Did you know that improperly forming your company could result in exposing yourself to unlimited personal liability, state or regulatory penalties, paying unnecessary taxes, or failing to obtain financing?
Choosing the right entity for your business is crucial to your success. Yet many entrepreneurs are unaware of the dangers in forming and operating their business as a legal entity.
The internet is filled with thousands of pages of information on starting your business—so much information that it’s almost impossible to determine what the best choices for your business are.
Here are four dangers in forming your business without the right advice:
1. Your Personal liability. Perhaps the biggest risk to improperly forming your company is that, if you were to be sued, a court could declare that your company structure (called a corporate “shield” or “veil”) should be disregarded and that you as the business owner should be held personally responsible for paying your company’s debts or lawsuits.
This can happen when you don’t have the proper paperwork in place to show an operating business entity, commingling funds between your personal and business accounts, or otherwise ignoring the corporate formalities as an important day to day protection against liability.
We often see entrepreneurs who use do-it-yourself websites to form their companies. It’s a common belief that once you obtain your charter or articles of organization, there’s nothing more to do. This couldn’t be further from the truth! Creating a successful liability shield through a company isn’t just about what you do on day one, but on properly maintaining your business every day. Major business decisions should be voted on and minutes and records of resolutions kept. Annual meetings (at least) should be held. Bylaws and operating agreements should be kept current. Make sure when you form your company that you are getting these documents as a necessary part of your protection. It’s all about creating a visible record that separates you from your company.
Often entrepreneurs can accidentally expose themselves to personal liability by forming the wrong type of company. While some business entities, like corporations and limited liability companies, offer a good level of liability protection in almost every state, some entity options are poor choices when trying to create a strong corporate shield. General partnerships, limited partnerships, and sole proprietorships (dbas) generally offer much less liability protection than corporations or LLCs. Also, accidentally selecting the wrong designation when setting up your LLC with the state could also undo your personal protection (such as forming an obligated member entity).
2. State or regulatory penalties. If you set yourself up in the wrong business type, you could face penalties or sanctions from state or other government bodies. For example, a professional corporation would be improper to form unless you were a qualified under the law to participate as a shareholder in that professional company.
Additionally, failure to maintain your company could expose you to state penalties and fines. If you don’t keep a registered agent or if you fail to pay your annual report fees, you could be fined or your company administratively dissolved altogether.
Make sure you keep your company maintained, your fees and reports paid, registered agents active, and addresses current.
3. Paying more taxes than you should. Don’t be taxed more than you should be! Certain types of corporations are taxed separately from the owners of the corporation (corporate and personal income taxes may both apply.) Therefore, in some circumstances you may have a higher tax burden since you’re paying taxes twice—once at the corporate level and once again on your personal income tax return. Many other business entities do not treat corporate income as taxable; the income “passes through” directly to the owners. This can sometimes result in lower overall taxes.
On the other hand, setting up a tax pass through like an LLC will often treat the way it taxes its owners differently, and you may be liable for self-employment taxes instead of being treated as an employee. Additionally, in some states, being an LLC makes you liable for franchise, excise, and other types of taxes that you may not be liable for if you were organized as a partnership.
Keep in mind each company’s situation is truly unique and what’s best for one might not be best for another. You should speak with a qualified business attorney and tax professional to determine what’s right for you.
4. Trouble getting funded. One of the most frustrating parts of starting a business is obtaining business funding. What can be even more frustrating is being turned down because your business structure is not up to par.
We’ve seen situations where a bank turns down a business for a loan because its corporate books were not up to date or missing important operating provisions.
Another way you could experience difficulty getting funded is if you are seeking venture capital funding and you have not properly set up your company in a way that VCs need to make investments. Many venture firms will only invest in certain business entities. It’s imperative that you understand the importance picking the right entity if you are looking for private investors.
Fortunately, often the poor structuring can be fixed in order to attract investments or be approved for a commercial loan. But unraveling the corporate mistakes and restructuring the company can take months and cost thousands of dollars in attorney and accountant fees.
These dangers shouldn’t scare you away from starting the business of your dreams. But it’s important to think carefully about your business situation and determine which of the many entity types are right for you. You can learn a lot from research on the Internet or good business guides. However, every entrepreneur’s situation is different and businesses are not one size fits all. If you have questions about your business, instead of trying to figure it out on your own, we recommend speaking with qualified legal and tax professionals to obtain personalized advice for your new company.
The startup attorneys at PUSHTOSTART provide real advice for entrepreneurs forming new businesses. If you would like to learn how PUSHTOSTART can help you start a business, click here.