To Incorporate or Not Incorporate: When Choosing the Right Business Entity, Don’t Forget No Entity

When attorneys talk about “choice of entity”, that is usually referring to whether a client should form a corporation, LLC, or limited partnership.  It’s usually a foregone conclusion that the client will form one of these three kinds of business entities.  Liability protection, pass through taxation, gross receipts fee, flexibility, and management structure are factors that are compared and analyzed.

But hold the presses. What about not forming an entity at all?  With courtside seats to the business entity game, I see far too many boxes of bits and pieces of paper, unopened envelopes from the Franchise Tax Board, and frustrated clients who have formed an entity online and later regret that they formed an entity at all.

Here are some basic considerations for all entrepreneurs who are considering incorporating their first business:

1. Are you aware that you can start a business without forming a corporation or LLC? Yes, in the United States it’s extraordinarily easy to start a business, and there is absolutely no requirement that you form a corporation or LLC to get a business off the ground.  A lot of businesses, including my own, started as a sole proprietorship.
2. Do you have a good reason to form a corporation or LLC? The key reason that forming a corporation or LLC makes sense is liability protection.  If you have no assets to risk, there’s very little to protect, and virtually no reason to incorporate.  In other words, if you are a recent college grad who is eating ramen and living the start up dream, there’s no reason to incorporate.  In fact, a corporation won’t even provide liability protection unless it is adequately capitalized.   See, http://www.eminutesonline.com/inadequate-capitalization-courts-know-it-when-they-see-it/.  Further, if you’re the chief cook and bottle washer, you can’t protect your assets from your own actions, so a corporation might not even provide any liability protection at all.  See, http://www.eminutesonline.com/the-corporate-veil-of-protection-%e2%80%93-an-imperfect-shield/. Good reasons to incorporate are: (a) you are creating a business structure with investors or partners, and (b) you have assets to protect from the liability arising from the business.
3. Do you have the resources to maintain a corporation or LLC? You cannot have a corporation or LLC without filing annual tax returns and paying state franchise tax ($800/year in California).  For most of us, that means you should not form a corporation unless you can afford to pay a CPA to prepare the annual tax return and you have the resources to manage a little extra bookkeeping to keep your corporate expenses separate from your personal expenses.
4. Taxes benefits are icing not the cake. While it’s possible that there might be some benefit to incorporating from a tax standpoint, tax benefits are the icing on the cake, not the cake.