Alana and Sherri
The two sisters met at the Law Offices of Boyden & Zook to determine which entity to use for their salon business. Alana’s friend Jay was a handsome, single attorney in his mid 30’s. He quickly got down to business with his new clients.
Jay told them they had a number of choices: LLCs, LPs or C and S corporations. The key, Jay said, was to pick an entity that offered limited liability protections and allowed them to minimize payroll taxes. He explained that while most people didn’t realize it, payroll taxes, which are supposed to fund the Social Security and Medicare entitlements, are huge. On the first $110,010.00 of income (as of this writing) they are 15.3% of your payroll. After $110,010.00 in income (again, at this writing – but it keeps going up) they would continue to pay the 2.9% Medicare component on all salary payments, plus an additional 0.9% Medicare surtax for high income individuals ($200,000 for single employees and $250,000 for marrieds).
Sherri had questioned the 15.3% figure. On her paycheck from the jewelry kiosk at the mall the amount deducted was only 7.65% of her salary. Jay explained that the employee’s wage was reduced by that amount and then the business paid on top of the employee’s wages the same 7.65% amount, thus a total of 15.3%. The important thing to realize was that when you were both the employee and the owner, as the sisters would be in their business, you paid both halves. So your payroll taxes were 15.3%.
If you were paid a salary of $50,000.00 from the business the amount going to the government was not just your half (or $3825.00) but as an owner the full amount, or $7,650.00. That is a lot of money year after year going into a system that is technically bankrupt. Jay advised them to look at their next Social Security statement. In the body of the letter the government admits that the system is not solvent.
So the girls, Jay explained, wanted an entity with taxation that would allow them to minimize payroll taxes. That entity he explained was the S corporation. With an S corporation you can pay yourself a reasonable salary (and pay the 15.3% on that salary amount) and then flow any profits above your salary to yourself as dividends, without payroll taxes. (Of course, on all of it you pay your regular income taxes. At a top income rate of 35% plus payroll taxes of 15.3% you are at a hefty government take of 50.3%, with state taxes not even included.)
An example helps explain all of this. Suppose the ladies were doing well with their salon. They are earning a salary on all of the work they do directly but on top of that they make money, as most beauty parlors do, by renting out chairs to other stylists and by selling shampoos, lotions and other high profit margin beauty products. The money coming into the salon is as follows:
| Alana | $55,000.00 |
| Sherri | $55,000.00 |
| Other Salon income | $30,000.00 |
On their $55,000.00 in salary income because they are both owners and employees they will pay $8,415.00 in payroll taxes. On the remaining $30,000.00 in income, from chair rentals and beauty product sales they will not pay $4,590 in payroll taxes because the income is not derived from salaries. Instead, it is generated from rentals and sales in the salon.
Jay explained if they set up as a general partnership with both of them as owners or if they set up with one of them as owner through a sole proprietorship the owner(s) would have to pay $4,590.00 in extra payroll taxes on the $30,000 in other salon income. Alana noted that that was a lot of money year in and year out. Choice of entity, as she was coming to appreciate, was important.
Jay continued by noting that while he liked LLCs for their asset protection there were regulations holding that a business LLC would also have to pay the $4,590 in extra payroll taxes. But he had a solution, which he would get to in a minute.
Jay then discussed the difference between an LLC and an S corporation for asset protection purposes. There were two types of claims to deal with. Attack #1 was brought by a customer against the business. It was an inside attack brought directly against the business. Attack #2 was brought by a claimant independent of the business, for example, a car wreck victim. This attack is an outside attack. Someone who has gone to court and won a claim against you for something unrelated to the business can then try and get at your assets, which includes your ownership of the business.
A car wreck victim whose claim exceeds your insurance may want to collect by getting at your business assets.
Jay drew a picture to explain.
In Attack #1, a customer could get a judgment against the entity and reach the assets inside the entity, be it an LLC or a corporation (either C or S). Before Alana could finish saying, “That’s not asset protection,” Jay explained that it was important to realize what the claimant couldn’t get. While they could get what the entity owned – in their case beauty supply inventory, equipment and a customer list – they couldn’t get what was outside the entity – their house, their individual bank account and other personal assets. The asset protection came from using the entity to protect the customer’s claim from reaching their assets outside the entity.
Jay went over it three more times so that the sisters grasped the concept. He noted that they didn’t teach this in school, although they should. This was much more important, he felt, than a quadratic equation. (When was the last time you used ax2+bx+c=0?) And because choice of entity was never, ever taught, you had to go over it a few times to really get it.
Again, in Attack #1, the inside attack, a successful claim against the company (by an angry customer or a bullying vendor) would be satisfied (paid off) with company assets but not their personal assets. On the other hand, Alana noted, if they had used a sole proprietorship or a general partnership all of their personal assets would be exposed to such a claim. Sherri agreed that by using the wrong entities they could lose it all.
Jay was glad they now understood Attack #1 and moved on to Attack #2. This Attack, he noted, had nothing to do with the business. It was one brought by someone who, for example, got into a car wreck with one of the sisters when they weren’t doing any business driving. In the event their insurance company didn’t cover the claim the car wreck victim could seek to get at their business assets by gaining control of their interest in the company.
The difference in how this was handled by each entity was significant. With an LLC formed in a strong protection state like Wyoming or Nevada, the claimant could only get a charging order. This is a court order ‘charging’ the car wreck victim with the right to recover monetary distributions. If no distributions were made, the claimant had to wait to be paid. Claimants, and their contingency fee attorneys, do not like to be put into this position. Importantly, Jay noted, the claimant did not have the right to get into the business and make decisions and vote to sell off all the assets to pay his claim.
Jay then discussed what could happen with an LLC formed in a weak protection state like California or New York. In those states the claimant could reach inside the LLC and sell all the assets. When Alana again said, “That is not asset protection,” Jay agreed. If you were going to form an LLC the choice of state of formation made a big difference.
Jay then discussed how Attack #2 would be handled in an S (or C) corporation. In that scenario the judgment creditor could reach and control the shares of the corporation. If Sherri were sued and the judgment creditor got control of her shares equaling 50% of the company all sorts of problems could ensue. First of all, Alana would suddenly have a new and, in almost all cases, uncooperative partner, a partner who wants to sell the company and get their money as soon as possible. Secondly, with a 50/50 split between Alana and the judgment creditor they would be in a deadlock situation where nothing would ever be resolved. Both Alana and Sherri clearly saw that a corporation
