In my September column , we looked at mistakes to avoid when forming a partnership. Many entrepreneurs, however, aren't comfortable in remaining a sole entity and require a level of legal protection not afforded by a sole proprietorship.
That leaves a corporation or LLC as the next most viable option for a startup.
While some owners think incorporation is only for "big" companies, there are a number of reasons even "small" entrepreneurs should think about incorporating, mainly from the standpoint of personal liability protection.
In the U.S., each state governs the corporation structure and its own legal requirements for forming one. Generally, a corporation is treated under the law as an individual person, with full legal standing, and may own property, sue and be sued, and enter into or make contracts.
While the number of sole proprietorships outnumbers corporations, most of those entities exist by default--meaning the owners have taken the easiest and least expensive road to getting their businesses off the ground.
What those owners fail to see, however, is the downside of having all of your "business eggs in one basket," and many are just a lawsuit away from losing every asset in their name--including their home, cars and any personal or investment savings.
While forming a corporation or LLC is less expensive and easier than ever before, here are some things to avoid to get your corporation off the ground. If done correctly, your business will continue to thrive long after you've decided to sell your ownership stake and move onto better and evermore profitable business ventures.
- Incorporating without getting the advice of a good CPA
Since every state has different requirements and tax tables for corporations, and because there are different types of corporate entities (S corporations and C corporations, in addition to the separate category of LLCs), forming a corporation without getting input from a good CPA can cost you money in the long-run. Why? Because of the different ways corporate income and LLC income can be treated. In addition, very few states will permit a company to change business structures once that structure is decided upon, so it's important upfront to choose your entity wisely. Generally, you want to get the most personal liability protection with the best tax advantages for your specific situation, and only a good numbers person can look at your current situation and long-term goals to give you the kind of sound objective counsel you need to make the best decision.
- Thinking the corporate veil gives you unlimited liability protection
While a corporation affords liability protection, it doesn't extend that protection to criminal acts, fraudulent practices or using the corporation to further your own personal interests, such as raiding corporate coffers for personal expenses. In short, there's no free ride, especially in business, and a quick glance at headlines from large corporate failures such as WorldCom or Enron show the personal and financial toll taken on corporate officers who engage in activities that go beyond the law.
- Incorporating, then operating without getting the proper local business licenses
Just because you incorporate doesn't mean you don't have to follow the guidelines of your local municipality when it comes to getting proper licenses and permits. Too often, owners discover they are not in compliance with local business ordinances--even if they are properly incorporated--and end up paying thousands in fines or back taxes, or worse, a combination of both with loads of additional penalties.
- Incorporating and then not filing periodic paperwork or taxes as required by your state
Once you incorporation, a certain amount of maintenance and follow-up is needed to keep your operations in compliance. Typically, this means updates on ownership, any changes in the resident agents, changes in corporate officers, and of course, any tax liabilities for your particular state or municipality. Failure to file current paperwork or taxes (as in the case of not getting your local licensing up to date), can be a costly proposition for companies that need resources to go to more productive uses than late fees or fines. This is especially true if you have employees and are subject to payroll taxes at a state or federal level.
- Incorporating without sufficient capital
While every owner can benefit by protecting personal assets from business liabilities, owners need to be aware that a lack of capital can be detrimental to a corporation keeping its corporate veil. Why? Should you be sued as a corporation and you don't have enough revenues, assets, capital or insurance to cover your liabilities, some courts will aggressively pursue you as an owner and hold you personally liable--all in the name of finding assets. Again, the advice of a CPA or attorney can be invaluable in helping you determine how much capital you will actually need, and can assist you especially if your company will be dealing with the public (vs. a B2B). Sometimes capital levels differ with the category of business you will be in, so knowing what your metrics are up-front can save you headaches and thousands of dollars down the road.
Generally, incorporation is the best form of business for the small-business owner--including startups. The advantages in terms of personal asset protection, credibility, taxes, ability to finance operations and the enduring nature of the corporate entity far outweigh the disadvantages--but only if you plan properly.
Getting sound financial and legal advice may up your cost of incorporation from a few hundred dollars charged by online services to a few thousand charged by a CPA or attorney, but in the long-run, the costs of doing things right pale in comparison to the hard costs of being in the wrong type of corporate structure. Or worse yet, finding yourself subject to fines and penalties you never knew existed.
The author is an Entrepreneur contributor. The opinions expressed are those of the writer.