Saturday | February 04, 2012
Should You Incorporate? Not Before Reading This.
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By
Alexander Fabish
11 March 2010
So you’ve got a company name and a business plan, heck, you may even have a customer or two ready and willing to pay for your services. All you need to do now is file your articles of incorporation and you’ll be good to go…
Not so fast. It seems that many young business people assume that when starting a business, the best way to go about it is to form a separate business entity, a Limited Liability Company (LLC) or corporation, for the many benefits they offer. In some cases this may be true, but the fact of the matter is that choosing a business structure is an extremely complex decision and forming a separate entity can oftentimes, especially for startups, be more trouble than it’s worth. Due to the overwhelmingly favorable view of forming an LLC or corporation that seems to be presented by this publication, I’ve decided to take the contrarian view and point out a few drawbacks that should be considered by anyone thinking of starting their own company.
Corporations/LLCs do not offer bulletproof asset protection
One of the most common arguments in favor of forming a business entity is that it allows for protection of personal assets. The first question most budding business people need to ask themselves is: “What assets?” Although your ‘98 Civic and acoustic guitar may be very dear to you, are they really enough to warrant the additional responsibilities of maintaining a corporation or LLC? Even if you do have a significant amount at risk, don’t think for a second that incorporating guarantees you’ll hold onto your stash if the court rules against you.
The easiest way to lose the liability protection of a corporation or LLC is to disregard the many rules governing these entities. If you fail to document an annual meeting of shareholders or you use the company bank accounts for personal expenses, the court could decide that you are using the entity as an alter ego and might “pierce the corporate veil” to hold you personally accountable for your company’s debts. In the case of a tort, a situation where your personal actions are considered negligent, your business entity will not afford your assets protection either. Also, many inexperienced business people assume that because they own a corporation or LLC, they’ll be able to borrow capital through the entity without any personal obligation to pay back the loan. Sorry. Despite the “Inc.” after your business name, no legitimate lender is going to loan money to a newly formed company without adequate assets backing up the loan, meaning until your company is worth something, you will most likely have to personally sign the loan, making you, as well as your company responsible for any debt obligations.
A corporation or LLC is required to hire an attorney to represent it in court
Many small business people end up in court due to a disagreement of some sort, often not involving a large sum of money. If your business is a separate entity, a lawyer must represent you in court, which makes any sort of litigation expensive. For example, say your landscaping company paid $5000 for a number of trees from a local nursery and the trees end up being delivered a week late and look as if they haven’t been watered since the Clinton administration. If your company is a sole proprietorship, you could represent yourself in court in an attempt to win reimbursement. If your company is a separate entity, unless you’ve passed the Bar, you’ve got to hire Joe Moneybags Esq. and pay him $150 an hour to represent you. In short, you’re out five grand.
Forming, maintaining, and dissolving an entity is more expensive and time consuming
To do business as a corporation or LLC, you must first go through a registration process, and then, when doing business, abide by various formalities, all of which can be costly and time consuming. In the case of a corporation, this means that while you’re deciding whether you want to be the CEO or the CFO, paying incorporation fees, holding and documenting the annual meeting of shareholders, or filling out corporate tax forms, your sole-proprietor competitor down the street is out making money. Also, for the majority of small businesses, the tax treatment for sole proprietors is as good as or better than a corporation or LLC (Many people believe that due to the “Pass-through” nature of LLCs they will end up paying the same amount of taxes as a sole proprietor, this isn’t always the case: in many states LLC owners have to pay a “Franchise Tax”).
What if you don’t have to worry about paying taxes because your company is losing money faster than Charles Barkley in Vegas? If your company is set up as a sole proprietorship, all you need to do is tie up any loose ends and then stop doing business. If your company is a separate entity, dissolution can be a far more complex process. If the company is owned by multiple people and they’re no longer on good terms (which is often the case when a business is going under), often a lawyer will have to be brought in, turning what was originally just a complicated situation into a costly one.
What all this means is that the choice of business structure should be taken very seriously. Although they do offer many advantages, owning a corporation or an LLC may be overwhelming and unnecessary for a beginning businessperson. As a general rule, it is usually easier to switch from a sole proprietorship/partnership to a corporation/LLC than vice versa. Many business owners start as a sole proprietorship and once they expand, they will “upgrade” their business to one of the structures that offers more protection from liability. This route offers the dual advantages of allowing one to confirm that a business will be successful before investing unnecessary time and resources into its structure; and allowing the businessperson to concentrate on doing business in the crucial start up period, without having to spend much time satisfying structure-based formalities.
Whatever the type of business you choose, there is no substitute for due diligence, do not move ahead before you understand the structure you’ve chosen.
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