Making It Legal:

I’m often asked, “Why can’t I just incorporate in Delaware?” Well, for many small businesses, it doesn’t make legal or financial sense to incorporate in Delaware if all of your business activities are going to take place in, say, North Dakota. In many instances, you’ll end up doubling your formation filing fees, adding to the level and complexity of the tax returns you’ll need to file, and increasing your costs.

One of the cost increases comes in the form of needing a “registered agent” to accept legal papers for you in the state of formation. What are the requirements for a registered agent? Ryan Roberts, Esq. has a cogent post on the subject, but here are a few highlights:

• No P.O. boxes
• Available during normal business hours
• Keeping your business address on file current

Today’s Basic Training query comes from a solopreneur who is stymied by needing to take the next step in forming a business entity.  It certainly can get confusing.  There are legal considerations, tax considerations, and cost considerations, just to name a few. Plus, there’s the pressure to make the perfect choice before your business has really had a chance to unfold. No wonder entrepreneurs get that “deer-in-the-headlights” look when they think of it!

Q.:  I am in Alabama, and I am an independent insurance agent. My CPA is saying that I need to incorporate my business for tax reasons. I am the owner and the only employee. I am 1099′nd under my personal social security number.  I have a dba for my business name.  I’m searching to see if I need to do an LLC, or an C, or S Corp. I am confused because it is only me and an LLC looks to be for maybe a partnership. I want to save on my taxes, but I am confused on which way to go. I have talked to other tax preparers and they are no help either. As of now I use my personal checking account for everything. I was told that I need to get an EIN, and keep everything separate and I would pay myself a salary.

A.:  When choosing a form of business entity, there is always a delicate balance between the legal and tax issues involved.

Here are some general guidelines:

1. It’s often smart to form a business entity–not just for tax reasons, but also to get the benefits of shielding your personal liability. Both corporations and LLCs are designed to shield you from personal liability UNLESS (like with lawyers), state law doesn’t permit you to shield yourself from malpractice/professional liability.
2. If you are the only owner of your business, and you don’t foresee bringing in any other business owners, many states permit LLCs and corporations to be owned by one person. If that is the case in Alabama (and if the costs for forming LLCs and corporations are similar), at that point your decision of which form to choose may well rest on which form will provide you with better tax advantages.
3. Because forming a business entity involves both legal and tax considerations, speaking to tax preparers will only give you part of the guidance you need. That’s why it’s important to also consult with a local business attorney, so that you can get the full scoop on your legal options. You may want to reach out to your local bar association for referrals, or speak to your colleagues to find out who they have used for their business formation issues. 
4. Once you speak to a local business attorney to get clear on your options and preferences for business form, then confirm your assessment with your accountant to make sure that the best choice from a legal perspective is also the best choice from a tax perspective. LLCs and corporations (both S and C) are taxed somewhat differently. Based on what you’ve been earning over the last couple of years, your CPA should be able to estimate what you would pay in taxes if you were an LLC versus an S Corp versus a C Corp.  if your CPA cannot do this for you, you may want to switch to an accountant who is more familiar with the different tax regimens.
5. For reasons of “good business hygiene,” you should definitely consider obtaining a separate business bank account– whether or not you form a separate entity. Usually, all it takes is to go into your bank with a copy of your business registration.
6. Once you’ve formed a new entity, you can easily obtain an EIN online through www.irs.gov.   

Carrie and Matt McCulloch are not only husband and wife, they’re first-time business buyers and the owners of Kinected, an up-and-coming pilates studio in NYC.  I had the pleasure of sharing a speaking panel with Carrie (along with Terri Coffel, CPA, of Citrin Cooperman and Sally Anne Hughes of Hughes Klaiber LLC) on the subject of “Buying a Business: New Opportunities in Today’s Environment.”

For those who find themselves on the entrepreneurial path–whether by choice or by circumstance–buying a business can provide a wonderful alternative to building one from scratch.  If you do your due diligence right, you can inherit a steady customer base, workable space and predictable cash flow. A nice contrast to the often hardscrabble road of starting from Square One.  Still, you do need to make sure that you’ve carefully reviewed your finances–as well as the business opportunity itself–to make sure that you’re not purchasing a pig in a poke.

It helps to have a solid team of advisors, as Carrie and Matt did: a business broker to help review the deal, accountants to go through the financials and attorneys to protect your downside.  They also had experience in the pilates field and in running pilates studios, which made them savvy scouters of the right opportunity. Put all that together, and you have a beauiful business that’s also a center of wellness!  Check out this video clip that gives a little insight into Carrie and Matt’s philosophy and approach.

I was recently contacted by an entrepreneur (”Marie”) for a “rush job”: She had formed an S-Corporation about a year ago, and now a couple of investors were waiting in the wings to take an equity piece of her company. She needed the deal signed, sealed and delivered within two weeks.

Now I won’t say that’s impossible (although given my current caseload, I couldn’t fit her in). And you certainly don’t want attorneys dragging their heels when you have a deal that needs to get done. But bringing on an equity investor is not something to take lightly. Leaving aside the legal issues, there are a number of tax and valuation issues that need to be addressed.

And here’s what smelled fishy:

• If these were sophisticated investors, they’d know that these kinds of deals take time (and they’d want their own counsel to review it).
• If they were pressuring Marie to do the deal fast, there could be something about it that could come back to bite her in the future.
• And if these were just “friends and family investors,” what’s the rush?

Here’s another problem. Marie had formed an S-Corporation. But an S-Corporation is not a legal form of business that permits passive investors. In order to accommodate them, they’d either have to become active participants in the business (which they probably wouldn’t want), or Marie would have to change her tax status to a C-Corporation (which takes time and could affect the timing of the deal). 

The moral of the story: Even assuming Marie had found the right investors, she didn’t have the right legal foundation for inviting them into her company.  Sometimes it’s not so much understanding the details (like “entity-level taxation” or “limitations of liability”), but knowing where you want your business to go.  Have a look at  my article, “Uncover the Stories Behind Business Entities,” which tries to put a human face on a sometimes complicated and technical decision.

So you start your business from home. Makes sense, so you can keep costs down. But then you realize that your home address–nay, your home state–lacks a certain cache. What to do?

Q: I currently have a business in Michigan. I am looking into e-commerce; however, my product is a fashion item. Unfortunately, the state of Idaho is not the fashion hub of the world. As a result I recognize negative implications of having my address on my web page and my shipper information reads Boise, Idaho. What are my options short of relocation to get my address to read N.Y. or Miami?

A: The only way to legitimately have your address read N.Y. or Miami is to have some form of business presence there. This doesn’t mean you need to physically relocate your business. However, if you start to use either of those addresses (N.Y. or Miami), you would have to register to do business in those locales, plus you then would be on their radar for paying taxes.

Before you make the switch, you may want to do a little digging/research to see just what kind of impediment is really would be (in terms of $$) to remain in Idaho. Idaho may not be the fashion hub of the world (yet), but given that your potential customers will be purchasing online, it may not make much of a difference to them where the product comes from (unless association with N.Y. or Miami will form the basis of your marketing). If it does, speak to your accountant about the fees and costs (from a tax perspective) associated with having a presence in NY or Miami–you may find that the additional sales you generate could well outweigh the additional tax and cost burdens.

This tragic story of insufficient planning is just another example from the Department of Not-Beginning-With-The-End-In-Mind. So many entrepreneurs get all “over the moon” about getting launched and off the ground that they ignore thoughts about their exit strategy. What do they want to get out of the business? How will they exit? Will they sell the business or will they want to bring in investors (as was the case here)? If that’s the case, what might be some of the obstacles to accomplishing that goal?

As Ryan Roberts reports about these “Shark Tank” losers (kudos for Ryan; I spend my spare time watching NCIS), they had intellectual property that was a vital part of the business.  But the owners of the company (and the company itself) didn’t own the IP outright. No IP, no meaningful business. No meaningful business, no investors. Back to the drawing board.

Inspirational, thought-provoking and handy is this list of 101 Tips from 50 Small Business Bloggers, compiled by Gregory Go.  I particularly liked fellow attorney Anthony Cerminaro’s comment:  “If you don’t like what you’re doing, try something else.”  Kinda reminds me of the comedian Henny Youngman’s comments:  “If at first you don’t succeed … so much for skydiving.”

Q.: I have always been advised, by CPAs, that until a small company has a specific NET income of approximately $100,000, incorporating is out of the question.  The fees associated with Inc. may not be worth the trouble of incorporating. Wrong? If wrong, why? Thank you.

A.: A $100,000 threshold?  Hmmm.  Plenty of companies are incorporated every day for businesses that are just starting and have no income whatsoever.  Depending on your state, incorporation costs only about $300 to $800–and is a one-time expense–so I don’t see why a business earning a net income of, say, $50,000 wouldn’t be able to absorb that. In fact, the owners of small business corporations have been known to put a lot of expenses through the company, precisely so that they don’t show a lot of net income for taxation purposes.  The corporation could have a gross income of $250,000, but with salaries, rent, expenses, taxes, etc., it only shows a net income of (for example) $80,000 for income tax purposes.  Is that company too small to incorporate?  I don’t think so.

There are important legal reasons to incorporate.  A disgruntled vendor who sues you doesn’t care whether you’re earning $25,000 or $250,000  If you aren’t operating your business through a corporation (or limited liability company), your personal assets are at risk.  Or if a customer comes into your business, trips, falls and smashes her head open, you could be personally responsible for any damages.  Your earnings capacity isn’t the issue:  your asset protection is.

Finally, if you’re looking to work as an independent contractor, more and more companies want to be sure they’re dealing with corporations or LLCs so that there aren’t any misunderstandings about payroll taxes and entitlement to employee benefits.  You could find that there are fewer opportunities open to you–especially for longer-term projects–because bigger businesses don’t want to get caught in the IRS/Department of Labor’s net.

Why open yourself up to personal liability when you don’t need to?  Today’s query comes from someone wanting to know that fundamental first question: “What form of business should I be?”

Q.:  I’m wondering what kind of company you would recommend for me to register under for a clothing company. I was thinking going Limited Liability because I would not be personally responsible if companies came after me for some reasons and couldn’t take my personal assets. Which one would you recommend because I don’t really know how much money I’m going to make in the first year.

A.:  For all but a v-e-r-y few situations, I recommend that entrepreneurs form either a corporation or a limited liability company.  There are simply too many variables and pitfalls in starting and running a business . . . so why leave your personal assets exposed? 

Which form of limited liability entity you choose, though, depends on a number of factors:

• Where the business will be located
•  How many people will own the business
• The nationality of the business owners
• Whether you will involve passive investors in the company, or want to take the business public
• The federal, state, and local taxes that may be levied against the entity
• The costs of formation
• Your exit strategy and what you want to get out of the business

Before you take the step of forming the business, make sure you’ve taken the time to calculate the kind of financial investment you’ll have to make in startup and ongoing costs.  While 1st year’s revenue will be guesswork, you can have a more solid sense of what’s involved with the right financial planning.  It will also help you decide whether the venture will be worth the risk and financial investment.

When you’re in business by yourself, the math is easy.  But when you have multiple owners, how should you share the spoils?  That’s the nature of this week’s basic training post.

Q: How should I divide profits in an LLC?

A: Especially in an LLC, you have many options for how to divide your profits. There’s no hard-and-fast rule. The formula you choose can depend on a number of factors, including:

• The number of people actively involved in the day-to-day operations of the business
• Whether there are any passive investors who have contributed capital
• The extent to which the active owners are actively involved (e.g., are some full-time with the company, whereas others are only part-time?)
• The non-cash contributions the owners have contributed to the company (e.g., inventions, client lists or other intellectual property) and the value placed on that contribution
• The time commitment each owner is prepared to make to the business (are some in it for the long haul, whereas others want a quick ROI and to move on?)

It’s not something you want to take lightly, because it will guide the amount you’re required to pay someone to buy him or her out, should the time come. Best to speak to an attorney and an accountant in your area who can specifically guide you to the result that’s right for your company.

Your employees can become your next competitors if you don’t handle the relationship carefully . . . and by “carefully,” I mean having non-solicitation agreements and other understandings (in writing!) with your employees.

But some folks are “old-school,” or don’t want to spend the money.  As a result, their employees are considered working “at-will” and free to leave at any time.  From the perspective of the soon-to-be entrepreneur, can you take your employer’s clients?

Q:  We’ve been working for a company for more than a decade and have finally reached the point where we want to set up our own shop in the same industry. Most of the client relationships are with us, as the owner is very hands-off and many people don’t like him. We have no employment contracts. One of our concerns was transferring clients, specifically when is the earliest we could advisably do that? We’ve been moving forward with our plans, but we’ve realized that it would be far more practical for ourselves and for the clients, who otherwise could feel at sea, to be able to speak with them in advance.  How can we do so?

A:  While I appreciate your concerns about leaving clients “at sea,” employees do have a duty of loyalty to their employers in that you should not solicit clients, take files, etc., while still on the job (you can take your contact database), nor should you use “company property” (company phones, computers or make the announcement at a client  meeting or during your workday).

Best (safest) way to handle it is to get your ducks in a row, leave Friday afternoon, and contact everyone after you’ve left.  Do not use your work e-mail for these kinds of conversations. The longer the time delay between leaving your job and contacting the clients, the stronger your defense to a lawsuit that you took clients on company time.

Another way would be to contact clients on your own time (again, from your homes and not during workdays or hours) to let clients know you’re leaving and that you’ll be back in touch in a week or so to let them know where you’ve landed.  Two problems with that approach:  1. The client may want more information than it’s appropriate to give at that time . . . so if you’re concerned about their being “at sea,” that could leave them even more worried about how and when their needs will be handled; 2. There is a meaningful risk that if any of the clients lets the owner know (even inadvertently) that you’re leaving before you tell him, this could be bad for you and give the owner something to hang his hat on in litigation–whether or not you have an employment agreement).

A few more things to consider:

• Will your clients really be “at sea”–are they that fragile?–if they are notified after you leave?  It’s really so much cleaner if you can wait.

• Check the client agreements to make sure that there are no non-solicitation or exclusivity provisions in their contracts–for example, that if they are solicited by another agency (or by former employees of the agency), they’ll give the owner prior notice.

• Depending on the clients’ feelings of loyalty to the owner–if you tell them before you tell him, they might be put off in the sense of your not acting totally aboveboard and with integrity.  More of a character issue and their feeling of trust working with you going forward than a legal issue.

You may have plenty of opportunities to get it (legally) right . . . but not as many to hear me speak on the subject! 

For those of you near Brooklyn, N.Y., on July 15, stop by the Brooklyn Creative League, where I’ll be talking about everything you need to know about business law in 90 minutes.  (Well, not quite . . . but close!)  In this entertaining and lively session, I’ll provide entrepreneurs with an overview of the most common legal issues they will face as they start and build their businesses.  I’ll touch on:

• How to choose the right form of business
• Working with business partners
• What to look out for in your commercial leases
• How clear contracts make for happy clients/customers
• Intellectual property: what to protect and how to protect it
• Choosing the right attorney/advisory team

RSVP: Contact the Brooklyn Creative League at info@BrooklynCreativeLeague.com or (718) 576-2104.

Date:  Wednesday, July 15, 2009
Time:  9:30 to 11 a.m.
Location: Brooklyn Creative League, 540 President Street (between 3rd and 4th avenues)
(Take N/R Subway to Union Street)
Price:  Free for members; $10 non-members