One of the first questions you’ll have to address as a contracting business owner is how the company should be structured. Your decision will have long-term implications, so consult with an accountant and an attorney who can help you select the form of business ownership that’s right for you.
In making your determination, you’ll want to consider the following factors:
- your vision regarding the size and nature of your construction business;
- the level of control you wish to have;
- the complexity of the structure you’re willing to deal with;
- the contracting business’s vulnerability to lawsuits;
- the tax implications of the different ownership structures;
- the expected profit (or loss) of the business;
- whether you’ll need to re-invest your earnings into the business; and
- your projected need to take cash out of the business for yourself.
The vast majority of construction businesses start out as sole proprietorships. These types of businesses are typically owned by one person who has with the day-to-day responsibility for running the business. Sole proprietors own all the assets of the business, as well as the profits generated by it. They also assume complete responsibility for its liabilities and debts. In the eyes of the law and of the public, the contractor and the business are one and the same.
Advantages of a Sole Proprietorship:
- It is the easiest and least expensive form of ownership to organize.
- Sole proprietors are in complete control and, within the dictates of the law, may make decisions as they see fit.
- Sole proprietors receive all income generated by the business to keep or re-invest.
- Profits from the business flow directly through the business to the owner’s personal tax return.
- The business is easy to dissolve, if desired.
Disadvantages of a Sole Proprietorship:
- Sole proprietors have unlimited liability and are responsible for all debts against the business. Their business and personal assets are legally exposed.
- Owners may be at a disadvantage in raising funds, and are often financially limited to using funds from personal savings or consumer loans.
- Owners may have a hard time attracting high-caliber employees and additional contractors, and those who are courted and motivated by the opportunity to own a part of the business.
- Some traditional employee benefits, such as owner’s medical insurance premiums, are not directly deductible from business income (and only partially deductible as an adjustment to income).
In a partnership, two or more people share ownership of a single business. Like proprietorships, the law does not distinguish between the business and its owners.
The partners should have a buy-sell agreement that sets forth how decisions will be made and how much time and capital each will contribute to the business, as well as questions of salary, how profits will be shared, and even supervisory oversight and separate everyday duties, etc. This agreement will also describe how future contractors will be admitted to the partnership, how disputes will be resolved, how partners can be bought out, and what steps will be taken to dissolve the partnership, when needed. Similar to a pre-nuptial agreement that must be signed before the wedding, it’s hard to think about a “breakup” when the business is just getting started. But many partnerships split up at times of crisis, and unless there is a defined process, there will be even greater problems.
Advantages of a Partnership:
- Partnerships are relatively easy to establish; however, time should be invested in developing the partnership agreement.
- With more than one owner, the ability to raise funds may be increased.
- The profits from the business flow directly through the business to the partners’ personal tax returns.
- Prospective contractors may be attracted to the business if offered the incentive to become a third partner.
- A business usually benefits from partners who have complementary skills.
Disadvantages of a Partnership:
- Partners are jointly and individually liable for the actions of the other partner(s).
- Profits must be shared with others.
- Since decisions are shared, disagreements can occur.
- Some employee benefits are not deductible from business income on tax returns.
- The partnership may have a limited life; it may end upon the withdrawal or death of a partner.
Types of Partnerships:
- General Partnership: Partners divide responsibility for management and liability, as well as the sharing of profits and losses, according to their internal agreement. Equal shares are assumed unless there is a written agreement that states differently.
- Limited Partnership and Partnership with Limited Liability: “Limited” means that most of the partners have limited liability (to the extent of their investment), as well as limited input regarding management decisions, which generally encourages investors for short-term projects or for investing in capital assets. This form of ownership is not often used for operating contracting businesses. Forming a limited partnership is more complex and formal than a general partnership.
- Joint Venture: This type is similar to a general partnership, but is clearly for a limited period of time or for a single project. If the partners in a joint venture repeat the activity, they will be recognized as an ongoing partnership and will have to file as such and distribute accumulated partnership assets upon dissolution of the entity.
A corporation, chartered by the state in which it is headquartered, is considered by law to be a unique entity, separate and apart from those who own it. A corporation can be taxed, it can be sued, and it can enter into contractual agreements. The owners of a corporation are its shareholders. The shareholders elect a board of directors to oversee the major policies and decisions. The corporation has a life of its own and does not dissolve when ownership changes.
Advantages of a Corporation:
- Shareholders have limited liability for the corporation’s debts and judgments against the corporation.
- Generally, shareholders can only be held accountable for their investment in stock of the company. However, officers can be held personally liable for their actions, such as the failure to withhold and pay employment taxes.
- Corporations can raise additional funds through the sale of stock.
- A corporation may deduct the cost of the benefits it provides to officers and employees.
- A corporation can elect to file for S-corporation status, if certain requirements are met. This enables the company to be taxed similarly to a partnership. (It is designated an S-corporation for Subchapter S of Chapter 1 of the Internal Revenue Code.)
- It’s easier for shareholders to sell their shares in the construction business—and the business itself—when they want to retire.
Disadvantages of a Corporation:
- The process of incorporation requires more time and money than other forms of organization.
- Corporations are monitored by federal, state and some local agencies, and there may be more paperwork to fill out in order to comply with regulations.
- Incorporating may result in higher overall taxes. Dividends paid to shareholders are not deductible from business income, so the income can be taxed twice.
- There is a potential loss of control over the business and decisions regarding its direction, etc.
A tax election only, this enables the shareholder to treat earnings and profits as dividends or distributions and have them pass through the business and directly to their personal tax return. The catch here is that if the shareholder is an employee of the company and the company makes a profit, he must pay himself wages that meet standards of “reasonable compensation.” This can vary by geographical region (as well as by occupation), but the basic rule is to pay yourself what you would have to pay someone else to do your job, as long as there is enough profit. If you don’t do this, the IRS can re-classify all of your earnings and profits as wages, and you’ll be liable for all the payroll taxes on the total amount.
Limited Liability Company (LLC)
The LLC is a type of hybrid business structure. It’s designed to provide the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership. Formation is more complex and formal than that of a general partnership. The owners are members, and the duration of the LLC is usually determined when the organization papers are filed. The time limit can be continued, if desired, by a vote of the members at the time of expiration.
“If you’re waiting for a freak time in the free market to go into business, when the demand for your product or service is much greater than your would-be competitors’ ability to supply that demand, you probably shouldn’t go into business.”
Nick Gromicko, founder of InterNACHI
An asset is anything of value in your name, such as a house, a vehicle, your business, and even your bank account. Unfortunately, if you are successfully sued by someone who is unhappy with the results of the work that you performed — regardless of whether the lawsuit has merit — attempts will likely be made to tap some of your assets as compensation if you wind up on the losing side. In order to protect your home and personal property from being exposed to such liability, along with your business assets beyond your E&O insurance, it’s important to safeguard all your assets through a collection of techniques known as asset protection. Taking some of these urgent precautions will ensure that, in the event that you lose a lawsuit brought against you and your construction business, your home, personal vehicle and other personal property will be exempt from garnishment, repossession or seizure. It will also provide you with the opportunity to rebuild your business.
Approximately 50,000 lawsuits are filed daily in the United States, which equals one lawsuit for every 17 Americans, annually. In professions that are predisposed to litigation, such as home construction, medicine, law and business, the chances of being sued are considerably higher, although unscrupulous opportunists may target anyone who they perceive as having deep pockets. And there are plenty of ways besides litigation that unprotected assets can be taken away, such as through identity theft, divorce, death, healthcare costs, probate, auto accidents, home fires, floods and bankruptcy, to name a few. Any of these events can ruin someone’s finances if they lack proper asset protection.
The first things every new small business owner should consider include the following:
- Incorporate. Incorporating a business limits the owner’s personal liability in lawsuits filed against the business because a corporation or LLC is considered under the law to be a separate legal entity from its owners. The reason for this is that in Western legal systems, corporations and LLCs are treated as entities that are separate and distinct from their owners. Therefore, the owners of an entity are not personally liable for the debts of the entity. However, the “corporate veil” can be pierced in certain circumstances, such as when it can be proven that the business owners did not obey corporate formalities.
Typically, courts will not allow the corporate veil to be pierced, except in certain factual circumstances. Courts consider a variety of factors to determine whether the corporate form should be disregarded, including:
- whether the corporation is operated as a separate entity;
commingling of funds and other assets;
the failure to maintain adequate corporate records;
the nature of the corporation’s ownership and control;
the absence of corporate assets and under-capitalization;
the use of the corporation as a mere shell;
disregard of legal formalities; and
diversion of the corporation’s funds or assets for non-corporate uses.
Generally, if an entity looks like it is not the alter ego of its owner(s), the courts will treat it as a separate entity. While every case is different, there are steps an inspector may take to reduce the risk that a court might pierce the corporate veil of the inspector’s business entity. The following strategies are recommended:
- Obtain a separate Employer Identification Number (also known as an “EIN” or Taxpayer ID number) from the IRS. Corporations are required to do this, but LLCs with a single owner are not because a single-member LLC owner may use his or her Social Security Number. Nevertheless, we recommend that single-member LLCs obtain their own separate EIN.
- Open a separate bank account for your corporation or LLC.
- Do NOT mix personal money and business money.
- Do NOT pay personal expenses from a business account.
- Do NOT pay business expenses from a personal account.
- File the required annual report with the Secretary of State in your jurisdiction.
- File required tax returns for your business.
- Title business property in the name of the entity.
- File business property tax returns if required by your state.
- Prepare minutes of meetings of shareholders and directors (for corporations), and minutes for annual meetings of members (for LLCs).
- If the corporation or LLC has more than one owner, make sure there are written bylaws (for a corporation) or a written operating agreement (for an LLC).
- Keep licenses and insurance in the name of the entity.
- Make sure the public knows your business is a corporation or LLC. If a customer knows he or she is doing business with a corporation or LLC and voluntarily chooses to do so, the customer is not in a good position to ask a court to pierce the corporate veil. On the other hand, if the customer has no knowledge of the existence of a separate entity, a court may determine that equity requires it to pierce the corporate veil. Therefore, the wise inspector puts the public on notice by including “Inc.” or “LLC” on the inspector’s website, advertisements, forms, and business cards.
- Use a family limited partnership (FLP). Family limited partnerships are specially designed partnerships that consist of general and limited partners. The FLP allows an individual to maintain full control and enjoyment of their property while separating themselves from actual legal ownership. A creditor of a single partner cannot reach the assets owned by the partnership because the partnership, as an entity, owns the asset. This does not prevent the partnership from being sued, but it will keep certain assets separate and unexposed to legal liability or claim.
- Purchase professional liability insurance (E&O). The costs of insurance premiums are generally small compared to defending a lawsuit.
- Keep major assets encumbered. If you own property free and clear, you can imagine how attractive that is to a judgment creditor. Many contractors lease their company vehicles to prevent them from becoming a target.
- Check your state’s homestead exemption. Homestead property protection laws help protect your home from creditors (as well as help provide survivors with a home after the death of the primary wage earner).
To be effective, asset protection should be performed years before you find yourself in financial trouble. Any transfer of ownership of property after the emergence of a significant claim may be deemed fraudulent, which can result not only in seizure of the asset anyway, but significant civil penalties. After a claim arises, you need debtor and possibly pre-bankruptcy planning, as asset protection becomes more difficult as legal proceedings progress. Most importantly, have an attorney and an accountant guide you through the process of asset protection. You need these experts to make sure that asset protection planning is performed competently and, even more importantly, within the parameters of the law. Professionals will make sure that you use appropriate legal structures to safeguard your assets without deliberately defrauding creditors.
TIP: Read this article on Defending Your Website.
In summary, contractors should invest in legal asset protection strategies to keep their business assets separate from their personal assets, and also to ensure that, should they face a tough legal battle, they will be able to re-establish themselves when the dust settles. Deciding the form of ownership that best suits your contracting business should be given careful consideration. Use your key advisors to assist you in the process.
Join our discussion about how contractors can protect their assets.