Monday, January 2, 2006

Should You Form A Corporation or LLC

This is an interview with attorney Anthony Mancuso, an expert on business formations and the author of many best selling titles including LLC or Corporation? How to Choose the Right Form for Your Business.

NOLO: Tony, when people find out that you’ve written all these books on business formation and corporations and LLCs, is there one common question that you’re often asked?

ANTHONY MANCUSO: People usually ask a very general question. ‘What is the best form of business?’ When they hear that I write books for Nolo. I usually tell them the best form is no form at all until you have a reason to think about. If you’re worried about lawsuits, if you’re going into business with someone else and want to make sure you have an agreement in place that covers some of the contingencies then it might be time to start thinking about it.
Typically, once people worry about limited liability issues or take a look at insurance costs and worry about uninsured risks and those types of things, that’s when they may think about forming an LLC, a limited liability company. When they want to raise capital, or find that they’re making a little too much money and getting taxed on everything, then they may think of forming a corporation to shelter some money in their corporation. But generally, that’s my answer: wait until there’s a need, and it becomes important more than a theoretical question.

NOLO: Is the LLC always the best choice for the owner of a start up business, seeking to limit personal liability?

ANTHONY MANCUSO: It generally is and people that haven’t heard the news about LLCs often think of S Corporations, but really the LLC has replaced the S Corporation. [The LLC] lets you form a legal entity that insulates you from liability for business--that’s claims against your business--and at the same time it keeps your current tax status. So if you’re a sole proprietor and you form a one-person LLC, you’ll continue to be taxed as a sole proprietor. If you’re a partnership and you convert to an LLC, you’ll continue to have your business taxed as a partnership so you don’t change your tax status.
And another important part of it is if you’re ever thinking of having your business own real estate, it can be a very, very big mistake to form a corporation because you’ll get hit with double tax on the appreciation of any real estate owned by the business. That’s not true of an LLC.

NOLO: If you’re trying to form an LLC or a corporation by yourself, that is without the aid of an attorney, are there one or two things that you really need to watch out for?

ANTHONY MANCUSO: The first thing is to really stay focused on forming an LLC in your own state. If you go on the web and you take a look at a number of the books, you may see a lot of talk and titles about forming a Delaware LLC or a Nevada LLC or forming out-of-state where the taxes are lower. That doesn’t do you much good. In fact, it just creates more problems. You want to stay in your home state because that’s where you’ll be taxed ultimately. It won’t matter if you form a Delaware corporation and you make your money in California, California is going to want to tax you anyway. So you won’t save anything. In fact, you’ll be setting yourself up for double costs if you do that.
So, stay within your own state. I would suggest if you know someone who’s experienced with business taxes and law, it’s always a good idea to have a consultation with them for an hour, just to make sure about your decision to form an LLC and the tax consequences. Because LLCs, if they’re co-owned, they’re taxed as partnerships and partnership taxation is quite complicated and there’s a number of elections to think about ahead of time. So it’s really a good idea, particularly from a tax perspective, to go over your decision to form an LLC with a tax person who really knows partnership taxation.

NOLO: There’s a lot of advice available for people who want to form an LLC or a Corporation, but you don’t see much discussion about what it takes to shut down one of these entities. How hard is it to dissolve an LLC or a corporation?

ANTHONY MANCUSO: Well, fortunately, most Secretaries of State have online forms to do it. It’s usually just a one-step process. At least legally it’s a one-step process. You’ll file a Dissolution Form in most cases, with the state, and it’ll dissolve it. It’s a little more involved from a tax perspective because you have to get a tax clearance usually as well from your state tax agency and that’s simple enough. Some states though it’s not quite as simple. In California, for instance, that has its own tax forms, it doesn’t follow the federal tax forms, you’ll have to file a special tax form with the Franchise Tax Board. But you’ll also need a tax clearance.

NOLO: Income shifting seems very complex. Is there an easy way to describe what that is?

ANTHONY MANCUSO: Try to not think of it as income shifting because it’s all your money and it continues to be your money. But if you form a corporation, you can split your income between yourself and your corporation. And the way to think about it is if you start making more money than you actually put in your pocket, if you have an unincorporated business form, what happens is since we have a progressive tax rate structure, the more money you make, the higher your tax rate is. That's your marginal tax rate--that is, the amount of tax you pay on each new dollar earned in your business.
So, since that can go up to 35 percent, some people feel that their marginal tax rate is a little high because they’re really not seeing that money. That money is being kept in their business. So, if you incorporate, you can keep some of your money in the lower corporate 15 and 25 percent tax bracket.
So, if it’s really kept in your business anyway, you can save some money. I wouldn’t suggest incorporating just for this reason although some people who are desperate to save every possible tax dollar do talk about it this way. I tend not to. It’s just one of a number of factors in the decision to incorporate but it can help save you a little money so that maybe money kept in a corporation is taxed at 25 percent. If it were taxed to you, if you had an LLC or a partnership or a sole proprietorship, it might get taxed at a 10 percent higher rate, at 35 percent.
So, you can save some money if it’s being kept in your business because corporate tax rates start lower than most business owners’ marginal tax rates. So, instead of paying 35 percent, keep it in your Corporation, you could pay 15 or 25 percent of that money.

NOLO: If you register your business in one state, what does it mean for you to have to qualify in another?

ANTHONY MANCUSO: Qualifying means you have to file papers, very similar to incorporation papers or LLC articles of organization. It’s basically having a formal legal presence in another state. If you have only incidental contacts in another state, you sell through mail order, over the web, or you have a physical presence in another state, you generally don’t have to qualify and you shouldn’t worry too much about it. But, if you start having a real presence there, if you hire people who are there, who are telecommuting and they’re on your payroll but they live somewhere else, you can maintain inventory in another state, if you travel there a lot and talk to people a lot, if you just really start becoming more physically present in another state, then it’s time to think about qualifying. Basically, it’s a similar process to incorporating or filing articles for an LLC in another state. You have to pay a qualification fee, and you have to appoint a registered agent in that state.
The downside of not doing it when you’re required is that you won’t be able to sue other people in another state if you have to – if you have contracts in another state, you won’t be able to enforce them. And generally, to use the courts in another state, you’ll have to qualify and pay any back penalties for not qualifying.
So, it’s just neater all around, once you’re physically present in another state, to just go ahead and file those papers and pay the initial fee. They’re not terribly high and it just makes you fully legal in the other state you’re working on.

NOLO: Tony, you hear lawyers talking about ‘piercing the corporate veil,’ what is it and how often does it happen?

ANTHONY MANCUSO: Yeah, it’s a really bad mixed metaphor, but it generally means that the owners of a corporation or of an LLC can be held personally liable for the debts of the business or claims made against it. So, someone can sue your LLC or corporation and if they can convince a court to pierce the corporate veil, they can go after your personal assets. And, of course, the main reason for forming an LLC or a corporation is to insulate yourself from those type of personal liabilities, and in fact, they’ve defeated your incorporation or your LLC formation and that’s something you don’t want to see happen.
It’s very, very rare and that’s the main thing to keep in mind. It only happens in cases where someone has committed a fairly serious fraud against someone else, and a court determines that the only fair way to resolve a dispute is to hold someone personally liable.

NOLO: Tony, you often read that the District of Columbia and Massachusetts are the only two states that require at least two members to form an LLC. But that’s not true any more, is it?

ANTHONY MANCUSO: Up until recently they did require. They were the last two-holdout states that required two members to form an LLC. And now, there’s a carry over from the old tax rules that no longer apply.

NOLO: Of all your books, which is the one that’s probably best for the business owner who doesn’t know which business entity or which business form to adopt?

ANTHONY MANCUSO: The one that I’ve done that I like, that goes into a little more depth than the typical business form comparison book is LLC or Corporation? It digs beneath the surface a little bit more than the average business comparison book and talks about the tax and legal ramifications of forming an LLC or a Corporation and converting from one to the other.
Those convergency areas are very important because during the life cycle of a business, it’s not enough to form the right entity, you also have to consider when you’re forming a business, how it can migrate to another form, and your initial choice will determine that.
So, if you choose the wrong one to start with, you often can’t move to the next proper choice as your business evolves.

NOLO: Do people really need to worry about personal liability if they have sufficient business insurance?

ANTHONY MANCUSO: If you feel comfortable with your current level of coverage, given the type of business you’re in, then you don’t really need to worry too much about your business form at least for legal liability reasons. You may want to form a particular type of business for tax purposes. But the main reason to form an LLC or corporation for legal purposes is to limit your liability. If you have adequate insurance, by the way, you’re in the minority, but if you do, then maybe you don’t have to think about it, and you can just go about your life and your business without worrying about this. But, for most people, that’s not true.
If you’re dealing with the public, if you have people come on your premises, or if you’re doing any kind of contract type of business with others it’s just truly these days that disputes often end up in Court or have the potential to – it helps business owners sleep better at night to have this type of automatic liability insurance, this kind of automatic insurance they obtain by incorporating or forming an LLC.

1 comment:

Jeff said...

The problem with the LLC is that many states (e.g., California and New York) have added junk fees to LLCs. In California, the LLC pays the "gross receipts fee" and in New York, for example, the LLC must pay a publication fee. In these states, a corporation might be a better choice if a choice is necessary at all as the author nicely puts it. I have written about this extensively at