supermikenews

My views on software, programming, Linux, the Internet, government, taxation, working, and life.

Tuesday, April 10, 2007

Does Your State Wear Business Repellent?

I had a cousin from South Carolina in the USA ask me to research for him whether it would be better to form a C corp or an LLC, and whether to do it in his home state of South Carolina or to do it in a tax-friendly state such as Nevada or Delaware. His business was the Free Software Model, where he gives away freely downloadable software as a lure but then sells customization consulting, manuals + CD media, and tech support. What I found may surprise you.

Note that my information here is from a lay citizen, not a lawyer, so please check these facts yourself and consider consulting a lawyer.

LLC or C Corp?

Benefits

As a micro-startup company, an LLC has obvious benefits. It's the least hassle for forming a startup company. It has the least tax burden. You are not a sole proprietor, and not a corporation because the SC law states you are "unincorporated". Therefore, you do not have to file quarterly corporate income taxes based on estimation of forecasted income and, instead, must file LLC member income. In other words, revenue into the business is distributed to its members. This revenue is then used by the members to pay its expenses and then return a profit to its members. This business income then is filed by each member on their individual non-business tax returns as self-employment income for their percentage ownership of the business, not taxed at the LLC level. Another benefit of an LLC is that it provides more legal protection than a sole proprietorship -- creditors and legal judgments against you can only go so far as assets and income in the business, not your private assets and saved income.

Disadvantages and Concerns

On the issue of a C corp versus an LLC, I found that some businesses in very rare cases may not work with you as a contractor unless you are a C corporation. I know of one power company that refused to work with me as an LLC and I had to convert in order to land this lucrative contract. The power company wouldn't even work with me as a sole proprietor, S corp, or LLC. Also, some investors may not work with you as an LLC and prefer a traditional C Corp.

Another disadvantage is that if you are an LLC or corporation in one state, and wish to do business in another state, you "must formally register, file annual reports and pay annual fees to obtain authority to conduct business in those states." The question is mirky, however, when one receives consulting services from a business in another state, or has an online business. Right now the consensus is either covered by the US federal moratorium on online business taxation, and vague laws that do not clearly explain consulting income across states. If you went with the flow, the general cluster on this issue for this type of business is to form an LLC or corporation in one state and freely consult in another state without having to formally register, file annual reports, or pay annual fees in those states. However, saying that, in states where you clearly have business-owned property and use it for conducting business only within that state, then it is clear you must formally register, file annual reports, and pay annual fees to obtain authority to conduct business in that state. Or, rather, a business may not wish to do this until they are caught.

Taxes and Fees To Consider

In general, a USA business may incur the following kinds of taxes and fees:
  • Corporate Income Tax -- also called Estimated Income Tax, and is paid quarterly. Is a tax based on the percentage of business income and is paid at the federal and potentially state, county, and/or local levels. Most often it is only paid at the federal and state levels and the county collects its money from a business license or sales tax. If not the case, then the state usually collects the state, county, and/or local level taxes and redistributes them.
  • Corporate Sales Tax -- paid quarterly on sales revenue and is paid at the state level at least, but may also include the county and local level as well.
  • Corporate Use Tax -- in some cases, services and goods purchased regularly from other states may be subject to a use tax.
  • Retail License -- this is usually a one-time, very small fee but in some cases may need to be renewed annually and is only necessary for businesses selling retail goods and services for which they collect Corporate Sales Tax.
  • Corporate Property Tax -- paid annually and is based on intangible business property, mostly, but in some cases personal business property as well. This is usually paid at the county level but may in some cases be owed at the local level as well. Typically, however, corporate property taxes are paid at the county level and the county collects the taxes for the local municipalities.
  • Franchise Tax Fee -- also known as a Corporate License Fee, paid annually to the state (and perhaps to the county and local levels as well) and is the license to conduct business from that state (or county or city, depending). In some states, this fee is not a set cost but a small percentage fee based on corporate income.
  • Annual Report Fee -- paid to the state and is the report of business for a corporation or LLC.
  • Various Payroll Taxes -- these deal with W2 employees who collect a salary from the business. A business withholds a large percentage of their income to pay payroll taxes, which are broke up into FICA, social security, medicare, and potentially other taxes. This is usually collected at the state level.
Typically, however, an LLC will usually only have to pay all of the above except the Corporate Income Tax because an LLC is not a corporation. To remove even more burden, one can form a Nevada LLC and remove the burden to pay sales tax. And to go even further, one can form a Delaware LLC to remove the burden of paying sales taxes and property taxes. If the LLC does not have any employees, and, instead, has members, the payroll taxes do not apply as well.

Why South Carolina Wears Business Repellent

In South Carolina, however, the normal design of the LLC
is flawed and corporate income taxes (estimated income taxes) must be paid quarterly. (See "Estimated Income Tax Payments".) It's as if in one breath they call it a corporation, but in another breath they call it an unincorporated entity! In Delaware or Nevada, however, the LLC is clearly an unincorporated entity and one does not have to pay estimated income taxes.

Also comes the question of nexus, or where your business headquarters is located. Typically you have to pay a state, county, and/or city municipality a set of taxes and fees based on where the nexus is located. If you form an LLC in Delaware but South Carolina finds you to be a business in their state, they could charge you back taxes and take you to court for illegally operating a business within their state with out a license. Unfortunately in South Carolina and most states, the question of nexus appears to be a mix of objective points and subjective thoughts (PDF), and still pending court decisions that flip-flop back and forth on this issue. In a landmark case, Geoffrey vs. South Carolina, South Carolina was able to force Geoffrey to pay delinquent back taxes because it considered the nexus of that business in its state and not Delaware and was losing sales revenue, and the only evidence SC could turn up for nexus was that the company trademark, held in Delaware, was being routinely purchased from a bank transaction originating in South Carolina.

One problem with nexus for an online business is that you are not really geographically in a given state. You can have web servers in one place or multiple locations, mail servers in another, product shipping from another, and have consultants that fly out from various regions. So how do you define nexus in such a complex scenario? Again, this is up to each state's interpretation of nexus, which has so far been largely objective and subjective and not bound by a clear definition of the law. Moreover, it is possible for two or more states to argue that the nexus is in each one, and therefore companies must be formed in each one and taxes paid in each one. In such matters there is only an expensive legal solution in the courts of each state. However, the general consensus is that wherever you respond to pay bills or pay for fees, this is where your nexus is located. Many states do not currently check that, however, and usually the states which do will go after the larger companies that abuse this or which have been reported.

There are more reasons. Unlike many states of USA, South Carolina charges fees and taxes at the county and local level, not just the state and federal level like several other states do. This creates a lot of complexity and may require unnecessary legal wrangling at multiple levels of government when simply paying fees to the State and Federal Government would do just fine. Also, many states have some tax and fee exemptions for consulting businesses or custom software businesses, but not South Carolina.

So, let's wrap this up about some of the major reasons not to form a business in South Carolina, especially a software business:
  • An LLC in South Carolina has unclear language in the law. It is claimed to be an unincorporated entity where members must file taxes individually as if they are sole proprietorships, but then it is claimed to be an entity that must file corporate estimated income taxes quarterly.
  • South Carolina has few laws on its books compared to other states about modern forms of businesses such as an online business or software consulting firm.
  • South Carolina continues to charge fees at the local and county levels against businesses rather than doing what most states do, which is to only charge at the state and federal levels.
  • If you pay your bills and fees for a business from a bank transaction that originates in South Carolina, then you cannot claim you are a Delaware or Nevada LLC or corporation.
  • For a very small business, the whole notion of having to pay corporate estimated income taxes is obtuse because you may earn $50,000 one quarter and perhaps no more than $2,000 in all the remaining quarters. Failure to pay enough could get you penalties, but how do you define "enough" based on something you cannot adequately forecast into the future? It is good, therefore, that a few states are smart to this fact and have eliminated corporate estimated income taxes or have provided a way out by properly recognizing what an LLC is designed for.
  • By South Carolina having backwards laws about taxation and especially online, software, or consulting businesses, while other states may have more modern laws, it presents an easy situation of double taxation, such as when a nexus is claimed by two states.
  • Being able to avoid quarterly anything in a business is a blessing but because of South Carolina's obsession with its version of nexus, small startups located in the state cannot form Delaware corporations or LLCs to avoid quarterly sales, property, and income taxes.
  • South Carolina, in some areas, has high property taxes. Also, some states have moved largely to sales taxes and either greatly reduced or eliminated property taxes, but not South Carolina.
The Internet Has No Geography

Something I have said in previous years is that the Internet has no geography. What I mean is that a consumer who is overtaxed from one website, or has a cost that is higher because the company behind the website is paying high taxes --
this consumer can easily go to another country or state's website, often get a comparable product, and often at a cheaper price. In the global marketplace, existing tax laws do not accommodate this model very well. In the past with brick and mortar businesses, it was hard to physically get up and move, and was hard for customers to drive far away, so high taxation was possible by this means. But now a business can relocate far easier, and can grab its consumers from all around the world. Now with the Internet being the boom for the future, the states do not need to kill the goose that lays the golden eggs. Instead, they need to find modern, innovative, streamlined, and easily understandable ways to achieve their tax goals for their budgets. Part of the problem are the states' bloated budgets of overspending and innefficiencies, especially inefficiencies formed by nepotism and the lack of enforcement for fighting waste, fraud, and scams. However, the other part of the problem is that states need to see the long range benefits and tax revenues they can achieve by reducing red tape now.

Let me give you an analogy. In India, the British banks pulled out and caused a huge financial problem for the country in the 1980s and 90s. India got smart, however, and realized that instead of sending that burden to its people and creating a spiraling problem of poverty or mediocre tax revenue, they went in the other direction. The other direction was that they invested in education and training for the Information Economy, cut red tape, and spread the globalization message abroad loud and clear. In the end, their economy has skyrocketed with new businesses from micro-businesses all the way to major billion dollar corporations, and the revenue windfall has been fantastic for them. In stark contrast to this, with few exceptions, the United States state and county governments, however, act very byzantine with their stodgy old ways, not accepting change, not working towards a solution that is harmonious for their budgets as well as the entrepreneurs they should be encouraging, not discouraging.

South Carolina is a classic example of a state that wears business repellent, that fails to wake up to the modern age, that discourages young startup companies, especially ones designed for the future economy -- the Internet Economy. Where it should be providing clear, new interpretations and enhancements of its laws, it holds firmly to its confusing set of existing laws designed for older business models. Where it should be providing harmony not just for itself, but for entrepreneurs' needs as well, it provides confrontation and acts as a repellent.

Collecting sales tax from goods paid for over the Internet or with electronic transactions such as PayPal are also a controversial area. The general consensus, which may or may not be legal, is that businesses must collect sales tax from customers located in its same state of nexus, but not from other states. For the other states, most USA citizens are warned on their state and federal taxes that use taxes apply for Internet purchases made with businesses outside their state. However, up to now, few do and this issue has yet to go through a sufficient legal challenge.

Attempts at trying to fix the Internet sales tax problem have been clumsy. Some states have gone too far, working only in their greedy, short-term interest, and are killing some small businesses on the Internet. For example, some states and the Federal Government have audited PayPal transactions so that they could chase down missing sales, use, and income taxes. This sort of action could end up killing the geese that lays the golden eggs. What if a budding Google was in that mix of businesses? Instead, states need to be graceful and lenient to very young hatchling businesses, and shift some of this lost tax burden to wealthier businesses. However, when you read the news in almost any county in the USA, the tax cuts and incentives you see are given mostly to the larger, wealthier businesses, just the inverse. This is about as backwards as one can get.

Conclusion

There can be some easy answers for states, but they must be willing to see long-range benefits to short-term losses. They must work towards greater harmony with micro-startups, listening to their needs, and cutting red tape on this part of the business cycle. They must work to get larger businesses to help pay for this burden so that businesses can thrive and grow. They must modernize their tax and business laws, taking into account a harmonious taxation that can work in the age of the Internet, as well as software and consulting firms, that does not seek to kill the geese that lay the golden eggs. States need to work together to find a common tax code that takes into account that if it is too harsh, Internet consumers can easily go elsewhere. Last, the concept of nexus must be ironed out so that it will not matter which state you choose to start your business because a uniform tax code and set of business laws will evenly accommodate a nexus in any state. For this, it may take a good bit of assistance from the Federal Government in Congress and the Department of Justice.

As for the answer to my cousin, I'm afraid he has three uncomfortable choices. He can form a Delaware LLC and try to maintain a low profile so as to stay off the radar of South Carolina revenue laws, and get a good lawyer to defend the fact that a South Carolina LLC is not like an LLC in any other state. By going this route, he avoids sales, property, and estimated corporate income taxes. Or, he can form a South Carolina LLC but then must file quarterly estimate income taxes as well just like his business was a corporation. Also, by going the South Carolina route, he must pay high taxes when you add up the total cost of sales, property, and estimated income taxes. His third logical choice, although most expensive, is to move the headquarters of the business to another more tax-friendly state with a clear head on its shoulders so as to avoid the most sales, property, and income taxation it can.

It is not that taxation is bad. We all must do our part. It is just that we have a case in this day and age of bloated, inefficient government, where more taxes seem to make no dents in state budget deficits. And when taxation is to high, customers go elsewhere. Last, when states wear business repellent not just by tax laws but by business laws, it's self-defeating to their own long-range benefit as other states modernize to prepare themselves for a global economy augmented by an Internet.

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2 Comments:

  • At Wed Sep 03, 10:57:00 AM MST , Blogger Nicolas C. said...

    I like this post. I'll have to keep it in mind because I plan on running my own business soon. I know it’ll be challenging, but I’m up for it and will appreciate all the help I could get with the ins and outs of running a business. Instead of starting one from scratch, I've thought of buying a business. Any suggestions? Advice? Thanks.

     
  • At Thu Sep 04, 07:55:00 AM MST , Blogger W. Beckmen said...

    @Nicolas -- There are a number of resources available online. There's BizTrader.com, which is an online global marketplace where you can buy a business, or even sell a business. You can also use it to find a lender, broker, accountant, etc. It's a good place to find a business on the Internet.

    Then there are always local small business groups. They can also be very helpful, and it doesn't hurt to network.

    Good luck!

     

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