Should I form an LLC or S Corporation? With Ericka McKenna
Starting a business? Confused if you should form a limited liability company or S Corporation? In this episode I talk to Ericka McKenna, a business transactional attorney at McKenna Brink Signorotti LLP about the differences in LLCs and S corporations. Key points discussed include: liability protection, corporate formalities and tax treatment differences between the two entities.
If you or someone you know have questions about forming a LLC or S Corporation, contact Ericka McKenna at mckennabrink.com to discuss with her the proper entity for your business.
Thank you to Ericka McKenna for joining me on the podcast today. Be safe and well.
Transcript
Ryan Lockhart (00:02):
Welcome to the show, everybody. This is, I know a lawyer. My name is Ryan Lockhart. Your host for the day, this podcast is brought to you by McKenna Brink Signorotti LLP. We are a boutique law firm in Walnut Creek, California. So you can check us out at mckennabrink.com. This is episode two and today's topic is, should I form an LLC or an S corporation is a question that we get quite often. And usually when a person is starting a business. So today to discuss this topic with me I'm joined by Erica McKenna. The McKenna in McKenna Brink Signorotti. Hey, Ericka, how are you doing today?
Ericka McKenna (00:36): I'm doing well, Ryan. Thanks for having me.
Ryan Lockhart (00:38): Yeah, thanks for joining us. Just let the audience know. Ericka will be basically be a cohost at various episodes in the future. So I just recruited her for that anyways. So Ericka, why don't you just tell the audience a little bit about your practice and what you do?
Ericka McKenna (00:53): All right. Hi everyone. My name is Ericka McKenna and I am a transactional business attorney. What does that mean? That means that I draft contracts for businesses in all stages of their operation, whether it's forming them, helping them operate, doing their contracts with vendors, doing certain contracts with employees, and then helping their business transfer. Whether it's doing buy, sell agreements, shareholder agreements, stock sale agreements, asset sale agreements. Whatever's needed to transfer a business from one person to the next.
Ryan Lockhart (01:31): Awesome. We'll disclose that Ericka and I have been working together for about eight years with the exception about seven months in there. I can't believe it's been eight years already, but time flies by it does. All right. So we're going to talk about LLCs and S Corp or S corporations. Like I said, you have to get this question quite a bit. I imagine. And we've talked about in the past, so let's just assume I'm a new, I'm a new person coming in and saying, Hey, I'm going to start a business. I had one friend tell me I need to have an LLC. And another friend told me I need an S corporation. Quite frankly. I don't know what either of those mean. So do I even need them? How do they work?
Ericka McKenna (02:12): The quick answer is yes, you need one. Either one is better than not. So let's step back a bit and say you don't form an LLC or an S corporation, but you're starting a business. Well, the default is that you're a sole proprietorship. And the problem with being a sole proprietor is that it gives you no liability protection. What does that mean? If there's a claim that arises in the course of your business, for example, someone walks into your business and falls or you get into a dispute with a client about whether you upheld your end of a contract. If they file a claim against you and you're a sole proprietor, they could get to all of your personal assets. That means not just the assets of your business, but everything that you own personally, you know, your house, your personal bank account.
Ericka McKenna (03:11): So the main benefit of forming an entity, whether it be an LLC or an S corporation, is that you get liability protection, the state views, LLCs and corporations as separate entities. So what that means is if a claim arises as part of your business, the person who's making a claim against, you would never be able to get to assets outside of the business. So liability protection, that's why you need to form something. You ask the question though, of LLC or S Corp. What's the difference? There are differences. The main being corporate formalities, what I mean by that is LLCs are much simpler. There aren't a lot of rules that you have to follow in order to maintain that LLC existence. The owner of the LOC you're called a member. So the member is in charge of the LLC. It can make the decisions.
Ericka McKenna (04:25): You don't have to keep minutes or hold meetings or do any sort of formal procedures in that regard. You only have to file. What's called a statement of information with the secretary of state once every other year. So it's fairly simple. Two operate as an LLC from a corporate formality standpoint S corporations, there's a bit more stringent requirements that you have to do. You have to hold annual shareholder meetings. You have to hold board meetings. I mean, do you have to have a board of directors? You have to elect officers. All California corporations are required to have a president, a secretary, and a treasurer. So those things, shareholder meetings, board meetings, officers, they sound complicated. But really they aren't, if you are a single person corporation, meaning there's just one owner, you could be all of those positions. You could be the sole director. You could be the president and the secretary and the treasurer, but you do need to put together annual minutes and keep all of your corporate records together. And you have to report every year to the California secretary of state. So there are a few more hoops you have to jump through to be an S corporation. But once you put procedures in place, it is still fairly simple.
Ryan Lockhart (06:09): Yeah, it sounds quite easy, but it sounds a little strange. They have all those different hats on, if you're the only person in a corporation and you got to document what your internal conversations with yourself, Ericka McKenna (06:22): That's what they require. And it sounds funny. But the reason you do it is to get that liability protection, California, go ahead.
Ryan Lockhart (06:35): Go ahead. So if I have a house and I'm going to start a business, I'm obviously concerned about protecting my house. So either one of these would protect my house, correct. Okay, good.
Ericka McKenna (06:45): Yes. As long as you are truly keeping everything separate, that means you have a business bank account. You aren't, co-mingling your personal funds with your business funds. And when you do transfer money in and out, you're documenting what it's for, whether you're paying yourself as an owner or paying expenses, everything needs to be documented as to why funds are moving in between or from your personal account to your business account and vice versa.
Ryan Lockhart (07:17): So keep it clean and formal sounds like exactly. Okay. Does it matter the kind of business that I have is one, like, let's just say, I'm going to open up some retail shop. Is it better to have a corporation or an LLC, or does it matter?
Ericka McKenna (07:32): For the most part? It doesn't matter, but there are some instances where it does for example, construction companies, the recommendation is that they be a corporation for the most part. And that's because the contractor state licensing board requires that LLC post the larger bond. So for the most part, if you're in construction, you're going to be forming a corporation, not an LLC. So there are some specifics like that, but for the most part, whether you want to be an LLC or an S corporation will depend on a tax analysis. So I'm not a tax attorney, but my general understanding is that LLC fees are taxed on their revenue. Whereas as corporations are taxed on their income. And so I always like to have a client defer to their accountant who would be more familiar with their actual projected financials to know what is the best tax treatment? Should I be an LLC or an S corporation?
Ryan Lockhart (08:50): Well, the good news is, is I am a tax attorney. So now the audience knows why we work well together. So anyways, there's one thing I will say, if you have a, if you have a business, that's going to be holding real estate and that's pretty much a real estate holding business, investment properties, something like that. I, this is like one of my big things I want to pound in. You know, out there is LLCs. Llcs are the way to go for real estate holdings. Cause if you have a real estate in an, a corporation or an S corporation, and you ever want to move the real estate out of a corporation, that can be a taxable event, most likely in an LLC, you have way more flexibility to move real estate in and out. And, and try to at least mitigate or eliminate any taxable event with that going to the tax structure of LLCs versus S Corps.
Ryan Lockhart (09:34): And this is where the, the letter S in S corps comes from because an S Corp is really just a regular corporation. That's made and S election. They call it an S election to not pay corporate corporate tax at the corporate level. So it's called a pass through entity. Llcs are already like this, their pass through entities as well, meaning that income revenue is generated by the company, whether it's an LLC or an S Corp. And the corporation, the LLC is going to pass the tax attributes and the income down to it's either a shareholders or its members. And it's those shareholders and members who are going to go report and pay the income tax itself on their personal tax returns. That's the pass through function. So usually when you come to LLCs, you got a little bit more flexibility on, on how to allocate income and expenses and deductions amongst your members.
Ryan Lockhart (10:22): S corporations are very stringent when it comes to this, it has to be pro-rata. So if you have, let's say five shareholders in an S Corp, and they're all different percentages that whatever is passed through to them has to go via those percentages of ownership. So that's kind of like, it's, like Ericka said, really, when it comes down to the LLC or S Corp, most of the time, I think it comes down to this tax question of how do they want to be taxed? S Corps is a very easy to operate on the tax side, because it is a pro rata amongst all the different owners. So the accountants love that because they just get to, you know, they know what it's going to be when it comes to LLCs. And, you know, let's say it's a bunch of different business partners together that want to allocate income a little bit more to this guy, or a little bit more to this woman.
Ryan Lockhart (11:07): That's do some different things with their deductions, make it harder to track, but it is available. So that's kind of the big one. I think when it comes to the tax side and a hundred percent that there should be an analysis done by an accountant or CPA for the business owner to run these run some sort of models saying, Hey, if we hit our revenue targets for this next year, as we start this business, how can we tweak the taxes? What's it going to look like, you know, a good accountant or CPA will be able to do that model for them. And at least if it's about more information, more information for the business owner, as they try to plan out where they're going, you have any thoughts on that?
Ericka McKenna (11:45): Well, I guess I have a question for you and, you know, tell me if I'm wrong, but I sort of hear this magic number of $250,000. If you're bringing in less than $250,000, then it probably makes sense for you to be an LLC. And if you're bringing in more than it probably makes sense for you to be an S corporation, have you ever heard that? Is there any truth to that?
Ryan Lockhart (12:10): Okay. So one of my favorite hobbies is dispelling some myths about taxes out there. I have heard this number out there a little bit. I don't think there's a lot of truth to it because I seen it both ways. I've seen, you know, revenue is less than two 50 in an S Corp because they're looking for very specific things that an S Corp might give them. And that's really about the ease of the tax allocations. So when you're talking about more than 250, I have seen many LLCs that have more than two, 250,000 in revenue annually, because they want the flexibility of the LLC when it comes to tax allocations. And that's an overriding factor over the ease of what the S Corp might give them. Plus the other thing about S there's one other restriction in an S Corp that doesn't apply that often, but it might apply a little bit more here, you know, in the Bay area is all the shareholders in S Corp have to be basically U S based taxpayers.
Ryan Lockhart (13:06): So you can't have a foreign investor in an S Corp. It violates the S election requirements. So that could be a factor, but most of the time, it's just either, do they want the flexibility of LLC partnership tax reporting, or do they want the ease and, you know, easy way to figure out what the tax is going to be for an S Corp. And that's how most of the time I come across with the clients is that right there, but there could be some other, I mean, this is where the CPA, the accountant needs to be part of the discussion, because there may be some other factors that we were not, we don't know client doesn't tell us, but they tell their accountant. And so that's why I think it's a good discussion to have with all, with all the advisors and the client, just to make the right decision. And it can be done pretty quickly.
Ericka McKenna (13:52): I agree. I love that team approach. I love when a client comes to me and they're immediately able to tell me who their accountant is, and we circle in that accountant and make a group decision, you know, because what's right for one client, won't be the right decision decision for the next client.
Ryan Lockhart (14:11): Yeah. How many times have we gotten what I call the cleanup job? And it's usually from an accountant, a CPA or somebody else who came to us and say, Hey, here's my client. They, they set up their own entity and it's messed up. Can you clean it up? That happens a lot, right?
Ericka McKenna (14:26): It happens a lot. And because it happens a lot, we often have to convert entities, convert them from one form to another form, because it was realized soon on that they shouldn't have formed as they did. So it, it does happen.
Ryan Lockhart (14:43): It does exactly. There's one other tax part of forming an entity. Correct. And that's the California franchise fee. I love it.
Ericka McKenna (14:53): The eight, $800, right?
Ryan Lockhart (14:55): They call it a fee instead of tax. It's like, you gotta pay this fee just to have your entity.
Ericka McKenna (15:02): That's right. So in California, you could do no business. You could make no money and you will still have to pay the California franchise tax board a fee of $800 per year, just for the pleasure of being able to do business in California. So everyone loves that one. Yep.
Ryan Lockhart (15:21): Yeah. They call it, I love this one page, little voucher at the bottom. They want you to cut off and mail it in with a check.
Ericka McKenna (15:27): Right. But, you know, I tell my clients that it's worth it. The liability protection that you are getting is worth the $800 a year that you have to pay regardless of how your business does in my mind, it's worth it. So, you know, when you come and you're ready to form a business, you're looking at your initial startup costs, but then that annual $800. And in my opinion, it's, it's well worth it.
Ryan Lockhart (15:56): So real quick, Ericka, if, if the client comes and says, I want to start an LLC, what, how long does that take? And what is it? What is involved?
Ericka McKenna (16:05): It doesn't take very long. You know, the California secretary of state usually takes about a week or two to turn documents around. You can always pay for them to be expedited on a 24 hour basis. If you have a true need to get your entity up and running quicker. But for the most part, if a client comes to me, I'm able to hear about their business, ascertain all of the information that I need, put formation documents together within a day or two client signs them. We get them off to the secretary of state. So for the most part, you know, within two weeks, you could be up and running. You can open a business bank account and you can start operating under your LLC name.
Ryan Lockhart (16:50): Great. And of course we, I'm assuming secretary of state's operating under COVID.
Ericka McKenna (16:56): They are, they are operating. Recently they took away the option to expedite things. But you know, things are changing on a daily basis, but they have remained open, meaning they're still accepting filings. They're still accepting formation documents.
Ryan Lockhart (17:17): All right. So sounds like if I'm going to start a business and I am going to choose an entity, there's a couple, there's at least some analysis that should be done, whether it should be an LLC or an S Corp. If I have an accountant or a CPA, I should bring them into the discussion. And I can get this done pretty quickly. That sounds great to me. So where do I sign up?
Ericka McKenna (17:38): Well, you can contact us. You said the information before, but mckennabrink.com has all of our contact information and we are here and ready to help you with your business.
Ryan Lockhart (17:50): Right. Sounds good. Any, any final thing that I might have forgotten to ask you about?
Ericka McKenna (17:55): I don't think so. You know, give us a call and let's talk about your specific business and see how we can help you.
Ryan Lockhart (18:02): All right. Well, thank you Ericka, for joining me today. And that was Erica McKenna and no problem we'll will do this again. We have some other topics we're going to discuss in the future, so, but congratulations, you made it to episode two. So there we go. Starting it off now. All right. Great. Well, thank you everybody. And hope you enjoyed your 4th of July weekend and enjoy the rest of COVID summer as I'm calling it. Thanks Ericka.
Ericka McKenna (18:25): Thanks Ryan. Bye.