In the enthusiasm and excitement of starting up your own construction company, the decision as to what type of corporation you should establish may not seem like a task worth wasting much time on.
And for the first few months it probably won’t make much difference at all whether your business structure is a sole proprietorship, a partnership, a limited liability company, a C-corporation or an S-corporation. But come time to pay the taxman, the difference may cost you a lot of money. And as time goes on, other issues emerge as well, such as financing, employee benefits and stock options. Should your company seek work outside the state where you incorporate, failure to follow the out-of-state licensing and incorporation laws might even cause you to forfeit all the money you receive for a job.
It’s fairly easy to describe the legal differences between the different entity types. But applying these general principles to your specific needs can be tricky. For this article we talked with several lawyers familiar with the construction business and corporate structure, but they all emphasize that there is no one-size-fits-all solution. To get the best arrangement for your company you need to sit down with your lawyer and your accountant and discuss how these choices will affect your business now and in the future.
Admin and paperwork
Of the different ways to organize a business, proprietorships and general partnerships are considered “unincorporated,” in that the owner or owners of the business and the business itself are considered one legal entity. In the remaining types: limited partnerships, limited liability companies, S-corporations and C-corporations, the business and its owners are considered separate legal entities.
The sole proprietorship and the general partnership are the easiest businesses to establish. A sole proprietorship is run by one person, a general partnership by two or more.
“You can run a proprietorship out of your personal checking account, as long as the business bills are clearly identified as such in the checking account records,” says Russell Agosta, national managing partner, construction, real estate and hospitality for the accounting firm Grant Thornton. “You can pay your personal bills and your business bills all on the same account.”
An LLC requires that you file papers to establish your corporation, but beyond that it’s almost as simple as setting up a proprietorship or partnership, says Philip W. Peters, a partner with Thelen Reid, a law firm with an extensive history of clients in the construction business. “Your operating agreement can be three pages. You can create a custom, private entity and not have to strictly follow the corporate formalities you have to follow with a C-corporation or an S-corporation. So a lot of entrepreneurs like that.”
In S-corporations and C-corporations you have to have annual meetings, elect an annual board of directors, issue stock certificates and maintain a stock ledger as well as keep detailed records of all important business decisions. While these may be appropriate, they are not strictly required for LLCs.
Liability: putting yourself at risk
The most serious drawback to having an unincorporated proprietorship or general partnership is personal liability. You, as the owner or owners of the business have no personal protection from lawsuits against your business. If for whatever reason your business is sued, the plaintiffs, if they win their case, can claim all the assets of the business and your personal assets as payback for accidents, injuries and debts. They can clear out your checking account, your savings and retirement accounts, stocks you may own and personal property. (Some states allow you to keep your house and one car – cold comfort that, though).
In an LLC, limited partnership or corporation, plaintiffs in a lawsuit can take all the assets of your company, but they can’t ordinarily touch your personal property or bank accounts. Workman’s comp, bonding and general liability insurance can cover a lot, but all these policies have limits and once those limits are exhausted it’s you – and perhaps even your family’s – future on the line.
“A sole proprietorship just seems short sighted,” Peters says. “Why not take a belt-and-suspenders approach and protect your house and personal assets against a risky project or unknown liability?”
There is also another business type called a limited partnership involving a general partner and any number of limited partners. The general partner runs the day-to-day functions of the business and is liable for claims and lawsuits. The limited partners are passive investors and have no liability and limited control over operations. But these are complex and less common among construction contracting companies.
The taxman cometh
Taxes are perhaps the most important consideration in choosing a corporate structure. Sole proprietorships, partnerships, LLCs and S-corporations are considered “pass through” tax entities. In other words, the taxes owed by the business pass through the business and land squarely on you or you and your partners. If, after you’ve crunched all the numbers, you find that your company cleared $100,000 in profit, then you have to pay personal income taxes – at the personal income tax rate – on those profits. And that includes both your regular income tax and social security and Medicare taxes (15.3 percent) on all the profits. If you’re in a high income bracket, or you have a boom year and make a lot of money, those taxes are likely to be higher than if they were being taxed as corporate profits.
But paying this tax in an LLC, partnership or proprietorship or partnership is relatively uncomplicated.
In C-corporations taxes on profits are paid twice, once by the company at the corporate tax rate and again by the shareholders when these profits are distributed as dividends. This is sometimes referred to as the double taxation of C-corporation dividends.
A 1997 change in the laws allows owners of unincorporated businesses to use a “check the box” option in tax filing giving them the choice of being taxed as a corporation or a pass- through entity.
Taxes on dividends are a particularly hot topic right now. Shortly after it took office, the Bush administration dropped this rate to 15 percent. But unless Congress decides to renew these laws, they may revert to the previous levels, and company owners/stockholders may soon have to again pay 35 percent on their dividends.
Shareholders and financing
LLCs and limited partnerships also give you a lot of flexibility in how you distribute ownership and profits. Anybody and any number of people can be a owners in an these. Owners can even be other corporations. LLCs can be managed by the owner/members or by a single manager. And the owners/shareholders of an LLC can divide up the profits in any manner or percentage they choose. Profits can be split equally among all owner/shareholders or the corporation can agree to give the top manager the lion’s share of profits and distribute a much smaller percentage to the non-managing owners. It’s your company – you make the rules. Likewise with partnerships and proprietorships.
S-corporations are a bit more restrictive. At one time you could only have 35 stockholders in an S-corporation, but that number bumped up to 75 and then just recently went to 100. The owners of stock in an S-corporation, however, can only be U.S. citizens. And there can only be one class of stock in an S-corporation, no preferred stock other separate, preferred classes of stock. This eliminates a lot of venture capital financing, Peters says, in that venture capital financiers often want preferred stock and some kind of dividend and liquidation preferences. Other corporations and LLCs cannot be investors in S-corporations either, although recently the rules were changed to allow ESOPs (Employee Stock Option Plans) to be investors in S-corporations.
C-corporations offer the greatest range of stock and investment options, and a C-corporation is the only structure you can use if you want your company to become publicly traded. Taking a company public brings a boatload of paperwork and legal fees, but publicly traded companies also have the advantage of being able to raise capital easily and the prestige and strength of being an exchange traded company. C-corporations can create voting and non-voting classes of stock, and that stock can be held by institutional investors and other non-human entities.
Changing an existing corporate structure
Changing from one type of incorporated business to another type of incorporated business is relatively simple. Just work out the details with your accountants and lawyers and file the appropriate certifications with the relevant states and tax authorities. A reorganization is a lot different from a negotiated transaction with a third party, Peters says.
What you will need to do is to review all the contracts you have current, both in jobs and with suppliers. “You may need to review all those and make sure the reorganization is not in violation of your existing contracts, Peters says. “You may need to get consents from key customers and banks. Hopefully all your contracts say that you have the right to change type of entity without consent.”
In changing from a proprietorship or partnership to a corporation, one way to finish out contracts is to subcontract the work to the new corporation, finish the work as a proprietorship and then have the new corporation bill the proprietorship, Agosta says.
State specific laws
Every corporation has to register in the state it does business in. That makes it imperative you work with a lawyer who knows your state’s business registration laws as well as its contractor’s licensing requirements. And many states have significant differences in their laws.
California, for example, does not allow contractors to work as LLCs or limited liability partnerships. If you want to do business in California you have to be a sole proprietor, a partnership or a C-, or S-corporation, says Paul Berning, a partner in the construction and government contracts department at Thelen Reid. And obtaining a contractor’s license in California can sometimes take months, he says, even for fully qualified companies with established businesses in other states.
New York is another unique example. General business orporations can’t practice architecture or engineering there unless they were licensed as of 1935. North Carolina also has strict rules about who can practice architecture. “A lot of times a contractor wants to team up with a design professional, but trying to figure out what kind of entity can do this gets very complicated and varies from state to state,” Berning says.
“If you are thinking of pursuing work in another state, you want to work with a knowledgeable lawyer in that state who is familiar with the construction industry and these issues well before you start bidding on a project,” Berning says. “In some states it’s even against the law to pursue work without a license.”
You also have to have good legal advice when changing entities. “We’ve seen instances where somebody changed his form of business but he didn’t get his license for the new entity. He thought his license for the old business covered the new entity. Suddenly he’s accused of being an unlicensed contractor. And if you’re an unlicensed contractor in states that require licensing, in most of those, you can’t sue to be paid for the work.”
In California, Berning says, the project owner can make an unlicensed contractor give back all previous payments. “They don’t have to pay your retention and you can’t sue for it,” he says. “And if you have a really aggressive owner or general contractor, they’ll sue for what’s called ‘disgorgement’ to make you give back all the money they paid you so far.”