Incorporation for Startups
If you want to be taken seriously by customers, suppliers, and everyone else, you are strongly advised to incorporate rather than operate as a sole proprietorship. Unincorporated businesses tend to trigger “here today; gone tomorrow” suspicions in most business people. Even if they have no concerns about your integrity, there will be questions about your level of business sophistication if you are unincorporated.
The message here is: set up a corporation or LLC for everything but a short-term business whose existence will be numbered in months rather than in years.
Business Legal Structures
When someone starts a business, one of the important decisions that he must make is to determine what type of business organization it will be. The three main choices have been, until recently, sole proprietorship, partnership, and corporation. This decision is crucial in terms of the tax consequences, the authority given to individuals associated with the company, and potential liability (that is, the financial responsibility) for each person connected with the business.
In 1977 Wyoming was the first state to enact a law authorizing a new type of business organization, the limited-liability company (LLC). By 1997, all 50 states had passed legislation authorizing the establishment of limited-liability companies, although each state’s laws differ slightly from one another.
The most common business structures are:
* sole proprietorship
* general partnership
* limited partnership
* limited liability partnership
* corporation (including S corporations)
* professional associations
* limited liability companies
* business trusts
* professional corporations
There are six common issues that distinguish the different business forms:
* risk and control
* continuity of existence
* expense and formality
Taxation is one of the more significant issues. It’s extremely important to use professional expertise and tax software to minimize the tax burden.
A one-person company generally has only three choicesof business form: sole proprietorship, corporation, or a limited liability company. Multiple people typically have the additional options of general partnership, limited partnership, or a limited liability company.
Liability is a risk that one exposes oneself to when starting a business. Two types of risk are tort risk and contract risk. A tort is an intentional or unintentional harm to the person or property of another. Some examples of tort risk are worker injury, product liability, automobile liability, and general liability, such as when somebody falls on a wet floor. Examples of contract risk are financing risk and risk with vendors and customers.
Tort risk can be protected against by using insurance. 99% of businesses can get an insurance policy against all tort risks. Excess insurance beyond standard liability limits often is not needed. For example, in medicine most people will settle claims at policy limits, because otherwise too many activists would protest if physician’s personal assets could be easily taken.
Liabilities associated with contract risk can be limited in the contract itself. For example, software user agreements may have a general liability limitation equal to the price paid for the software.
Traditionally, there was a tradeoff between liability and taxation. However, S corporations and LLC’s have changed that tradeoff so that a company can have limited liability and pass-through taxation.
As the simplest form of business legal structure, the sole proprietorship is viewed as being one and the same as its owner. The sole proprietor incurs little expense in setting up this form of business, and it is the most common structure among small businesses.
The general partnership is an association between two or more people in business seeking a profit. General partnerships have pass-through taxation and the owners are personally liable for the debts of the business. General partnerships can be formed with little formality, but because more than one person is involved it is wise to have a written partnership agreement stipulating the terms of the partnership.
Limited Partnership (LP)
The limited partnership comprises general partners who run the business and are exposed to personal liability, and limited partners who invest in the business and have only their invested capital at risk.Limited partnerships are especially useful for raising capital since they permit investors to participate financially in the business without incurring personal liability.
Limited Liability Partnership (LLP)
The limited liability partnership is similar to a limited partnership except that all partners in an LLP enjoy limited liability.Limited liability partnerships are common among professionals such as attorneys and accountants, who are not allowed to use corporations to limit their liability. Limited liability partnerships offer both the pass-through taxation of a partnership and the liability protection of a corporation.
The corporation is the most common form of business entity among larger companies. Unlike sole proprietorships and partnerships, corporations are separate and distinct from their owners in the eyes of the law. As a separate entity, corporations have several distinguishing characteristics including limited liability, easy transferability of shares, and perpetual existance. Corporations also have centralized management who may be different persons from the actual owners.
Limited Liability Company (LLC)
Venture capitalists do not like the flow-through taxation associated with LLC’s. However, in many cases an LLC is better than an S corporation for taxes because there are fewer hurdles and income can be allocated more flexibly.
The Uniform Commercial Code
Businesses are formed under state laws and are governed by the Uniform Commercial Code (UCC), which made business laws similar in all states. Before the UCC, businesses had to know and deal with the different laws in all of the states in which they operated. Note however, that Louisiana still is under the Code of Napoleon. Other uniform laws include the UPA, RUPA, ULPA, and RULPA.
Selecting a State of Incorporation
The internal affairs of a corporation are governed by the laws of the state in which it is formed. A corporation does not have to have an office or do business in the state in which it is incorporated; it need only have a registered agent in that state. There are companies such as CT Corporation System that will act as a registered agent in the state of incorporation.
Delaware often is the preferred state of incorporation. Initially, Delaware gave management better rights in the event of a takeover, so in the 1940’s and 1950’s many corporations moved there. Delaware set up a court system that has expertise in commercial transactions and well-developed corporate law. Other states improved their corporate legal systems, but virtually every corporate attorney is familiar with Delaware law.
Delaware also has the Delaware Asset Protection Trust, which permits one to set up a trust that cannot be touched by creditors but that allows one to get one’s money. Most other states require irrevocable trusts that prevent one from accessing one’s money once it is in the trust. The state of Alaska responded with a similar trust, but added spouses and children to the list of creditors that could not get at the money in the trust. Delaware responded likewise.
Advantage of Incorporating in One’s Own State
If the company does not plan to obtain venture capital funding, it may be best to incorporate in the state in which the company plans to do business. Doing so has the following advantages:
* Local attorneys are familiar with the local law
* One can have an intrastate securities law exemption.
* There is the convenience of geographical proximity.
* The corporation does not need to register as a “foreign” corporation in the state of operation if it is incorporated there.
The selected name must be available in the state of incorporation. In choosing a corporate name, one needs a name that can be used in every state in which the corporation will do business. It is best to coin a name that is not a common word in the language. “Exxon” and “Pentium” are examples of such words.
Issues to Consider when Selecting a State
Some of these issues may be important to your corporation. In any case, they can serve as a starting point for questions to ask.
1. How many incorporators are required by the state, and whether the incorporator itself can be a corporation.
2. The minimum number of people required to form the corporation.
3. The minimum capital requirement, if any.
4. The state’s fees for filing the articles of incorporation.
5. The state’s annual corporate franchise tax.
6. The state’s corporate income tax and whether earnings from operations outside the state are taxable. The State of Delaware taxes non-Delaware resident shareholders of S corporations on their distributive share of S Corporation income based on the percentage of that income derived from Delaware sources. If a Delaware corporation has no Delaware source income, these taxes should not be an issue.
7. Whether the corporation is allowed to keep its books and records outside the state.
8. The state’s court system’s reputation of fairness in business cases.
9. Whether the corporation is allowed to have its principal place of business outside the state.
10. Whether there is a state inheritance tax on non-resident shareholders.
11. Disclosure/privacy- whether the state requires public disclosure of the names of shareholders.
12.Whether the state requires a corporate bank account in that state (Delaware does not).