CHAPTER 1
What Legal Entity Should I Be?

As a practicing business attorney for 18 years, I have heard it all when it comes to incorporating a business. Many think that incorporating their business will help them cut the federal tax bill or avoid paying state income taxes completely. First-time entrepreneurs often have misconceptions about incorporation, usually resulting from an optimistic desire for lower taxes or third-hand advice from a friend or a friend's accountant. When small business owners fall prey to some of these myths, the consequences can range from higher taxes to misunderstanding their personal liability. To gain a better understanding of these myths, it's important that you understand some of these misconceptions surrounding incorporation.

• Incorporating can help with avoiding state taxes:

  Those starting a business in California might be jealous of neighbors in Nevada who don't have to pay state income taxes. Many entrepreneurs believe that they can incorporate in a low tax or no tax state and their business is not required to pay any income taxes. It sounds like a great strategy but it does not work. When it comes to state taxes, it does not matter where the business is incorporated. What generally matters is where the owner operates the enterprise. Those living and running a business in California still need to pay state taxes on the income earned in California even if the company is incorporated in Nevada. Moreover, Nevada requires an annual filing of the list of officers and directors of the corporation and requires a business license. These fees can add up very quickly and outweigh the benefit of paying no state taxes.

• Incorporating protects the owner from all personal liability:

  Incorporating is a critical step for separating an owner from the business, but it does not absolve the owner of all personal responsibility. As the proprietor of a business, the owner can still be held personally liable for the business in several situations. If a business proprietor signs a contract in the owner's personal name, personally guarantees a loan, does not keep up with corporate compliance paperwork, or commits a crime, the owner will be personally liable.

• It's better to wait until a product is ready for the marketplace:

  Many small business owners prefer to avoid legal paperwork until they absolutely have to deal with it. Some believe there is no need to incorporate until they start selling a product or service. This line of thinking is wrong on two counts: First, liability issues related to a business can arise long before products hit the marketplace; for example, an employee, independent contractor, or vendor might sue the owner for related reasons. The second reason to incorporate early is related to an owner selling the company, as it's more desirable to treat the sale proceeds as long-term capital gains than ordinary income. The stock in your company must be held for more than one year.

Make no mistake, it is critical to form a corporation for entrepreneurial activities to minimize personal liability. In some cases, these business legal entities can lower taxes, but incorporating should never be considered an easy way to avoid taxes.

Before I explain which legal entities exist and which one would be a good fit for you, it's important to understand what exactly is a startup.

What Is a Startup?

Merriam-Webster's dictionary defines a startup as "the act or an instance of setting in operation or motion." This is not a helpful definition to the newly formed business. The reality is that there is no one definition any two entrepreneurs or business owners agree on. Most say a startup is determined by its age, growth, revenue, profitability, or stability. Neil Blumenthal, co-CEO of Warby Parker, defines a startup as "a company working to solve a problem where the solution is not obvious and success is not guaranteed." Another entrepreneur, Adora Cheung, CEO of Adora, stated: "A startup is a state of mind. It's when people join your company and are still making the explicit decision to forgo stability in exchange for the promise of tremendous growth and the excitement of making immediate impact." The Small Business Association sums up the word startup, "In the world of business, the word 'startup' goes beyond a company just getting off the ground. The term startup is also associated with a business that is typically technology oriented and has high growth potential. Startups have some unique struggles, especially in regard to financing. That's because investors are looking for the highest potential return on investment, while balancing the associated risks."

The best definition of a startup was provided by Alyson Shontell while she was the editor-in-chief of Business Insider US. "A startup is an emotional roller coaster that can either result in massive failure or success, after which one's bank account total may either drastically increase or decrease. The person behind a startup is a founder, an often very bright, somewhat crazy person who finds a normal 9-to-5 job dull and is deluded into believing he or she can change the world by working tirelessly in front of a computer screen. The relentless work has been known to shave a few years off a founder's life while adding premature gray hairs, but it can be very rewarding both emotionally and financially for those who pursue it." I could not agree more with Alyson Shontell's definition.

Now that we have a definition of what a startup is, I can answer the number one most frequently asked question in the Startup phase.

What Legal Entity Should I Be?

When starting out, it is important to determine what form of business structure will work best for your specific situation. Choosing the best legal structure for your business requires knowledge of your line of work and understanding of local state and federal laws. The legal structure you choose for your business is one of the most important decisions you will make in your startup process. Your choice of structure can greatly affect the way you run your business, impacting everything from liability and taxes to control over the company. Choosing the right business entity allows an entrepreneur to reduce liability exposure, minimize taxes, and ensure that the business can be financed and run efficiently. It also provides business owners with a mechanism for ensuring that the business operations will continue, rather than be automatically terminated, upon the death of an owner.

When choosing a business entity, you should consider the following:

• Are your personal assets at risk from liabilities arising from your business?
• Are you able to offer ownership to key personnel?
• What are the continued costs of operating and maintaining your business?

Here is a list of the most commonly used legal structures for business and the advantages and disadvantages of each one is explained in detail below.

Common Legal Entities:

• Sole Proprietorship
• Partnership
• Limited Liability Company - including: Series LLC
• Corporation - including:
  • C Corporation
  • S Corporation
  • Close Corporation
  • Benefit Corporation
  • Professional Corporation
  • Nonprofit Corporation

Sole Proprietorship

The most common and simplest form of business is a sole proprietorship. Many small business owners launch their companies as sole proprietorships, in which they and their business are essentially one and the same. An individual proprietor owns and manages the business and is responsible for all business transactions, including its debt. If you want to be your own boss and run a business from home without a physical storefront, a sole proprietorship allows you to be in complete control. Sole proprietorships do have some advantages. They are quick and easy to set up, as no paperwork is required to be filed with the state, they do not require large amounts of money, and accounting is relatively simple. However, sole proprietorships have many disadvantages as well.

The biggest disadvantage is that there is no separation between the assets of the business and the owner's personal assets. This means that anyone who sues the business for any reason can potentially receive a judgment for the business owner's personal assets, such as cash kept in personal checking or savings accounts, the family car, or even the business owner's home. Another big disadvantage occurs if the sole proprietorship wants to borrow money. Because there is no separation between business and personal assets, many sole proprietors have to use their personal assets, such as their home, as collateral for a loan. If the business fails and the owner does not have enough money to pay off the loan, the lender can take the owner's home and sell it to get its money back. Needless to say, this type of ownership is the riskiest and, to make things worse, the courts do not see any difference between a sole proprietorship and its owner. So, when the owner passes away, the business ends.

Partnership

Other forms of business ownership include forming a partnership. This entity is owned by two or more individuals. There are two types of partnerships: a general partnership, where all is shared equally including the assets, profits, liabilities, and management responsibilities between the partners; and a limited...