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Previously, I discussed the tax implications of choosing an S Corporation over an LLC. Today, I will compare the registration costs between an S Corp and an LLC. Registering a business begins at the state level. Since I live in California, I can only tell you what I have learned about registering in California. Fortunately, registration at the federal level is quick, painless and free. More about this later.

S Corporation

An S Corporation is very similar to a C Corporation when it comes to registration. When registering a corporation, you start by filing a document called “Articles of Incorporation” (also known as “Certificate of Incorporation” in other states) at the Secretary of State. The Articles of Incorporation (PDF) are legal mumbo-jumbo that describe the name, purpose, agent of service, initial directors and liability limitations pertaining to your corporation. There is no form. It is a bullet list that you have to prepare and sign that will be reviewed and approved by the Secretary of State. However, there are some minimum and specific verbiage that must be included word-for-word.

Due to scarce documentation on how to prepare the Articles of Incorporation, attempting write one yourself can be quite intimidating. Lucky for you, we’ve gone through the painful process and, after several attempts, successfully incorporated. To show our gratitude to the startup community that has taught us so much, we have created IncBaby.com, an instant Articles of Incorporation generator, to help you incorporate for FREE! My research indicates attorney / accountant fees run between $800 and $1500. Hopefully, IncBaby will save you a bundle. Unfortunately, there’s not much we can do about the filing fees. The Articles of Incorporation will cost you $100 and a $15 special handling fee. If your Articles of Incorporation are rejected, the $100 check is returned to you along with instructions about what you need to change, but the $15 processing fee is forfeited. When you resubmit, you will have to pay another $15.

Within 90 days from when your Articles of Incorporation are approved, you will need to file a Statement of Information (Form SI-200 C (PDF)) that provides biographical information about your corporation, its officers and agent of service. This will cost another $25. Thereafter, you have to file a Statement of Information annually at $25/year.

Limited Liability Company (LLC)

Registering an LLC is somewhat simpler because there is actually a form (LLC-1 (PDF)) for you to fill out. That takes away a lot of the guess work. The LLC-1, better known as Articles of Organization, will cost you $70. There is a similar $15 special handling fee. You will also need to file a Statement of Information (Form LLC-12 (PDF)) and pay $20 within 90 days from when your Articles of Organization are approved. Thereafter, the Statement of Information must be filed biennially at $20/year.

Common Costs

In addition to the costs above that differ between LLC and S Corp, there are common costs that are inevitable for both ownership structures. Bear in mind that I am only keeping tab of registration and maintenance costs here, exclusive of other startup costs. Taxes are already discussed in my previous article.

Registered Agent

Both LLC and S Corp in California are required to appoint a registered agent of service. The agent of service can be a company or an individual, but your corporation cannot be its own agent of service. Some prefer to just list one of the owners as the agent of service, some list their attorneys or whoever filing the incorporation documents. What you need to realize is the agent of service is required to be available at all time during regular business hours. That means if you list yourself as the agent, you cannot take vacations, you cannot go for a coffee break, nor can you take a piss. It is unlikely though possible that while you are busy reading the Playboy magazine in the restroom, somebody tried to deliver a service of process (notification of litigation). If you missed the documents, it could lead to a default judgment. In this case, I decided to bite the bullet and went for one of the big three registered agent of service providers - National Registered Agents, Inc. (NRAI). NRAI costs me $120/year. The other two are The Company Trust Company (CT) and Corporation Service Company (CSC). Both charge upwards of $250/year. Reputation is important here. Most companies that offer online filing kits also bundle six-month or one-year service of registered agent. How reliable their registered agents are I don’t know. They typically charge $100/year. The Fortune 500 and legal community would not even go near anyone other than the big three when it comes to registered agents. Draw your own conclusions.

Name Reservation

If you are registering an LLC or a corporation, you are probably using a fictitious name. That is, a name you made up or the name of your imaginary friend from third grade. It’s possible that a name like “Baba The Bird” is already used by some other business in your state. If this is the case, you will have to pick another. The California Secretary of State website allows you to check if your name is available. If your name is available, you can pay $10 to reserve your name for 60 days while getting your Articles of Incorporation ready. But make sure you register under the same applicant who reserved the name lest you run into what I call a self-imposed deadlock (i.e. you are holding the name you reserved but you need it released so you can incorporate).

Federal Registration (Employer ID Request)

At the federal level, you will need to request a Federal Employer ID Number (FEIN). This is the equivalent of your SSN that identifies your company at the federal level. In the stone ages, companies used to file a Form SS-4 (PDF) to get an FEIN. Nowadays, you can get an FEIN immediately online. There is no fee associated with this filing.

Federal Tax Entity Election

At the federal level, if you want to go with the S Corporation you will need to make the election by filling out Form 2553 (PDF). A multi-member LLC will be taxed as a partnership for tax purposes unless you fill out the Form 8832 (PDF) to elect to be treated as a corporation. There is no fee associated with this filing. But you must make the election within 2 months and 15 days of the beginning of the tax year (or the date you are incorporated, whichever is later) you wish the election to take effect. Timing is crucial here. If you miss the deadline, your company will be treated as a C corporation until the S election takes effect next year.

State Employer ID Request

You will need your Federal Employer ID Number (FEIN) before you can get a State Employer ID Number (SEIN). You can get an SEIN the stone-age way via Form DE-1 (PDF) or immediately online for free.

Business Licenses

Some occupations like contractors are required to have licenses to operate in California and most likely other states. Fortunately, in the business I’m engaged in, no business license is required. So I have no idea how much a business license gonna cost ya.

City Registration

Most cities would require you to register your business. You will most likely have to pay an annual fee to maintain your business registration with the city. Check with your city officials regarding the form and fees you need to pay.

Summary

Below is a table that summarizes the different costs for LLC and S Corps discussed, exclusive of common costs.

So there are some savings to be had by registering an LLC when compared to an S Corporation. But the savings will neither make nor break your business. The almost $100 savings in five years with an LLC does not outweigh the tax benefits and tax code stability offered by an S Corporation in my opinion.

In my previous post, I talked about the four ownership structures available to choose from. Eliminating the ownership structures that don’t provide limited liability protection, I’m left with two choices: a limited liability company (LLC) and a corporation.

LLC Tax Implications

If you recall from Part 1 of this series, owners of LLCs are called members. An LLC can have one or many members. Because LLCs are treated as pass-through entities, income (or in LLC lingo “guaranteed payments”) to member managed LLCs are taxed as ordinary / earned income to members. What’s important here is that each member is treated as an employee. For those of you who are not familiar with self-employment, being self-employed certainly has its perks. But it also has its fair share of drawbacks. Self-employment taxes, for one, ends up doubling your tax bill. Here’s an example:

I am a managing member of Qovax, LLC and am involved in day-to-day operations. IRS will treat me as an employee. As an employee, I will have to pay 7.65% in taxes (6.20% social security and 1.45% medicare) on my portion of the income. But since I am also a member of Qovax, I am self-employed. Employers pay the same amount of social security and medicare taxes that are deducted from employee paychecks. So I end up paying 15.3% (7.65% x 2) of employment taxes. Ouch.

The observant reader will notice that one can avoid the self employment tax by making a distribution to members at quarter or year end instead. This will work only if the member receiving the distribution is a passive member in a manager managed LLC, that is someone else has to run the company for you. A passive member cannot be involved in day-to-day operations. Following this, it is only logical that the member contributes her share of capital in exchange for ownership in the LLC. Otherwise, it is easy for the IRS to choose to treat her as a member who earned her ownership stake from services rendered to the LLC. Thus, she will still be liable for self employment tax. Hence, it is crucial to document members’ capital contributions to the LLC in the operating agreement.

Corporation Tax Implications

With a corporation (both S and C), you would still pay the same 15.3% in employment taxes. But a corporation provides the ability to split your income. What this achieves is a potentially lower income tax rate. The table below outlines the 2007 corporate and individual income tax rates

Note that a corporation pays a lower tax on the first $75,000 of income when compared to a couple. If your corporation earns under $75,000, by retaining more income at the corporation level and paying less salary to yourself, you stand to pay lower taxes on the bigger retained income amount and higher taxes at the smaller personal income amount. This advantage vanishes once your corporation earns more than $75,000. So choosing the corporation structure based on this factor alone may prove unwise unless you expect your business to stay stagnant once it hits $75,000 in income.

In the past, a corporation used to afford the owner more fringe benefits compared to an LLC owner. For instance, you can deduct self-insured medical reimbursements, 100% health insurance, life insurance and dependent care premiums. But beginning in 2003, health insurance is also fully deductible for LLCs that are taxed as partnerships. As such, the advantage in fringe benefits that a corporation has over an LLC has narrowed significantly.

The double taxation is a double edged sword; it can reduce your taxes if your corporation earns less than $75,000 as discussed above, but after $75,000 your taxes increase significantly. As an owner of a corporation, the owner is taxed at the corporate level and then again when a salary or dividend is paid to the owner. The current 15% tax on qualified dividends is what Warren Buffett would call a rich man’s tax. The wealthy tends to earn the majority of their income from investments. This form of income is known as passive income. Qualified dividends and capital gains are taxed at 15% while average wage earners are usually taxed at an effective rate of 30%. If you really hate to pay double tax, there is an alternative - an S Corporation.

An S Corporation is much like an LLC. It is basically a corporation treated as a pass-through entity. What that means is you don’t pay taxes at the corporate level, only at the personal level. Of course, that also means you don’t get the benefit of a 15% qualified dividend tax. Income to an S Corp, whether it’s distributed or not, is subject to your normal income taxation minus the employment taxes. But resist from salivating over the 15% tax rate for C Corporations. You only get the 15% tax rate after your C Corporation has paid its taxes on the dividend you are distributing to yourself.

So how is the S Corporation different from an LLC? The paperwork and, depending on which state your business is incorporated, the state taxes. I live in California, where the mild weather, sunny days and beautiful beaches don’t come free. In California and several other states such as Texas, an LLC also pays a state franchise tax. The Franchise Tax Board (FTB) of California levies an annual $800 minimum franchise tax on LLCs. In short, you pay $800 a year regardless of whether you make a profit or not. This gets even better if your LLC earns more than $250,000 in revenue. An LLC in California is taxed based on its gross receipts! Although this LLC fee has been declared unconstitutional by the San Francisco Superior Court in a recent case, you are still required to pay the fee annually until the tax code is changed. You could file a protective claim for a refund on the taxes you paid but due to its pending nature, I’m not sure I want to play that game.

Of course, since the S Corporation structure has been around longer than the LLC has, the CA FTB has long implemented a similar minimum tax of $800 for S Corporations. The good news is the similarity ends there. An S Corporation is taxed on the greater of $800 or 1.5% of net income at the corporation level annually. Plus, first year S Corporations are exempted from paying this $800 minimum tax.

Comparing LLC and S Corporation

If you are running a high revenue, high pre-tax margin (income after all expenses before taxes as a percentage of gross revenue) business, you would be paying less tax with an LLC. On the contrary, you will pay more tax on a high revenue, low pre-tax margin business. To illustrate, an S Corp with 20% pre-tax margin on $1 million revenues will pay $3,000 in taxes. An LLC, on the other hand, will pay $6,000. But if your pre-tax margin is, say, 50% on $1 million of revenues, an S Corp will pay $7,500, while an LLC will be paying $6,000. To put this into perspective, Microsoft earns a five-year average pre-tax margin of 38%. Once your pre-tax margin exceeds 40%, you will likely save on tax going with an LLC as long as the current LLC tax on gross receipts remain in place. Having said that, considering the aforementioned supreme court ruling, I wouldn’t bet on the survival of this benefit for too long. It’s unlikely that a startup earns that much in revenue in first few years. If it does, and the tax code for LLC survives the supreme court ruling, an LLC may be your best bet. For now, S Corp seems like a better choice to me. Don’t forget that you can convert to an LLC later should you find yourself in the “unfortunate” event that your company is becoming too profitable.

The laws governing an LLC are still evolving and probably still have a long way to maturity. Importantly, the Federal tax code (PDF) does not have an equivalent ownership structure for LLC. A multi-member LLC can elect to be treated as a corporation or a partnership. A single-member LLC can elect to be treated as a corporation or sole proprietorship. If you do not file Form 8832 (PDF) to elect to be treated as a corporation, the IRS will treat a multi-member as a partnership and a single-member as a sole proprietorship for tax purposes (the liability protection remains intact). This begs the question, “Why choose an LLC if you are going to elect an underlying tax entity that is not an LLC?” The answer, some say, lies in the next few topics I will talk about. First, let’s look at what it costs to register and maintain an S Corp and an LLC.

Choosing an ownership structure for your new business is really not as hard as extracting your wisdom tooth on your own. If you file taxes yourself, you are probably well equipped to do this without a lawyer or an accountant. Remember, you can always choose to convert to another form of ownership later.

To begin, let’s examine the four types of ownerships you can choose from:

Sole Proprietorship

When I read about another tort case in the news, it often reminds me of the word “extortion”. Granted, not all tort cases are frivolous, there is still room for improvement in tort law. Like everyone else, I work hard to earn a living. In the process, I hope to accumulate some assets in my lifetime. I’d hate to lose everything in a lawsuit. When you run your business as a sole proprietorship, you are risking all your assets. That’s a good enough reason for me not to choose the sole proprietorship.

Partnership

But if you have a partner, which most startups do, sole proprietorship is out of the question. For multiple-owner businesses, a partnership offers the ease of formation much like a sole proprietorship and pass-through taxation (there is no tax at the partnership level). However, partners in a partnership are liable for each others’ actions. A limited partnership affords invested capital protection for the limited partners, but the general partner, who manages day-to-day operations of the business, is liable for all actions. If you work for your business, you are a general partner. Hence, a partnership structure still does not offer the limited liability I’m seeking.

Limited Liability Company (LLC)

This brings us to the next ownership structure: a limited liability company (LLC). An LLC is like a souped-up partnership. It has the pass-through taxation advantages of a partnership plus, as its name implies, limited liability for its members (owners of LLCs are called “members”). The major difference between an LLC and a partnership is that an LLC is legally recognized as a separate entity, hence the limited liability protection advantage. Although I compared an LLC to a partnership, it is possible to form an LLC with just one member to take advantage of the limited liability protection.

Corporation

There are two types of corporations: a C Corporation and an S Corporation. A C Corp offers the same limited liability protection that LLC offers. Most publicly traded companies are formed as C Corporations because this ownership structure has been around for a long time. The regulations governing C corporations have matured and therefore well understood by many. Despite its popularity, a C corporation has its drawbacks. One that stands out is its double taxation. That is, your corporation is taxed once at the corporation level and a second time when wages are paid to you. Yuck!

Tired of paying so much tax, the rich businessmen came up with the idea of an S Corporation. Someone once said “Tax laws are written by the rich for the poor.” Indeed. The S Corporation is, as you might have guessed, a C Corporation with the pass-through tax advantage. Since I hate paying too much taxes as well, I thought a C corporation is not such a good idea.

Deciding Between LLC And S Corp

Since both LLC and S Corporation provide the same liability protection, the decision boils down to several points to consider:

1. Tax implications
2. Registration and maintenance costs
3. Compliance
4. Employees and future ownership changes

Before I brush off liability protection altogether, it is important to bear in mind that your personal assets are only protected if you have conducted your business within legal boundaries. If you sell drugs, commit fraud or worse deliver spam to my e-mail, not only your personal assets are on the line, I will personally come after your firstborn.

In my next post, I will discuss the tax implications of choosing an LLC and a corporation. Stay tuned!