eMinutes Blog

Most Entrepreneurs Should Not Incorporate

May 6, 2012

Seems like a shocking thing for a lawyer who forms corporations to say – but after talking to hundreds of entrepreneurs, it is clear to me that too many entrepreneurs are wasting money when they incorporate.

My law firm is forming 500 free corporations for first-time entrepreneurs, so I have spoken with hundreds of passionate people who would love us to help launch their businesses.  I embarked on a mission to help entrepreneurs realize their dreams, but I see a personal duty to ensure that I don’t instead deliver a nightmare of paperwork, accounting, and hassle.

This weekend, I spent time with the entrepreneurs at Startup Weekend New York City.  One the participants, Sarah, explained to me that she formed a LLC to save taxes, but the only result I see from incorporating in her case is that Sarah wasted $1600 on the New York publication fee, as well as the cost of forming the LLC in the first place.  My advice to Sarah – dissolve the LLC.

Sarah is not alone.  So many people tell me (enthusiastically) that they are “ready to make the company legit” or they want to “take the next step”, but this is really a silly notion, because incorporating does little to legitimize a small business.  My own business, for example, existed (profitably and happily) as a sole proprietorship from 1997-2005 when I finally incorporated.

Sarah’s story is so common among entrepreneurs that I suspect that the majority of all companies formed online should never have been incorporated in the first place.  I’m not passing judgment on their likelihood of success.  I’m just saying that they did not need to incorporate to get their business launched.

When lawyers talk about forming companies, the “choice of entity” question refers to whether the business should be structured as a corporations (S or C) or LLC or perhaps a LP.  After speaking with so many entrepreneurs, I think the “choice of entity” question should start with carefully asking whether the entrepreneur needs to incorporate at all.

So what’s wrong with incorporating?  There’s nothing wrong with incorporating.  It’s just that it costs money (sometimes a lot of money) to maintain the corporation once it is formed.  And too many entrepreneurs don’t understand the cost of maintaining their corporations once they are formed.

One of the most amazing things about forming a business in America is that you can just do it!  There’s no need to incorporate to launch a business, and I wish more entrepreneurs understood that they have a choice about whether and when to incorporate.

To figure out whether incorporating makes sense, an entrepreneur needs to do some simple cost versus benefit analysis.  Is the benefit of doing business as a corporation worth the cost of maintaining the corporation in the future?

So what’s the cost?  Plan on a couple of thousand dollars per year to maintain a corporation once it is formed.  This breaks down into the cost of preparing a tax return for the company, the state annual filing fees, and the minimum franchise tax.  The cost of maintaining a corporation in the future is so frequently overlooked — even shocking to many entrepreneurs  — that maybe the online incorporation websites should be required to break it down before the entrepreneur supplies his or her credit card to complete the transaction.

Sarah from Startup Weekend looked at me intensely and explained that she did not need to prepare and file a tax return or pay any sort of franchise tax, because her company had no revenue. She added confidently that she had not filed for three years since forming her LLC.  Sorry Sarah.  You’re in for a big surprise.  A tax return has to be prepared and filed, along with the minimum franchise tax ($800 in California), even if the corporation is making no money.

So there better be a good reason to incorporate.  Sometimes there are crazy but legitimate reasons to incorporate.  For example, a business plan competition winner recently called me to incorporate, because he could collect his $10,000 prize only after he incorporated according to the rules of the competition.  It seemed that the school had a misguided vetting process that used the decision to incorporate as the indicator that the winner was serious enough about the business to justify the prize.  Another example of a quirky reason to incorporate relates to the Apple App Store.  App Developers who plan to sell their apps like to incorporate, because it’s easier to transfer shares of stock of a corporation that owns an app than to navigate the bureaucratic process controlled by Apple to transfer an app.

But these aren’t the real reasons to incorporate.  These are just quirky exceptions.  There are only two real reasons to incorporate: (1) to document a deal with partners, and (2) liability protection.  What about tax savings?  It’s highly unlikely that average entrepreneurs will experience any tax savings whatsoever.  For most entrepreneurs, incorporating actually just increases the tax that is paid in the form of a “minimum franchise tax” that all incorporated businesses are obligated to pay.  For the most part, legitimate business expenses can be written off by an unincorporated business.  For high wage earners, it is possible to use a corporation to reduce self-employment taxes (subject to stringent limitations) and take deductions for certain uninsured medical expenses.  But tax savings are just the icing on the cake, not the cake.  It is highly unlikely that a business owner who earns less than $200,000 would see any tax benefit from incorporating.

So let’s talk about the two good reasons to incorporate.  The first is documenting a deal with partners.  A corporate structure does an excellent job of making the ownership and roles of co-founders, but if you are a solopreneur without partners, there is no benefit here.  Naturally, many entrepreneurs anticipate raising money from investors or bringing on partners.  If that’s your business plan, there is still no reason to incorporate if inviting others to your party is far off in the future.  And even if it’s happening in the next calendar year, you could save yourself a couple of thousand dollars by holding off until New Year’s.

Liability protection is probably the best reason to incorporate.  The idea is that forming a corporation protects your personal assets from liability arising from the operation of the business.  That’s a very good thing, but so many entrepreneurs are striving for “ramen profitability” and have no assets to risk.  If that’s your situation, or your business is not yet “live”, or your business is really not that risky, you should ask yourself whether the ongoing cost of maintaining the corporation is worthwhile.

Each entrepreneur has to answer these questions for herself.  People perceive risk and benefit differently, but what’s important is to ask the question.

Our attorneys are admitted to practice law in California, New York, and Texas.
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