Setting Up a Construction Business
Today, businesses in the construction industry have two good choices for entity formation that will provide personal liability protection: incorporation or setting up limited liability company (LLC). Which alternative is the better choice?
It depends…
Liability protection
Any type of business with the potential for personal injury should select the type of business entity that will afford liability protection for owners. While insurance can go a long way in providing coverage for certain events, owners will sleep better at night knowing that their home, savings account and other personal assets are beyond the reach of injured parties and other creditors. All businesses within the construction injury have the potential for personal injury; employees and customers alike can easily suffer from a fall or other injury on a worksite no matter how much care and precautions are taken. And, too, there is potential liability for unpaid debts or employees causing injury to others.
Two options for creating personal liability protection are corporations and limited liability companies. Neither sole proprietorships nor general partnerships can offer this type of liability protection.
Corporations and LLCs are formed under state law--by filing articles of incorporation (for corporations) or articles of organization (for LLCs) with the secretary of state in which you do business. Each type of entity can be formed in a state other than the one in which the business is located, but this then requires the company to file to do business within the state of its operations--usually a needlessly cumbersome strategy.
A corporation or LLC can be used if there is only one owner or multiple owners.
Income taxation
While a corporation is a corporation under state law, for federal income tax purposes, there are two types of corporations: A regular (“C”) corporation and an S corporation. A C corporation is a separate taxpayer--it files a return and pays income taxes on its profits. In contrast, an S corporation is merely a conduit to pass income, gains, losses, expenses, and tax credits to its owners. Each owner of an S corporation reports his or her share of the business’ income, losses and other items on a personal tax return.
Note: S corporations cannot be used if any owners are nonresident aliens, corporations, partnerships or other entities (other than certain trusts).
For federal income tax purposes, the LLC is like an S corporation--not a separate taxpayer but only a conduit to pass through the business’ pass income, and other items to its owners, to be reported on the owners’ returns.
- Single LLC owner--For federal income tax purposes, the LLC doesn’t exist (it’s even referred to as a “disregarded entity”). The LLC doesn’t file any separate return. Instead, LLC income or loss is simply reported on the owner’s personal income tax return--he or she completes Schedule C, which is attached to Form 1040 (assuming the LLC owner is an individual and not a corporation).
- Multiple owners--the LLC files a partnership return (Form 1065, U.S. Partnership Return of Income). This acts as an information return to tell the IRS about the business’s activities. Schedule K-1 of Form 1065 is used to allocate income, deductions, etc. to members, usually according to their ownership interests. Each owner then reports this allocation, called a “distributive share,” on a personal tax return (specifically on Schedule E of Form 1040. For example, say you own 50% of an LLC that owns a roofing business. You report 50% of the net income from the LLC on your own tax return. (Allocations can vary from actual ownership interests in some situations as provided in the LLC’s operating agreement.)
Annual filing fees. Even though S corporations and LLCs are not separate taxpayers, there may be annual state filing fees. These vary from state to state. Usually, there is flat filing fee for an S corporation. The amount of the LLC fee in some states is tied to the number of owners, which can create a higher annual cost for maintaining an LLC than an S corporation if there are many LLC owners; other states have no annual filing fees for LLCs.
IRS scrutiny. Choice of entity can affect the amount of IRS attention given to a business return. While this can change from year to year, it has been historically true that corporate returns (C and S) have lower audit rates than Schedule Cs used by one-owner LLCs. Those in the construction industry who are sole owners might prefer incorporation to minimize audit exposure.
Employment taxes
There is a big difference in the tax treatment of owners of corporations (C or S) versus LLCs when it comes to employment taxes. Corporate shareholders who work for their business are employees. As such, their compensation is subject to FICA (Social Security and Medicare) taxes. As is the case for rank-and-file employees, both the owner and corporation contribute to FICA.
In contrast, LLC owners are treated as self-employed individuals. As such, all of their net earnings from the business are subject to self-employment tax (which covers both the employer and employee share of FICA. Thus, LLC owners may pay more in employment taxes than their corporate counterparts.
Example: Say a business with a sole owner produces a $90,000 profit for the year, half of which is distributed to the owner. In the case of an S corporation, the owner reports $45,000 in compensation, plus $45,000 in net profits ($90,000 reduced by a deduction for compensation to the owner). Only the $45,000 of compensation is subject to FICA.
In contrast, the LLC owner reports all of the $90,000 as net earnings from self-employment; there is no deduction for a distribution to the owner. All of the net earnings are subject to self-employment tax. Note: The IRS has yet to rule definitively on whether there are exceptions from self-employment tax treatment for LLC owners in special situations.
Caution: An S corporation owner cannot avoid FICA by simply not taking any compensation. The IRS insists that an owner receive reasonable payment for services rendered. There is no dollar or percentage guideline on what’s reasonable for this purpose. Generally, figure that reasonable compensation is what would have to be paid to an outsider to perform the work that the owner does for the business.
Final thoughts
If a construction company owns plans to own a building in which to operate a showroom or store equipment, it is usually advisable to keep property ownership separate and distinct from ownership of the operating business. The building can be owned by an LLC formed for this purpose, even if the business is owned through a corporation, and then leased to the corporation.
Separate ownership provides more flexibility to the owner. It makes the sale of the building easier and facilitates estate planning. It also can allow for greater tax deductions with respect to the building. The reason: Rental losses can be claimed only to the extent of the owner’s tax basis (usually cost) in the building. Basis can, in the case of an LLC, include the owner’s share of mortgages on the property held by the LLC, effectively allowing the owner to claim a greater amount of depreciation and other deductions.
Because of the importance in entity selection and the various factors that must be considered, it may be advisable to discuss the matter with an attorney before making a choice.
This article was written for BizFilings by Barbara Weltman, a popular guest speaker on small business issues. She has lectured at national and regional conferences sponsored by prestigious forums such as SCORE, Barnes and Noble, The Learning Annex, and the U.S. Small Business Administration.
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