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.
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:
- 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.
- You may not be able to finance a new car.
- You may not be able to lease office space.
Key point 1: 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 2: 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 3: 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.
As a sole proprietor, you no doubt have a company bank account. You can use that money for your business or personal expenses.
At the end of the year your CPA will help you determine which part of that money was deductible for business expenses, and which portion was for personal expenses.
Often your CPA will find that you spent a lot of money on personal items that are not deductible business expenses. Still, the only consequence to you is that your net profit is higher than you thought, so you owe more in taxes than you expected.
It’s very different in a corporation. There must be a separate checking account used for business purposes only. Using that money for personal reasons is called “commingling of funds,” and the consequences are dire. A judge may actually set aside the corporate veil because you ignored the fact that the corporation is a separate legal entity from yourself – leaving you totally exposed.
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 usually means money is put into a corporate checking account, and stock for the corporation is issued to whoever capitalized it (usually an individual, but it could be another entity.) There are certain guidelines in each state that ask, “Did you capitalize the corporation with enough money/assets, or was it too thinly capitalized?”
But what exactly is “too thinly capitalized?”
Lately an unfortunate trend has been appearing in the courts. They’ve adopted a sort of “20/20 hindsight” in some situations, and companies in high-liability sectors like manufacturing are especially at risk.
For example, let’s say you’re a widget maker with five employees, and you’re capitalized -at $50,000 and have a $1 million insurance policy – which is appropriate, because widgets are cheap and you don’t sell many.
Then one day, Joe Employee cuts off a hand with the box slicer, and saddles you with a $3 million lawsuit. The court says, “Mr. Business Owner, when you formed this company you should have known that Joe would slice off a hand someday, and you should have known that your insurance would cover only $1 million of the $3 million he’d want.
Since you only have $50,000 in capitalization, we’re going to consider your company too thinly capitalized. Therefore, we’re going to allow the piercing of your corporate veil to recover the rest.” Crazy? Of course. But true.
(Nevada, by the way, is one of the few states – if not the only one – that allows you to thinly capitalize the corporation, meaning as little as $100 is sufficient capitalization in Nevada.
You can capitalize a corporation or LLC with cash, assets and, in most states, services. However, services can create a tax problem. For example, say your partner owns 50% of the corporation and capitalizes it with $25,000. You own the other half, and you capitalize it with services (called “sweat equity.”) The IRS says you received an asset without paying anything for it; therefore they treat that $25,000-worth of services as personal income to you.
That means you have to claim $25,000 in personal income… but you never earned the money. What you did get was stock in a company, and now you have to pay taxes on it.
One solution might be for your partner to loan $24,000 and then have both partners capitalize the entity with $1,000 each. Just remember, the corporation has to pay back the $24,000 as a loan, whereas in the first case it was a capital investment which does not have to be paid back. This is a potential problem with partners when it is not clear whether the money is capitalization or 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.
Other benefits to incorporating:
- Adds Credibility
- Tax Advantages – Deductible Employee Benefits
- Easier Access to Capital Funding
- An Enduring Structure
- Easier Transfer of Ownership
- Centralized Management
What are the disadvantages of incorporation (these are some reasons many stay a sole proprietorship even though that may be a very bad idea for them)?
- There is more complexity and expense with forming a corporation.
- There are more extensive record keeping requirements.
- The cost involved is more than just being a sole proprietorship.
In Which State Should You Form Your New Entity?
Nevada Corporation Code allows for the indemnification of all officers, directors, employees, stockholders, or agents of a corporation for all actions taken on behalf of the corporation that they had reasonable cause to believe were legal. This indemnification includes any and all civil, criminal and administrative action. (See NRS 78.751.) These two laws provide complete protection for the officers and directors of Nevada corporations, as long as they act prudently in their roles.
The other significant change in Nevada law is the abolishment of joint and several liability. Joint and several liability means that should a judgment be entered against several defendants, they will each assume equal liability for the full amount of the judgment, regardless of their relative fault in causing the damages. Nevada now requires the court to assign a percentage of fault to each defendant, from zero to one hundred, with the total equal to 100 percent. Every defendant found liable is required to pay a share of the total judgment no greater than his or her fault.
NV vs. DE
This is one of the biggest questions we are asked on a daily basis. The following chapter will lead you through some of the differences between the two states and point out some advantages and disadvantages. Please feel free to flip to page 13 for a quick chart on some of the specific differences.
What about Nevada vs. Delaware?
The main rights in Delaware law benefit shareholders of public corporations. This attracts large, public companies that trade on variousexchanges across the country to provide the best protection to their shareholders. Delaware’s corporate law, with regards to corporate takeovers, is the strongest in the U.S. However, for everyone else, the following chart illustrates several benefits of Nevada over Delaware:
Nevada vs. Delaware
It’s No Secret: Nevada Beats Delaware!
Nevada’s liberal incorporation laws offer more privacy and less disclosure than the once popular Delaware, making it the most advantageous state in which to incorporate.
Here are some of the specific differences:
|State Corporate Tax||No*||8.7%**|
|Disclosure of principal business location outside Delaware||No||Yes|
|Report actual number and value of stock listed||No||Yes|
|Freely exchanges information with other states and the IRS||No**||Yes|
*Nevada has a Commerce Tax Return but no fee is required if your sales are under $4M in the state of Nevada.
**To verify this information, call the state corporate tax department of Delaware at (302) 577-3300
**Even though this type of information sharing has not been the practice of Nevada in the past, in today’s world, the IRS is realistically able to get its hands on any information they deem necessary to further the cause of “fair and reasonable taxation.”
Delaware’s state corporate tax amounts to 8.7%. Delaware also requires disclosure of the principal place of doing business outside the state, requires the corporation to report the actual number and value of its stock, and freely exchanges information with the IRS.
When you form an LLC or corporation you want to make sure it is a complete formation and set up correctly to help match your business credit goals. We recommend our sister company, NCP. Go to this link to learn more about their incorporating services.