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Selling a Product with a Partner*
Selling a Product with a Partner*
- Now we bring into play all three entities.
- We need to bring into the following factors:
- What is the personal W-2 income of each partner?
If above $84,900 in 2002, an S corporation can only possibly
save 2.9% in taxes on distributions. If less, than this amount,
an S corporation may be possible as long as all the C corporation
tests are met.
- What is the gross profit of the business
in 12 months?
- What are the net profits of the business
in the next 12 months?
- Will the business accumulate a net worth
each year? Does it create a business that can be sold 3-5
years from now, or will it be all service orientated with
a couple of employees with no systems so when the day the
partners stop working, is the day it stops bringing in revenue?
If so, then an S corporation can be a possibility. If a large
asset base is in place then this may eliminate an S corporation
because it is difficult to protect the stock of an S corporation
from a personal lawsuit by one of the partners.
- Do the partners want to take advantage of
the C corporation benefits; calendar year end, fringe benefits,
going public, lower tax rates.? Because the business will
be selling a product, the personal service corporation category
will not be a problem. The personal holding corporation category
will not come into play because of an active business.
Let's look at a couple situations and the reason
we choose a particular entity:
Situation # 1:
- Each partner is quitting his or her jobs
to start this new business. This is their only source of income.
They expect a net profit of $40,000 the first year off gross
revenues of $400,000.
- The product they are selling is vitamins.
- They keep a small inventory and client does
have repeat orders.
- They do not manufacture the vitamins. They
have a low overhead. Their office will have the basic computers,
furniture and phone system.
- They will have three other employees.
- They will not have enough money to take advantage
of all fringe benefits.
- The day they stop working, their business
goes down tremendously.
- They expect to grow about 10% per year over
the next three years.
- They meet all the S corporation requirements.
Conclusion. A
S corporation may be the best answer in this situation for several
reasons;
- They will have the opportunity to save SE
taxes on about 50% of their net profits or about $20,000 each
(a savings of 15.3%).
- They are not taking advantage of fringe benefits
(a C corporation benefit).
- They do not need to protect the S corporation
stock. Because the value of the company is low.
- They do not have other income personally,
so their personal tax bracket is rather low.
- They meet all the S corporation requirements.
Other notes: An LLC would make no sense because
they lose the 15.3% tax savings, and the charging order will not
be a major advantage because there are no assets to protect in
the business.
What would have to change to look at a C Corporation?
If both partners already earned above $80,400 on a W-2 and they
had other income that pushed them into the 39.6% personal bracket.
Also, if they wanted the C corporation to pay for fringe benefits.
What would have to change to consider an LLC?
If both partners already earned above $80,400 on a W-2 and the
LLC would accumulate business assets and a net worth by creating
a duplicable system.
Situation # 2:
- Each partner earns $150,000 in W-2 income
and is in the 36% federal tax bracket. They already have a
401k at their company and full health benefits. They already
have life insurance personally.
- They will be investing in a new computer
company that will expect a net profit of $150,000 the first
year off gross revenues of $1 million. They will oversee part
of the operations on a part time basis (so they will be actively
involved), but hire a manager and employees to run the business.
They have already developed the software in the past. They
will be providing money and the software to get this company
started.
- The product they are selling is computer
software to increase office efficiency.
- They are developing a loyal customer base
and will be creating more software products in the future.
- They do have some overhead. Most of their
assets are computer copyrights on the software product.
- They will have seven employees by end of
year one.
- They will not need fringe benefits (they
have them personally at their current jobs.
- This business will continue to add a new
worth each year.
- They expect to grow about 40% per year over
the next three years.
- They meet all the S corporation requirements.
Conclusion: An
S corporation can be ruled out for two main reasons:
- The investors are already in the above the
SE level of $80,400 for the year.
- The company will really gain in value with
a client base, which means the ownership interest needs to
be protected; therefore, this is more important than saving
2.9% in an S corporation.
What about a C corporation? Here is the verdict.
- Fringe benefits are not important to them.
- They are in a high personal tax bracket and
may not need more money personally. They may want to keep
the profits in the company (retained earnings) for future
growth and expansion. The C corporation tax rates may help
them with overall lower tax rates.
- They are not really considering going public
at this point. It could be a possibility at some point.
What about an LLC? Here is the verdict.
- Provide immediate protection from a personal
lawsuit (because of charging order protection).
- Profits at years end will flow through to
the partners which are in a higher tax bracket. If money is
needed for growth and expansion the partners may receive a
K-1 with no money but just a tax bill. If the outcome is to
reinvest the money to grow the company each year this may
not be the best entity. If the outcome was to stabilize the
growth and take the profits out (similar to receiving dividends
from a utility stock) then an LLC may make sense.
In this case, a C Corporation may make
the most sense. The money will be kept in the company for future
growth and expansion. The tax rates will be slightly lower than
if the profits flowed through to their personal tax bracket. They
will need to protect the stock of the C corporation with an LLC.
If they own the company 50/50, they both may consider an LLC to
hold 50% of their ownership interest in the C Corporation. The
personal LLC should be taxed as a partnership. They may also consider
a separate LLC to own the copyrights or any patents. This is a
safe asset that can be leased to the operating C corporation.
If they both own equal parts of the copyrights or patents they
may have the LLCs that will own 50% interest in this C Corporation
own them. The key is to make sure these two LLCs own only safe
assets. A huge mistake would be to title a piece of real estate
to one of these LLCs.
These results are our opinions. It is recommend
to get the opinion of your attorney and CPA. If you have any questions
please call our offices at (800) 351-5111.
* Should you have a partner?
A. The advantages:
- Allows you access to additional experience
that you do not have and to pay a salary to because they are
an owner like you.
- They may bring capital to the table that
you need.
- They will be there for support with important
decisions.
- You will have a teammate to be there with
you when you are burning the midnight oil.
- You may be able to double your efforts in
getting the company started much faster then if you just did
it alone.
- You now have the option of partnership taxation
that has tremendous advantages:
- Being able to contribute assets tax-free
and distribute assets tax free-IRC 721 & 731.
- The charging order protection from a personal
lawsuit.
B. The disadvantages:
- You will need a buy sell agreement. It is
critical before the business starts to plan as to how to shut
down or sell the business or sell just your interest
before you start operating. This agreement will tell you how
you may get out of this arrangement if it does not
work. This will save a lot in legal fees in the long run and
perhaps more importantly it will save friendships. Unfortunately
most people do not spend the money that they should to
have an attorney put together a buy sell agreement from
the start. Typically, this is the stage that the ideas of
becoming rich are being discussed and how great everything
will be working together. Sometimes it may appear 'negative'
to bring up the question, "what if this doesn't work
out?" What if one partner wants to grow this
into a $10 million company and work 70 hours per week for
8 years, and I only want it to be a $2 million company and
only work 70 hours per week the first three years? Again,
typically this is missed, who will do what is loosely
discussed, no contracts or agreements. Then 8 months later
when there is $50,000 in the checking account many times partners
develop amnesia as to what they discussed and agreed upon
eight months ago, especially as to how the money was to be
spent. One partner may want to go on a vacation or take extra
money out of the company because it is 'doing so well' and
the other partner remembers agreeing to only taking a minimal
amount of money out the first year and absolutely no vacation
time!
The bottom line is that if you can not get
through a buy sell agreement up front and agree in writing
to who will do what, DO NOT GO INTO BUSINESS WITH EACH OTHER!
- You know you will have someone you
will have to discuss each major decision. Even if they own
2%, they will be involved. By yourself you do not have anyone
to consult with to make these decisions, while with a partner
you do. This also brings into play your partner's spouses
opinion and perhaps their families. Remember you went into
business with probably one spouse, not the other or their
family.
- An increase in legal liability because of
this partner. Do you know every minute of the day what you
partner is doing or just said to a customer, vendor or employee?
Do they cause you legal liability without you even know it?
- You may realize that you have been influenced
by a partner who is not as sharp as you were told in the beginning.
You may have made some very poor business decisions with
this partner that you may not have made otherwise.
In conclusion there are advantages and disadvantages
for having a partner and not having a partner. Depending on whom
you listen to you will be able to find success stories and failures
for each situation. Be sure that you consider the advantages
and disadvantages for your situation and take all the precautions
and you more than likely will avoid most of the pitfalls suffered
by many
Ready to Incorporate,
Build Business Credit &
Keep the IRS Off Your Back?
Call NCP Today at
1-800-351-5111
Avoid Costly Mistakes!
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