money & business

As any company grows & realizes some level of success (whether lasting or fleeting), the question arises - what do we do with the profit?

Conventional wisdom would have us investing in diversified stocks or (more likely) Real Estate. However, online marketers, as a group, can't accurately be labeled as conventional.

I have been running businesses (into the ground!) for as long as I can remember. About 6 years ago, I decided to run my own in the ground instead of someone else’s business. Like many small business owners I struggled for a few years & then found a niche. Additionally, I had acquired an impressive working knowledge of things not-to-do…the hard way.

I went with an LLC for my first business. The reason was, like many who choose an LLC, for simplicity.

LLCs are disregarded entities for tax purposes unless you make the election to be taxed as a corporation before March 15th. Effectively, any profit from a standard LLC is taxed at personal rates. If you aren’t anticipating a large profit - this is the easiest way to go.

It never occured to me that the business might actually turn a real profit. Fortunately, both for me & the space shuttle program that my tax payments support, the business finally found its stride & began turning a respectable profit. It had become apparent that I hadn’t thought this out thoroughly in regard to tax planning. The current business (primarily online publishing) also lacks diversification…too much of the income is dependent on a small handful of other companies. If one of them changes a policy, the business will feel it.

I needed a new gig - both for tax planning & for income diversification. So, I decided to form a second company to address some of these issues. The new business performs several functions including investing, some limited online marketing, & some intercompany sales/leasing. This is where the confusion begins. Which is business structure is best?

For Business Incorporation, there are 3 basic choices with some small variations.
LLC (limited liability company), C-Corporation, & S-Corporation:

As mentioned, the LLC is the easiest to set up & causes the least brain damage at tax time…provided you don’t make a big profit, in which case, the damage might be inflicted elsewhere on your person. Unless an election is made to be taxed as a corporation, taxes are paid based on the owner’s tax rate.

The C-Corp is the most complex which spooks some business owners who might benefit from the structure in regard to tax liability. A C-corp pays tax on retained earnings at the entity level while a LLC or S-corp are pass-through taxation at personal rates (this is the simple explanation.) The employees of a C-corp would then pay taxes again on any distributions (dividends). Many might frown on the choice of a c-corp due to this double taxation at the entity level & the tax on distributions. However, this is not necessarily as bad as it sounds. There are ways to minimize the impact.

Depending on your tax bracket, a C-corp may offer better tax advantages despite the spectre of double taxation. Typically owners in C-corps are paid by w-2 salary. This is a business expense for the corp & thus taxed only once (at the personal rate). After payroll, employee benefits, & all other business expenses, any remaining profit is taxable as retained earnings.

For 2006, The corporate tax rate begins at 15% for the first $50,000 in retained earnings.

The next 25,000 is taxed at 25%.

The next 25,000 is taxed at 34%

The next 235,000 is taxed at 39%

The next 9,665,000 is taxed at 34%

The next 5,000,000 is taxed at 35%

The next 3,333,333 is taxed at 38%

All taxable income above 18,333,333 is taxed at 35%

That sounds more complicated than it needed to be - but surely our trusted leaders had their reasons for the, seemingly, arbitrary schedule. Regardless, most of the upper brackets are not a short-term issue for small business owners & businesses which would be subject to the rates at the higher end of the schedule have rooms or buildings full of accountants & tax attorneys.

For many small business owners, the Corporate tax rate on retained earnings is lower than their personal rates up to the first 75,000 in retained earnings. In effect, if you don’t take the (excess) income as salary or dividend distributions, you can put (more of) the money back to work than if it were subject to your personal tax rate.

There are also other ways to reduce the taxable income in a c-corp as well. One favorite is real estate. Some companies will set up a separate holding company (not another c-corp…more on this later) for real estate acquisition & lease the asset back to the c-corporation. The income from leasing is, largely negated in the short term through depreciation & real estate expenses/deductions. One advantage to this structure is that it is an investment as well as a tax saving strategy. There are similar structures which revolve around leasing trademarks or other intangible assets. These might be investments or they might simply be tax shelters depending on whether or not the asset has any value to anyone else. I used to work for an automotive service company which had over 100 branch locations. They owned most of the real estate & rented it to the branch at fair market value. The structure was set up so that even if the branch showed break-even on the profit/loss statement, the company still made money on the real estate. This is common in larger businesses but may be a strategy which can be implemented for a smaller-but-growing company.

The question remains what to do with the retained income over 75,000 when the short-term tax benefit begins to diminish… spend it or distribute it. A C-Corp provides the ability to create a great number of non-taxable employee benefits such as Health benefits, dependent care assistance, group life, retirement programs & more. Certain rules & exclusions apply. Consult the IRS guide to fringe benefits & (of course) your accountant. There is also the option to simply leave the money in the company which would make it subject to the schedule above. Be aware that accumulated earnings in excess of 250,000 may be subject to an accumulated earnings tax of 39% on the amount above 250,000. This may be avoided if the company has a valid (& well-documented) reason for not distributing the earnings as a dividend … such as saving for expansion. The IRS wants to be sure you aren’t using the company as a glorified piggy-bank.

To briefly revisit the idea concept of real estate held by a c-corp, the common reason for not using this structure is the specter of double taxation. Upon sale of the asset, the c-corp has a taxable event as well as the shareholders having a taxable event. The other biggie is that the capital gains tax rate available to individuals is not available to c-corps. In effect, the sale could result in a corporate tax rate of nearly 40% on the gain. Ouch. In most cases, a pass-through entity such as an LLC or s-corp might be a better vehicle for this type of activity.

One possible solution which effectively negates the issue (regardless of entity type) would be to keep the asset... forever. No sale, no taxable event.

Online lending has been around for years, however a viable platform for Peer-to-Peer lending is a new arrival. Now there are two. The summaries are written from a potential lender’s perspective.

For US borrowers & lenders, There is Prosper.com. Prosper was founded by Chris Larsen, founder of E-Loan. It seems to be a promising site which, if policed properly, could grow exponentially. Prosper has been called the eBay of lending. While eBay has been wildly successful, the growth has not been without casualties. I can speak knowledgeably as a former eBay powerseller who walked away from eBay, in part, because the fraud & phishing attempts became a problem. Fortunately for eBay someone has surely moved in to take my place. Party on, Meg. While still a young site & a bit rough around the edges, Prosper.com strikes me as an implementation which could work if they succeed in building a community. I did join Prosper with the intention of lending some funds through one of my business accounts. Unfortunately, at this time, Prosper.com will only issue 1099’s to individuals and is, for most purposes, a consumer to consumer site. In this regard, Prosper very different from eBay which facilitates b2b, b2c, & c2c transactions.

Similar in concept is Zopa.com, a UK based p2p lending site which is planning a US debut. Zopa is slightly different in that instead of bidding to lend to a particular borrower, lenders can choose from risk-rated groups of borrowers. Lenders can also choose the interest rate. On the UK site lenders wishing to lend over £25,000 or more or are lending in the course of a business are welcome. However a license is required. Hopefully, Zopa.com will use a similar model & include businesses as lenders in the US launch. This small business will be among the first lenders in line.