January 22, 2012 Stop! Think Before You Incorporate
We work with a lot of college student entrepreneurs, young entrepreneurs and first-time entrepreneurs. We are often asked “..should we incorporate or form a Limited Liability Company (“LLC”)?” Sometimes, these entrepreneurs have visited a lawyer first, and have already incorporated or formed an LLC.
Based on our experience of often, “picking up the pieces”, we have developed three rules for these entrepreneurs. (Note that these do not apply to sponsor-backed (VC/PE/Angel) companies, but strictly to “bootstrapped” businesses that are funding operations with personal funds).
- Before you make the decision to incorporate or form an LLC, visit an accountant who is familiar with closely-held businesses and discuss, quantify and thoroughly understand the following and ensure these additional and often substantial costs justify the corporate benefits:
- Income Taxes differences of a C Corporation, S Corporation, LLC, Proprietorship
- Secretary of State initial registration fees,
- Secretary of State annual fees/taxes
- Resident Agent fees
- Minimum annual State Income Tax
- Income Tax compliance fees
- If you decide to incorporate or form an LLC, do not get talked into incorporating or forming in Delaware or Nevada – do it in the state where you are physically located. Delaware and Nevada are fine choices for sponsored-backed companies or companies about to go public, as the do have certain advantages, such as the Delaware business law flexibility and the Nevada indemnification benefits. For bootstrapped companies, though, these advantages are not worth the additional registration fees, annual fees and compliance costs – you will get a better return from these funds by investing them in your business. If you raise VC/PE/Angel funds, you can always choose to change your state of incorporation very inexpensively and with someone else’s funds.
- Do NOT incorporate too soon. Even though your lawyer may be pushing the personal liability protection of corporations and LLCs – there is a good chance that no one will sue you, especially if you do not have substantial assets (such as college students). If you do get sued for Negligence or Fraud, the corporate veil will not protect your personal assets. If you decide not to incorporate, ensure that you register the business with your city or town (file a DBA) and have the proper Property and Casualty insurance. Also, if you have other partners, ensure that you develop and sign a comprehensive agreement that details issues, such as ownership of IP, ownership percentage of business, funding issues, tax allocations, withdrawal of a partner from the business, and all other potential issues involving the business. It is best to agree to this early in the life cycle of the business and then draft the agreement and, then, present to a lawyer to edit, finalize and memorialize.
IRS Circular 230 Disclosure
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this document is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter that is contained in this document.