Construction companies are typically organized around the specific talents of a group of individuals. After all, the distinctive proficiencies involved with constructing, renovating, repairing and maintaining buildings aren’t “entry level” skills. They’re often passed down through generations, making the industry talent-centered.
Successful construction business owners know not only how pieces of building components are put together, but also how costs are incurred, paid and managed. Nevertheless, even the savviest contractors will need help making some tax and financial decisions. Case in point: entity choice.
Choosing the ideal business structure for a construction company isn’t a textbook exercise or a simple decision. On the contrary, entity choice may evolve over time, essentially molding itself around the relationships that owners have with one another (if there are more than one) and with the business itself.
Two main factors
For large companies, making a choice between partnership, limited liability company (LLC), corporation or S corporation tends to affect a smaller proportion of the total number of people employed by the company. Employees are employees, whether the company is a corporation or a partnership. Two main factors to consider as year end approaches are financial risks to the owners and tax effects of executive compensation — including how the company earnings flow to the owners or members.
In a larger company, shareholders and directors can be distinct from managers and executives. Owners or key decision makers may have a passive role and may not even be involved in day to day operations, while executive managers may have less of a stake in company earnings. When owners and directors don’t manage, owners collect passive distributions and directors set policy, while executive managers are compensated with equity incentives based on their management performances.
On the other hand, smaller companies without separate owners or boards of directors to govern them may lean toward sole proprietorships, or partnerships or LLCs with small numbers of partners. This is because of the low cost and lesser amount of time required to form and maintain these business structures.
Sole proprietorships and partnerships are also exempt from standard state registration and corporate filing fees. The variegated costs and intertwined recurring tax filing deadlines of a complex corporate structure quickly may be burdensome and can hamper a small company that has only a handful of workers.
Risks to consider
As construction companies get large enough to become bonded and build, own and rent their own large structures, financial risk management becomes increasingly important in choosing the right entity type.
Corporations are attractive because the corporate veil protects owners and their growing equity stakes from risks such as accident claims or torts attacking the company’s financial structure. Choosing a C or S corporation provides protection, so owners’ assets aren’t put on the line.
Some LLCs provide similar protections, while sole proprietorships and partnerships don’t automatically offer such protection. It’s also good to beware of supply houses that ask construction company owners to personally guarantee their accounts. This negates any protections the owner might have by way of corporate structure.
Without a corporate veil, a sole proprietor or partner may have his or her personal assets awarded by a court to some claimants who sue the business. This can ruin both the company and the financial standing of the owner.
Taxes and payroll
How owners get paid is a second important factor in construction company entity choice. Tailoring business structure to the owner’s or owners’ personal tax status is key — particularly as the business grows and expands and the company owners may incur tax exposure from multiple entities.
For example, payroll is required for corporations and S corporations, while small partnerships and LLCs don’t always have payroll. It’s important to analyze the tax implications of taking payroll vs. taking only profit distributions. The competing forces of payroll tax vs. self-employment tax can sway one way or another from year to year depending on tax law, the volume of your revenues and your business’s profitability.
Changes under the Tax Cuts and Jobs Act (TCJA) have many business owners favoring noncorporate structures and S corporations because their qualified income can now, under certain conditions, be reduced by 20% when they figure their tax liability. In contrast, owners of C corporations are still taxed on the corporate side and then again on distributions, but the corporate income tax rate was lowered across the board. In an S corporation, a carefully chosen combination of payroll and distributions is attractive because of the deductibility of payroll and its taxes. Every business type has its positive and negative characteristics.
As year end approaches, you’ll understandably want to focus on assessing and managing your 2019 tax liability. But set aside some time to re-evaluate your entity choice, as well — especially with the TCJA adding layers of complexity to this decision. Undertake both tasks with the help of your CPA; he or she can guide you toward staying true to your personal, business and financial priorities.
Own rental real estate? Consider forming an LLC
Many construction companies reach a point where they have the assets and opportunity to buy and manage their own rental properties. When significant rental real estate is owned, the limited liability company (LLC) structure may be the right choice.
LLCs offer a simple tax structure, while risk protection can be provided by insurance so that corporate filing fees, payroll and administration costs are minimized. Be aware, however, that rental income may be classified as passive and would then be taxed differently from construction revenues. Discuss the decision with your CPA.
The content featured in this article originates from our bi-monthly Contractor Newsletter. Subscribe below and stay in the know.