Incorporating You

Incorporating You

© 2002 Elena Fawkner

Running a business involves risk - the risk that the business
may either succeed brilliantly or fail miserably. Or neither.
The upside is high -- financial and (perhaps) time freedom;
independence; unlimited earning capacity. The downside
is equally steep, just in the wrong direction -- potential
financial ruin if you've staked everything you own on your
business's ultimate success and thrown your career down
the proverbial to boot. If you're running your business as
a sole proprietorship or a general partnership, make no
mistake -- everything you own is on the line.

There's a lot that can go right and wrong in a business. A
lot of it out of your control. But the extent of your personal
financial liability for what goes wrong is one thing you can
and should control.

The answer is to form an entity separate from yourself to run
the business.

WHICH BUSINESS ENTITY?

As you probably already know, you have several choices
when it comes to your business entity. The most basic is a
sole proprietorship, followed by a partnership (general or
limited), a limited liability company ("LLC") and a corporation
(either a general "C" corporation or an "S" corporation - more
about these later).

Although sole proprietorships and general partnerships are
relatively straightforward and inexpensive business entities
to establish and maintain, hence their popularity, neither
of them protects you from personal liability.

If you're a sole proprietor, you've probably made this election
by default - by doing nothing other than starting a part-time
Internet business out of your spare bedroom, most likely.

A limited partnership will protect the limited partners from
personal liability beyond the extent of their capital
contribution to the partnership, but limited partners cannot
participate in the management and control of the business
so that's not a good option for most of you reading this
article. Needing to control and manage your own business
is most likely non-negotiable.

As an attorney, I generally recommend that small business
owners, including (especially!) home-based and Internet
entrepreneurs, incorporate at least as soon as they are
generating sufficient profits from the business that the
amount of tax payable on such profits equals or exceeds the
minimum franchise tax payable in the state in which the
business is being conducted. In California, for example,
one of the most onerous states in the U.S. when it comes to
taxes, the annual minimum franchise tax is $800 per year.
Therefore, as soon as you're generating profits the tax
on which is $800 or more in a year, there is no tax
disadvantage to incorporation and every advantage.

HOW DOES INCORPORATION PROTECT AGAINST PERSONAL
LIABILITY?

Quite simply, when you form a corporation (or an LLC),
you're forming a separate legal entity. This separate legal
entity has the power to enter into contracts, own and
dispose of assets, hire and fire employees and generally do
anything that a sole proprietor could do. The difference
between the corporation and the sole proprietorship, however,
is that only the corporation's assets are at risk, not the
owner/shareholder's (beyond the shareholder's contribution
to share capital, that is).

Let's take an example. You run a part-time Internet
business. You're still working a day job and this is really
just a way to make a little money on the side to save
for your annual Hawaiian vacation and even more expensive
spa stay for your dog while you're away. To you, this is
only a pocket-money venture and so you don't really think
of it as a business at all, really. So you don't give a
second's thought to the fact that you're running a business
as a sole proprietor.

You register a domain name that, unbeknown to you,
violates a Macrohard trademark. You create a website
for that domain and, lo and behold, overnight (of course,
because this is the Internet) your business becomes
successful beyond your wildest dreams due, in no small
part, to site visitors mistakenly believing they are doing
business with Microsoft's arch-rival.

Macrohard, meanwhile, sees all of this and figures your
gain is its loss and sues you for an account of profits
based on your misuse of its trademark. And wins. It
gets a judgment for $100,000. Then it executes on its
judgment. And you lose your house, your savings and
your business.

Now let's look at a slightly different scenario. You're
fortunate enough to have read this article before you
established your business and formed an S-corporation,
Hawaii Here We Come, Inc. The only asset of HHWC, Inc.
is the domain name and website. So, when MarcoHard
gets its judgment against HHWC, Inc., the only asset
it can touch is the domain name and website. That's
bad enough, of course, but you did, after all, violate
their trademark. But get this. Because they're in your
name, not HHWC, Inc.'s, you still have your house
and your savings.

HOW LIMITED PERSONAL LIABILITY CAN BE LOST

Merely incorporating is not enough to avoid personal
liability, however. As a director and shareholder, you
must run your corporation or company (if an LLC) as
a separate legal entity, NOT your alter ego! This
means you can't just siphon off cash from the
corporation's bank account to pay your house mortgage.

Do that, and the court will "pierce the corporate veil"
in a heartbeat, thereby exposing you to full personal
liability on the grounds that the corporate structure is
nothing but a sham designed to unfairly protect you from
personal liability.

It is also particularly important that you follow all
corporate formalities such as those set out in the by-laws,
passing board and/or shareholder resolutions for major
decisions and holding annual meetings of the shareholder(s)
to elect the directors and directors' meetings to elect
the officers.

Also, don't think the "corporate veil" will protect you
from criminal acts such as filing a false income tax
return, because it won't.

SO HOW DO I GET MONEY OUT OF THE BUSINESS?

You are paid by the corporation as an owner/shareholder
in the form of dividends and/or as an employee in the form
of a salary.

CORPORATION OR LLC?

While both corporations and LLCs limit your personal liability,
there are differences between states when it comes to
how other states' LLCs are treated in this regard. By
contrast, corporations are treated uniformly when it comes
to personal liability. Especially if you're operating an
Internet-based business where you can be transacting
with people from pretty much anywhere, for the greatest
certainty concerning your personal liability, a corporation
is preferable to an LLC.

One of the advantages of an LLC as a business entity is that
the profits and losses of the LLC "flow through" to the
personal income tax return of the members. However, if you
make a "subchapter S" election when forming the corporation
(thereby forming an S-corporation), you can achieve the
same result.

S-CORPORATION or C-CORPORATION?

Although the S-corporation's profits and losses flow through
to the shareholders (rather than the S-corporation being
taxed as a separate entity as in the case of a C-corporation),
S-corporations are limited to 75 shareholders and, generally,
those shareholders must be U.S. citizens or resident aliens.

You would therefore not be able to have foreign shareholders
with an S-corporation (but you can with a C-corp), which may
be an issue, particularly for Internet-based businesses with
shareholders from various countries.

Also, you cannot have multiple classes of shares with an S-
corporation so this will not work if you want to issue preferred
shares, for example. You'd need to form a C-corporation
instead.

WHAT'S INVOLVED?

Forming a corporation is a relatively straightforward matter
(at least for an attorney) and shouldn't cost you more than a
few hundred dollars depending on the complexity of the
corporate structure. Most attorneys would charge between
$500 and $1,000 for a straight C or S-corporation.

At its simplest, a corporation can have a single director and
shareholder with that same individual holding each of the
three required offices (president, secretary and treasurer).
(If a corporation has three or more shareholders it must have
a minimum of three directors but if it has fewer than three
shareholders, it may have the same number of directors.)

Your attorney will prepare and file articles of incorporation
with your State's Secretary of State, and then prepare
by-laws and organizational minutes. You'll need a Federal
Employer Identification Number (SS-4) from the IRS and,
if you have more than one shareholder, a buy-sell agreement
to ensure that the shares do not pass to shareholders
unacceptable to the other shareholders.

Your attorney will also attend to annual filings with the
state (a statement of officers and directors is usually required
to be filed every one or two years) and make sure you stay in
compliance with state corporate requirements (such as annual
minutes etc.).

Taking the time and trouble to think about the legal
structure of your business may seem like overkill when
all you're doing is running a fun little business out of your
spare bedroom in your spare time. But fun little businesses
have a way of becoming very unfunny major headaches
when things go wrong. No matter how small or fledgling
your business is, do yourself and your family a big favor
and at least think about incorporating. What may seem
like a pleasant past-time today could be anything but
tomorrow.

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Elena Fawkner is an attorney and editor of A Home-Based
Business Online ... practical business ideas, opportunities
and solutions for the work-from-home entrepreneur. She
offers discounted, fixed-rate legal services to her ezine
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