like real estate, essentially making monthly payments to yourself, should you have to close up the corporation, you don't lose all that."
As an added bonus, in the case of real estate, you avoid possible double taxation on capital gains if the property's value increases over time when you sell the building.
There are some limits to the protection of a corporation, however. According to experts, banks may require new businesses seeking funds to personally guarantee loans to their corporations. Also, one-person or family-owned business will be held personally liable for unpaid taxes on the corporation. If you in any way commit fraud in the corporation's name, you are certainly liable.
In the end, finding the right corporate structure is not an easy choice. Which brings you back to where you started: before you incorporate, start a new company, sell your company or split off from the family business, consult a lawyer and CPA to decide which path is the best fit for you.
"It may be cheaper on the front end to start your business by yourself, or try to incorporate on your own, but it will probably cost you three or four times as much later trying to clean up the mess you've made," Stabell says.