Saturday, February 15, 2014

Should You INCORPORATE?

If you decide to incorporate, your State Corporation Commission can be your best friend - or worst enemy, depending on what State you are in.


Many pot smokers sit around and say things like "Corporations are, like, evil, man, because, like, you know, all they are interested in, is profits!"

But of course, we are all interested in profits, for ourselves.   Even the pot smoker wants money - so he can buy more pot.   What pisses them off, of course, is that everyone else, it seems, has money, and they don't.   Profits are only evil when they are someone else's.

A Corporation is a legal entity constructed to allow a group of people to pool their assets together to invest into some business or enterprise.   In addition, a corporation can be used as a shield to protect individual assets from the liabilities of the corporation.

If you own Exxon stock, you are not liable if they crash a super-tanker into the Alaskan coastline.   However, if the company makes money, you may get paid in the form of dividends or in terms of capital gains.   You are an investor in the enterprise, not an active participant, so you are shielded from liability.

And the reason why we do this is to encourage people to invest in enterprises.   If we did not have corporations or stocks, businesses would have to borrow money to raise capital (either through loans or bonds) and borrowers, although having rights in bankruptcy, would have no say at all in the operation of the business.

For an individual or small business, the idea of incorporating looks attractive, as it promises the ability to shield your personal assets from the liabilities of the business.

Is this a worthwhile proposition?   It depends on the nature of the business and the State you are in.

For example, if you run a small retail store, and sell to the public, and someone slips and falls in your store, then you may be liable for damages, if that person is hurt.   Similarly, if you go bankrupt, and the store owes creditors thousands of dollars, you may be personally liable for those debts - if you are a sole proprietor.

However, if you are a majority shareholder or even sole shareholder of Retail Store, LLC, you might argue that the Corporation is liable in these instances, not you, and your personal wealth might be shielded from lawsuits or bankruptcy of the corporation.

The key word here, of course, is "might".

In some instances, it may be possible to pierce the corporate veil, particularly when the corporation is not being run as a corporation, but merely run out of the back pocket of the sole owner.  In addition, certain personal services and professional services might not be shielded by a corporation, particularly in some States.

For example, you run a hair salon, and you incorporate in your State.  You burn the scalp of a customer by leaving the perm solution on their hair too long, and now they are permanently bald.   They sue you, and you argue that since you are incorporated, you have no personal liability, and your $1M in assets is shielded, and the hair salon, which is nearly broke, has no money to pay out.

Nice try, but it likely would fail.   You personally performed the service in question, and thus would be personally liable (just as one of your employees would be personally liable, if they did the deed) and you can't duck out of it by arguing that the shell corporation (which is kept broke or nearly broke all the time, by passing through all profits to your personal account) is on the hook, and not you.

And this is why you have insurance - and why your now-bald customer will go after the insurance company, and not you.

For professionals, the situation is similar.  In the Commonwealth of Virginia, at least, you cannot shield yourself from professional liability by using a Corporation.    So, as a Lawyer, if you commit malpractice, you can't argue that you are not liable, but your shell Sub-S Corporation is.   You are still on the hook, which is why we carry insurance - and pay a lot for it.

You might not be shielded from the debts of the corporation, either.   When you go to borrow money, the banker will ask you (and your fellow shareholders) to personally guarantee the note.  Why?  Because bankers aren't stupid (although people think they are, over and over again).   They know that if they lend money to an LLC, and the company goes bust, they can't go after the owners.   So in order to play, you'll have to pay - and in effect sign the note personally, putting your own assets at risk.

I was incorporated as an LLC at one time (Robert Platt Bell, PC) but dissolved the Corporation once I laid off my staff.   Since the LLC did not shield me from professional liability, and since I had no employees (no employment liability) and no office (no slip-and-fall liability), it made no sense to fill out all those forms every year and file an extra tax return, for no real gain.

Many attorneys do incorporate as an LLC, however, but usually to insulate themselves from liability of their fellow attorneys in their practice (which might be a partnership of LLCs or an LLC of LLCs or whatever) and to insulate themselves from the debts of their partners.

I also formed a second LLC, Hollin Hall Holdings, LLC, which owned all the investment Real Estate we had.   As a landlord, there are all sorts of liabilities that you can incur, and it is useful to have an LLC to insulate yourself from those liabilities - to the extent possible.   Also, it allows you to have a group of investors get together to invest in the company, and then divide the proceeds and profits - and by keeping separate books, you understand how much the enterprise is making, as opposed to having the funds co-mingled with your own assets.

By the way, the term "Co-mingled" does not denote a crime.   I had a friend, who was even a lawyer, who thought that "co-mingling" was some sort of criminal activity.   In some instances, yes, it is - if you are co-mingling money that belongs to someone else, with your own personal funds.   But this does not mean in all cases that "co-mingling" is some sort of nefarious scheme.

I dissolved Hollin Hall Holdings, LLC when we sold the investment properties.    We still have one condo, but there was little point in keeping the LLC alive for that, considering we are well-insured, and most of our assets are un-attachable, as they are in retirement accounts.   The hassle of filing tax returns for the corporation, keeping up corporate records, and paying annual corporate dues, outweighed the advantages, at that point.

Which brings us to the next point:   Your State, and how it views corporations.

In Virginia, the State is very pro-corporation.   Call up the State Corporation Commission, and they will send you a "how to" pamphlet on how to incorporate, as well as sample forms.    The annual fees are cheap, and they are very helpful if you need them.

California, on the other hand, has the pot-smoking "Corporations are evil, man!" attitude, and charge huge fees and make it a pain in the ass, to maintain a corporation.  

So consider what State you are in, before you even try this.

Bear in mind that you will have to file annual tax returns, annual corporate reports, maintain corporate records (meeting minutes, notes, corporate seals, resolutions, etc.) and register your corporation with the IRS as a subchapter-S corporation.

Yes, Subchapter-S.   If you are an individual or a small company, that is the way to go, really.   There are two types of Corporations, named after their respective sections of the IRS code - Subchapter-S and Subchapter-C.

Subchapter-C corporations are taxed at the corporate level, and again at the shareholder level.   GM is a Subchapter-C corporation.   You likely don't need to go this route, as it really costs you a ton more in taxes.

A Subchapter-S corporation does not have taxation at the corporate level.  Rather, profits "pass through" to shareholders, who then pay taxes at ordinary income rates.   You are limited in the number of shareholders that can be in the company, and thus, Subchapter-S corporations are ideal for small businesses, but ill-suited for a large company.

Most Subchapter-S corporations have suffixes like "LLC" or "Limited Liability Company" or the like.   This is required, usually, by the State Corporation Commission.

Is it worthwhile to incorporate?   That depends on more factors than I can address in this brief article.   I would talk to your accountant (and you should have one, if you decide to incorporate) as well as an Attorney.   The initial costs are pretty low, but there is a fixed, but small annual cost in filing the extra tax returns, annual reports (and annual fees) to the State Corporation Commission, as well a the hassle of the paperwork.   Add in accountant's fees and the like, and you are looking at $500 to $1000 a year in extra expenses.

If you are running a home-based business, maybe such a step isn't necessary, and being a sole proprietor is sufficient.   If you are running a brick-and-mortar store, with employees and customers (as well as inventory, accounts payable, and the like) maybe such a step might make more sense - particularly when there is more than one owner.  Stock ownership is a useful vehicle in allowing co-owners to define their ownership rights in manners other than 50/50.

For me personally, it made sense, when I had well over a million dollars in Real Estate to manage, as well as a busy law practice.  But even then, I still had to guarantee all those mortgages, personally.  And my professional liability was not shielded by the LLC.

As I sold off my Real Estate business and downsized my law practice, having these corporations made less and less sense, so I dissolved them.

So that illustrates another aspect of the equation.   It might make sense to incorporate at some time in your life - but not at others.

So, think it over carefully.  A lot of people rush into incorporating, thinking it is essential, when starting a business.  They saddle themselves with some extra paperwork and overhead at the get-go, which might not be really necessary, at least at the beginning.

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