Almost every day, I have another startup coming to me and asking for advice about how they should form the legal entity of their business. Almost every day, my answer is the same — Talk to your lawyer. I want to preface this piece by making it clear that I am not qualified to provide legal advice. What I can do is give you a brief, high-level understanding with which you’ll be able to make a better-informed decision.
Unfortunately, talking to a lawyer first isn’t possible for all of us. Legal fees can be unnecessarily high when it comes to articles of incorporation, with many lawyers charging literally thousands of dollars for a service that simply doesn’t justify that sort of cost.
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What’s probably even more dangerous, however, is that so many of us wait to form our businesses into a legal entity that protects us from litigation and puts a shield over our personal assets. Nellie Akalp, CEO of CorpNet, explains:
That’s the message I want to put out there. No matter how small you are, even if you’re a sole proprietorship, incorporating or forming an LLC is always a smart idea. Small business owners don’t see the ramifications and the consequences if they’re sued.
Akalp’s CorpNet is a service that helps businesses to find and file the right paperwork in order to get their company legal as an S, C or LLC entity. She makes it clear, though, that CorpNet cannot provide legal advice and only offers statements of facts when it comes to how corporations are designed.
I talked with Akalp this week about the mistakes that businesses make when trying to set up their corporations. Interestingly, the “who, what, when, where and why” method of sorting works best for figuring out what you need to do. But we’re going to flip the order so that things make sense from start to finish.
It’s also worth noting that the things we’ll talk about here only apply to businesses in the United States. If you’re starting your business in other parts of the world, we’ll hopefully get a series together to help you make those decisions, but this is geographically-limited information, for now.
The short answer to this section is “everyone”. For so many of us, we operate under the idea that we should build our business as a sole proprietorship and then form the business entity at a later point. Akalp’s earlier comment gets into the gist of why you want to flip this mentality.
In short, the moment that you decide that you’re going to work with a client/customer/etc, you need to be protected. We live in a litigious society where “sue them” seems to be the answer of choice. With personal judgements that can last up to 22 years, it’s vitally important that your personal life is protected.
First and foremost, what you’re looking for in setting up your business entity is liability protection. If something goes wrong and you get sued, your personal assets are protected. Going back to that statement of 22 years, that is concerning what are known as creditor judgements. So not only are you protecting what you have today, but you’re protecting what you’d like to have in the future.
There are other benefits, as well. Taxes can be lower for corporations than they are for an individual and you’ll have access to deductions that you wouldn’t have otherwise been able to claim.
Of course, having the ability to have credit and capital in the name of your business is a huge advantage. There’s a level of professionalism that’s involved with seeing a business name followed by an LLC or Inc. that you don’t get when people are writing checks to “Bob Smith”.
Here’s the section that’s not quite so easy to answer. In short, there are four common types of business entities, so we’ll give you a brief overview of them here.
- Sole Proprietorship: You and yourself. The business is you and you are the business. There are very few benefits to a sole proprietorship, other than simplicity. You most likely will not be able to set up financial or credit accounts in the name of the business and if anyone decides to take your business to court, they’re going after your personal property.
- S Corporation: These are directed at small businesses and can have some great advantages for those who qualify. However, there are limits that are set as to the number of owners as well as who can be an owner of a corporation filing as an S Corp. Beyond that, all owners are liable for taxes based upon a percentage of their ownership.
- C Corporation: The short version of this story is that, if you’re planning on raising capital by issuing stock, you’ll need to have a C Corp. It’s not always the best choice for small business owners but it is exactly where you’ll want to go if VCs and other large-scale funding are in your future plans.
- Limited Liability Company: LLCs are all the buzz of the past few years. They require less complexity in order to be operated but they still offer the protection that pushed you to form the entity in the first place. LLCcs do not have to file separate taxes, rather the owners file themselves and so the company’s profits and losses are subject to the tax rates that are given to the owners. Non-US owners are ideal for an LLC, as are trusts, estates and other corporations since there are considerably looser limits placed onto who can have ownership of an LLC.
Akalp asserts that there are two most-common mistakes when it comes to forming companies. Creating the wrong entity is the first, so this overview should offer you some insight into that. Beyond the type, though, the other biggest issue is a matter of location.
In the US, it’s quite common to see businesses incorporated in the stats of Delaware or Nevada. There are financial benefits to both of these states, as well as some pro-business reasons. Akalp cautions against forming companies in states in which you do not live, however, offering some guidance.
As a general rule of thumb, if your corporation or LLC will have less than five shareholders or members (a condition which applies to the bulk of small businesses), it’s best to incorporate or form an LLC in the state where your business has a physical presence.
Akalp warns against the long-term effects of setting up a business in another state, as well. Due to the logistics of banking, lending and other factors that you’re almost certain to run into as a business, it’s almost always more cost-effective in the long term to form your entity in the state in which you live, regardless of the short-term gains.
Often times, in fact, businesses can find themselves having to pay doubled fees simply because of wanting to do business in other states. Registered agents are often required in the state of filing, even if the company doesn’t physically do business there. Annual filing reports, filing fees and state taxes are other factors to consider, as well. Finally (and possibly most importantly) your state in which you do business will eventually decide that it’s tired of not getting taxes from you. The accrued fees and penalties of having not filed those taxes can quickly out-weigh any initial savings that you might have seen.
We started here, but we only brushed the surface of the topic so it’s worth revisiting. The entire landscape of incorporation has changed over the past few years. Akalp started a company called MyCorporation.com after having graduated law school in 1999. At that time, the idea of using online services to incorporate your business was essentially unheard of. Akalp had a big goal of helping out small businesses, though, and she went to work.
By 2004, the company was doing $1 million in gross revenue every month and tax software company Intuit decided that it wanted a partnership. Akalp eventually removed herself from MyCorporation.com and, after her non-compete ran its course, she found herself wanting to get back into the same type of company. Today, CorpNet touts some of the lowest fees in the industry, as well as some of the most complete services. For as little as $29 (plus the fees set by each individual state) you will have all of the paperwork that you need to walk into a bank and open an account.
That’s why Akalp says that it should be a day-one action rather than the eventually status that we often give to it. However, Akalp knows that her’s is not the only player in the space. There are big names such as LegalZoom, Incorporate.com and RocketLawyer that are all biting at the same piece of the pie.
It’s with that in mind that you have perform due diligence. Look at the Better Business Bureau ratings, check out published testimonials and try to find some reviews on your own that aren’t included on each site. Just as you wouldn’t trust only your gut to know the market for your product, it’s worth the time to do your homework when it comes to the products offered by other companies.
It’s an important step and, guilty as charged, it’s one that I neglected to take at an early stage but have since rectified. While I’ll stress again that this isn’t the comprehensive guide, including everything that you need to know, it should make a good starting point. So get legal, then get working. We’re entrepreneurs. Changing the world is just another day at the office.
This post is part of our contributor series. The views expressed are the author's own and not necessarily shared by TNW.