THE FIRST STEP
When you operate a business, the key question you need to ask is why should I incorporate? You will learn that it makes a lot of sense to incorporate your business to separate your risk and personal assets, just as it makes sense to separate your business and personal credit. If you need a recommendation to a top company to help incorporate your business, please call our offices at 1-888-313-6333.
Anyone who operates a business, alone or with others, may incorporate. Under the right circumstances, the owner of any size business can benefit!
Reduces Personal Liability – This is by far the biggest reason to incorporate or form an LLC. It makes no sense to be a sole proprietorship unless you have no assets or you don’t have any future assets coming. Unfortunately, many CPAs advise their clients they don’t have to incorporate until they reach a certain profit level. Overall, we strongly disagree with this advice because getting sued is so very costly. If you are sued as a sole proprietorship you could lose your personal assets. Most people do not consider what happens to them by just being sued (regardless whether they win or lose the case.)
Here are just a few things you would be unable to or have a difficult time doing if your business were to be sued:
1. You may not be able to get a loan for a new home, refinance or take a second mortgage on your current home (because most applications ask, not if you have a judgment against you, but if you are BEING SUED!). Even a frivolous lawsuit can prevent you from doing things financially. At best, you would have to pay a much higher interest rate because you are considered a higher risk now to the lending institution.
2. You may not be able to finance a new car.
3. You may not be able to lease office space.
Key point: Even though many professionals will say that you are protected by insurance, you can still be sued, and lose a lot of money, without ever having a claim against your insurance policy. This is just one major reason to form a corporation or LLC to operate your business. Creating a legal entity separates the business entity from you personally so that any legal action can only affect that entity and not you personally!
Key point: If you have a claim of $10,000 with your insurance company they will usually pay it. However, if you have a claim for $900,000, they will have an attorney from the insurance company visit you, basically to find out if there is a loophole in the insurance policy where they don’t have to cover you. And of course, even if they do, you will probably be cancelled or your rates will skyrocket!
Key point: Even if you incorporate you still have to do things properly! As mentioned earlier, a corporation is a separate legal entity from you. If the corporation is not treated as such and is sued, you need to know that a plaintiff may decide to go through the corporation and after you personally if there aren’t enough assets or insurance in the corporation. This is called “piercing the corporate veil.” There are three major areas that, if not handled properly, can cause the corporate veil to be pierced:
1. Lack of corporate formalities. Meaning, when you, as the officer of the corporation, go on a business trip the corporation must have a meeting to authorize you to go on that business trip. This is difficult for some to understand, especially if you are a one person corporation and you wear all the hats! It is like giving yourself permission. But again, you have to do it because the corporation is NOT YOU. It must be treated as a separate legal entity. In an LLC you may hear people say that you do not have to do the same formalities as you do with a corporation. While this is somewhat true, it is changing. Actually the main reason a CPA sometimes recommends an LLC is because of lack of formalities. However, in research, when it comes to piercing the LLC veil we have discovered cases where the judge will look at corporate cases for guidance and they end up looking at formalities. Due to that factor it is now being called “piercing the entity veil” instead of “piercing the corporate veil” or “piercing the LLC veil.” Therefore, NCP, being conservative, now does corporate formalities for LLCs as well and our LLC record books have over 50 pages of resolutions because of this. We are probably one of the few companies in the U.S. that do this.
2. Commingling of funds. When you are a sole proprietorship, you have a bank account. You can use that money for your business or personally and your CPA, at the end of the year, will help you to determine which portion of that money was deductible for business expenses and which ones were personal expenses. Many times the CPA comes back and says you spent a lot of money on personal items that are not deductible business expenses. Therefore your net profit is higher than you thought so you owe more in taxes than you thought. In a corporation this is different. The corporation has a separate checking account and should be used for business purposes only! If you use the money for personal reasons, that is called commingling funds with your personal account. A judge may set aside the corporate veil because you ignored the fact that the corporation is a separate legal entity from yourself.
3. Lack of proper capitalization: When you form a corporation it has to be capitalized. That means money, usually, is put into a corporate checking account and the stock of the corporation is issued to whoever capitalized it (usually an individual, but it could have been another entity). There are certain guidelines in each state that ask, “Did you capitalize the corporation with enough money or assets or was it too thinly capitalized?” We have seen cases in California where a computer company capitalized a corporation with over $40,000 and it was deemed too thinly capitalized! Then the corporate veil was pierced because of that! Nevada is one of the few, if not the only, states that allows you to thinly capitalize the corporation, meaning as low as $100 has been fine in cases in Nevada. You will learn that you can capitalize a corporation or LLC with cash, assets and, in most states, services. You will learn that services can create a tax problem. For example, one partner owns 50% of the corporation and capitalizes it with 25k, the other partner (you) own the other 50% and you capitalize with services (called sweat equity). The IRS says you received an asset without paying anything for it, therefore, they treat the 25k for services as personal income to you. Meaning, you have to claim 25k in personal income and you never earned the money. What you did get was stock in a company and now you have to pay taxes on it! This is a company challenge with partners if one contributes services. One solution might be for the partner to loan 24k and then have both people capitalize the entity with $1,000 each, which would be fine. Just remember, now the corporation has to pay back the other 24k as a loan, whereas in the first case it was a capital investment, which does not have to be paid back. This is a big problem with partners where it is not clear whether the money is all capitalization or part of a loan.
Key Point: You will learn that in Nevada it is very difficult to pierce the corporate/entity veil, even if you don’t do the three previous items properly. Nevada has NEVER had a case pierced for those reasons, only for outright fraud! If you are serious about incorporating, the bottom line is that there are some responsibilities required to obtain this level of protection. For a few dollars more you should incorporate in Nevada first, THEN register as a foreign corporation or LLC in your state of operations to protect the corporate/entity veil! If you incorporate in a weaker state and your veil is pierced you are right back to where you did not want to be. You will be held personally liable and now you CANNOT do all those financial transactions we spoke about, plus you might lose the lawsuit and lose your personal assets!!!
Summary: Incorporating helps separate your personal identity from that of your business. Sole proprietors and partners are subject to unlimited personal liability for business debt or lawsuits against their company. Creditors of the sole proprietorship or partnership can bring suit against the owners of the business and can move to seize the owners’ homes, cars, savings or other personal assets. Once incorporated, the shareholders of a corporation have only the money they put into the company to lose and usually no more.