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Homebuilder Help: What type of legal entity should I choose?

This is a loaded question with lots of different correct answers, but let's take a look at what I think is best. If you disagree, please let me know in the comments! Bear in mind, this is just my professional opinion and please confer with an attorney before you finalize any of these decisions.


Sole Proprietor

If you are just getting started, you technically don't even need a legal entity. You can just set up shop as a sole proprietor and try your hand at a few home builds to see if this industry is a good fit. You can use your own name or you can register a name with your state. Plus, you can even request an EIN from the IRS to mask your own SSN so you don't have to give out sensitive personal information on your W-9. You will probably even get your EIN right when you submit your application online to the IRS. You can even use this arrangement to setup payroll and hire W-2 employees, but you might want to stick with 1099 contractors if you are starting out small. Just be sure to carefully consider the definition from the IRS as to who is a W-2 employee instead of a 1099 contractor. All of your taxable income and expenses will be reported on your personal 1040 Schedule C.


Single Member LLC

Moving forward, we all know operating as a sole proprietor isn't the best long term strategy. If you want, you can skip that phase and jump right into creating a single member LLC (aka "sole member LLC"). There are tons of online sites that offer this service, or you might benefit from building a relationship with an attorney you trust. This at least gives you a legal entity that you can start working with and it opens the door to unlimited growth potential. This might make it a bit easier to obtain things such as business liability insurance, credit lines, bank accounts, and more. Depending on your state and the Articles of Organization you obtain from your attorney, it could also provide some legal protection to you personally in the event one of your customers or subs tries to sue you. Ironically, the tax reporting here does not differ from being a sole proprietor... you still report all of this activity on your personal 1040 Schedule C.


There are some tax advantages available to a sole prop or single member LLC because you can probably leverage the Qualified Business Income (QBI) deduction. It might not be as advantageous as an S-Corp election we will discuss next, but it does not come with the admin cost of an S-Corp either.


For the two arrangements just discussed, these are fabulous legal entity setups and will make it easy for you to get up and running to churn profit. Bear in mind, you have to be 100% owner for these to work best, you cannot share ownership with anyone else. If you were to bring in any other owners or partners, it would immediately require a higher administration cost because you have to file a separate tax form for the business, usually a 1065. With this, comes expense, red tape, and cost. I would think carefully before bringing in any additional owners/partners in this phase.


S-Corp Election

Next up in the phase of growth is the S-Corp election. Assuming you started as a sole prop or a single member LLC, you don't even have to dissolve your current legal entity. Just work with an attorney or an accountant to file IRS form 2553 by March 15 to make an S-Corp election. You don't need to apply for any new tax numbers such as EIN or payroll withholding registrations with the IRS or your local state. You will, however, have to start filing a separate tax return for the business on form 1120S, which will come at an increased cost. This remains true even if you remain the only owner.


Tip: your time is best spent away from these admin tasks and focusing on your core service/product offerings. If you find yourself spending too much of your own time on these admin tasks, definitely consider the help of a professional. They can probably do it faster with fewer mistakes and get you back to your core business faster.


Depending on what your attorney says, you can start to add additional owners when you become an S-Corp. As a matter of fact, an S-Corp can have up to 100 owners with varying levels of stock ownership percentages. All of this income will get divvied up based on how you and your attorney structure your operating agreement.


With an S-Corp, you must put yourself on payroll and pay yourself a reasonable salary. Why is this? It's because distributions you take above and beyond your salary are not technically subject to self employment tax (however, they may be subject to capital gains tax or income tax, depending on how long you've been in business). So in order to make sure you are paying into Social Security and Medicare, you need to pay yourself a reasonable salary.


What is a reasonable salary? Well, I would start with a Google search because there are tons of resources out there that will guide you on how to pick your number. Truthfully, it is a short sighted benefit to choose a low salary because it could mean you'd have more funds to give yourself dividends and skip the self employment tax. On the other hand, if you are selected for an IRS audit and they determine your salary was too low, they could reclassify all of your dividends to be wages, which would generate a nasty payroll tax bill.


For the "reasonable" salary, some experts encourage us to consider what it would cost to hire an outsider to do our job. Others recommend splitting up your responsibilities into the type of work you are performing. As a business owner, we all know you are wearing at least 17 different hats, so the wage for you to do basic admin work would be different than the wage for managing your job sites. There are even payroll services out there who will just process your payroll once per year so you can meet the requirement of that salary, but keep in mind this will require a lot of cash all at once!


I find putting the business owner on a salary is a great arrangement. Not only does it give you a steady income stream personally, but it also puts value on your time. Too many home builders quote their bids and they don't include any cost for *their* time. They're so worried about all the subs and vendors that they don't even think about the professional skills they bring to the table themselves. Therefore, I think the S-Corp election is a great arrangement with the owner taking a regular paycheck.


Conclusion

In conclusion, if you are just getting started you can get your feet wet by becoming a sole proprietor or even a single member LLC. As your business grows, you can transform your legal entity by making an S-Corp election which will enable you to operate more like a traditional corporation, without all the headache of a name change and re-registering with all the government entities to get started.




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