Editor's Note: The information presented in this article IS NOT TO BE TAKEN AS LEGAL ADVICE. The authors of this article are not practicing attorneys at law. Nothing herein is to be construed as legal advice from the authors of this article or the employees of this website. Seek formal guidance from an attorney registered to practice in the state in which you operate. Corporate law varies state by state.
The authors are sharing their understanding of the pros and cons of various types of business structures and strategies for legally protecting your hard-earned assets. Some of the tips and advice presented is going to be slightly off depending on the state in which you operate and the present status of the U.S. tax laws and judicial system. The intent is to provide you some ideas to consider and to investigate via the proper experts (attorneys and CPAs).
WARNING REPEATED: Consult a licensed practicing attorney before taking any actions upon the suggestions shared in this article.
Protecting Your Assets
For most business owners, the type and number of corporations they should be using to run their business doesn't draw sufficient attention until AFTER their assets come under fire. By then, the game is lost.
You MUST set up your asset protection long before a threat arrives. The first priority for new business owners is getting going. What usually happens is the owner dumps everything into a single incorporated business.
Something goes wrong; the business comes under fire; it gets handcuffed by litigation; and the owner is prevented from generating income.
If the assets are properly protected, the owner may be able to generate income with the assets that aren't being attacked and use the money to fend off the attack on the impaired assets. Otherwise, the owner is probably hosed.
Common Asset Threats
At some point in time, your business is likely to face one or more of six common threats.
- Financial stress
- Divorce (it had to be said)
- Stockholder death
- Tax liens
We would like to address unionization as to avoid confusion about our position on construction unions.
We are neither biased towards nor against construction unions. Signing up with the unions is often a great decision for an owner. And that's what it should be - the owner's choice.
As we understand the regulations (consult your attorney) the voting rules that were written for manufacturing apply to contractors as well. If 51% of your field employees vote to unionize, congratulations, you're now required to get your workers from the hall.
Such a sudden, unexpected rise in labor costs can put your company at great risk. If you have moved your hard assets into a separate company, you should have the ability to shut down your suddenly unionized operating company and open a completely new one. Then switch your leases around to rent your building and equipment to your new, non-union operating company. You could be back up and running within 24 hours.
Other Considerations & Benefits
Asset protection is not the only reason to thoroughly consider your corporate set up and to use multiple corporations to run your business.
- It is easier to value your business.
- It is easier to sell your business.
- It is easier to bring your investors.
For small construction companies, the business is usually worth the value of its assets.
The exception to that rule of thumb is where you have created a business that runs itself and you can prove it. The best proof is where you've opened branch offices in other cities that are as profitable as the home office (i.e. franchises).
If you haven't successfully set up a self-running business, the only people who are apt to offer you more than twice the annual net are your employees and a national roll-up. Neither of which is very likely.
The reason having multiple companies makes attracting investors easier is that multiple companies offer greater protection of their investment.
Most of the risk in your business comes from the operations side (contracts and people). By moving the operations risk away from your collateralized assets, your lenders and investors can more easily recover their money if need be. That makes them more willing to invest (through equity purchase or loan).
The owners of my former consulting business started up a new company almost every time they made a new real estate investment or bought an existing business. Our poor bookkeeper must have been running the books on at least 10 companies. When the owners decided to go their separate ways, splitting their holdings up turned out to be quite simple as each business contained a single asset. They didn't have to move assets between businesses.
Types of Corporate Structures to Consider
Several business structures have been legalized by U.S. tax law and judicial case law. Each has advantages and disadvantages.
Generally, the greater the asset protection the worse the tax hit. We are going to briefly explain the pros and cons of the four most common business structures for contractors.
- Sole Proprietorship
- "C" Corporation
- "S" Corporation
- Limited Liability Corporation
What It Is:
You are operating a business without any legal separation from your personal assets. Sole proprietorships are far more common than they should be.
Easy to get started with minimal reporting requirements. Zero start-up costs.
All debts of the business are debts of the owner (including those created by lawsuits). Sole proprietorships enjoy far fewer tax deductions than do incorporated businesses. They offer virtually no asset protection.
Due to the ease and low cost of incorporating a business ($500 +/-), sole proprietorships should be avoided. Don't let their ease of getting started blind you to their danger.
What It Is:
The standard form of incorporation in America. The C corporation is a completely separate entity from its owners.
The C corporation is the ultimate in personal asset protection for the owners and managers. The C corporation's legal obligations apply to the corporation, not to the employees who run it nor the individuals who own its stock - except in extreme cases of mismanagement (see Enron).
This protection is commonly referred to as the "corporate veil." Piercing the "corporate veil" refers to an attempt to get to the assets of the owners. Piercing a C corporations' veil is quite difficult and usually requires the finding of owner fraud. Fraud accusations are very tough to prove.
Another advantage of the C corporation is that it allows the owner(s) to install an Employee Stock Ownership Plan (ESOP) that minimizes income taxes and funds the eventual buy-out of the owner.
The primary disadvantage of a C corporation is double taxation. The company pays taxes on its income. Then, any left over money that is distributed to its owners is taxed as personal income to them.
What It Is:
A subchapter S corporation is a special form of C corporation that transfers the income tax liability directly to its owners' tax returns. This means that the company's income reaches its owners' pockets with less tax being taken out by the government.
An S corporation is usually bound by the same laws as the C corporation. Like the C, it is considered a unique entity separate from its owners.
All actions taken by the controlling managers must be in the corporation's best interest. When attacked by outside agents, this rule comes into play if one of the owners has withdrawn money that could or should have gone to a lender.
In many ways, the S corporation is the best of all worlds. Its tax advantages are fantastic while it performs well as a barricade against lawsuits reaching the personal assets of the owners.
You can't set up an Employee Stock Option Plan in an S corporation. Its protection of personal assets isn't as solid as that of the C corporation. Options for raising capital are more limited than with a C corporation.
Limited Liability Company
What It Is:
LLCs' popularity has grown rapidly. They work really well for multiple-owner businesses - especially when those owners are other incorporated businesses. Their tax treatments are similar to those for S corporations.
LLCs give you asset protection similar to an S corporation.
LLCs allow you to keep $50,000 of net income in the business tax-free. That can be very beneficial cash flow around the fiscal year end.
The ownership structure and management rules are adaptable to the needs and whims of the owners and can be modified almost at the drop of a hat.
LCCs require an operating agreement that explicitly lays down the rules of the business including who has authority to change the rules, distribute money, etc. LLC operating agreements take longer to prepare than do the documents for a standard S corporation.
Our Recommended Approach
Here is our advice.
- Incorporate any and every business you run - ALWAYS!
- Set up a separate corporation for land and buildings.
- Set up a separate corporation for major equipment.
- Set up a separate corporation for your operations which employs your workers and signs your construction contracts.
- Lease your equipment to your operating company.
- Lease your land and building to your operating company.
Three cautionary notes.
Warning 1: You may end up paying higher insurance premiums by using multiple companies.
Warning 2: Do not attempt to move workers among your companies to avoid paying overtime.
Warning 3: Don't be shocked when your lenders:
1. Ask for, or create, a combined balance sheet.
2. Try to tie up ALL of your assets as collateral.
Ron Roberts teams with Guy Gruenberg as The Contractor's Business Coach. They show contractors how to grow their businesses profitably. To sign up for their FREE Newsletter or join their Private Club, visit www.FilthyRichContractor.com.