In this episode, series regular Jay Reyero joins us to debunk the common misconception of being “taxed as an LLC”. Tune in as we clarify the distinction between entity structure and tax classification and share the various ways an LLC can actually be taxed. Understanding how different structures affect taxes can be very useful for both your business and personal finances.
Listen to the full episode using the player below, or by visiting one of the links below. If you have any questions or would like to learn more, email us at info@byrdadatto.com.
Transcript
Intro: [00:00:00] Welcome to Legal 123s with ByrdAdatto. Legal issues simplified through real client stories and real world experiences, creating simplicity in 3, 2, 1.
Brad: Welcome back to another episode of the Legal 123s with ByrdAdatto. I’m your host Brad Adatto with my co-host Michael Byrd.
Michael: As a business and healthcare law firm, we meet a lot of interesting people and learn their amazing stories. Our clients commonly come to us with the latest word on the street that they heard from a friend. This season, Brad, we’ll talk about stories with a common legal urban legend and seek to either prove or disprove the legend. This season’s theme is Fake or Real.
Brad: Interesting. Michael, have you ever quit a job?
Michael: He’s right into anything, man. Just kind of push me in the face.
Brad: Feeling it.
Michael: Well, Brad, I have had three jobs in my professional life. I’m not going to count before that because they were all like [00:01:00] internships and stuff that just ended naturally. And I had to quit my first two jobs in order to take the next one. And of course, you, Jay Reyero and me were all together when we quit our last job.
Brad: Yeah, Michael, I don’t know if we quit our last job so much as we moved on to other opportunities
Michael: We graduated.
Brad: Yes. But speaking of Jay Reyero, series regular, he’s actually an audience member in our studio today, and I think it’d be great to add him to the mix. So, Jay, have you ever quit a job?
Jay: Well, I guess besides the one we all quit together or graduated together, and besides the internships and other things that naturally just expired, I have quit one job and that was when I was in sixth grade. I was the door monitor. And after waking up and being at the door at seven o’clock in the morning while all my friends were hanging out in the cafeteria, it only took me about two times before I decided that was not for me and I quit. And I did what a respectable [00:02:00] sixth grader would do, I walked in there, I scratched my name out, and I left. Not joking,15 minutes later, that teacher walked into that cafeteria and just laid into me in front of all my friends, made me come stand at the door for the rest of the time before I quit for the final time. And I learned my lesson. It was pretty embarrassing.
Brad: Well, and audience members who don’t know, Jay’s like me, skipping a meal, it’s worth quitting. I understand that one. Well, Michael and Jay, I’ll ask you both this question. Have you ever heard of quiet quitting?
Michael: Yeah. I mean, there’s been a lot of stuff in the news about that really kind of in the post-covid era. But essentially my understanding of it is, quiet quitting is a softer approach than outright leaving a job. So, it’s not literal, it’s more of a play on words. So rather than a worker quitting their jobs, they just kind of [00:03:00] quit the idea of working – going above and beyond. They’re doing the bare minimum, I guess you would say. And maybe they’re hopefully hoping that they’ll get fired at some point. I don’t know. They’re mailing it in. This is just out of the blue random kind of hypothetical, but let’s pretend like there was a podcast and there was a guy named Miguel and a guy named Brett. And Miguel was so sick of Brett singing on the air all the time, and he was so tired of Brett talking about stuff from the eighties and seventies that Miguel was like, “I just am going to mail it in. I’m not going to prepare anymore, and maybe…”
Brad: This sounds like a real story.
Michael: But then inevitably Brett would redeem himself with some sort of 13 year old joke and bring Miguel back from quiet quitting.
Brad: Oh, okay.
Michael: It’s just hypothetical.
Brad: Hypothetically speaking, audience members.
Michael: [00:04:00] Well, and seriously, as a type A personality, I cannot fathom the idea of just giving up on something that I was expected to be doing.
Brad: Well, I guess, Jay, back to you. Besides quiet quitting your first job in sixth grade
Jay: That was a loud quit at the end of it. Yeah, I’ve heard of it. I have three daughters and anytime you ask them to clean their room, take a shower, pick up after themselves, that’s basically quiet quitting. That’s fair.
Brad: Well, Michael, before we are partners, were you ever attempted to quite quit then?
Michael: Did you mean to ask why we have been partners? I mean, if so, then of course not. No. I would not dream of quitting you, Brad.
Brad: What about you, Jay?
Jay: Besides this podcast right now, no.
Michael: Well, Brad, I don’t know where you’re going with all this stuff, with these quiet quitting jobs. And I guess we’ll flip it back on you now. Have you ever quit a job [00:05:00] or been tempted to quiet quit? It’s kind of, I don’t know why I’m asking that. I doubt you’ve ever done anything quietly.
Brad: You know, not really. I mean, just like you, some are internships that kind of come and go. And in the professional world, I felt like I always graduated to, to the next job and actually in a pretty good term. So, besides us doing this firm together and moving from New Orleans to Dallas, no, I haven’t really ever quit a job.
Michael: Okay. Well, I’m nervous to ask the next question, but why are you so interested in learning about quitting?
Brad: Well first off, I forgot to say, true, I have never done anything quietly, that was actually correct. But as we mentioned earlier, we get these interesting articles that we see every once in a while and there’s this new trend coming outta Japan where they’re quitting and I guess they’re kind of quietly or respectfully quitting.
Michael: I’m curious. Tell me about this.
Brad: Well, apparently in the Japanese culture, it is notoriously encouraged to not really have a good work life balance at all. [00:06:00] And with this context, apparently, anything related to quitting causes workers anxiety because their job is their life. They’re committed to it. So workers feel ashamed, or they’re guilted into that they shouldn’t be quitting their job. So what does a Japanese youth do when they want to quit, but they’re too nervous to tell their boss? Well, they outsource it to another company.
Michael: Oh, wow. That kind of reminds me, I think we talked about this on a prior episode where people in Japan and some other countries were outsourcing friends and family for their wedding photos and birthday parties, dates and other Instagram-able moments.
Brad: That’s right. So the dread of telling the boss has spawned in this niche industry where about 25 companies that will help person resign or quit them since they don’t want to do it themselves. One of these companies, the name is Exit, and allows the client to pay like [00:07:00] $144 or 20,000 yen to help do that. And the Exit will contact the client’s employers to inform them of the decision to quit, allowing the employee to avoid any anxiety, induce confrontation with their superiors, basically developing an entire new job scope for being professional quitters.
Michael: I’m thinking you need to put Exit on retainer for whenever you and I have competitions with each other,. So you can, you know, like the chicken parments that you can have someone gracefully let you quit.
Brad: That was a pretty good one. So some employers receiving these outsourced resignations said it reflects negatively on the workers because hey wouldn’t do it themselves. And other employers said they were grateful for some honest feedback because departing employees really are candid for the actual reason for leaving.
Michael: I can’t decide what would be worse, texting a resignation or outsourcing. Does quiet quitting or outsource quitting have anything to do with today’s show? [00:08:00]
Brad: Actually the opposite. Before the show, Jay and I were catching up on some of the highlights of today’s story, and he mentioned some of the facts, and I was thinking eventually we could eventually tie it into today’s story.
Michael: All right. Well, I’m curious, let’s get into today’s story. And today we’ll be answering the question, fake or real, my company can be taxed as an LLC Jay, why don’t you get us started?
Jay: Alright. So today’s story is going to revolve around a very successful business founded by our main character. We’ll call him Mr. Miyagi. And critical to the business was his rockstar employee, Mr. LaRusso.
Michael: I’m utterly shocked that we have not yet talked about the Karate Kid in an episode at this point yet – or maybe we have, I don’t know. But for those who don’t know, this is an eighties movie and at least the first one or two of them were in the eighties. And there’s been a remake and even a Netflix show called Cobra Kai that [00:09:00] both my wife and I watched together, that is based on the original Karate Kid franchise.
Brad: And we actually have mentioned the Karate Kid, if we remember, there was a Cobra Kai Med Spa, one of our episodes. But that’s all right. Our audience members, those who listen, will already know that Daniel son walks on, walks off.
Michael: Oh man.
Jay: And we just lost him.
Michael: Can you non quietly quit?
Jay: So as I mentioned, Mr. LaRusso was a rockstar employee. He was responsible for a significant amount of annual revenue for the business. So, as you can imagine, it was very critical that Mr. Miyagi keep Mr. LaRusso around and prevent him from leaving and potentially taking business to a competitor.
Brad: Makes sense so far, it sounds like a good plan of action.
Jay: So he reached out to us and he decided, you know what? I want to give Mr. LaRusso ownership in the business to show not only my [00:10:00] appreciation for what he had done for the business, but also I want to make sure he won’t leave.
Brad: And for audience members, that’s pretty common when you have these key employees and you’re trying to incentivize them to keep around. And we can talk Michael, in a second about the options that you typically have. But a lot of times when you’re asking them to come in and giving them some type of ownership interest, a lot of times there are amazing benefits, they’ll call those golden handcuffs. But Michael, we’ve talked about this in other shows, but considering in any given business, you have the golden handcuffs side of it. But what are some of the advantages that come from equity ownership versus non-equity ownership?
Michael: Well, the advantages can be found in the fact that you’re changing the nature of the relationship. So you are going from a dating relationship to being business married when you’re owning stuff together. And that allows you to redefine how things work when you’re co-owners. So you might be able to [00:11:00] have non-competes that are more enforceable and stronger in some states where they’re not enforceable for employees. They can be enforceable in a co-ownership situation. Or you can create financial disincentives now for the person to leave. And that’s allowable because again, because of the change nature of the relationship. It’s hard to talk about these advantages without also considering that there are downsides.
Brad: Yeah. And there are downsides. Remember that now this person is an owner with you, besides still being your employee. So they’ll still have to show up and do their job, and because of that, they’ll have access to the financials of your entity. You have to be willing to share and be open and transparent. And second, as hard as it is to be figure out, you know, how do you bring them in as an owner? It can be even more difficult to remove them as an owner. There’s a ton of documentation and factors to consider, you know, if done simple. If it’s [00:12:00] done correctly, it’s not a very simple, much less speedy process of just bringing someone in or out of the organization as an owner. So Jay, do they have these conversations or did you have these conversations, Mr. Miyagi?
Jay: So, not before he had made the actual decision, but as soon as he reached out, that was my plan to do so. And I mean, this isn’t uncommon when the first thing people think about is how do I reward someone in my organization. The gut reaction and the first thing off the top of my mind is, well, let’s give them some equity. But as you guys talk about, it’s not simple. There’s a lot of factors to weigh, and so that’s what I wanted to have that conversation about.
Michael: And what did you learn?
Jay: So I learned that Mr. Miyagi had in some way without really knowing it, thought about many of the things that we had discussed and that you guys mentioned. And that, more importantly, it seemed as I started kind of probing more about Mr. LaRusso and why he was important and being there, [00:13:00] many of the things that we would want to see in an employee that would be a good candidate to get ownership, really was there. And so, ownership seemed to be trending in the right direction for Mr. Miyagi and Mr. LaRusso.
Brad: Well, I guess we’re going to learn more, but simple conversational, simple process, right?
Jay: Yeah, that’s what they always say, right? No, I mean, Mr. Miyagi, he didn’t have the infrastructure in place. He had always owned this business, always by himself, always ran the business by himself. It’s easy to make decisions when it’s just you and you only answer to you. And so, as you guys have alluded to, we had a lot of work to do just to first develop what that framework was of bringing on an owner. But then, you know, that also meant we had to get into the details of what does giving ownership to Mr. LaRusso actually look like?
Michael: And connecting it, to my point earlier, you’re changing the nature of the relationship. We’ve talked on prior episodes about that. Like, what do you do when you have two people that are [00:14:00] partnering together? Even if it’s a disproportionate partnership, it may be a small amount of ownership that ultimately Mr. LaRusso would receive. You still have to consider this. And we’ve always framed it in the four C talk. And at a very high level, the four C talk is the things that can make or break a business partnership together. And that’s the cost, the compensation, the control, and the contingencies – the what ifs. And so if you can kind of work through those things, you have a framework at the end of it that will hopefully, you know, reduce the risk of it blowing up. So, focusing here on the details around giving ownership, where did you start?
Jay: So first I wanted to start with a very simple conversation, just asking Mr. Miyagi, had he thought about the mechanics of giving ownership.
Brad: Yeah, and audience members, I mean, that’s a pretty strong statement there because there’s different types of ways in which ownership is “given”. So it could be that [00:15:00] he gives some of his ownership or sells some of his ownership directly from Miyagi to Daniel’s son. Or in other situations, the company’s just issuing additional shares or stock depending on how it’s set up. And that impacts – that type of sale is going to be different than person to person versus entity/person. And also can, as you’d imagine, affect the funds themselves as to how the money’s generated from the company and or to the person.
Michael: There’s so many considerations kind of jumping off of that because you also want to have a strategic conversation about whether there’s other people like Mr. LaRusso that may be a candidate in the future. It’s super common for businesses, particularly businesses that are scaling to set aside some form of equity for their key employees that they want to retain from that sort of strategy. And going off your point, [00:16:00] Brad, obviously we’re not tax attorneys. But whether you are selling it individually or whether the company is issuing ownership has its implications. And if Mr. Miyagi decided to give ownership as a part of this retention strategy, maybe it’s a small amount, there’s tax implications there that can ultimately be problematic. So if you as a company give, you know, $200,000 worth of ownership to an employee and don’t have good tax counsel, that could end up being $200,000 of taxable income to that employee, which might be super prohibitive when they have to write that check for $200,000 worth of income that they didn’t actually obviously receive in the form of cash. So, Jay, had Mr. Miyagi thought about these types of things?
Jay: Not really. I mean, like a lot of clients, he’s focused more on the post ownership compensation, the financial [00:17:00] terms, and what that looked like. And so, I mean, my next question naturally is, okay, well have you talked to your CPA about some of these issues? I mean, we’re not tax attorneys, but we know, like Michael, you’re saying there are tax implications that we have to plan for before moving forward. And so, again, as Brad talked about, this is sometimes not that simple.
Brad: And I guess hopefully you’re not hitting, being a dead horse here. The tax planning is essential. And based on the story so far, I’m assuming Mr. Miyagi has not spoken with the CPA.
Jay: Nope.
Michael: So did you just direct him to go and speak with the CPA?
Jay: Well, no. You know, as we talk about both tax and legal, it’s very complex terminology and know-how, and it becomes a game of telephone when you try to do that, and so I always find it best. Let’s just jump on the phone. I’ll talk with the CPA, we’ll talk the same language and just kind of hash it out. Just us two together.
Brad: Yeah, it makes sense. So did you pick up the phone and [00:18:00] call the CPA?
Jay: So I did. But first, I needed to get a little bit more information, don’t want to go into the conversation completely blind, and so I wanted to be as productive as possible. So I asked Mr. Miyagi some questions about the big picture, his idea for the post ownership compensation, what some of the financial splits were with him and Mr. LaRusso. And more importantly, I needed to also kind of confirm what he had in place right now.
Michael: And so what did you find?
Jay: Well, so the most important question that I asked that drives a lot of the discussions with the CPA when you get on the phone, I said, how was your business taxed?
Brad: And I guess the question for today is, did Mr. Miyagi know how his business was taxed?
Jay: Of course, he very plainly and confidently said, my company is taxed as an LLC.
Michael: Wow, he must have known he was going to be a star on the show. That’s amazing. Because Mr. Miyagi set you up perfectly to answer today’s question. Is it fake or real [00:19:00] – my company can be taxed as an LLC?
Jay: It is. And I would say coming after the break. But we all hate that. So I will say the answer is fake.
Michael: Wow. Okay. Well, let’s go into a commercial and on the other side, dive deeper into why the answer is fake.
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Brad: Welcome back to Legal 123s with ByrdAdatto. I’m your host Brad Adatto with my co-host Michael Byrd. We’re still sitting here with series regular Jay Reyero. Now Michael, [00:20:00] this season’s theme is Fake or Real. Jay just told us a story about Mr. Miyagi and his star employee Daniel Sun or Mr. LaRusso. You know, let’s kind of revisit that story.
Michael: So, quick recap. Mr. Miyagi, who ultimately hired us, owns his own business. He had his star employee, Mr. LaRusso, and had made the decision that he wanted to issue equity to Mr. LaRusso. This was a kind of a retention type strategy. We talked a little bit about kind of the golden handcuffs and the pros and cons to consider there. As the story progressed, and Jay was exploring this with Mr. Miyagi, he learned from Mr. Miyagi that his entity was taxed as an LLC. That was the answer he got. And that brought us to the question of the week, which is, is it fake or real, my company can be taxed as an LLC? And Jay, before the commercial break, you [00:21:00] said it was fake and that a company could be taxed as an LLC, yet we hear this all the time. So, let’s clear this up for the audience.
Jay: Yeah. So like you said, this is a very common confusion and it really stems from a confusion between entity structure and tax classification. I mean, I’ve even seen legal professionals and sometimes other tax professionals confuse it as well. An LLC is an entity, it’s a created by state statute. It’s not a type of federal tax election. So let’s take it step back and kind of go high level. When you’re starting a business, typically there are two principle filings that occur. First is at the state level, and this incorporates or forms the company as a legal entity with the state. And so, you’re filing documents to create a limited liability company, a professional limited liability company, corporation, professional corporation, [00:22:00] even a limited partnership. you know, some states, this is a very simple process; file a form, get it stamped, pay a fee, that’s it. Others, especially in the professional entities, there’s a multi-step process that involved. But this is creating the entity and having it come to life – be born. The second step is then you’ve got to file something with the IRS to obtain what we call the federal employer identification number or the EIN. This is essentially the entity’s social security number. And so this filing’s done online, it’s done with the IRS website. It can be done phone, fax, and mail as well. But it’s at this point, during this filing that you have to notify the IRS, “Hey, this new business that I just created wants to be treated from a federal tax perspective as a certain way.” And in that answer, there is no tax classification that exists.
Brad: Yeah. And audience members, where people get confused is because when you look at this [00:23:00] form, which the IRS calls the form SSS four, it’s real fancy, and when you obtain this EIN, there’s a box that you actually can select that you are in a LLC. So when you’re forming the LLC, people click that box and think that’s their tax classification. That choice for the LLC is an entity that dictates the federal tax election available to the entity. So you’re saying I am an LLC? Yes, but now there’s additional step that comes with that.
Michael: Yeah. And there’s four different potential ways an LLC can be taxed. So you have a disregarded entity classification, you have partnership tax classification, you have a C-Corp and an S-Corp, and so a super high level summary of these. A disregarded entity is sometimes used when there’s one owner. And the owner, basically it’s a format by which the tax return ends up on the individual’s tax return, [00:24:00] so the entity is disregarded from an IRS perspective. Kind of somewhat similarly, the partnership taxation is when you have two or more owners and you elect to be taxed as a partnership. And so the entity, again, the gains and losses get passed down to the individual tax returns from the corporate, from the partnership if you’re if the LLCs tax partnership.
Then finally you have the different corporation elections. You have a S Corp, which also has that pass through component to it. It just has a bunch of rules that go with who can own it. Only individuals can own it with a couple of exceptions. There are rules on how dividends can be distributed. This is really common in small businesses, but it’s important to understand these limitations if you’re set up that way, especially when you’re doing something like Mr. Miyagi’s doing, which [00:25:00] is to bring another owner into the equation. And then finally, the C Corp is more of a traditional, the entity pays its own taxes and it’s completely separate from the shareholders. The downside to this that’s kind of classic is that you could end up in a double taxation situation where the court pays taxes and then dividends money to the owners, and then they pay taxes on that. And so, there are certain strategies where all of these will make sense. It’s just really important to understand that’s the menu of choices you have when you’re in an LLC format.
Brad: Well, Michael, you threw down some serious knowledge. I hope our audience is not quite quit by hearing all this knowledge. But it’s good. I think audience members is really important when Michael broke down. But Jay, what does it have to do with the getting this EIN then?
Jay: So, here’s the thing. Kind of keep it simple. When you obtain an EIN from the IRS, you’re really just telling them what type of entity [00:26:00] you are and then they assign a default classification at that point when you get that EIN. So the default for an LLC when they’re a single owner is disregarded. And if you have multiple owners, the default is partnership. As Michael just said, an LLC can be taxed in a variety of different ways, including S-Corp and C Corp. But after you get assigned, you have to file a new form to tell the IRS, “Oh, by the way, I don’t want that default. I want to go ahead and select S-Corp or C-corp.” And the similar for corporation – if you’re a corporation, the default C-Corp, but if you want to do S-Corp, you have to file it. So I think when you’re just – the thing to keep in mind is when you’re getting the EIN, you’re just telling them what entity you are, they’re assigning you a default, but then there may be more steps to actually choose the ultimate tax election you want
Brad: Audience members, hopefully you’re still with us and your brains have not turned a mush with all this tax talk from Jay and Michael. But as you can tell, it gets complicated real quick when selecting the proper tax election and LLC. Another important takeaway is, this selection of the [00:27:00] federal tax election will not impact the state tax payments. That is actually based on your actual state laws and the choice of entity with that state.
Michael: Yeah, good point. Jay, so when Mr. Miyagi said his company was taxed as an LLC, that was wrong. Yeah.
Jay: I mean, as soon as he said it, I knew what he meant. Like we frequently hear this all the time. So, I’d already known this business was an LLC, knowing the default classification and how they work. But more importantly, how most operational businesses choose to be tax. I assumed going in that it was going to be tax as an S-corp. I didn’t say that to him, but instead confirmed it with the CPA through my conversations.
Michael: Excellent. So as we’re getting near the end, Jay, do you have final thoughts?
Jay: Yeah, I mean, I think the final thought for me is, remember this is a two-step process of creating an entity that can kind of help clarify the difference when you’re ever, you’re asked that question. And so, I think it’s good for business owners to be [00:28:00] able to accurately describe it because it helps make strategic planning in the beginning with us so much easier. We can answer a lot of questions or knock off options based on that knowledge right up front. And so just kind of having that, but also being in tune with your CPA to kind of understand all the implications behind these decisions, so that way you’re not finding yourselves not able to go a certain path because of decisions you made early on.
Brad: Yeah, I mean, those are all great points, Jay. And I think for audience members, the takeaway is depending on the tax election that you choose instead of an LLC, it can impact the future potential owners. Meaning that, if you are an S-Corp and you want one day to have investors come in, they can’t come in as a business or as an entity, it has to come as an individual. So ,there is a lot of planning and thought that needs to come into what election you choose with that LLC. And those are some of those conversations you’d have with your attorney and your CPA before you choose it because the impact is huge. [00:29:00] So Michael, final thoughts for today’s episode.
Michael: Well tip for those out there that are thinking about quiet quitting, if it’s in your job description to form an entity and you want to quiet quit, just go form that entity. When you get the EIN just check the box LLC and do nothing else. And when people ask, you can just say, I’m taxed as an LLC. Would that work?
Brad: I guess so. I don’t know. Well, audience members, that’s all the time we have today. Next Wednesday, join us when we continue down this journey of determining these different myth for fake or real and MP has full practice authority. Thanks again for joining us today. And remember, if you like this episode, please subscribe, make sure to give us a five star rating and share with your friends.
Michael: You can also sign up for the ByrdAdatto newsletter by going to our website at byrdadatto.com.
Outro: ByrdAdatto is providing this podcast as a public service. This podcast is for educational purposes only. This podcast is not constitute legal advice, [00:30:00] nor does it establish an attorney-client relationship. Reference to any specific product or entity does not constitute an endorsement or recommendation ByrdAdatto. The views expressed by guests are their own, and their appearance on the program does not imply an endorsement of them or any entity they represent. Please consult with an attorney on your legal issues.
