The primary reason for a company to do this is because it wants the operational and organizational flexibility of the LLC, but it also wants to reduce self-employment taxes. We find this to be an extremely cumbersome method of doing business and accounting.

Tax (Photo credit: 401K)

We are firm believers in the KISS principle (Keep It Simple, Stupid). If you want your business to be taxed as an S corporation, why not just use a corporation rather than a limited liability company? Or start as an LLC and when you are making so much money it makes sense to be taxed as an S-corp, why not convert the entity? This is a good problem to have.

The LLC entity eliminates  many of the formalities that a corporation must observe to preserve its corporate status. The LLC does not require bylaws, a board of directors, meetings or minutes , for example.

But electing to be taxed as an S-corporation takes away much of this benefit.

To be taxed as a small business corporation, all the members of the LLC  must meet the requirements of S-corporation shareholders. There cannot be more than one class of membership interests, more than 100 members, and the members cannot be corporations, partnerships, LLCs or non-resident aliens.  In addition, the S-corp must comply with all the withholding and reporting requirements of an employer, which is not necessary if an LLC has no employees other than its members. It will also have to make quarterly estimated tax payments. The entity will have to file a tax return itself, where the LLC does not necessarily file a return at the entity level.

Any new company that wishes to be taxed as an S-corporation has  two months and fifteen days after the  LLC is formed to file the S-corp election with the IRS.

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While many business owners are savvy enough to select the proper entity on their own, many do not understand the difference between trade names and trademarks. Others accidentally give the rights to their logos and other commissioned artwork to their graphic artist and the content of their website to their web host.  Some will think they can choose whether a worker is a contractor or an employee.  A good business attorney can address these issues on the front end, and save much expense and aggravation later.

Likewise, a good certified public accountant isn’t just a number cruncher — he or she is a trusted advisor who understands your business and today’s economic climate.  CPAs evaluate business ideas, plan for growth, minimize taxes, monitor cash flow and help keep proper financial records.  Poorly set up books can make it impossible for companies to track costs, make profits and attract financing.

Those of us that work with startups are familiar with the intersection of  providing value and penny-pinching, and can often work with the bootstrapped entrepreneur on how the services are provided and paid for.

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S corporations combine the most beneficial aspects of partnerships and corporations. Like standard C corporations, a properly formed, properly capitalized and properly maintained S Corporation should protect the owners from liability other than their capital contribution. S corporations, however, avoid the double-taxation problems of C corporations.

In making an “S” election with the IRS, the corporation elects to pass corporate income, losses, deductions and credits through to the shareholders (in proportion to their percentage of ownership) for federal tax purposes. Each shareholder must then report the flow-through of income and losses his or her personal tax return and pay taxes at his or her standard income tax rate.

S corporations are often a good choice for start-ups because of the limited liability, flow-through tax treatment, and possible payroll tax advantages they offer. Not everyone, however, can be the owner of an S-corp. There be no more than 75 shareholders, other corporations cannot serve as shareholders, foreign citizens cannot be shareholders, and only one class of stock may be issued.

For taxation purposes, S corporations must file IRS Form 1120S U.S. Income Tax Return for an S Corporation to report all income, gains, losses and deductions for the company. The company may also need to make estimated payments for (a) the tax on built-in gains, (b) the excess net passive income tax and (c) the investment credit recapture tax. Additionally, like all businesses, the S corporation must pay employment taxes, including Social Security, Medicare and unemployment.

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• Do You Really Need a Lawyer to Form a Corporation? (nclawlife.com)
• Choosing a Business Structure: Sole Proprietorship (nclawlife.com)
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Corporations, whether C corporations or S corporations, are formed by filing articles of incorporation with the Secretary of State. So long as they are properly formed, properly capitalized and properly maintained, they should shield the owners from personal liability for the debts and obligations of the company, except for the amount of their capital contribution.

The owners are called shareholders, and are issued shares of stock. The shareholders elect a board of directors, who then elect officers to carry out the day to day business of the corporation. Often times in small corporations, the same individual or individuals can serve as shareholders, directors, and officers.

To be properly formed, a corporation must have an organizational meeting and issue shares. It is not enough to merely file articles of incorporation with the secretary of state. Each year it must hold annual meetings of shareholders and directors and file an annual report with the secretary of state.

When it comes to taxes, a corporation has its own tax identification number and pays taxes just like an individual. IT must file an annual form 1120 U.S. Corporation Income Tax Return as well as quarterly estimated taxes. A corporation generally is entitled to the same deductions as a sole proprietor and can take additional special deductions only available to corporations.

C corporations may offer several tax advantages, however, with respect to deductibility of retirement contributions, group insurance premiums, and other benefits. The main downside to forming a C-corporation is double-taxation: the corporation itself pays taxes on profits when the income is earned and the shareholder also pays tax on dividends. For this reason, few small businesses are C-corporations.

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The LLC is still considered a relatively new business structure, although it’s been around for more than 30 years. The LLC, like a corporation, is a separate legal entity from its owners. It is formed by filing articles of organization with the Secretary of State. An operating agreement is recommended, but not required. So long as it is properly formed, properly capitalized and properly maintained, it should limit the owner’s personal liability for debts and actions of the LLC to the amount invested in the company. LLCs are owned by members and can be managed either by the members or managers. Neither members nor managers must live in North Carolina. It is

LLCs are desirable because they are flexible as to management participation and allocation of profits and losses, yet they provide limited liability. It is also possible to make an S-election for an LLC so that it is taxed the same way as an S-corporation. This is valuable when the owner wants to treat some profits as dividends to minimize income tax. LLCs and S-corporations (which we will discuss in detail in another post) are similar in that they both pass-through income directly to the owners, but they have vastly different rules on deductions, salary and self-employment taxes.

LLCs do require an annual report to be filed with the Secretary of State.

LLCs are classified as either single-member or multiple-member, and the designation has a big impact on how taxes are reported. Single-member LLCs owned by an individual report all income and expenses on a schedule to Form 1040. Multiple-member LLCs report all income and expenses on a partnership tax return Form 1065. LLCs are responsible for all employment-related taxes and must issue W-2s and 1099s as required. Members of the LLC are subject to self-employment taxes on all earnings or shares of the profits.

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When people are starting a business, they are often very confused and overwhelmed as to how to choose an entity, or even whether they need one. Many entrepreneurs look at limiting their legal liability but never consider the tax implications of their business entity. The only entities which provide limited liability to owners (with respect to both tort and contract liability) are S corporations, C corporations, and limited liability companies. Before selecting the entity, it is essential to review the tax implications as well as the legal ones.

In a series of blog posts, I will discuss the various available entities (sole proprietorship, partnership, limited liability company, C-corporation and S-corporation) and some tax issues associated with each.

Sole Proprietorship:
Many entrepreneurs start their businesses as sole proprietorships, where the owner and the business are one and the same (sometimes known as “hanging out a shingle”). This is certainly the simplest way to begin. There are no formalities required. But, if the business is sued or has a hefty tax debt, you are financially responsible. Many risks of having a sole proprietorship can be addressed with insurance.

From a tax perspective, the business profits are reported on the owner’s personal income tax filings under his/her Social Security number, and the income will be taxed at the owner’s standard personal income rate. The owner must file form 1040, and 1040 ES Declaration of Estimated Tax For Individuals. The owner is responsible for paying self-employment taxes. There are many deductions available as well.

Once you hire employees, you should consider forming a limited liability entity to protect yourself from the acts of the employee.

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The mailing reportedly encourages recipients to send $125 to Corporate Services, Inc., which would provide appropriate minutes to avoid dissolution. The Attorney General and the Secretary of State have secured a temporary restraining order against Corporate Services, Inc. to halt this mailing. If you receive such a mailing, fax a copy of it to the Secretary of State at (919) 807-2010 or send it to your business lawyer.

Nevertheless, this mailing does make a good point. To retain their limited liability, corporations do need to file annual reports and associated fees with the Secretary of State’s office, hold annual meetings of shareholders and directors, and keep minutes of the meetings.

In addition, just filing Articles of Incorporation is merely the first step in forming a corporation. To be properly formed, the corporation must have issued shares, named directors and officers and held an organizational meeting. If you have not taken all these steps and are not holding annual meetings of shareholders and directors, you are not getting the legal protection you think you have, and your personal assets could be at risk in a worst-case scenario.

We work with a lot of entrepreneurs who have let the formalities slide because they were busy running their business. It is relatively easy to bring a corporation back into compliance, so I encourage you to find a business attorney to assess your risk and estimate the costs of bringing your corporation into compliance.

Today, I am following up that post with the view from the attorney’s perspective. Almost every corporate attorney I know has spent hours cleaning up DIY-formations. Here’s a sampling of what we fix:

• Selecting the wrong entity. Probably the number-one question I get is C-corp, S-corp or LLC? Astoundingly to me, people often embrace the recommendations of their brother-in-law, mechanic or neighbor and resist the advice of legal and tax professionals (as in “my brother-in-law has an LLC and says that’s what I need to be”). The differences between the different forms of organization in the eyes of the IRS can result in significant amounts of money. And it is very easy to make a wrong choice or check the wrong box on a confusing tax form.
• Failing to complete all steps of formation (no bylaws or operating agreement, failure to make timely IRS filings, failure to name officers, directors or managers, failure to issue stock or hold an organizational meeting).
• Not obtaining an EIN, getting an “extra” one or getting one when you don’t need it. The rules governing when you do and do not need a new EIN are more complex than any rational person would imagine, unless they work for the IRS. Sorting this out can take hours away from your core business.
• Picking a corporate name that violates a third-party’s trademark. Think about all the time and money you will have wasted in promotional materials, signage and branding if you find out downstream that your business name violates another person’s trademark. You also need to protect your company’s intellectual property (business name, trademarks, copyrights, inventions, trade secrets).
• Not addressing and minimizing other risks (appropriate insurance, good form contracts, good business practices, proper use and treatment of assets, etc.).
• Failing to have buy-out agreements. If you do not have an appropriate operating agreement, or shareholders agreement, you’re saying that you’re perfectly comfortable knowing that one morning you might wake up and find that your new partner is the pothead/slacker son of your old partner.
• Not holding annual meetings. Corporations must hold annual meetings of shareholders and directors to name directors, approve major decisions such as bonuses, benefits, leases, name changes, changes to the capital structure, etc. If you’re audited, one of the first things the IRS asks for is the Corporate Minute Book.

In addition to being able to help you select the proper entity and place of filing (Nevada, Wyoming, Florida, Delaware or the Old North State), good business attorneys will connect you to other reputable professional service providers — bankers, accountants, insurance agents, financial planners and web designers. We know where to send you for free or low-cost business services to make sure your business plan is sound, or to get assistance with Quick Books, marketing, sales or hiring employees. We will make sure your ongoing filings with the Secretary of State are current and that the corporation is holding requisite annual meetings. In short, we take an ongoing professional interest in your success.

I am really interested in the local experiences, good and bad, with attorneys and DIY formations.

Not everyone realizes that business owners are able to file Articles with the North Carolina Secretary of State on their own without an attorney. In addition, there are many services around that can help entrepreneurs form corporations or limited liability companies (LLC). These include online services, forms from books/guides sold in office supply stores, and online forms available from the Secretary of State.

So, do you really need a lawyer to form your corporation?

Yes. Well … maybe…

Let me ask you some questions: Should you form a C-corporation, an S-corporation or an LLC? What do you do after you file your articles? What assets should be transferred into the company and how do you do it? What do you need to do to maintain your limited liability? If you don’t know, or you don’t understand the differences between the available entities, you probably shouldn’t form your own corporation.

If you don’t know, none of these cost-saving services are going to be able to tell you; that’s unauthorized practice of law. They can tell you what’s on the menu, but they can’t recommend what to order. And the problem with a bad choice is not mere indigestion. Setting up your business entity incorrectly or incompletely can lead to tax penalties, unprotected personal assets, no limited liability and lost peace of mind.

Forming an entity without legal counsel works best for single-member entities that don’t expect to bring in additional owners or outside capital, hire employees or set up multiple locations (particularly multi-state locations). It may also make sense to set up your own entity if you had an attorney set up a prior entity, and you are following a similar business model, with the same people as before, and nothing has changed in any of their lives. In reality, of course, every deal is different, people change, laws change, and the structure that you used last year may not be the best structure this year for this situation.

What an attorney adds.

While many people have used these services and are happy with the results, almost every business lawyer I know has a story (or two or three) about incomplete, incorrect or ill-conceived formations done by clients “going commando.”

If you plan to raise money from outside investors, hire employees, open multiple business locations, pay only those taxes that you really owe, or if your business is in a highly regulated field, you absolutely need the services of a competent business attorney. By the time you fill your online shopping cart with your best guesses, you are getting close to what you’d pay for an attorney…and you are getting a lot less for your money the online route.

In addition to being able to help you select the proper entity and place of filing (Nevada, Wyoming, Florida, Delaware or the Old North State), good business attorneys will connect you to other reputable professional service providers — bankers, accountants, insurance agents, financial planners and web designers. We know where to send you for free or low-cost business services to make sure your business plan is sound, or to get training on Quick Books, marketing, sales or hiring employees. We will make sure your ongoing filings with the Secretary of State are current and that the corporation is holding requisite annual meetings. In short, we take an ongoing professional interest in your success.

Bottom-line: if the initial organization is not done correctly and completely, or if you choose the wrong form of entity or state of incorporation, the costs to unravel the errors greatly exceed the savings of “doing-it-yourself.” As they said in Ghostbusters, “Who ya gonna call?!”

If you have decided to form your own entity, particularly using an online service such as Legal Zoom, The Company Corporation, BizFilings, etc., a couple caveats:

1. As with any significant online purchase, research the vendor. Find people you know who have used these services personally (ask around on Facebook, LinkedIn, or Twitter) and ask about their experience. Check with the Better Business Bureau and the NC Department of Justice for complaints on file. What are your options if things go bad? Can you get your money back?

2. This may not be the time to go with the cheapest alternative. The low rates advertised are often “teaser” rates and the companies will try to upsell you at every turn. Make sure you know what you are getting, and most importantly what you are not getting. Understand what you need to have a complete formation, and what comes in each price-point package. How long does it take and how much does it cost to get it faster? By the time you add express services and ala cart documents (shareholders agreement, DBA, tax filing documents), the price may not be that different from an attorney’s fee.

I realize that every profession has its “princes” and its “toads” and the legal profession is no different. There is no shortage of bad experiences with attorneys, and a quick internet search shows no shortage of bad experiences with do-it-yourself strategies. I’d love to hear what has worked and hasn’t worked for you.

Related articles

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