Selling a Product with a Partner*

Selling a Product with a Partner*

1. Now we bring into play all three entities.
2. We need to bring into the following factors:
1. What is the personal W-2 income of each partner? If above $80,400 in 2001, an S corporation can only possibly save 2.9% in taxes on distributions. If less, than this amount, an S corporation may be possible as long as all the C corporation tests are met.
2. What is the gross profit of the business in 12 months?
3. What are the net profits of the business in the next 12 months?
4. Will the business accumulate a net worth each year? Does it create a business that can be sold 3-5 years from now, or will it be all service orientated with a couple of employees with no systems so when the day the partners stop working, is the day it stops bringing in revenue? If so, then an S corporation can be a possibility. If a large asset base is in place then this may eliminate an S corporation because it is difficult to protect the stock of an S corporation from a personal lawsuit by one of the partners.
5. Do the partners want to take advantage of the C corporation benefits; calendar year end, fringe benefits, going public, lower tax rates…? Because the business will be selling a product, the personal service corporation category will not be a problem. The personal holding corporation category will not come into play because of an active business.

Let’s look at a couple situations and the reason we choose a particular entity:

Situation # 1:

1. Each partner is quitting his or her jobs to start this new business. This is their only source of income. They expect a net profit of $40,000 the first year off gross revenues of $400,000.
2. The product they are selling is vitamins.
3. They keep a small inventory and client does have repeat orders.
4. They do not manufacture the vitamins. They have a low overhead. Their office will have the basic computers, furniture and phone system.
5. They will have three other employees.
6. They will not have enough money to take advantage of all fringe benefits.
7. The day they stop working, their business goes down tremendously.
8. They expect to grow about 10% per year over the next three years.
9. They meet all the S corporation requirements.

Conclusion. A S corporation may be the best answer in this situation for several reasons;

1. They will have the opportunity to save SE taxes on about 50% of their net profits or about $20,000 each (a savings of 15.3%).
2. They are not taking advantage of fringe benefits (a C corporation benefit).
3. They do not need to protect the S corporation stock. Because the value of the company is low.
4. They do not have other income personally, so their personal tax bracket is rather low.
5. They meet all the S corporation requirements.

Other notes: An LLC would make no sense because they lose the 15.3% tax savings, and the charging order will not be a major advantage because there are no assets to protect in the business.

What would have to change to look at a C Corporation? If both partners already earned above $80,400 on a W-2 and they had other income that pushed them into the 39.6% personal bracket. Also, if they wanted the C corporation to pay for fringe benefits.

What would have to change to consider an LLC? If both partners already earned above $80,400 on a W-2 and the LLC would accumulate business assets and a net worth by creating a duplicable system.

Situation # 2:

1. Each partner earns $150,000 in W-2 income and is in the 36% federal tax bracket. They already have a 401k at their company and full health benefits. They already have life insurance personally.
2. They will be investing in a new computer company that will expect a net profit of $150,000 the first year off gross revenues of $1 million. They will oversee part of the operations on a part time basis (so they will be actively involved), but hire a manager and employees to run the business. They have already developed the software in the past. They will be providing money and the software to get this company started.
3. The product they are selling is computer software to increase office efficiency.
4. They are developing a loyal customer base and will be creating more software products in the future.
5. They do have some overhead. Most of their assets are computer copyrights on the software product.
6. They will have seven employees by end of year one.
7. They will not need fringe benefits (they have them personally at their current jobs.
8. This business will continue to add a new worth each year.
9. They expect to grow about 40% per year over the next three years.
10. They meet all the S corporation requirements.

Conclusion: An S corporation can be ruled out for two main reasons:

1. The investors are already in the above the SE level of $80,400 for the year.
2. The company will really gain in value with a client base, which means the ownership interest needs to be protected; therefore, this is more important than saving 2.9% in an S corporation.

1. Fringe benefits are not important to them.
2. They are in a high personal tax bracket and may not need more money personally. They may want to keep the profits in the company (retained earnings) for future growth and expansion. The C corporation tax rates may help them with overall lower tax rates.
3. They are not really considering going public at this point. It could be a possibility at some point.

1. Provide immediate protection from a personal lawsuit (because of charging order protection).
2. Profits at years end will flow through to the partners which are in a higher tax bracket. If money is needed for growth and expansion the partners may receive a K-1 with no money but just a tax bill. If the outcome is to reinvest the money to grow the company each year this may not be the best entity. If the outcome was to stabilize the growth and take the profits out (similar to receiving dividends from a utility stock) then an LLC may make sense.

In this case, a C Corporation may make the most sense. The money will be kept in the company for future growth and expansion. The tax rates will be slightly lower than if the profits flowed through to their personal tax bracket. They will need to protect the stock of the C corporation with an LLC. If they own the company 50/50, they both may consider an LLC to hold 50% of their ownership interest in the C Corporation. The personal LLC should be taxed as a partnership. They may also consider a separate LLC to own the copyrights or any patents. This is a safe asset that can be leased to the operating C corporation. If they both own equal parts of the copyrights or patents they may have the LLCs that will own 50% interest in this C Corporation own them. The key is to make sure these two LLCs own only safe assets. A huge mistake would be to title a piece of real estate to one of these LLCs.

These results are our opinions. It is recommend to get the opinion of your attorney and CPA. If you have any questions please call our offices at (888) 627-7007.

A. The advantages:

1. Allows you access to additional experience that you do not have and to pay a salary to because they are an owner like you.
2. They may bring capital to the table that you need.
3. They will be there for support with important decisions.
4. You will have a teammate to be there with you when you are burning the midnight oil.
5. You may be able to double your efforts in getting the company started much faster then if you just did it alone.
6. You now have the option of partnership taxation that has tremendous advantages:

1. Being able to contribute assets tax-free and distribute assets tax free-IRC 721 & 731.
2. The charging order protection from a personal lawsuit.


B. The disadvantages:

1. You will need a buy sell agreement. It is critical before the business starts to plan as to how to shut down or sell the business or sell just your interest before you start operating. This agreement will tell you how you may get out of this arrangement if it does not work. This will save a lot in legal fees in the long run and perhaps more importantly it will save friendships. Unfortunately most people do not spend the money that they should to have an attorney put together a buy sell agreement from the start. Typically, this is the stage that the ideas of becoming rich are being discussed and how great everything will be working together. Sometimes it may appear ‘negative’ to bring up the question, "what if this doesn’t work out?" What if one partner wants to grow this into a $10 million company and work 70 hours per week for 8 years, and I only want it to be a $2 million company and only work 70 hours per week the first three years? Again, typically this is missed, who will do what is loosely discussed, no contracts or agreements. Then 8 months later when there is $50,000 in the checking account many times partners develop amnesia as to what they discussed and agreed upon eight months ago, especially as to how the money was to be spent. One partner may want to go on a vacation or take extra money out of the company because it is ‘doing so well’ and the other partner remembers agreeing to only taking a minimal amount of money out the first year and absolutely no vacation time!

The bottom line is that if you can not get through a buy sell agreement up front and agree in writing to who will do what, DO NOT GO INTO BUSINESS WITH EACH OTHER!

2. You know you will have someone you will have to discuss each major decision. Even if they own 2%, they will be involved. By yourself you do not have anyone to consult with to make these decisions, while with a partner you do. This also brings into play your partner’s spouses opinion and perhaps their families. Remember you went into business with probably one spouse, not the other or their family.
3. An increase in legal liability because of this partner. Do you know every minute of the day what you partner is doing or just said to a customer, vendor or employee? Do they cause you legal liability without you even know it?
4. You may realize that you have been influenced by a partner who is not as sharp as you were told in the beginning. You may have made some very poor business decisions with this partner that you may not have made otherwise.

In conclusion there are advantages and disadvantages for having a partner and not having a partner. Depending on whom you listen to you will be able to find success stories and failures for each situation. Be sure that you consider the advantages and disadvantages for your situation and take all the precautions and you more than likely will avoid most of the pitfalls suffered by many.

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