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Chris Daming, J.D., LL.M.

Chris Daming, J.D., LL.M.

Chris is the founder and CEO of LegalGPS. Previously, he served in the Army (82nd Airborne), then went to law school and got his J.D. and LL.M. He practiced law and ran the Startup Legal law firm before founding LegalGPS.

Recent posts by Chris Daming, J.D., LL.M.

5 min read

A Guide to Sellers' Permits & Sales Tax

By Chris Daming, J.D., LL.M. on February 23 2021

You need a seller's permit if you need to collect sales tax. You need to collect sales tax in certain situations where you're selling goods or services. So then the question is -- when do I need to collect sales tax? Let's use this 4-step process to find out.

Step 1: Identify the state or states in which you will be making sales

Where are the customers that are purchasing your product? What state/city are they residents of? Note this and then you'll use it in Step 2.

Step 2: Determine if you have a “nexus” in those states

To decide if sales tax is applicable to a particular transaction, you look to whether you have a nexus with that jurisdiction. Nexus means sufficient physical presence -- i.e. do you have a physical presence, like an employee or a warehouse, in that jurisdiction. 

This rule determines if your business is liable for collecting sales tax for sales in a particular jurisdiction even if you’re not registered in it. There are a lot of factors which can create “physical presence” in a particular state. Having an office, an employee, or even temporary business activities will be enough to create it.

Because of the popularity of online sales, several states have enacted laws expanding what nexus is. In those states you may be taxable under the nexus law even if you do not technically have a physical presence.

Click-through nexus

One nexus example is “Click-through nexus”. Your business has click-through nexus with a state in which you have an affiliate who refers customers to your website and receives commission from your sales in that area. You will usually only be required to collect sales tax if the commission credited to the click through website reaches a certain threshold. For example, let’s say you sell clothes in Arizona and your business is not physically present in California. And let’s say the threshold amount differs from state to state.

You have an affiliate in California who makes a reference to your shop through his website and receives commission from your sales. These circumstances might be enough to create “Click-through nexus” between your company and that state. Keep in mind though that there are other affiliates who might not refer through a website nor receive a commission but whose affiliation might trigger the creation of a nexus between you and that state.

Drop shipping

The third situation when sales tax is applicable is drop shipping. Drop shipping is a retail method which involves a third party, the shipper. In a drop shipment transaction, the retailer does not have the product in his inventory. He sells the item through his website or via phone. After this, he asks the supplier to ship the item to the end customer.

Step 3: Determine if the goods or services you sell require the collection of sales tax in those states

You can usually find this out by identifying your industry and searching that way. For example, we would search “Software as a Service” or SaaS when trying to identify what sales taxes needed to be collected.

Some services like grooming services or repairs to property can require collection of sales tax, while others like accounting services are often not taxed. Additionally, certain goods may not require sales tax (certain foods or medicines, for example).

Step 4: If required to collect sales tax, determine requirements for the state(s) and local governments

Conduct your research in each state on the Department of Revenue website. State governments want to collect sales tax that is owed, and they do a great job educating business owners on required taxes.

Once you’ve determined your need for a sellers permit, you will need to register with the state or states where you will be collecting sales tax. The process is done online on the state’s Department of Revenue website. Once you have obtained your seller’s permit, your corporation will be authorized to collect applicable sales taxes.

Example:

Will sells novelty hats online. He organized his company in Delaware because he heard that there is no sales tax there. But his goods ship from San Francisco, where his office and warehouse is.

Will created a viral video about why he decided to start selling his hats, and the company became very popular, particularly in San Francisco and entrepreneurs in Silicon Valley.

He was a bit overwhelmed with the sudden exponential increase in demand. To cope, he just focused on meeting every order as soon as possible. He made more than a million dollars from this sudden spike in interest over his hats. And since he was in Delaware, he didn’t collect sales tax on any of the sales.

A year later, he received notices from San Francisco and California telling him to pay sales taxes on the sales he made in San Francisco and California. Unfortunately, since he actually had a presence in those areas, he was supposed to collect and pay sales taxes for those sales. And what’s worse--since his customers had already paid and the sales were already complete, he couldn’t go back and tack the sales tax price onto their purchases. So he had to foot the bill himself, which put his company out of business since he operated on such low margins.

Will could’ve avoided this by having a better understanding of sales taxes and by collecting the sales taxes at the point of sale.

 

Other FAQs on Sales Tax & Seller's Permits

Who collects the sales tax?

All parties involved can be from different states and it can be difficult to decide what tax rules should be applied. The main problem in this situation is to identify sales tax nexus. There are four possible situations. When both retail and supplier have nexus in a particular state, the retailer is responsible for collecting sales tax. The same rule applies in case when only the retail has nexus in that state.

On the other hand, in a situation when only supplier has nexus, he becomes responsible for sales tax and will therefore collect from the retailer. Consequently, the supplier will collect sales tax for the transaction between him and the end customer.

The retailer can avoid sales tax by using the exemption given to resale. If you do business like the retailer here, be sure to secure the required documentation so you can properly avail of the exemption. In general, tax rules related to drop shipping differ from state to state, especially those related to supplier taxation. States like California, Nevada, Massachusetts or Wisconsin will impose taxation, but there are other states which don’t tax the supplier in such situation.

Use Tax

Finally, when both retailer and supplier don’t have nexus, the customer is responsible for paying the use tax if the state law there imposes it. For example, if your business is located in Illinois, the supplier is from Virginia and you sell a product to the customer from North Carolina, neither you nor your supplier will be liable for sales tax. In this case, the customer will be the one who pay use tax for the product he bought. (of course, almost no customer actually does this).

Also worth noting is that if you have a nexus, you typically have to register as a foreign entity and vice versa (not always, but often).

3 min read

What is a Foreign LLC or Corporation?

By Chris Daming, J.D., LL.M. on February 22 2021

If you “do business” in other states, you need to file for foreign registration in those states that tells the state that you’re doing business there. So the question is, “How do I know if I’m doing business in another state?” What does “doing business” mean?

The easiest example is if you’re physically located in a state but you filed your LLC, corporation, or nonprofit in another state (think: Delaware in particular) for tax or other reasons. If that’s the case, you need to file for foreign registration in your home state that you’re physically located in.

There are other times when you might or might not be doing business in other states. It’s usually based on the types of transactions you have with someone in that other state. Are they “INTRAstate” or “INTERstate” transactions?

INTRAstate VS INTERstate Transactions

Generally, Intrastate Transactions will require foreign registration, while Interstate Transactions do not.

INTRAstate transactions are those conducted within one state’s borders. For example, if your company expands and opens a warehouse in another state, and will sell products from that location to people in or outside that state, you will need to file for foreign registration.

INTERstate transactions are those conducted across state borders. If your company is located in your home state, and you have transactions (sell products, services) in other states, you will most likely not be required to file for foreign registration. Amazon used to be the perfect example of this. They had warehouses in only a few states and when they sold goods to customers in states that didn’t have those warehouses, they could argue they weren’t doing business in those states.

Other Considerations

Here are some other important scenarios when filing for foreign registration may be necessary:

Consideration 1

If you have employees or a physical address in a state, you should probably register.

For example, you have a physical presence if you have an office located in another state where your employees go to work or meet with clients, a store where people shop, a warehouse where goods are stored, or a restaurant where people eat.

Consideration 2

If your company conducts a substantial amount of business in another state.

The definition of “substantial amount” is still being interpreted even at the Supreme Court level. If you have a physical presence, you probably are conducting a substantial amount of business.

On the other hand, if you run an online business with out-of-state clients that you don’t meet with in other states, you don’t conduct enough business to the point where you need to file for foreign registration.

Consideration 3

If a shareholder in another state conducts business within that state.

If your business partner or active shareholder in your business lives in another state, meets with clients in that state, stores business goods, has business real estate, or is otherwise running a part of your business from another state, you need to register in that state.

Activities that Don’t Require Filing

States vary, so it’s important to check state requirements (search for “foreign registration requirements in [state name]”), but here are some scenarios that generally do not require filing for foreign registration:

Scenario 1: Maintaining, defending, or settling a lawsuit. Just because you are sued or sue someone in another state does not mean you need to register there.

Scenario 2: Holding board of director or shareholder meetings in another state. You can hold your meetings out-of-state without needing to register.

Scenario 3: Borrowing money or acquiring mortgages from someone in that state. A new loan from an out-of-state lender doesn’t require registration

Scenario 4: Conducting non-repeated transactions completed within 30 days. Courts consider this an “isolated transaction.” Some states have a longer time limit than 30 days (Maryland for example does not have any time limit). To be safe, if your transaction takes more than 30 days from start to finish, just check the time limit for the state the transaction is taking place in.

The time limit can start as early as when the client engages your business and end as late as when the final payment is made. It will vary depending on the state. If the client is expected to pay you over time (think 3 easy payments of $19.99 over 3 months) then you should consider registering. If the sales contract calls for multiple deliveries or multiple payments over more than one month, you should register.

Scenario 5: Profiting from online transactions with out-of-state clients. Having clients in a foreign state who use your online services or order your products online, by itself, is not enough to require you to register in those clients’ home states.

Topics: Corporation LLC
8 min read

LLC and S Corps: which one is better?

By Chris Daming, J.D., LL.M. on February 17 2021

When you're trying to decide LLC v. S Corp, you should first make sure you understand the full picture of choosing your entity.

This blog is great at giving you a deep dive of state and tax law entity comparisons with LLCs and corporations for small businesses. We'll do a two-step process: Step 1: Pick your state law entity. Then Step 2: Once you have a state law entity, we'll know your choices for tax law entity and help you identify the best fit. So let's get started:

If a business has one owner, you have five choices:

  • LLC + Disregarded Entity;
  • LLC + C corporation;
  • LLC + S corporation;
  • Corporation + C corporation; and
  • Corporation + S corporation.

If those choices aren't clear to you, get the background on them first here.

Step 1: Pick your State Law Entity

(LLC or Corporation)

While your state-law entity choices for a single-owner Small Business are LLC or corporation, more businesses in this category choose LLC. Typically, LLCs have an advantage as a state law entity because:

Why LLCs are better than S Corps

LLCs are easier to form and easier to operate.

They’re easier and faster to form and require less ongoing corporate formalities that are required by corporations. With corporations, you’re supposed to hold annual shareholder meetings, elect a board of directors, have regular board meetings, elect corporate officers, and pass resolutions, among other things.

And let's be completely honest -- there's not much of a difference for most single-owner businesses between LLCs and corporations. It's funny how if you ask 10 different business attorneys what entity is better for you, I'd wager that 70% of them will say LLC. The other 30% would say corporation.

And oftentimes if you dig deep enough, the answer was either LLC or corporation simply because that's what the attorney was used to -- those are the better forms he or she had. (this isn't always true of course -- but is true enough to note). 

Corporations are more complex

So, it's nice that LLCs are simpler. If you’re a corporation, you have to file additional tax paperwork. (We’re assuming that no one in this small business category will be a C corporation, so we’ll only cover S corporation here.)

If you’re an S corporation, among other things, for taxes you have to file:

  • Form 1120S - S corporation tax return. This is for informational purposes for the IRS, not how you pay tax, since being an S corporation makes you a pass-through entity.
  • Schedule K-1, Shareholder’s Share of Income, Deductions, Credits, Etc. S corporations use this schedule to report to each person who was a shareholder at any time during the S corporation's tax year (and to the IRS).
  • But also, even if you’re the only owner, the IRS will consider you to be an employee of your company, so you’ll have to file the employer forms (even if you’re the only “employee” and owner). You’ll also have to pay State Taxes, even if you don’t have any other employees.

One caveat—you can usually get around a lot of that by hiring a payroll service for around $50/month. But the point is—being a corporation can involve more work.

If you’re an LLC, you’re not considered an “employee” of your company and because (assuming you’re the only owner) your entity is considered “disregarded” by the IRS, typically the vast majority of tax-related work you need to do is on your own personal tax return.

LLCs often can have the same or better liability protection

Limited liability companies do have a couple of true advantages when it comes to limitation of liability.

Preserving the "Corporate Veil"
One advantage is that LLCs make it easier to preserve a company’s “corporate veil.” One of the factors courts consider when determining whether to “pierce the corporate veil” is whether the business owners observed required corporate formalities. “Piercing the corporate veil” means that a court will hold a company’s owners personally responsible for the company’s liabilities.

With corporations, this usually involves holding annual meetings of shareholders and directors, board approval of important decisions, and the like. And it’s very common for small business owners to completely neglect these formalities after they have an attorney set up their company. Such formalities are usually less involved with LLCs.

Charging Order Protection
Another liability advantage is what is known as charging order protection. Think of this (very loosely) as a corporate veil in reverse. Whereas the corporate veil protects business owners from the liabilities of their businesses, charging orders protect businesses from the liabilities of their owners.

When a business owner’s judgment creditor executes a judgment against their ownership in an LLC, the creditor’s exclusive remedy is a charging order, which is essentially a lien on the owner’s distributions from the LLC.

The creditor isn’t permitted to take the owner’s membership interest from the owner or take company assets from the LLC, but the creditor does have dibs on the business owner’s distributions from the LLC. This can permit the business owner to preserve the business to a certain extent in difficult situations.

One important caveat

But, before you make your decision, it’s worth balancing the slight advantage LLCs have versus whether they could cost you any extra fees. For many states, LLCs are the same or less in fees than corporations and are less of a hassle. But for some states, the fees are substantially higher for LLCs (California in particular) and so if you’re a hobby business, LLCs might not make sense.

If you see that an LLC makes sense, then you need to figure out if you should elect S corporation as your tax choice of entity or retain the default classification, disregarded entity. If a corporation, then you’ll almost always select S corporation, but check out the tax choice of entity post to make an informed decision.

Step 2: Pick your Tax Law Entity

The two most common entity choices for single-owner businesses are:
LLC + Disregarded Entity;
LLC + S corporation.

If you chose corporation for your state law entity, unless you’re a Startup, the vast majority of time you’d select S corporation. For that reason, this post examines what happens the vast majority of time -- an LLC selecting either a Disregarded Entity or S corporation as its tax choice of entity.

Most Common Approach

Here’s the most common tax entity approach for single-owner Small Businesses: they start out as an LLC taxed as a disregarded entity, then when they reach a point where they can pay themselves what the IRS would consider a reasonable salary and still have profits left over, they remain but an LLC but elect S corporation tax status.

A lot to unpack, but it will all make sense. Here’s some steps to walk you through the process.

First, determine your reasonable salary

Before you can determine what tax entity makes more sense between S corporation and disregarded entity, you’ll want to know what you would say the IRS would deem to be your reasonable salary.

The IRS gives you a lot of factors to consider (can see them all here), but in general, your reasonable pay is the “amount that a similar business would pay for the same or similar services.” In other words, determine what services you’re offering that, if you offered them to another employer, you would be paid $X for them. That’s your reasonable pay.

One nice tip the IRS offers is to use your public library, which might have reference sources that provide averages of compensation paid for various types of services. Or you can do an online search at sites like salary.com, glassdoor.com, or payscale.com.

Second, depending on salary, consider being taxed as disregarded entity

Running your company taxed as an S corporation is more complex. Once you’re an S corporation, your taxes get more complex, and you have to treat yourself as an employee. Many LLCs taxed as disregarded entities can handle their own taxes.

So, it makes sense for most businesses to initially be taxed as a disregarded entity, then when it makes financial sense, convert to an S Corp.

Why? It’s all a balancing act. There’s a lot more work with S corps and the tax advantages don’t kick in for almost any business until the business is profitable. Why is that?

Self-employment taxes

It’s all about self-employment taxes. LLCs taxed as disregarded entities have to pay self-employment taxes on all net earnings.

The self-employment tax rate is 15.3% and it’s divided into two parts. The first part is for social security and it’s imposed on all your net earnings up to $128,400 at a rate of 12.4% (the cap on the social security portion of self-employment taxes is tied to inflation, so it usually goes up a little each year). The second part is for Medicare and it’s imposed on all your net earnings without a cap at a rate of 2.9%.

But S corporations don’t pay self-employment taxes (or at least, not exactly). They withhold Social Security taxes at a rate of 6.2% and Medicare taxes at a rate of 1.45% from their employees’ paychecks and also have to match that amount by paying it to the IRS. So the combined taxes for Social Security and Medicare paid by the employee and the company is 15.3%—the same as self-employment taxes.

S corporation tax savings come into play if revenue is high and you’re profitable
The tax savings come from the fact that the S Corp only has to pay self-employment taxes on the reasonable salary the owner pays themselves. If there are profits after all expenses and a reasonable salary has been paid, then the S Corp only pays the ordinary income tax on those profits, not the additional self-employment taxes.

If you’re not profitable (i.e., if your business’s revenue isn’t greater than your expenses, which include your reasonable salary paid), then if you elect to be an S corporation, you’ll incur more fees, probably have to hire a CPA to prepare your corporate income tax return, have to run payroll, and other tasks that wouldn’t necessarily be required if you were simply a disregarded entity.

Also if you’re not profitable, you have more opportunities to take a “loss” to offset other income from your business if you’re a disregarded entity v. being an S corp.

But if you are profitable, then S corps start to make more sense. Some CPAs estimate that if you’re self-employed and your business generates $75,000 or more, then an S corp election would be smart. Others say $100,000.

Third, an important takeaway

Lastly, you should know that you can always convert your LLC taxed as a disregarded entity into an LLC taxed as an S corporation later. Many businesses starting off just want to get things running, aren’t sure how profitable they’ll be, and want to do whatever is simplest to start.

Then, after a year or two (if ever), if they become profitable, they’ll elect to be taxed as an S corporation for the following tax year. You can elect to begin being taxed as an S corporation in any year after you start your business, although there are deadlines for when you have to make the election in order for it to be effective in any given year.

To make an S Corp election, you file a Form 2553 with the IRS (explained in our S corporation section). If you want to elect S Corp status for the current tax year, you need to make the election in the first two months and 15 days of that year. If you want to make the election for next year, you can file it anytime in the current year.

To get more guidance, including a look at what state is best to form your LLC or corporation in, check out our LLC vs. S Corp vs. C Corp ultimate guide.

2 min read

Best State & Tax Entities for Startups

By Chris Daming, J.D., LL.M. on February 17 2021

For startups, your for-profit, state-law entity choices are (1) LLC or (2) corporation. If you’re a Startup, we’re assuming you have plans to (either now or in future) issue equity compensation and/or seek investors. If this is the case, almost all Startups in this scenario choose a corporation that is taxed as a C corporation.

Corporation taxed as C Corp

Why is that? Doesn't C corporations have the dreaded “double tax?”

They do, but the only way you get double-taxed is if you have profits. And if you’re a startup, in virtually every case, you won’t start off profitable. So then that issue is not a problem for you until you’re profitable (which often takes years for startups).

The biggest exception is if you’re going to invest a lot of your money in the first few years of the business but have someone else (you if you have another source of income, your spouse, etc.) that you can use the losses for. In that case, it can be smarter to start off as an LLC or S corp. If it’s your own investment, you can probably take it as a loss with the S corp with some exceptions. And can definitely take it as a loss with an LLC.

But if you’re in that scenario, talk to an attorney -- if you have a ton of money to invest in the company, it’s worth talking to an attorney to find out how to minimize the taxes you pay.

Exceptions aside, C corporations are best for startups particularly for three reasons:

  1. They’re simplest when it comes to equity compensation (which a lot of startups provide);
  2. Venture Capitalists can't invest in S corporations
  3. Investors don’t like to have to file taxes in multiple states. With an LLC or S Corp, they'll potentially have to file taxes in any state that the business generates income.

Delaware is best

So then the issue is -- where should you form your C Corp? In general, for startups, Delaware is best. There are a lot of reasons for this (many of which are probably overblown and don't apply to most businesses), but it's simply the standard that VCs like to see. 

2 min read

Why Businesses with Multiple Owners Should Hire an Attorney

By Chris Daming, J.D., LL.M. on February 16 2021

If your business starts off with multiple owners, it usually makes sense to hire an attorney to help you initially. We'll go over that but first, some background.

Your for-profit, state-law entity choices are (1) LLC or (2) corporation. If you’re a multi-owner company with no plans for equity compensation or seeking investors, it can make more sense to form an LLC in most states.

There are some exceptions, but generally speaking:

  1. LLCs are easier to form and operate; 
  2. The liability protection is at least as equal as corporations; and
  3. They’re usually the same price or less, with some limited exceptions.

 

If you choose LLC and you have multiple owners, your tax choices are:

  • Partnership (default; most common);
  • S corporation (also common);
  • C corporation (almost no LLC elects this). 

If you choose corporation, your tax choices are:

  • S corporation (common for Small Businesses, occasionally for Startups but rare)
  • C corporation (default; common for Startups, but not Small Businesses)

Talk to an Attorney

We don’t want to mislead you over the complexity for multi-owner Small Businesses. It’s smart to consult with an attorney to help make this decision. You’ll want an attorney’s help with either your operating agreement (if you choose LLC) or shareholder’s agreement (if you choose corporation). And, most attorneys include choice of entity guidance as part of the package for helping you to start your business.

The easiest way to think of it is this -- if you plan on your multi-owner Small Business generating a reasonable amount of revenue or you’re investing resources into the business, it’s more than worth it to get the attorney’s assistance. There are too many factors that an attorney can advise you on that wouldn’t be able to be covered in any concise way that would be useful.

But, if you’re not planning on virtually any revenue and you’re just doing a hobby-related business with a partner (moonlighting artists, for example), then the simplest and cheapest route is to form an LLC and accept the IRS default tax-status -- partnership. The amount you would pay an attorney for assistance would likely cost more than any money you’d save from getting his or her advice.

That being said, disclaimer time: “always talk to an attorney.”